United Kingdom
Selected Issues
Author: International Monetary Fund
Publication Date:
02 Aug 2001
eISBN:
9781451981445
Language:
English
Keywords:
ISCR; CR; wage; appreciation; sterling; exchange rate; earnings inequality; mean wage; wage pressure; employment growth; hourly wage; Employment; Labor markets; Wage adjustments; aggregate wage distribution
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This Selected Issues paper analyzes the specialty about the cyclical expansion in the United Kingdom. The paper reviews the labor market data, wage inequality, and implications for inequality. The study examines the contributions of information and communications technologies investment to output and labor productivity growth in the United Kingdom. The paper provides a qualitative assessment of the impact of the appreciation of sterling on U.K. foreign trade, and its effects on competitiveness, and the sectoral composition of production.

Abstract

This Selected Issues paper analyzes the specialty about the cyclical expansion in the United Kingdom. The paper reviews the labor market data, wage inequality, and implications for inequality. The study examines the contributions of information and communications technologies investment to output and labor productivity growth in the United Kingdom. The paper provides a qualitative assessment of the impact of the appreciation of sterling on U.K. foreign trade, and its effects on competitiveness, and the sectoral composition of production.

United Kingdom: Basic Data

article image
Source: Office for National Statistics; and staff estimates.

September - November 2000.

December 2000.

Fiscal year beginning April 1.

Includes 2.4 percentage points of GDP in 2000/01 corresponding to the auction proceeds of spectrum licenses.

January - September 2000.

January - November 2000.

I. WHATt’S SO SPECIAL ABOUT THIS CYCLICAL EXPANSION IN THE UNITED KINGDOM?

A NEW PERSPECTIVE FROM LABOR MARKET DATA*

A. Introduction

1. During the latter half of the 1990s, the U. K. economy has been characterized by strong employment growth, low unemployment and high employment rates, and, despite the apparently advanced stage of the business cycle, relatively moderate growth in real wages. In an attempt to shed light on these developments, this paper explores recent labor market developments using micro data from the New Earnings Survey (NES).

2. Micro data (at the level of individual workers) have the potential to reveal patterns in the evolutions of employment and wages that could be masked in aggregate data. In addition, such data can be used to study composition effects that could make aggregate data misleading in certain respects. For instance, cyclical changes in the skill composition of employment could result in measures of average wages and average labor productivity being severely biased as measures of the returns to a given unit of labor input or the output per unit of labor input, respectively.1 Similar biases could result from changes in the sectoral and regional compositions of output.

3. In addition, such micro data could also shed light on differences in wage and employment developments across occupational groups, industries and regions. Using disaggregated data could be important for understanding asymmetries in labor market outcomes across these different dimensions and their potential macroeconomic implications.

4. The results reported in this paper paint a sanguine picture of labor market developments in the United Kingdom. Employment growth has been as strong for workers in high-skill (and high-wage) occupations as it has among lower-skill occupations, indicating that employment growth has been broad-based. This also implies that skill-composition biases in aggregate measures of average wages have not been significant. There is some evidence, however, that sectoral composition effects could be more important and could imply a slight downward bias in aggregate measures of average real wage growth. Overall, the analysis of composition effects does not reveal much evidence of underlying wage pressures that could be latent in the aggregate data. In addition, measures of average weekly hours and overtime hours, which tend to be leading indicators of the business cycle, show few hints of potential inflationary risks arising from labor market tightness. The implications of these results are discussed in the concluding section of the paper.

5. A striking phenomenon of the U.K. labor market over the last two decades, as in many other industrial countries, is the increasing influence of women in terms of labor force participation and employment. This paper also examines the quantitative importance of this phenomenon and its implications for the evolution of wage and earnings inequality and other aspects of labor market performance.

6. Another feature of the U.K. economy in the mid–1990s is that, despite sustained and historically high levels of investment in physical capital, labor productivity growth has remained muted (and so has TFP growth), even by the U.K.’s own historical standards. In the final section, this paper ventures an explanation that attempts to reconcile these and other stylized facts in both the microeconomic and macroeconomic dimensions. The explanation relies on the favorable effects resulting from the interactions of the labor market reforms of the last two decades and the stable and supportive macroeconomic policy environment that has characterized the period since the mid–1990s. If true, this explanation suggests a more benign outlook for labor productivity growth in the near future.

