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Finance & Development, March 1975
Article

What is incomes policy and what can it achieve?: If there is popular support for incomes policy, and if it is coordinated within a wider economic framework, it can be effective in moderating inflation.

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
March 1975
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Anne Roman is Braun

This article treats some basic issues of incomes policy that were discussed by the author in two recent studies published in Staff Papers of the Fund: “Compulsory Arbitration as a Form of Incomes Policy: The Australian Case” (March 1974); and “The Role of Incomes Policy in Industrial Countries since World War ll” (March 1975).

The term “incomes policy” is now commonly employed to cover specific measures aimed at moderating the rate at which money incomes tend to rise, by curbing the exploitation of market power by business and labor and by professional or other groups. Incomes policy is thus an adjunct to fiscal and monetary policy. Its purpose is to moderate the rate at which prices and costs tend to rise when the level of aggregate demand and employment is not so high as to force up prices and wages by creating scarcities or to provoke a balance of payments crisis.

Incomes policy in this sense is essentially an anti-inflationary device; it should not be taken to cover the whole range of policy with respect to incomes. Policies concerned with income distribution per se, such as measures to reduce the inequality of incomes, to eliminate very low wages, or to reduce poverty by social welfare legislation are not comprehended by the term. In practice, however, such measures are often adopted along with an incomes policy, because the labor organizations regard measures to improve the position of lower paid workers as a prerequisite for their cooperation in an incomes policy.

Types of measures covered

The objectives and methods of incomes policies differ widely with the political and institutional characteristics of the countries where they are applied. The measures they cover fall into the following categories:

  • Short-term intervention to prevent wages or prices rising by “freezes” or temporary controls. Such measures are often adopted in the hope that if increases can be temporarily prevented, conditions may later be more conducive to restraint and the increases may never occur; or the measures may be aimed at checking the development of inflationary price expectations.

  • Efforts to inform public opinion by publishing expert reports, creating advisory bodies, etc., in order to develop a consensus on what is an appropriate rate of increase in wages and salaries and on the need for moderation of pay claims if inflation is to be avoided. The aim is to bring the force of public opinion to bear as a curb on wage and price increases. This objective involves the more or less explicit formulation of a “guideline” for wage and salary increases and of concomitant ideas concerning pricing behavior, profit margins, and the shares of nonwage incomes in national income.

  • Mandatory, or voluntary, implementation of guidelines for wages and salaries, with or without measures of price control or profit restraint.

  • Measures aimed at restraining cost pressures in specific sectors (e.g., construction, basic industries, public services, rental housing), including provisions for investigation of price or wage decisions, for prior notification of price increases, for approval of wage settlements, and so on.

  • Operation of a coordinated system of wage and salary determination (often also covering farm incomes), with or without direct government involvement, as in Scandinavian countries, the Netherlands, and Austria; or through the medium of compulsory arbitration procedures for wages and salaries, as in Australia and New Zealand.

  • Long-term measures falling under the heading of “institutional engineering.” These include the provision of machinery for mediation and arbitration of disputes, for observance of “cooling-off” periods, and for sanctions against unofficial strikes; measures to reduce the area of disputes concerning employer, employees, and union prerogatives; clarification of legal status and duration of wage contracts, simplification of wage structures, systems of payment, etc.; reorganization of the union structure to avoid disputes about membership coverage, to simplify wage bargaining, and to lessen tendencies for a wage-wage spiral; and labor market policies to improve mobility or provide retraining facilities, in order to lessen the tendency for wages to rise while there is still considerable unemployment in some regions or among some categories of workers.

Use of incomes policies by industrial countries

Since World War II there have been three periods of strong interest in incomes policy; the immediate postwar years, the early 1960s, and the late 1960s into the early 1970s. The objectives, general approach, and specific measures adopted in these three periods differed widely as a result of the very different circumstances under which the policies were implemented.

In the period just after World War II, incomes policies were applied in a number of European countries in a context of scarcities of goods and critical shortages of foreign exchange. Policies then involved a considerable element of compulsion. Centralized wage control was enforced in the Netherlands, Norway, Finland, and Sweden, and coordinated wage policies were adopted in Austria and the United Kingdom, against the background of widespread restrictions, such as direction of labor, rationing of consumption goods, allocation of raw materials, price and rent controls, dividends restraint, and excess profits taxation. Since the international market was fractured by direct controls and high tariffs, wage decisions were to a large extent insulated from the influence of developments in other industrial countries, and the industrial countries in some respects approximated to closed economies.

