In-depth: Are UK pay increases too large or too small?

As Rishi Sunak says the government must make a “responsible” decision on pay to control inflation, Dr Duncan Brown analyses why average real earnings are now at the same levels as in 2005, and how the UK is falling behind other European countries. How do we resolve the pay perspectives of employees and economists and what is the role of employers and HR?

“We only got 5%.” A young woman’s honest appraisal of her employer’s recent pay award on a radio phone-in, in the context of her escalating food bills and rent, highlighted the diametrically opposed perspectives of employees and economists on the UK pay environment at the moment, with employers often struggling somewhere in-between.

For economists in the Bank of England and the Treasury, pay deals are at a “record 5.6%”, according to the latest IDS quarterly pay deals data, and total earnings growth at 6.5% (in the latest official monthly statistics) is worryingly high compared to the 2% target rate of inflation.

The governor of the Bank of England, Andrew Bailey, who was paid £576,000 in 2021, is worried, telling the BBC’s Today programme: “I’m not saying nobody gets a pay rise. What I am saying is we need to see restraint in pay bargaining, otherwise it will get out of control.”

The risks of the post-Covid and Ukraine war economic shocks, he told the House of Lords Economic Affairs Committee, are a return to a 1970s-style oil-price-driven, wage-price spiral, which has to be avoided at all costs.

Or as his chief economist Huw Pill put it less subtly on an American podcast: “British households need to accept that they are poorer and stop seeking pay increases and pushing prices higher.” Indeed, the prime minister has told the public to “hold their nerve” in the face of rising interest rates.

For employees, meanwhile, they are indeed feeling poorer. As the Fire Brigades Union general secretary Matt Wrack argued in February, threatening industrial action by his members, “firefighters, teachers and nurses didn’t cause this economic mess”. The FBU successfully secured a 7% pay rise backdated to July and a 5% increase from July 2023.

Governor of the Bank of England, Andrew Bailey
Photo: Jose Luis Magana / Associated Press / Alamy

Despite the gradually increasing pay awards that industrial action and a tight labour market are helping to deliver, UK workers are still seeing the cost of living escalate. The consumer prices index peaked at over 11% last year and remained at 8.7% in May for the second month running. The heralded reduction in food price inflation last week still puts it at some 16% year-on-year.

Worst of all, the lowest-paid employees suffer the highest rates of inflation as they spend a higher percentage of their income on necessities like food, energy and rent than those on average earnings. The European Central Bank estimates that the gap has increased over the past decade to a 1.9% higher rate in 2022.

As a result, the TUC’s research shows that UK real wages fell by 3.0% in 2022, the worst annual decline for 50 years. It forecast that employees will experience a similar 2.5% decline this year. That means £1,500 less for someone on average earnings and an estimated £1,800 less in real terms for a nurse.

Real earnings falling in Europe

The same phenomenon is happening throughout Europe. Despite a highly diverse pattern of pay levels across the EU, rates of average earnings have been escalating in the past 12 months, with a record annual increase in hourly labour costs of 5.8% for the EU at the end of 2022, compared to an average of 2.3% from 2010 to 2022.

This has led to a consensus of warnings from the economists at the European Commission, International Monetary Fund and European Central Bank (ECB) that price inflation is becoming “baked in” by high pay awards, eating up their real value even more.

The ECB’s Governing Council has expressed concern about the existence of schemes in which nominal wages are indexed to consumer prices and has called for this practice to be avoided.

Similarly to the UK, price inflation exceeds pay inflation in most European countries right now, leading to real earnings cuts of 2.4% on average in the EU last year.

The ECB was forced to confront the economist/employee pay contradiction directly itself earlier this year. Despite its advice to European employers not to react to or to link pay awards to inflation, the annual pay award they proposed for their own employees this year of just over 4% (double their own target for price inflation of 2%) was appealed by their trade union and staff committee.

In response, the bank has agreed to a staff wage review, only the second in its history, that will consider proposals for semi-automatic salary increases when prices rise. The head of the Ipso union, which represents ECB staff, said it was “asking for a more balanced approach” to setting pay, which takes account of price inflation and real pay.

Pay awards directly linked to prices and productivity were relatively common in the UK in the 1970s but became a casualty of that “stagflation decade” and are now rare except in a few charities.

The UK’s pay and cost-of-living ‘catastrophe’

What’s very different in the UK has not just been the lack of consideration of prices and real pay by many employers, but also that these real pay cuts are not just a short-term feature driven by the current economic environment.

They are a much longer-term phenomenon, moving progressively from ‘crisis’ to a ‘catastrophe’, according to the International Labour Organisation.