B. The Dataset

7. The New Earnings Survey (NES) is an annual survey that covers roughly one percent of all employed persons in the United Kingdom. It is conducted by the U.K. Office of National Statistics (ONS) in April of each year. The sampling frame is derived from the National Insurance records and, through their income tax records, information on employed persons from that sample are then obtained from their employers. Although worker characteristics other than gender and age are not available in the survey, it does contain a great deal of reliable information about earnings and hours as well as various occupational characteristics.

8. The NES has a panel element but, given problems with sample attrition over time and given the purposes of this study, the data are treated here as a set of repeated cross-sections. Since panel attrition could be systematically correlated with certain worker characteristics, this cross-sectional approach is also helpful for maintaining the representativeness of the sample, which is important for the analysis in this paper.

9. Note that, by construction, the NES does not contain any information on non-employed persons, so it can not be used to examine changes in labor force participation or other aspects of labor supply. In addition, since employers are traced through workers’ income tax records, the NES undersamples individuals whose earnings fall below the income tax threshold. Nevertheless, the NES remains the most reliable source of information on earnings and occupational characteristics that are relevant for the analysis conducted here.2

10. The analysis in this paper is based on NES data for the period 1975–99. Nominal variables such as hourly wages and weekly earnings are deflated by the RPI.3 The NES also provides very detailed information on industry and region of occupation and occupational classification. Various categories have been aggregated in each of these dimensions in order to present the data more concisely and also to ensure consistency over time in the classifications (which are not constant over the entire sample).

11. The ONS also conducts the Labor Force Survey (LFS), a quarterly survey of actual and potential labor force participants. This survey provides more detailed information on education levels and other attributes of individual workers. The LFS also contains information on earnings, hours and occupational characteristics, but these data are subject to recall bias and are considered much less reliable than the corresponding data in the NES. However, the ONS grosses up LFS survey data to match the U.K. population in many respects, thereby providing a more accurate picture of trends in labor force participation, unemployment and employment. Hence, although LFS micro data are not used in this paper, time series data from that survey (available through the ONS website) are used in some of the analysis below.

C. Basic Facts

12. To begin with, an overview of the main features of the labor market that can be gleaned from this dataset. Figure 1 shows the evolution of two measures of the returns to labor—the (real) hourly wage and (real) weekly earnings. The hourly wage measure is a more appropriate measure of labor input but weekly earnings subsume information about variations in weekly hours as well. The top panels, which show means and medians for the full sample, suggest an increase in wage inequality led by the upper half of the distribution as the mean has grown more over the entire sample than the median, using either measure of labor compensation. The lower panels plot annual growth in wages and earnings. An interesting feature is that both wage and earnings growth have remained moderate during the recent cyclical recovery and, despite an increase in 1999, have remained well below the higher levels seen in the mid–1980s and, occasionally, in the 1970s and early 1980s. Figure 2, constructed using LFS data, confirms that wage growth has actually declined in 2000 and that this is true of all of the main sectors of the economy.

Figure 1.
Figure 1.

United Kingdom: Evolution of Wages and Earnings

Citation: IMF Staff Country Reports 2001, 124; 10.5089/9781451981445.002.A001

Figure 2.
Figure 2.

Employment and Real Wage Growth

Citation: IMF Staff Country Reports 2001, 124; 10.5089/9781451981445.002.A001

Source: United Kingdom National Statistical Office, Labor Force Survey.1/ Four-quarter percent changes, seasonally adjusted.

Wage Inequality

13. Many authors have pointed to the labor market reforms of the 1980s and early 1990s as being likely to have had a salutary but delayed effect on labor market performance. One measure of labor market “flexibility” is the ability of the wage structure to respond to changes in the relative demands for workers of different skill levels and to industry-and region-specific shocks. Under certain conditions, the evolution of wage inequality can provide some hints about this aspect of flexibility in the labor market.