The second phase of strong interest in incomes policy occurred during a period of unusually strong competition in the international market for manufactures. This was the result of the construction of much new capacity in Western Europe and the Far East; the liberalization of direct controls and tariff reductions; and the creation of the European Economic Community (EEC), with consequent efforts of EEC firms to enlarge their markets and of foreign concerns to establish themselves within that area.

During the early 1960s attention was concentrated upon voluntary measures aimed at influencing the climate of opinion and the attitudes of the parties in wage bargaining. This was the heyday of the productivity guideline. Norms based on the principle that the rise in wages should not exceed the average increase in per capita productivity were adopted with two basically different purposes. In countries such as the Netherlands, Norway, Sweden, and the United Kingdom, the basic aim was to prevent pay rising faster than productivity in order to avoid loss of competitive power vis-à-vis countries such as the United States, Germany, Japan, and Italy, where industrial prices were under only slight upward pressure. In some of the latter countries, notably the United States and Germany, guidelines were established with the aim of reconciling a fuller utilization of manpower resources with the high priority accorded to price stability by the electorate. In either case, wage restraint could plausibly be presented to the wage earners as necessary for the maintenance of full employment in a world in which there were strong pressures for price stability.

The goal of incomes policy during this period was essentially to modify the working of the existing system, with the least possible interference with the market mechanism, by strengthening underlying forces of competition which, it was presumed, could be revived or brought into play. Interest centered on moderating wage increases rather than limiting price increases directly, because recent experience suggested that, if unit labor costs were restrained from rising, prices could be stabilized by aggregate demand policies.

Stronger measures were adopted by several countries faced with severe balance of payments problems in the late 1960s. In the United Kingdom, a mandatory incomes policy incorporating legal powers to prohibit or postpone increases in pay and prices was established in 1965 in an effort to avoid devaluation. Finland established a comprehensive incomes policy after devaluing in 1967; and in Canada, an independent Prices and Incomes Commission was set up in 1969 and attempted to organize a comprehensive package of income restraint. The Netherlands, Denmark, and some other countries made use of price-wage freezes, power to prolong wage agreements, and other measures in an attempt to curb a marked acceleration of the rate of price increase; and in 1971 the United States instituted a comprehensive policy of direct price-wage restraint. By the end of 1971 direct measures to restrain price increases were in force in nearly all the industrial countries, and wage increases were postponed or limited by government intervention in Finland, Ireland, the Netherlands, Norway, and the United States. Such intervention lessened when demand pressure eased in 1972 but again became widespread in 1973.

The increased emphasis on controlling prices in recent incomes policies reflected two factors: a growing belief that prices are more amenable to institutionalized control than wages and salaries; and a growing realization of the need for specific price restraints to prevent large wage increases in particular industries, which could set off an excessive rate of increase of wages in general. As the crucial role of efforts to maintain relative levels of pay in the inflationary process became evident, the case for coordination of wage and salary increases in an inflationary environment was strengthened.

Coordinated wages policy

Australian experience with compulsory arbitration suggests that two basic propositions must be borne in mind when considering the problem of implementing a coordinated policy for wages and salaries:

  • In a changing economic environment there will be a tendency for money incomes to rise more rapidly at certain points in the system than elsewhere.

  • Under a democratic government it will be impossible to maintain any form of incomes policy restraining the rise in money incomes unless the policy is generally regarded as equitable.

The most easily accepted notion of equity is that per capita incomes should rise in line, leaving the distribution of income unchanged. Wherever the existing distribution of income is the subject of intense political conflict, incomes policy is unlikely to be feasible.

In practice the notion of equity is most compelling where a direct comparison of rates of increase is easily made: in particular, between increases in pay accorded to different groups of wage and salary earners (for example, between increases for different workers in the same enterprise; wage settlements for different industries; and decisions affecting various occupational groups such as civil servants, municipal workers, professional groups, and the armed forces). Direct comparison is also possible between the movement of wages and salaries and of profits within a single concern or within a homogeneous industry.

It is generally more difficult to compare the movement of wages and salaries and of other per capita incomes (such as earnings from agriculture and self-employment, and unearned incomes from rent, profits, and dividends), because far less information is available concerning them. Besides, farm incomes, profits, and the like are expected to fluctuate more than wages and salaries. Nevertheless, broad considerations of equity are powerful here, too, and are likely to require that the share of wages and salaries in the national income be at least maintained over a period of years.

