Monday, 5 October 2009

Deconstructing public sector pay cuts

An Saoi and Michael Taft: There is a fundamental misconception about the fiscal impact of public expenditure cuts. It is assumed that a reduction in public expenditure of ‘x’ equals a reduction in the borrowing requirement / fiscal deficit of that same ‘x’ amount. For instance, Emmet Oliver writes in the Sunday Tribune:

‘A 5% across-the-board cut in public sector pay would yield savings of €1bn in a full year; a 10% cut would deliver €2bn.’

Our analysis tests this assumption using the example of public sector pay reduction. In doing so we have had to make some estimates (e.g. the proportion of top rate taxpayers, etc.). While these are approximations and, therefore, should be treated as ‘ballpark’ figures, variations will not result in substantially different results.

The net Public Sector wages and pensions bill for 2009 is estimated by the Department of Finance at €18.3 billion. We calculate the net savings of an across-the-board cut of 5 percent. We assume

• 60 percent of pay is taxed at the top rate
• 70 percent of employees are insurable
• 20 percent are in receipt of pensions
• No change in behaviour, (e.g. parents reducing their hours as the pay-off between additional work hours and childcare costs become less worthwhile).

5 percent of the gross Public Sector pay bill is €988 million.

Income Tax: Assuming €16 billion of the €19 billion is taxable (i.e. net of employer PRSI, pension contributions, pension levies, widow & orphans, etc), the reduction in taxable pay is €800 million. €480 million is taxable at 41% and €320 million at 20%, thus reducing the tax take by approximately €261 million.

Employer PRSI Based on the above assumption, 56% of the total payroll is insurable. Assuming that they receive pay cuts of €350 million, the Social Insurance Fund loses approximately €37 million. As the Fund is slipping into deficit, this must be made up by general taxation. There is no saving under this heading.

Employee PRSI and Health Levy: Again, making an assumption that 75 percent of the reduction in taxable pay is liable to PRSI, this would reduce the Fund by a further €24. For the Health and Income levies we assume a reduction of 4 percent – or €46 million.

Pension Contributions/Pension Levies/Widow and Orphans: Almost all Public Servants contribute to all three. The only exceptions are Civil Servants appointed before 6th April 1995, who pay the levy & W&O. Pension Levy/Pension Contributions are estimated by the Department to be €1.5 billion. A 5 percent reduction would amount to €75 million. As there is no separate pension scheme in place, Finance nets off current contributions against current pensions.

* * *

While a 5 percent reduction in the gross public sector pay/pension bill would reduce Government expenditure by €988 million, the after-tax savings would be €545 million, or 55 percent of the gross reduction.

It should be noted that the above includes a 5 percent cut in pensions. If these payments were excluded, both the gross and after-tax savings would be reduced further (pension payments make up 10.7 percent of the total pay/pension bill, or €2 billion).

However, the after-tax savings of €545 million does not represent the net savings to the Exchequer or the reduction in the borrowing requirement. For instance, with less money in the pocket there will be a reduction in VAT and Excise tax payments. This is not included in the above.

Further, it does not take into account any negative multiplier resulting in the reduction of net wages. For instance, the ESRI estimates that a reduction of €1 billion in public sector pay expenditure will result in the following:

• GNP to decline by €442 million in the first year, with a long-term effect (after six years) of a decline of €684 million

• Consumption to decline by 0.9 percent

The ESRI estimates that, on the basis of the impact to the economy, the borrowing requirement will be reduced by 0.3 percent. However, we don’t know to what extent they have factored in the above tax reductions.

Given all of the above, it is reasonable to assume that the net savings to the Exchequer / reduction in the borrowing requirement will be close to 50 percent of the gross reduction in expenditure. In other words, a 5 percent reduction in public sector pay/pensions – or approximately €1 billion – will not produce ‘savings’ of €1 billion. Rather they true savings will be close to €500 million.

If there is to be a fact-based debate over public sector pay, it is imperative that we get the numbers right.


Paul Hunt said...

Full marks for attempting to quantify the economic impact of this specific aspect of the proposed fiscal adjustment - although the impact of a decrease in bond spreads (difficult to quantify) is probably relevant also. I also concur with the general principle (which seems to underpin most posts on this site) that those who benefitted least - in relative terms - should be impacted least - again in relative terms - by the (multi-annual) programmme of fiscal adjustment.

My contention is that fiscal adjustment should be preceded and should be combined with a major economic adjustment. In August the CSO published "Measuring Ireland's Progress". Among all the data presented Graph 1.21 on comparative price levels of final consumption by private households (inc. indirect taxes), 1999-2007 and Table 1.22 on the sama data for most European countries 2003-2007 stood out.

The CSO noted that "since 2002 our price levels..have been about 25% above the EU-27 average; in 2007, Ireland had the second highest price levels among EU-27 countries after Denmark; in 2007, Ireland and Finland remained the most expensive countries in the Eurozone 15, with price levels in both countries around 20% higher than the average for the zone."