14. Wage inequality has risen quite substantially in the ILK. over the last 25 years.4 Figure 3 (top left panel) shows that the 90/10 percentile differential for the hourly wage has increased quite sharply from 1975 to 1999. The 75/25 percentile differential shows a more modest increase, suggesting that much of the increase in overall wage inequality has come from the top and bottom parts of the distribution rather the middle. The two lower panels indicate that within-group inequality among major occupational groups has trended upward in a manner very similar to the overall increase in inequality.

Figure 3.
Figure 3.

United Kingdom: Percentile Differentials for Hourly Wages

Citation: IMF Staff Country Reports 2001, 124; 10.5089/9781451981445.002.A001

15. The top right panel of Figure 3 shows that between-group inequality has also followed a similar pattern across broad occupational groups.5 In addition, the regional and inter-industry dispersion of wages have increased modestly. These results are similar to those for the United States, where both within- and between-group inequality have risen sharply in the last three decades.

16. Figure 4 provides a different perspective by plotting the change in log wages at different points of the aggregate wage distribution. The top left panel shows that wage growth was significantly higher at the top percentiles of the distribution than at the lower percentiles. An interesting point to note, however, is that cumulative wage growth from 1975–99 was only about 50 percent lower for the bottom percentiles compared to the top percentiles of the distribution. This is in sharp contrast to the experience of the United States, where the differences are more stark. In fact, in the United States, real wage growth at the lower percentiles of the distribution has actually been negative for most of the last two decades (see Juhn, Murphy and Pierce, 1993). The other panels of this figure break down the total log wage changes into changes over each of the three decades covered by the dataset. The dispersion of wages appears to have risen most sharply in the 1980s; the increase in the 1990s is significant but more moderate.

Figure 4.
Figure 4.

United Kingdom: Wages Growth Across Percentiles, All

Citation: IMF Staff Country Reports 2001, 124; 10.5089/9781451981445.002.A001

17. Figures 5 and 6, which show similar plots separately for men and women show that wage inequality has risen more for men than it has for women. The pattern of the sharpest increases in wage dispersion occurring in the 1980s is, however, true for both groups. The top panel of Table 1 presents (3-year averages off) percentile differentials of log wages for the full economy, as well as for men and women separately.6 One interesting aspect is that the increase in overall wage inequality is much lower than the increase among men or women. For instance, the change in the 90/10 differential from 1976 to 1998 is 0.39 for men, 0.30 for women, but only 0.28 overall. Changes in the corresponding 75–25 differentials are 0.24 (men), 0.20 (women) and 0.18 (all). This set of results has some interesting implications that are discussed in more detail in the next sub-section.

Figure 5.
Figure 5.

United Kingdom: Wage Growth Across Percentiles, Women

Citation: IMF Staff Country Reports 2001, 124; 10.5089/9781451981445.002.A001

Figure 6.
Figure 6.

United Kingdom: Wage Growth Across Percentiles, Men

Citation: IMF Staff Country Reports 2001, 124; 10.5089/9781451981445.002.A001

Table 1.

Wage Inequality in the United Kingdom

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Notes: Differentials of log hourly wages; 3-year averages centered on years shown. Wage residuals are from regressions of wages on sectoral and occupational dummies (and gender dummy, where appropriate). Maximal standard error for differentials shown above is 0.01.

18. One important question when analyzing changes in wage inequality is whether the changes are attributable to within- or between-group changes in inequality. A formal approach to get at this is to run annual regressions of individual wages on observable group attributes, thereby controlling for between-group variation, and to interpret inequality of the wage residuals as capturing within-group inequality.7 Percentile differentials of (log) hourly wage residuals are shown in the lower panel of Table 1. Within-group inequality clearly accounts for most of overall wage inequality. Interestingly, however, it appears that the changes in within-group inequality are markedly lower for women than for men. In other words, changes in the dispersion of occupational characteristics and/or sectoral preferences of employed women appear to account for much of the change in wage inequality among women. An analysis of this finding is left for future research.

