Good jobs, higher living standards?

A low pay, low productivity recovery has led to questions about the UK’s growth model. John Hawksworth and Nick C Jones show how ‘good jobs’ could lead to a more productive economy.

Heated debate about living standards – and what can be done to help lift them – has moved centre stage since the onset of the financial crisis and will no doubt continue to rage as we head to the general election.

While growth has returned to the UK economy, many households have yet to see the link between an upturn in national economic prosperity and a lift in their personal living standards.

In this essay, we argue that for the recovery to be lasting and have meaning in the day-to-day lives of the public, we need more good jobs; ones that are productive and rewarding in all senses, giving satisfaction, pride in doing good work, an opportunity for career progression, flexibility and (at a minimum) an income level sufficient to live on.

But to be sustainable, higher real incomes require higher productivity growth, which has been a missing piece of the UK economic jigsaw during the recovery to date. This requires the level of workforce skills to be higher, enabled by a demand driven education system that delivers work-ready candidates for employment which is critical to boosting productivity and real incomes in the longer term.

Ensuring that good jobs provide people with the opportunities to earn their way to a better standard of living requires a strategy working at two levels. Policymakers need to be concerned both to encourage the creation of more jobs in high productivity firms and sectors and to improve pay and productivity within low productivity sectors.

The pressures on spending

The recent decline in living standards has two main drivers. On the one hand is the rising cost of living. The period since 2007 has been a stressful time for many UK households. Many tough choices have had to be made as rent, food and utility bills have taken up an ever-greater proportion of total household budgets, which has imposed a particular burden on lower income households.

In particular, housing and utilities now account for around a quarter of total household spending. Our analysis suggests that these costs could rise further as a share of household budgets over the next 15 years, up to around 30 per cent by 2030 (see Figure 1).

The impact of the cost of living on individuals is not uniform because household spending patterns vary by income group. The proportion of household budgets that are spent on housing, fuel, food, transport and other goods and services differs significantly for the richest and poorest households.

We can see this from the results of the ONS Living Cost and Food survey, which collects detailed data on the spending patterns of 5,000 households. Figure 2 shows how the poorest households spend proportionately more of their income on food and housing costs compared to the richest households, who spend comparatively more on transport and recreation.

Rising food and energy prices therefore hit poorer households particularly hard, because they spend proportionately more of their income on food and utilities costs compared to the richest households.

Our analysis suggests that the relatively high rates of global energy and food price inflation over the past decade have fed through to a 40 per cent rise in overall consumer prices for the lowest income decile in the ten years to 2013, as compared to a cumulative rise of only around 32 per cent for households in the top income decile. This 8 per cent gap, when applied to average household spending for the lowest decile, equates to a potential additional cost of around £20 per week, or about £1,000 per year.

This represents a significant inflation premium for the lowest income households to have borne over this last decade. It should be noted, however, that this inflation premium has come down recently and will not always remain constant. But for the past decade it has been a material factor impacting lower income households.

In addition, there is the so-called ‘poverty premium’, whereby poorer households may sometimes face higher effective prices for the same goods and services as those better-off. This is due to factors like fixed standing charges on utility bills, inability to access discounts for bulk buying or direct debits, and much higher costs of credit. Unfortunately official price data does not allow us to quantify these potential effects, but they could be material for households with very low incomes and little or no access to bank accounts and online purchasing.

The earnings crunch

Then, on the other side of the living standards crisis there is the earnings crunch, which has seen real wages fall by around 7-8 per cent since 2007/8, although this has started to bottom out now (as indicated by the rollercoaster pattern to real wage trends shown in Figure 3). Real GDP rose by 3 per cent over the year to Q1 2014, and average GDP per head increased by around 2.3 per cent, but this growth may not match the experience of many ordinary people. Average real wages are reported by the ONS to have fallen slightly over this same period, although recent data has been volatile from month to month.

Part of the answer to this difference between GDP and real wage growth is that employment rates have risen strongly over the past few years. As a result, there have been more households earning, a significant portion of which have been self-employed, earning incomes that generally do not count as wages in the official statistics. The Resolution Foundation has argued that, if estimated incomes from self-employment were included in the average earnings data, the real decline since 2007/8 may have been greater at around 10 per cent rather than around 7-8 per cent for employees only (although lack of up-to-date official statistics make it difficult to be precise about these figures, which can only be illustrative for recent years).

Furthermore, retired households (a growing proportion of the population) have benefited from continued steady rises in real levels of the basic state pension, which remains the most important source of income overall for the retired population. This has offset a real decline in private pension incomes in recent years due, in particular, to lower annuity rates.

Looking ahead, one of the major uncertainties surrounding the shape of the UK recovery – and its sustainability in the long run – is what will happen to productivity and real incomes. In PwC’s March UK Economic Outlook we set out projections for three possible real income measures. As Figure 3 shows, whichever measure is chosen, real incomes are unlikely to return to previous peaks until towards the end of the decade: either 2018 (for average real incomes) or 2019 (for median real incomes).

In addition to the decline in average real wages, there are also important differences in the relative winners and losers. For instance, long-term influences from globalisation and technological change tend to favour high earners and squeeze those on low to middle incomes, as documented in research by the Resolution Foundation.