Conflicting ideas of equity

When an exceptionally high rate of profit is known to be earned by the typical concern in an industry, or by a single very large enterprise, this raises conflicting notions of equity. Wage and salary earners naturally take the high rate of profit to indicate that the capacity to pay higher wages exists and that their earnings are inequitably low in relation to those of the owners of the concern. If the wage earners secure a substantial wage increase in these circumstances, based on a vertical comparison between the movement of wages and profits within the industry, this disturbs the horizontal relativities between wages in this industry and those elsewhere, and it sets in motion pressures for commensurate wage increases in other sectors. But if the incomes policy authority attempts to withhold a large increase on equity grounds (since all wages cannot go up so fast without causing inflation), it is likely to be unsuccessful unless action is also taken to limit the exceptionally high rate of profits. Otherwise, the employees concerned will most probably succeed, in one way or another, in obtaining wage increases exceeding the “norm” laid down in the incomes policy. The outcome will be evident inequity between employees who are, or who are not, in a position to evade the restraint on wages and a consequent undermining of support for the incomes policy.

Thus, an incomes policy authority must face a continual series of challenges arising from the need to reconcile the tendency for incomes to rise more rapidly at certain points in the system than elsewhere, with the necessity of satisfying the public’s concept of an equitable development of incomes. Policymakers must be continually seeking an economically feasible and politically tolerable compromise. The force of the concept of comparative wage justice virtually compels a uniform guideline for wage increases (possibly with somewhat more favorable treatment of the lowest paid workers). But if it is to survive, an arbitration system or incomes policy will have to accommodate any powerful pressures leading to above-norm increases in wages in particular sectors, which would otherwise be satisfied in contravention of the incomes policy. This means that success in achieving a moderate rate of wage increase under a system of coordinated wage fixing will be conditional upon limiting the tendencies leading to above-norm increases in certain sectors and, as far as possible, avoiding situations that encourage rapid wage increases in particular sectors of the economy.

The need for coordination of economic policies

One rather clear implication is that a noninflationary development of wages and salaries is unlikely to be achieved under centralized wage determination if there are sharp reversals of economic policy aimed at securing a rapid recovery of employment in recessions by stimulating particular sectors, notably the construction sector. The successful maintenance of an incomes policy over a period of years will only be feasible within the framework of a wider coordinated economic policy aiming consistently at certain goals—among them, the maintenance of a reasonable degree of price stability. In other words, incomes policy is essentially a supplement to, not a substitute for, sound fiscal and monetary policies; and it requires that the equity considerations necessary for the maintenance of the incomes policy be respected in the formulation of fiscal and monetary policy.

Price-wage policies

One possible strategy, attempted in the United States in recent years, is to require all large enterprises (pacesetters in wage bargaining) to furnish prior notification of price increases and information on profits and to set a ceiling on the average rate of profits. But if this strategy is to be effective as more than just a shock weapon, the system of reporting will require a very large supervisory staff. Moreover, it is liable to impose considerable costs in the form of delays and rigidities in day-to-day business operations and of distortions to take advantage of loopholes in the control system.

An alternative strategy is to make enterprises or industries that grant wage increases in excess of the norm liable to selective price surveillance or control. The authority administering incomes policy may have the power to refer wage claims or pricing policies in particular industries or enterprises to an independent organization for investigation when an important issue relating to the national incomes policy or other questions of national interest is involved. Such an independent body could consider and report on the industry’s economic position, past productivity performance and prospective gains, pricing behavior and scope for price reductions in the industry, and, if necessary, it could suggest methods of enforcing either greater wage or price discipline by government action. The threat of such an investigation, involving adverse publicity and the risk of greater government interference, may serve as a real deterrent to “price gouging” or to the granting of large wage increases in a favorable demand situation. The operation of the United Kingdom’s National Prices and Incomes Board during the 1960s provides a useful precedent here, although its work was not sufficiently integrated into the general management of incomes policy.

Two features of special concern in seeking to limit above-norm wage increases are the wage leadership of sectors of unusually rapid productivity growth and the impact of external price movements.

Wage leadership of sectors with rapidly rising productivity

Industries of rapid productivity growth are usually characterized by large-scale units of production, capital intensity, difficulty of entry for new producers, and high rates of investment based on high gross profit rates (inclusive of depreciation). These same characteristics create a strong bargaining position for labor and encourage the development of strong unions. When rapid productivity growth is brought about by the application of new techniques or the commissioning of new capital, it requires changes in the methods of operation and a work force willing to adopt new methods. In these circumstances there will be a powerful incentive to grant above-norm increases, in order to secure the gains in productivity or to avoid the risk of losses occasioned by shutdowns in highly capital-intensive industries. For the enterprise, “productivity bargaining” presents a means of achieving cost reductions by promoting higher productivity and better industrial relations. The problem of preventing such arrangements from stimulating similar wage increases elsewhere in the economy has not yet been successfully resolved in any incomes policy. Nevertheless, it would appear that the gearing of some above-norm wage increases to changes in work practices is a necessary feature of any system of wage determination and that any lasting incomes policy must seek to find a practicable compromise between the wish to restrain the rise of money incomes in general and the need to permit above-average increases in earnings as a means of securing cost reductions through improvements in productivity.