The latest data from the Office for National Statistics (ONS) show that real average earnings are, astonishingly, at the same level in April 2023 as they were in November 2005 – just £497 per week.

A plot of the UK’s economic GDP growth and average earnings growth shows a very close relationship throughout the post-war period. When the economy grew faster so did wages, and at times of recession, pay growth fell. Even in the depressed 1970s most UK employees still experienced real earnings growth.

That relationship started to diverge early this millennium and especially after the financial crash of 2008. Since then, we have had low economic growth by historical standards, but even lower pay growth. Analysis by John Van Reenan at the London School of Economics confirms that the strong historical association between the rates of productivity and wage growth has been broken.

The figures show that, between 2000 and 2005, real weekly earnings rose by about 15% amid a buoyant economy. They then increased more slowly, by 5%, in the run-up to the 2008 financial crisis.

The impact of that crash on public and private sector wages effectively wiped out all the gains in the previous eight years, before recovering slightly in the three years leading up to the Brexit referendum. In May 2016 adjusted weekly pay stood at £493 per week. Since then, excluding the effects of Covid, wage growth has never recovered.

Paul Johnson, director of the Institute for Fiscal Studies, described this as a “completely unprecedented period with no earnings growth… We have had 15 years of essentially stagnant earnings, and if you look at the Bank of England figures you struggle to find a comparable period since the Napoleonic wars”.

Surprisingly widespread

By 2026 the IFS estimates that average household earnings will be £30,800, compared with £43,700 if wages had risen at the same pace as in the two decades before the banking crisis. In other words, households will be 42% poorer. Across Europe, only Greece, which was subject to stringent austerity controls after its economic collapse, has seen falls in real earnings anywhere near this extent.

The picture in the UK does vary significantly by occupation, pay level and age, although it is perhaps surprisingly widespread, with many professionals such as auditors, and new graduates, experiencing real pay cuts during the 2010s.

Tom Carver’s excellent analysis using ONS data shows that while there have been real earnings gains for some jobs, such as train drivers since 2012, there have been declines for most employees.

The biggest falls have been in the public sector. Nurses have seen a 10% drop in real pay, while teachers have seen a 20% reduction. This is in marked contrast to comparisons with other economies.

Perhaps it is not surprising that it is in these areas that we have seen the most prolonged industrial action over the past year, with demands from junior doctors – and now senior doctors – for pay restoration in real earnings terms. Although their demands for 20% and 30% increases may sound outrageously high, they are factually correct to say that this would restore their pay to its pre-2008 level in real terms.

So the key questions in this regard, for both economists and employees, are:

• What has caused this unparalleled decline in real earnings in the UK over the past two decades?
• And what can government, employers and their HR professionals do to help the UK return to more healthy economic and real earnings growth?

What is causing the drop in real earnings?

The causes of the UK’s extensive fallback in earnings growth, and productivity, are much debated by economists, particularly as to the scale of the negative impact of Brexit.

There seems widespread agreement that the effects have been negative, particularly on UK labour supply, and the debate is focused now on just how bad. The war in Ukraine has clearly had an effect, but the debate seems increasingly centred on the prioritisation of these factors, with perhaps surprising agreement on the key drivers.

First, the economic turmoil of the financial crisis in 2008 and then the pandemic, and also the halving of GDP growth in-between to an average of just 1.2%, have undoubtedly been a major contributory factor, with less investment by businesses and less profit available to fund pay awards.

Second, the government’s own investment record since the 2008 crash has also come in for increasing criticism as an important contributory factor, with its supporting economic orthodoxy of public spending austerity, low inflation and interest rates, accompanied by a succession of pay freezes and then low pay award caps set for the millions of its own public sector workers.

Former chancellor George Osborne may have defended the “financial flexibility” that these policies afforded the country to the Covid inquiry earlier this month, but the testimony of Dame Sally Davies, chief medical adviser between 2010 and 2019 was perhaps more convincing, as she described how “inequalities and disinvestment directly affected public health resilience” had contributed to growing levels of ill-health and poverty.

That low-interest-rate, low-inflation model has of course unwound with frightening speed since the pandemic. One of Osborne’s former colleagues Sir Jake Berry, referred last week to a “mortgage time bomb” being set off by higher interest rates, adding to the cost-of-living crisis and growing rates of in-work poverty.

George Osborne announces the national living wage in his 2015 Budget. Photo: Chris Yates/Alamy

But the deeper questions raised by the current situation are just why so many employees are unable to deal with this inflationary economic “shock” and why real earnings in the UK have been falling for so long. The 2010s’ so-called “jobs miracle” under Osborne in reality saw the rapid growth, particularly in the service sector, of a low-cost, low-skilled, low-paid, low-security, low-HR-investment employment model.