In particular, there is increasing polarisation in the labour market. Some high-paid jobs are being created in areas like business services and high value added engineering, as well as many low-paid jobs in restaurants and hotels, social care and retail. But there is less growth in middle income jobs as many of these have been outsourced to lower cost countries or providers, or mechanised/computerised by new technologies.

Indeed, we estimated in our March UK Economic Outlook report that around 80 per cent of the net addition to employment since early 2008 has been in relatively low-paying sectors, with most of the remaining net gains being in relatively high-paying sectors. The ‘squeezed middle’ of the employment spectrum has barely seen any net gains, despite strong overall employment growth over this period.

A ‘jobs rich, productivity poor’ recovery

As the UK economy recovers, it has been noticeable that higher real pay and productivity have been the two key missing pieces in the jigsaw of a generally improving picture. Since the financial crisis, productivity has fallen away dramatically. UK workers produce less per hour than their counterparts in France, Germany and the US with the gap widening since the financial crisis. And catching up matters: a 10 per cent boost in UK hourly productivity would be the equivalent of an extra £140 billion GDP every year.

The UK has avoided the levels of unemployment seen in past recessions, which is welcome, but as a nation we now work less productively than we did in 2007, with recent years showing no sustained recovery after the sharp falls seen in 2008 and early 2009. Figure 4 illustrates this recent ‘jobs rich, productivity poor’ recovery.

This productivity problem raises questions over the capacity of the British economy to support rising living standards for average households over a sustained period. In the long run, higher real wages will only be affordable if there are more sustainable long-term productivity gains through investment in new skills, technologies and processes. But how close is the link between pay and productivity in practice?

Textbook neoclassical economic theory certainly suggests that pay and productivity are closely linked because if companies pay workers more than they produce then profits will suffer, but if they pay less then workers will go elsewhere.

The so called ‘efficiency wage’ theory further suggests that, at least up to a point, higher wages can encourage workers to be more productive, as well as saving money by reducing labour turnover rates. Other theories emphasise the role of relative employer and employee/union bargaining power in determining how pay relates to productivity.

All of these theories have some insights to offer, but the link between pay and productivity will not be exact in the real world. For a start, employers also need to consider non-pay elements of total labour costs. In the UK, some of these extra costs (e.g. employer contributions to eliminate pension fund deficits) have been relatively large in recent years, making it hard to keep basic pay in line with productivity without reducing employment.

In addition, as discussed in a recent ONS paper, real wage trends also reflect rising import costs since 2007, due to a generally weak pound and relatively high global commodity prices. These factors have driven a wedge between what workers can buy with their wages and what UK companies charge for their products. This has meant that, while UK productivity growth has been unusually weak since the recession, real wage growth from the perspective of consumers has been even weaker.

Of course, there is a good side to low real wage growth as it has allowed companies to create a large number of jobs since mid-2009, keeping UK unemployment well below what it was in past recessions, or indeed what it has been in many other major economies. The downward flexibility in real wages has also allowed companies to keep on more workers, perhaps as an alternative to increased capital investment.

But while this might be welcomed from a social point of view in the short term in terms of keeping people in jobs, this kind of low wage, low productivity recovery will not deliver rising real living standards in the long run. Furthermore, if productivity is falling, then workers have little bargaining power to press for higher wages, so this can become a self-reinforcing cycle. We can see this also in the fact that UK households have had to run down their average savings ratio to fund an upturn in consumer spending over the past two years. That is not a sound basis for the recovery in the long term.

So what we need to do now is switch from a ‘low pay, low productivity’ equilibrium to one where both start rising strongly, which will also provide a more sustainable basis for consumer spending to continue to rise. But how might this happen?

In the short term, reasonably healthy domestic demand growth (which we expect to continue at least through the remainder of 2014 and in 2015 ) should allow greater utilisation of existing employees, pushing up average productivity growth and supporting higher real pay levels. But this expansion could run into the buffers if it is not supported by increased investment to boost the economy’s underlying productive potential.

Investing in the long term: closing the skills gap

In the longer run, therefore, we need a revival in business investment. This has generally been relatively low since the recession struck in 2008 due to credit constraints and high levels of demand uncertainty and risk aversion by companies. So we have seen a falling average ratio of capital to labour in the UK economy, leading to lower productivity and real wage levels (just as you would expect from standard economic theory).

Business investment has been picking up steadily from a low base since early 2013, however, and (barring major adverse shocks) it should pick up over the next few years in response to stronger demand conditions and a gradual easing of credit constraints. This additional investment should eventually push up productivity growth. This in turn should underpin real pay growth beyond the short term benefits from demand-side increases in the productive working hours of existing employees.

But there are still risks, particularly from major global shocks. For instance, conflicts escalating in Ukraine, Syria and Iraq and/or a renewed flaring up of the Eurozone crisis could lead to a spike in risk premiums and declining business confidence and investment in the UK and our major trading partners.

Alongside capital investment, there is also a need to boost both skills in the workplace and the engagement of employees to make the most of these skills. PwC’s Annual Global CEO Survey shows the importance of skills to business. For instance, last year almost two thirds (64 per cent) of the CEOs we surveyed said that creating a skilled workforce is a top business priority.