Newly established, capital-intensive industries pose a particular problem in this context. In many developing countries, one factor that has made it difficult, in recent years, to maintain an undifferentiated rise in all wages more or less in line with the growth of productivity has been the high rate of return in industries such as automobiles, engineering, and oil, where the price level was set by international prices plus tariffs while the level of pay remained lower than that of similar workers in the United States or Europe. The high rate of return in such industries is the result of deliberate government policy to provide inducements for the establishment of new industries in order to foster greater self-sufficiency of the economy. However, it inevitably follows that wage restraint tends to be lax, and the bargaining position of labor in these sectors is exceptionally favorable.

The impact of inflation in other countries

In an open economy, policymakers must expect that there will at times be powerful forces originating abroad, causing price and wage increases in export-competing or import-competing sectors. Insofar as these pressures are not mitigated by other measures, the incomes policy has to accommodate them or collapse. When external prices and wages are rising, the incomes policymakers have to decide not only the maximum rate of increase in prices and wages that should be tolerated but also the minimum rate of increase feasible under the prospective external conditions.

Consider an economy under fixed exchange rates, and with a given institutional framework, i.e., with given conditions regarding the degree of competition or monopoly prevailing in different markets, the extent of unionization, antitrust legislation, government interference with market prices, and so on. In the absence of incomes policy, there will be some natural rate of change in average money wages (occasioned by pressures for pay increases from specific groups of employees) corresponding to each level of aggregate demand and set of external conditions affecting world prices. When full employment is maintained and labor is organized, the natural rate of wage increase will be positive; and it will usually exceed the trend growth of productivity, if export or import prices are rising or if the balance of payments on current account improves sharply when world prices are stable. It may be possible through incomes policy to keep the rate of wage increase below the natural rate. However, the more ambitious the goal with respect to the difference between the natural rate of increase and the rate of increase that is hoped for, the more coercive the incomes policy will need to be with respect to mandatory price and wage controls and sanctions. It will also be necessary to attempt to reduce the natural rate by changing the institutional conditions; by legislation; by other measures to foster greater competition and to limit the monopolistic power of firms and unions; by compelling enterprises to divulge details of profits, wages paid, and pricing policy; or by intervening in the day-to-day operations of specific sectors.

Under fixed exchange rates, a rapid rise in foreign prices will render it next to impossible to maintain a coordinated wages policy. Rising profits in export-competing and import-competing sectors are likely to give rise to above-average wage increases, which will disturb the existing structure of relative pay and will generate a continuing process of cost pressures as other groups of wage earners seek to maintain their position on the pay scale. As the consequent price increases are reflected in a faster rising cost of living, pressure for large wage increases will be perpetuated by efforts to protect real wages from expected price increases. It may be essential, therefore, that any attempt to secure a long-run moderation of cost pressures by implementing a coordinated policy for wages and salaries should be shielded from these disruptive effects of foreign price inflation by allowing the exchange rate to appreciate.

The effectiveness of incomes policy

What Harry Johnson has called “the basic fallacy of incomes policy philosophy, namely the closed economy assumption” was to a large extent responsible for the tendency to write off incomes policy as a failure in the early 1970s. All too frequently the effectiveness of incomes policy was judged by the degree of success in reconciling high employment with price stability within a single economy, without considering the impact of an inflationary external environment.

It is important to recognize the changing context of incomes policy produced by the growing “openness” of the industrial countries. The influence on wage developments of conditions in the international market for industrial goods can be visualized as increasing progressively from the end of World War II until the adoption of flexible exchange rates in 1973.

Not surprisingly, the direct results of incomes policy in restraining the rate of wage and price increase were more apparent in the early postwar period than in later years, when the forces contributing to the international transmission of inflation had become more powerful. The fact that policies then had slight effect in moderating the current rate of inflation, does not, however, preclude the possibility that incomes policy measures commanding some degree of popular support nevertheless had a psychological effect in lessening the build-up of inflationary expectations and conflicts. In some countries the whole climate of income determination dramatically worsened after efforts to achieve an incomes policy were abandoned; and this does not seem to have been only the result of pent-up pressures accumulated while the price/wage policies were in force.

It would appear that the long-run benefits derived from popularly supported measures of incomes policy consists of not only the moderation of the rate of inflation that may be achieved but also the contribution that the existence of the policy can make to the smoother working of the political and economic system. With the current rapid rates of price increase, there is a growing realization of the need for incomes policy to lessen the threat which severe inflation poses to the political and economic institutions of the industrial world.

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