In fact, in terms of the skills and pay distribution of jobs in the economy, the UK has become much more like Portugal and Spain over the past 20 years than France or Germany; hence our lower levels of average earnings compared to the latter, and also a wider gap here between the lowest and highest paid employees.

Underinvestment

What too many HR functions gave their workers during the 2010s was Osborne’s “flexibility”, which translated into flexibility down into low pay and insecurity for their employees. The ensuing pandemic highlighted the essential role and often awful pay and conditions of frontline workers, for example in social care and retail, and the short-sightedness of cost-efficiency and shareholder-return-driven cuts in employee benefits, such as sick pay, during the 2010s.

As UCL’s  Professor Sir Michael Marmot, quoting Albert Camus, expressed it: “Pestilence brings the hidden truth of a corrupt [and divided] world to the surface”.

His research highlights the critical impact of underinvestment in health and wellbeing, by government and employers, on the economic, physical and mental health of employees. The latest employment figures from the ONS reveal more than 2.5 million UK employees are unable to work because of long-term sickness, increasing labour shortages and the intense work pressures in sectors such as health and social care.

Underinvestment in skills, what the economists call “supply-side” problems, is also a major factor in the restraints we have seen applying to business and employee pay growth. They also help to explain the continuing recruitment problems facing most employers and the resultant escalation in pay for the most in-demand jobs, be they HGV drivers, chefs or supermarket assistants.

While the impact of Brexit and the political and public response to current business leaders’ demands for increasing migration remain hugely controversial, the evidence for the negative economic impact of skills shortages continues to grow.

Analysis last year by the Learning and Work Institute found that the number of employees participating in government-funded learning in the workplace (e.g. apprenticeships), had fallen from 1.25 million in 2008 to just over one-fifth as many before Covid struck in 2020. And employer investment in training, which not surprisingly fell after the 2008 financial crash, has never recovered. It is down by 28% since 2005 to half the average spend per worker evident in the EU, and it is those with the lowest levels of qualifications and pay who are missing out most.

According to the Institute, this underinvestment “limits our chances to grow our way out of our current productivity and cost-of-living crisis” and puts successive governments’ ambitions of a high-skill, high-wage economy at risk.

Perhaps more controversial is the contribution of growing UK inequality to declining real pay in Marmot’s increasingly divided world. This debate is admittedly highly sensitive to the data you use and the exact time periods that you measure it over, never mind your political beliefs.

It is also complicated by the growing level and influence of the differentially high increases which we have seen in the misnamed national living wage, since it was introduced in 2016. This was increased most recently by a just-about-inflation-matching 9.7% in April, en route to the government’s target of raising it to 66% of the level of average earnings by 2024.

What the press release announcing the increase does not tell you however, is that not only has that average earnings target been declining in real terms, but also there is a growing number of employees are paid at or within 10% of the government minimum, with some 3.5 million UK employees still paid less than the “real” minimum rate of pay set by the Living Wage Foundation.

In-work poverty and inequality

According to the Joseph Rowntree Foundation, over 13 million people are living in poverty in the UK, more than four million of whom are children, and the majority of whom have at least one parent in work. In-work poverty – a phenomenon which the founder of the welfare state William Beveridge never even envisaged as jobs were then the solution to ‘idleness’ – has grown, as real wages in those jobs have fallen.

While minimum wages may have been going up, the other terms and conditions for low-paid workers, as the Resolution Foundation points out, have been getting progressively worse and are poor by international standards.

The UK for example, has over a million people on zero-hours contracts, and 32% of the UK workforce (mostly in low-paid work) receive less than a week’s notice for shifts, hours or work schedules. Our statutory sick pay rates are 11% of average earnings, compared with an average in the OECD of 64%, which is not great for a country when a pandemic hits, nor for productivity in the post-pandemic recovery.

The Resolution Foundation recommends that government and employers set higher standards and conditions for low-paid jobs, including making sick pay much more generous, offering earlier protection against unfair dismissal, increasing maternity and paternity pay rates, and introducing “living hours” and “living pension” arrangements.

What is indisputable is the fact that real pay cuts and growing in-work poverty at the bottom of the UK income scale have contributed to a widening gap with the escalating real incomes of those at the top of the wealth distribution. This was boosted by their capital gains evident throughout the 2010s, in areas ranging from house price growth to executive share options, which are taxed at a much lower rate than income.

The median earnings of CEOs in FTSE 100 companies for example went up by an inflation-beating average of 12% last year, from £3.72m in 2021 to £4.15m in 2022. The High Pay Centre calculates that this is 109 times the average pay level of their employees, up from a ratio of 50 times in 2000. So long-term real pay reductions exist for most, but not all, UK workers.

