Alongside the October 2018 Economic and fiscal outlook (EFO) the Government expressed its aspiration to end low pay, noting the definition used by the OECD, which corresponds to two-thirds of median earnings. This policy was not firm enough for us to incorporate into our central forecast. Nevertheless, in this box we drew on previous analysis from our July 2015 EFO – when the National Living Wage was first introduced – to illustrate the potential effect on the economy and public finances.

Alongside the Budget the Government expressed its aspiration to end low pay, noting the definition used by the OECD, which corresponds to two-thirds of median earnings. In the coming months, it intends to consult on the remit for the Low Pay Commission, bearing in mind the potential impact on employment and economic growth. (The current policy is for it to rise to 60 per cent of median hourly earnings by 2020.) As such, this policy is not yet firm enough for us to incorporate into our central forecast. Nevertheless, we can draw on previous analysis – set out in our July 2015 Economic and fiscal outlook, when the National Living Wage was first introduced – to illustrate the potential effect on the economy and public finances of setting a NLW of two-thirds median earnings.

In that forecast, we assumed that those earning below the NLW in the initial earnings distribution – roughly 16 per cent of workers – would earn that amount after its implementation, but that some workers earning above the NLW would also benefit, as employers would maintain some of the initial earnings differentials to recruit and retain personnel. We assumed that this ‘spillover’ effect would be smaller further up the earnings distribution, becoming negligible beyond the 25th percentile or, equivalently, at a wage 40 per cent above the NLW. We also assumed a similar spillover effect for workers under 25, including those earning less than the NLW.

It is likely that some employers will respond to an increase in paybill by reducing employment. We assumed in July 2015 that total hours worked would fall by 0.4 per cent for every 1 per cent increase in employer costs, with half of that passed through to numbers in employment and the other half reflected in average hours worked.

We can use this same analytical framework to estimate the potential effects of a further increase in the NLW. In doing so, we make two adjustments to our assumptions in July 2015:

  • A NLW set at two-thirds of median earnings would directly affect the wages of the bottom quarter of workers, a significantly greater proportion than previously. As before, we assume there are also spillover effects to those earning close to, but above, the new NLW. But the bell-shaped nature of the earnings distribution means that there will be many more such workers. If we retain our earlier assumption that spillovers apply to those with hourly earnings up to 40 per cent above the new NLW,a then around half of the work force would be subject to some spillover effect.
  • Consistent with our earlier analysis, there is limited evidence that previous increases in the National Minimum Wage and NLW have had a significant impact on employment.b In part, that is because some low-wage workers have little choice who to work for and their employers can exploit their market power to keep wages low. This may be less relevant further up the wage distribution. In addition, firms may be more likely to change their production methods when labour costs have risen substantially. So we would expect the responsiveness of firms’ demand for labour to its cost to be somewhat higher than in our original analysis. We have therefore assumed that as the NLW increases beyond 60 per cent, the responsiveness of total hours worked rises gradually to a fall of 0.5 per cent for every 1 per cent increase in pay.

Using these assumptions, we estimate that a rise in the NLW to two-thirds of median earnings would raise the unemployment rate by 0.4 percentage points in the ‘target’ year. In today’s terms that corresponds to a rise in unemployment of around 140,000, plus an equivalent reduction in hours for those remaining in employment. Average hours would be 0.4 per cent lower and real GDP 0.2 per cent lower than they otherwise would have been.

There is a high degree of uncertainty around these estimates, which we will revisit if and when more specific details of the policy are confirmed. But an increase to two-thirds of median earnings would put the NLW above that in most other countries, so there would be few international precedents to draw on. Moreover, while the NLW so far seems to have had only modest effects on aggregate employment, there has been clearer evidence of an impact in particular sectors, such as social care, where labour is a large share of costs and a high proportion of workers are affected.c Further rises in the NLW could therefore create particular pressures in specific industries.

To calculate the fiscal effects of a further increase, we would again use the same framework as in July 2015. We discussed the main channels by which the public finances would be affected in paragraph B.28 of that EFO. As well as effects on total hours worked, the change in the shape of the earnings distribution would be particularly important for welfare spending. Entitlement for some benefits relates to household rather than individual income, so it would be important to consider the effect on that distribution too. This is relevant because many workers on the NLW are second earners in their household. We have not estimated the potential fiscal impact of this latest intention, but the net effect is likely to be relatively modest.

This box was originally published in Economic and fiscal outlook – October 2018

a This is consistent with the findings in Butcher, Dickens and Manning (2012), Minimum wages and wage inequality: some theory and an application to the UK, CEP discussion paper no. 1177, which we also used to calibrate the size of the spillover effects in our July 2015 EFO.
b The impact of the NLW on employment and hours is discussed in National Miniumum Wage, The Low Pay Commission Report 2017.
c For more detail see More than a minimum: the review of the minimum wage, Professor Sir George Bain, March 2014.

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