The UK, in common with many advanced economies, has a chronic public expenditure problem that is overlaid by a more immediate acute fiscal challenge. Its public sector is significantly larger than any rough estimate of what an optimal level public spending would be, that is between a third and two-fifths of national income.
The combination of diminishing returns to higher public spending, the deadweight costs that arise in financing it and the allocation of significant share of resources to the less productive sector of the economy harms economic performance and hinders the medium-term growth of GDP per head.
This long-term chronic problem is aggravated by a structural budget deficit that is unsustainable and current levels of borrowing that would invite awkward and probably unfair bond market scrutiny of the sort that Ireland and Greece have faced.
Eliminating a structural budget deficit or creating a balanced budget in the medium term, although it would be a real achievement, would not on its own address the long-term chronic issue of the UK’s structural public sector problem. The key issue in public finance is how much is spent; how it is financed between borrowing and taxation is a second order matter.
Financing an inappropriately high level of public expenditure in an orderly manner will not overcome the structural economic problem that a public sector that is too large presents.
The UK needs what by historical standards is a large public sector to finance collectively education, health and social care and significant transfer payments to low-income and older households. The question is not about dismantling the state, but ensuring it is affordable and decisions about its size and scope are realistic.
Unlike the 1970s when the UK confronted similar problems, there are no easy or obvious targets to cut. There are no food and other consumption subsidies and there is no large nationalised industry sector where savings could be made by through privatisation.
The UK public sector has been distinguished over the last decade by several features: large increases in cash spending; a significant increase in pay and employment; and a disappointing productivity performance in general and particularly in those areas most favoured such as health. This disappointing productivity performance has been identified by the Office for National Statistics when measuring the national accounts and it is consistent with specific work done by the National Audit Office and Public Accounts Committee on, for example, doctors pay.
The premium paid to public sector employees in terms of wages has risen. In rough terms public sector pay is about 12% higher than in the private sector. An examination of the composition of the public sector workforce might imply that this premium reflects the skill composition where public services require a higher ratio of more highly trained employees, such as teachers, nurses, doctors, scientists and senior managers.
Yet that explanation appears much weaker when the public sector pay premium is disaggregated across the earnings distribution. The premium is at its highest for public sector workers at the bottom of the earnings distribution, where it is over 20%. There are, moreover, many examples where the public sector is paying senior managers significantly more than any notion of efficiency wages would warrant.
This is clear in local government, health authority management, some schools, and many government agencies. It also applies to the pay of hospital consultants and now that of GPs.
National pay bargaining arrangements result in regional public sector pay premiums that are much higher. Average public sector pay is about 30% higher than private sector pay in some regions. High concentrations of public sector employment combined with public sector pay rates that are significantly higher than local market pay creates serious local labour market distortions. These are further aggravated by national social security benefits that do not take account of local labour market conditions.
In combination there is a floor to wages that reflects high replacement ratio of benefits to local market pay in the private sector and a high reservation wage. The result is that many communities and whole regions in the UK have not just become ‘de-industrialised’ but de-marketised, in the sense that employment and pay bare little relationship to what would be set by the market.
The consequences are explained by Andrew Glyn and Esra Erdem in Jobs deficits in the UK regions. Public policy has entrenched and compounded regional economic and labour market disparities. Attempts to deal with regional disparities through vocational training, improved skill levels and regeneration have had little impact. This is because relative prices in labour markets cannot operate in regions in the context of large public sectors and significant transfer payments.
The overall ratio of public expenditure within national income needs to fall significantly and public sector pay and transfer payments need to take account of local labour market circumstances if the UK’s entrenched structural economic challenges are to be mitigated.
Warwick Lightfoot is a professional economist and the former economics editor of the European. He is the author of Sorry, we have no money, published by Searching Finance