Having fulfilling paid employment is also the cornerstone of an individual’s economic success and wellbeing. A growing body of research confirms the link between work and other aspects of good growth, for example between job quality and physical and mental wellbeing. This is consistent with research on what impacts on ‘happiness’.

Our research with think-tanks, the public and business shows that if growth is a pre-condition for jobs, then ‘good growth’ needs to go alongside the creation of good jobs. Acquiring skills is the necessary foundation both for individuals to get a job and also for businesses seeking to expand.

This foundation for success has been keenly felt in some of the places with which politicians and policy makers like to draw lessons, such as Singapore which is, of course, near the top of the class when it comes to international benchmarks of educational performance. Singapore (together with the Scandinavian economies) also ranks very highly on our ESCAPE index, which provides a holistic evaluation of national performance going beyond standard economic metrics like GDP.

In our last report on Government and the Global CEO, we interviewed Yeoh Keat Chuan, Managing Director of the Singapore Economic Development Board, whose views are illustrative of the challenge of creating employability:

If you are wondering if Singapore is fit for the future, the question is whether we are developing the right capabilities? How do we work with the universities and the educational systems to ensure that we build up the right competencies? […] And it is not just any university degree; we want to make sure that it is the right degrees which ensure that Singaporeans are employable. For example, if we see a big opportunity in terms of analytics, we work with our universities to make sure they are providing the right kind of training in order for Singaporeans to sign up and graduate with the right qualifications and knowledge.

The bottom line is that skilled workers are a prerequisite for innovation, good jobs and good growth.

Implications for 2015 and beyond:
the importance of employee engagement

So what does this mean for the manifesto writers? The importance of making sure that living standards rise as the recovery proceeds is clearly a critically important issue for the 2015 election and beyond. There are important policy choices, and manifesto pledges, to be made on a range of tax and welfare issues, including the minimum and living wages, as we have seen in a range of pronouncements to date.

For instance, at the recent conferences the Labour Party called for an increase in the National Minimum wage to £8 by 2020. And both the Liberal Democrats and the Conservatives committed to increases in the Income Tax personal allowance to £12,500.

There will no doubt be further important manifesto commitments to be announced on these areas of policy as the election draws nearer. But as argued above it is also important to raise the level of workforce skills, which is critical to boosting productivity and real incomes in the longer term, as well as increasing employee engagement.

There are also important developments needed in the education system to deliver work-ready candidates for employment. But for the recovery to be lasting and have meaning in the day to day lives of the public, we need more good jobs, ones that are productive and rewarding in all senses. According to our recent party conference Citizens’ Juries, while an acceptable job involves security, decent conditions and incomes to live on as well as work-life balance, good jobs must go further: job satisfaction, a stake in business success, an opportunity for progression and working with good people also needs to be part of the package.

With the election on the horizon, this has implications far beyond the making of pledges in manifestos. The role of public and private sector employers in stepping up to these issues is about more than just paying a Living Wage. A real focus is needed on employee engagement and its impact on productivity growth. Satisfaction with a job often comes from intrinsic value – and the belief that what you are doing is respected and socially useful.

Whether in the role of Chief Executive, a supervisor in a small business or a porter in a hospital, people need to see purpose in their work and understand how they add value. As Dr Steve Peters comments: ‘When we have a sense of purpose in life it brings with it a sense of meaning and this in turn leads to achievement, satisfaction and well-being.’

Employee engagement is particularly important for two further reasons. First, engaged employees will generally be more committed to their work and more productive as a result. The UK Employment Engagement Taskforce has set out the evidence for the connection between engagement and performance, quoting one study which found that business units with engagement scores in the top quartile averaged 18 per cent higher productivity than those units in the bottom quartile.

Researchers at Warwick University have produced similar findings on the link between wellbeing and productivity. Experimental work has found happier workers to be 12 per cent more productive than average, with unhappy workers being 10 percent less productive.

Second, employees who do not have clarity about organisational and personal goals, lack autonomy, or do not believe that they are listened to, are less likely to become active partners in redesigning their jobs for higher productivity working. In this respect, employee engagement needs to be understood not just as a means of motivating staff, but also as a way of drawing more people into the process of innovation, continuous improvement and the achievement of outcomes. The role of the line manager in today’s workplace is not just to set clear objectives and facilitate ongoing development, but to engage staff as service designers and problem solvers in their own right. Giving employees a sense of control and autonomy can be the key factor in delivering higher performance, achieving outcomes and coping with higher demands when resources are becoming scarcer.

This, in turn, requires the right collaborative culture within organisations, supported by institutional structures, such as HR departments, professional development policies and pay bodies, which facilitate dialogue between employees and those further up the organisational hierarchy: a ‘two way street’. Dignity and respect is as important in the workplace as in an elderly care home or a school classroom. This does not negate the need for hierarchy, but does point to the importance of information flowing in both directions, rather than simply from the top down.

There is no silver bullet to lifting living standards, but a focus on designing good jobs which engage staff is a good place from which to start.