19. Given the exalted status of the U.S. labor market as the standard that all other labor markets are measured by, the similarity (although not quite in degree) of the increases in wage inequality in the United States and the United Kingdom suggests that the United Kingdom has a rather “flexible” labor market. By itself, however, the increase in wage inequality or wage dispersion merits no such approbation. What matters is the joint outcome in terms of both quantities (employment) and prices (wages).8

20. On this metric, the U.K. labor market does in fact come out well since the increase in wage inequality has coincided with a strong employment performance, with employment ratios increasing for all skill levels and independent of observed skill attributes. Thus, there is reason to believe that the non-inflationary growth experienced in recent years might be the fruit of the labor market reforms undertaken in earlier years. This issue is discussed at greater length in the concluding section.

Women and the Labor Market

21. One feature noted above is that women appear to have had a significant influence on the overall wage distribution. Indeed, as in many other industrial countries, the share of U.K. women in total employment and in the labor force has increased markedly since the 1970s. Figure 7, based on LFS data, shows that employment and participation rates for women have continued to increase during the 1990s. The contributions of these changes to overall labor market developments, including changes in wage inequality, could have important policy implications. This sub-section presents some preliminary, yet fascinating, evidence on this subject.

Figure 7.
Figure 7.

Labor Force Status by Gender

Citation: IMF Staff Country Reports 2001, 124; 10.5089/9781451981445.002.A001

Source: United Kingdom National Statistical Office, Labor Force Survey.1/Ratios are for men aged 16-64 and women aged 16-59.

22. To visually examine changes in the wage distributions for men and women and their joint effects on the overall wage distribution, this chapter now turns to an examination of kernel density estimates (which are essentially smoothed histograms) of these distributions. Figure 8 shows, for selected years, kernel density estimates of the overall wage distribution and also those for men and women separately, with the latter distributions weighted by the respective shares of men and women in the total sample for each year.9 The striking conclusion from this set of plots is that the wage distributions for men and women have converged markedly over time, thereby partly diminishing the effects of rising within-group inequality on overall wage inequality. The relative importance of women in determining the shape of the overall distribution has clearly risen sharply over the last two decades.10 Figure 9, which shows a similar set of plots but restricted to full-time workers shows a similar phenomenon of convergence of wage distributions for men and women. The increase in the relative importance of women as a proportion of full-time employment is smaller than in the case of total employment, but is nevertheless quantitatively very important.

Figure 8.
Figure 8.

United Kingdom: Kernel Density Estimates, All

Citation: IMF Staff Country Reports 2001, 124; 10.5089/9781451981445.002.A001

Figure 9.
Figure 9.

United Kingdom: Kernel Density Estimates, Full-Time Workers

Citation: IMF Staff Country Reports 2001, 124; 10.5089/9781451981445.002.A001

23. In short, as this evidence suggests, more careful analysis of the determinants of participation decisions and occupational choices of women could be very important for understanding and interpreting aggregate labor market developments.

Developments in Weekly and Overtime Hours And Implications for Inequality

24. An important barometer of labor market tightness is the behavior of average weekly hours. Since employers find it easier to adjust labor input at the intensive margin (hours) rather than the extensive margin (employment) in the short run, hours tend to lead or be coincident with the business cycle in most industrial countries. Again, rather remarkably, both total hours and overtime hours have, if anything, declined moderately since 1995 (Figure 10). Although there is a secular decline in the total hours variable, the absence of an increase in this measure during a period of relatively strong output and employment growth is striking. Detrended measures of total and overtime hours, shown in the lower panels of Figure 10, confirm the typically procyclical behavior of these variables, with the current expansion providing a striking contrast. Figure 11, which shows hours broken down by gender and, in the lower panels, limited further to full-time workers, is consistent with this picture. One minor exception is that weekly hours for full-time women did rise marginally in the mid–1990s and stayed flat since then.

Figure 10.
Figure 10.