Jeremy Hunt is questioned by the Treasury select committee. Photo: PA Images/Alamy

How can we cure the decline in real earnings?

“We won’t do anything to prolong the inflationary agony that people are going through,” Chancellor Jeremy Hunt told MPs at Treasury questions in the House of Commons last week, reinforcing the views – and interest rate hikes – of Andrew Bailey, as the government’s route to return to their pre-Covid economic model of low rates of inflation and interest, as well as, most likely therefore, low productivity and pay growth.

The CEO of Qatar Airways similarly expressed a desire to return to the 2010s and the hope that it will become easier to recruit at Heathrow Airport once unemployment increases and cost-of-living pressures bite: “The only way we will get out of it is when people realise they have to get out of their home and back to their jobs and work to earn”.

Neither sounds very positive for real pay growth for most UK employees anytime soon. Around half of UK employers have made additional cost-of-living payments and offered financial wellbeing support, but as Kate Bell, head of economics at the TUC, observes: “The only real way to give working families security is a decent pay rise.”

Which may also be the only way to address the UK’s productivity malaise. An alternative, pro-employee economic point of view is currently gaining ground, amongst economists and employers, and not just trade union leaders.

In a rare profit forecast upgrade made this month, Next’s Lord Simon Wolfson, the longest-serving FTSE 100 CEO, attributed its higher-than-anticipated sales to the higher-than-Bank-of-England-wants pay awards evident in the UK in April. This has boosted people’s real incomes and spending power, one of the key drivers of economic growth in our service-dominated economy.

So why pay workers more? Doesn’t that just increase costs and depress profits? Tesco CEO Kevin Murphy justified its additional out-of-cycle pay award for store staff to £10.30 per hour, stating: “We try to ensure colleagues don’t have to go to food banks”. But he also said it’s “a key part of how we see the world”. Tesco has since increased its store assistants’ pay to £11.02.

This alternative philosophy involves investing in people, their skills, pay and progression, paying as much as you can afford rather than as little as you can get away with, boosting skills and real incomes and thereby adding value and enhancing growth rates in the wider economy.

Politicians as well as employers are recognising the failure of the low-pay, low-people-investment model. A growing number of countries and their governments are following the US example of ‘Bidenonomics’, which involves not just major capital investments but also investing in US domestic skills and productive capacity –  their human capital – as well as rebalancing the power dynamic between employers and employees, for example by strengthening trade unions.

And for employers and their HR leaders, our work at the Institute for Employment Studies (IES) highlights specific actions they can take that are linked to higher productivity and could help to realise that vision of a high-skills, high-pay, high-performance economy that prime ministers from Gordon Brown through to Boris Johnson have been so fond of talking about.

These include:

• Addressing low pay, which is actually associated with higher employer costs, through increased turnover, absenteeism and lower employee commitment. While not necessarily moving to inflation-indexed salaries, the cost of living is certainly assuming a much higher importance in pay bargaining.
• Fair pay practices, which as IES details in its research for the Equality and Human Rights Commission, are associated with higher levels of employee trust and engagement.
• Skills-based pay and progression, which as IES’s Europe-wide research project demonstrates, delivers potentially huge benefits for employers, with the additional costs far outweighed by an increase in added value and falls in recruitment and attrition costs.
• Profit sharing, employee ownership and share schemes. My recent research demonstrated that ”a greater presence of collective variable pay schemes coincides with better performance, especially at site level” as well as higher real and actual pay. The Employee Ownership Association has demonstrated a similar performance premium for employee-owned companies over quoted companies.

At our annual HR director retreat in Brighton, IES director Tony Wilson highlighted the need for genuine supply-side investment by government in order to address the UK’s longstanding low-productivity problem. Similarly, the Recruitment and Employment Confederation’s chief executive Neil Carberry argued strongly to our delegates for the need for them to “grow (more of) their own” and invest in the cultures and practices that underpin employee retention and performance.

A stronger emphasis on delivering fair pay and employment, including real pay growth and pay progression for all employees, stable contracted hours, and more comprehensive, compassionate financial wellbeing support, is what I am seeing in my work with an increasing number of HR leaders adopting as the route to achieving sustained high performance and productivity. Which is what sustained real earnings growth depends on.

In its recent study, McKinsey reported that “fostering a growth mindset among leaders and employees – for example, by providing training and internal advancement opportunities (with associated pay increases) – is a cornerstone of effective organisations” in the 2020s. Do you think Andrew Bailey will come to agree with them?

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