Andrew Smithers' comments on the report by the Institute for Public Policy Research on “Economic Justice”

Andrew Smithers
London, 4th October 2018

This Report, which was published in early September 2018, received much publicity, encouraged by the fact that the Archbishop of Canterbury was shown as a co-author.

The Report makes one extremely sound and important recommendation which has been, as far as I can find, completely ignored by the press. It proposes that management bonuses should be based on improvements in productivity. In addition, however, the Report makes two recommendations, based on faulty economic assumptions, which would do damage if implemented. It proposes a large rise in the minimum wage on the grounds that this would raise productivity rather than inflation and unemployment and a large rise in corporation tax on the grounds that this was a tax on shareholders, rather than on investment.

Productivity and the Bonus Culture
The Report correctly identifies the key problem for the UK economy as poor productivity due to weak investment “…it is investment…that is the real economic engine, driving both productivity and long-term economic growth…” It also correctly sees that the cause was a change in management behaviour “…the phenomenon known as short-termism.” It therefore recommends that “…executive pay packages should be simplified and linked to ….productivity.”

Had the Report or the press comment concentrated on this it would have been extremely beneficial. Sadly it proved to be another example of the press choosing to ignore the issue rather than debate it. It is also unfortunate that the Report makes other recommendations which conflict with the key one and which, if implemented, would be likely to damage rather than boost productivity.

The Minimum Wage
The Report claims that “low wages damage productivity…when wages rise, for example, through a higher minimum wage, firms are forced to find new and more productive ways of organising and training employees in order to afford higher pay.” In support of this contention the Report cites “Efficiency wage models of the labor market” by George Akerlof and Janet Yellen, who put forward the hypothesis that workers will work at less than their optimum level if they consider that their remuneration is unfair.# If this is correct, then labour productivity could improve without the need for any increase in capital stock if the sense of unfairness is reduced. (In models where labour quality is considered fixed, there would be an improvement in total factor productivity (“TFP”) and, in models which allow for changes in labour quality, the latter would improve.) It does not, however, follow from this that a rise in the minimum wage would increase productivity.

The hypothesis is that unemployment will be higher in an economy suffering from perceived wage unfairness, and that this can be induced either by a minimum wage that is perceived to be too low or by one that is perceived to be unfairly high in that it has depressed wage differentials too much. The hypothesis is set out in the equation e = min (w/w*, 1)##, so that the efficiency of the workforce rises if unfairness is reduced, for example by a rise in the minimum wage, but does not improve further once the optimal level (1) is reached. On the other hand, a rise in the minimum wage beyond this point may increase the sense of unfairness due to the compression of differentials, so that the overall impact of a rise in minimum wage beyond its optimal level will reduce productivity.

In the model unemployment occurs when the market clearing wage exceeds the fair wage. The exceptionally low level of unemployment in the UK today could thus be due in part to the large rises that have occurred in recent years in the minimum wage, as these will have caused the equilibrium level of unemployment to fall (i.e. a decline in the NAIRU). But this also reduces the likelihood that any further significant rise in the minimum wage will be possible without increased unemployment.

If productivity does not rise an increase in the minimum wage is likely to be damaging. The Akerlof and Yellen model compares two equilibriums in which the only difference is in the actual wage. A rise in the minimum wage would, however, also cause either inflation to rise or profit margins to narrow. In the absence of an increase in output this would be likely to lead to some combination of lower investment, reductions in the capital stock and higher interest rates to combat a rise in the NAIRU.
#This is set out in Chapter 16 “The Fair Wage-Effort Hypothesis and Unemployment.”

## Efficiency is represented by e, the actual wage by w and the fair wage by w*. Efficiency rises until the fair wage equals the actual wage but no higher and unemployment occurs when the market clearing wage exceeds the fair wage.

Please click on the "Download" link for the full comment, that also contains charts
Comments on IPPR report on social justice