United Kingdom: Average Weekly Hours—Total and Overtime

Citation: IMF Staff Country Reports 2001, 124; 10.5089/9781451981445.002.A001

Figure 11.
Figure 11.

United Kingdom: Average Weekly Hours by Gender

Citation: IMF Staff Country Reports 2001, 124; 10.5089/9781451981445.002.A001

25. A possible explanation for the atypical nature of labor input adjustment in the second half of the 1990s is that it reflects a permanent rather than temporary shock to productivity. If employers interpreted it as such, they would tend to increase employment rather than hours as they tried to adjust factor inputs to their optimal levels.11 But is this consistent with the low rate of productivity growth observed in the latter half of the 1990s? This issue is taken up in greater detail in the concluding section of the paper.

26. It is also useful to examine if changes in patterns of hours worked have influenced the evolution of labor earnings inequality. Systematic differences in weekly hours worked by workers at different points of the wage distribution could either exacerbate or dampen the dispersion of weekly earnings relative to hourly wages. For instance, it is possible that high-wage workers tend to work (and get paid for) more hours per week than low-wage workers. This would imply that wage inequality is a downward-biased measure of earnings inequality.12

27. The annual cross-sectional variance of weekly earnings can be decomposed as follows (all variables in logarithms):

Var (Earnings) = Var (Hourly Wages) + Var (Weekly Hours) + 2 Cov (Wages, Hours)

Figure 12 shows this decomposition for each year over the period 1975–99. For full-time workers (lower left panel), the variances of weekly earnings and hourly wages move very closely together, with the variance of hours worked and the covariance component being very small and roughly off-setting each other. The same pattern holds for the samples of men and women who are employed full time. Interestingly, when all women are taken together, the variance of weekly hours is much larger. This can be seen in the top right panel of the figure. For this group, the covariance component is positive and rises slightly over the full sample. Thus, the increase in earnings inequality among all women is slightly greater than the increase in wage inequality. However, the basic time profile of changes in inequality for this group, and for all workers taken together (top left panel), is essentially the same, irrespective of whether the wage or earnings measure is used.

Figure 12.
Figure 12.

United Kingdom: Variance Decomposition for Earnings

Citation: IMF Staff Country Reports 2001, 124; 10.5089/9781451981445.002.A001

D. A Disaggregated Perspective

28. The analysis in the previous section is suggestive of a reasonably well-functioning labor market. But, before assessing the economy’s potential for further non-inflationary employment growth, it is important to examine disaggregated data on different dimensions to look for demons that might be lurking behind the veil of the aggregate data. In particular, there is the possibility that aggregate measures of wage growth could be misleading if there were major compositional changes in the structure of employment. For instance, it is typically the case that employment of unskilled workers tends to be more procyclical than that of skilled workers. In other words, at the margin, relatively more unskilled workers are hired during expansions while more of them are laid off in recessions.13 This could result in a smaller apparent growth in average wages (because unskilled workers tend to have lower wages), which would be smaller than wage growth of each group independently or the growth rate of a composition-corrected measure of average wages.

29. Similar effects could result from shifts in the composition of employment from high-wage to low-wage sectors. One must, of course, be careful in interpreting the general equilibrium effects of such shifts but, even as a simple accounting matter, these shifts could have interesting implications for policy. A simple descriptive approach is to examine the evolution of employment shares and wage levels for groups classified on the basis of different occupational characteristics.

30. Figure 13 plots the shares in employment and aggregate hours (employment*weekIy hours) of four broad occupational groups over the period 1991–99. The share of managers, professional and technical workers in both employment and aggregate hours has increased significantly during the 1990s. The employment share of unskilled non-manual workers, primarily reflecting the increase in low-level service sector employment, also rose moderately over this period. The employment shares of both skilled and unskilled manual workers have fallen since 1991, reflecting changes in the structure of production in the economy and the secular decline in manufacturing sector employment. The shares of total hours reveal a pattern similar to that of employment for each group.

Figure 13.
Figure 13.