Despite some price deflation in the traded sectors since then, I have seen no evidence that these relativities have changed very much. Tackling these price level differentials should be the key policy target. As a small open economy Ireland has no future while these differentials remain intact.

Cutting pay and jobs (which is already happening to some extent in the private sector) seems to be the knee-jerk policy response. Cutting the excessive costs and prices that, in some respects, justify nominal pay levels, is much more difficult. These unjustified costs are surplus profits being captured in the sheltered parts of the private sector, but they also include the insider rents, inefficiencies and implicit taxes that arise in the public and semi-state sector.

Stripping out these costs would allow nominal wages and benefit rates to fall, but without a fall in real terms, and this would contribute to a further decline in prices.

I believe such an approach would attract widespread popular support. But it would need a collective acknowledgement by both the public and private sectors that all have been complicit, to some extent, in the build-up to this crisis.

And that is probably too much to ask for.

futuretaxpayer said...

This analysis underlines the point that the headline cut in the public sector paybill must be sufficiently large to deliver a significant improvement in the budget balance.

Michael Taft said...

Paul - I concur with the general thrust of your comments. Might I add that what we need before a 'collective acknowledgement' (and what would aid us all in getting there) is to have the full array of facts before us. We have discussed many issues before and though we don't always see eye-to-eye on, I'm sure you would agree that many aspects of the debate are taking place in the dark. We desperately need more light.

Futuretaxayer - would not such a large cut (larger than what An Saoi and I looked at) be ultimately self-defeating? What about the impact on growth, consumption and employment; a negative impact would cancel out much of the budgetary gains and weaken the ability of the economy to deal with continuing high debt levels. Don't forget - the pension levy achieved a headline 'saving' of €1.4 billion - but the deficit continued to spiral downwards. Another round of pay cuts may only end up lengthening and deepening the recession - a process that only postpones the day when fiscal consolidation strategies become effective.

Paul Hunt said...


I fully agree. Policy is being made on the hoof - and in the dark - without any set of guiding principles (except the minimisation of reputational damage for the permanent government and political survival for the transient one).

Sunshine is the best disinfectant but we seem to be headed into the winter our discontent. I'm afraid that I have no expectation that the current political/policy-making establishment will present the necessary data and analysis that is required to ensure the necessary public buy-in as it would reveal its complicity in the creation of this mess.

Paul Hunt said...


On reflection I feel I may have left you off the hook too easily. You are, quite understandably, adept at deflecting attention from any consideration of costs arising in the public and semi-state sector that might not be fully justified - and that contribute to excessively high prices.

As I understand it the current trades union line is "no change in public sector pay and jobs - and hands off SW rates and semi-states - and we will help to deliver necessary reforms over time". There is no recognition that there may be unjustified costs or serious ineficiencies in the public or semi-state sectors. Tactically this makes sense in the face of a Government sharpening the axe, but - across the board - it is this type of tactics that has contributed to the current economic mess.

In the face of the leniency being shown to the developers and the bail-out of the banks, I recognise it is difficult to ensure sufficient support for a strategic approach that is in the public and national interest. And why should the broader public sector take a hit when the fat cats look like getting away scot-free?

As a result, potential confrontation is being advanced as the best means of defending the broader public sector. I fully understand this, but I would plead for some reflection.

Public sector workers - and, particularly, those on the front line - know far more about the needs that must be met, about the resources required and about the efficiencies in service delivery that may be achieved than the indiscriminate axe-wielders in the DoF. It'll be hard-won, but tap into this resource and develop a programme of reform that will put the axe-wielders on the back-foot.

One thing you can be sure of is that cuts will be made. Strategically, it makes sense to be positive and pro-active. The confrontation route is likely to stiffen the resolve of Government and to be extremely socially divisive - not to mention the economic damage that will be incurred.

Not to deflect from my general point, but to highlight the fact that such a programme of reform need not involve job and pay cuts and yet deliver signifciant benefits, I return to our well-thrashed out ESB example. At the outset I need to emphasise that I have no problem with ESB staff pay. (But I think you can understand the public perception.) I fully agree with your earlier point that even a 10% reduction in ESB pay would have no discernible impact on final prices. The problem is Government policy in relation to the financing of networks and its pursuit of the optical illusion of competition. With its rock solid guaarantees of investment recovery the ESB could borrow up to 70% of the network assets (rather the current 25% and a reliance on up-front contributions from consumers in high final prices). And the ESB should be set free to compete in the wider regional market. In addition VAT rates should be reduced. Together these could reduce final prices by 15 to 20%.

I am convinced these kinds of reforms could be replicated to varying extents thoughout the public and semi-state sectors without impacting on pay or jobs, but the impact on the national price level would be signifciant.

And these reforms will need to be accompanied by development and enforcement of competition law to weed out surplus profit gouging in the sheltered private sector.

Taken together these reforms would have a signifciant beneficial economic impact. It would need hard work, courage and resolve, but the rewards would be great - and the current tactical course has little chance of success.