United Kingdom: Employment and Earnings by Occupation Group

Citation: IMF Staff Country Reports 2001, 124; 10.5089/9781451981445.002.A001

31. Interestingly, the group of managers, professional and technical workers also had the largest wage and earnings increases over this period, reflecting the increase in the relative demand for high-skill workers with technical skills. Further, given that this group had significant increases in both employment and real wages in the 1990s, employment growth during the current expansion has evidently not been built solely on low-level service sector jobs.

32. Figure 14 shows that, overall, the share of the broadly-defined service sector in total employment increased from 1991 to 1999, while those of other sectors declined or stayed flat.14 Although the average hourly wage in the services sector is not that different from that of other private sector industries, weekly earnings are significantly lower in services than in other sectors, possibly reflecting the existence of more part-time employment in this sector. This suggests that the reallocation of labor from other sectors to services could impart a downward bias at least to average measures of earnings growth. The next section of the paper explores this issue in greater detail.

Figure 14.
Figure 14.

United Kingdom: Employment and Earnings by Industry Group

Citation: IMF Staff Country Reports 2001, 124; 10.5089/9781451981445.002.A001

33. Figure 15 plots regional shares of employment and total hours for the period 1991–99 using a broad classification of regions into 4 groups.15 These shares have stayed relatively stable during the recent expansion, indicating that the expansion has had relatively symmetric effects on employment growth across these broadly-defined regions. Wage and earnings growth in these regions have also followed a roughly similar pattern in recent years although, in terms of wage and earnings levels, workers in London, the South East and the South West appear to do a great deal better. This presumably reflects the fact that higher-wage industries are located in those regions.

Figure 15.
Figure 15.

United Kingdom: Employment and Earnings by Region

Citation: IMF Staff Country Reports 2001, 124; 10.5089/9781451981445.002.A001

E. Composition Effects

34. This section presents a more formal analysis of composition effects on measured wage growth. For the analysis of composition effects during the current expansion, 1992 is chosen as the base year since that is widely regarded as the most recent cyclical trough. A brief description of the methodology (which is fairly standard in the literature) follows.

35. Let s denote the employment share of a skill group and let W be the average hourly wage for a skill group, with i being the index for skill group and t denoting the year. The aggregate average wage at time t, W¯t is then given by

Σi sitw it

36. As an accounting matter, one can ask how much of the change in the average wage over time is due to changes in group-specific wages and how much is attributable to changes in the employment shares of different groups.16 In other words, one can isolate the effects of changes in employment shares by calculating a measure of the average wage that strips out these effects. This is done by constructing a new average wage measure holding fixed the skill-group weights at their levels in the base period:

Σi siow it

37. This measure provides a composition-adjusted measure of changes in the average wage. A similar measure can be constructed on the basis of any group characteristic, including industry and region.

38. This framework is now used to look at composition effects of changes in the relative employment shares of different skill groups, based on occupational classifications. One additional factor that needs to be taken into consideration is that changes in employment may not accurately reflect changes in labor input since weekly hours worked could systematically vary across different groups. To account for this, total hours worked were calculated for each group and these were used to create measures of relative shares of total labor input.

39. Figure 16A (top left panel) shows the mean hourly wage and a composition-adjusted measure of the mean wage. The adjusted measure is constructed by holding fixed the employment shares of different occupational groups at their 1992 levels. Interestingly, the composition-adjusted mean wage (indexed to 100 in 1992) is at a lower level in 1999 than the unadjusted mean wage. In other words, consistent with the results of the previous section, it appears that there has been a shift in labor inputs towards high-wage occupations during this recovery. This suggests that, if anything, wage pressures are more muted than suggested by the aggregate data. The top right panel of this figure, which plots growth rates of the raw averages and composition-adjusted measures, tells a similar story and indicates that the evolution of both measures has been similar since the mid–1990s.

Figure 16A.
Figure 16A.

United Kingdom: Composition Effects: Wages

Citation: IMF Staff Country Reports 2001, 124; 10.5089/9781451981445.002.A001

40. The next two panels of Figure 16A look at industry composition effects. Consistent with the descriptive analysis in the previous section, it appears that there has been a relative increase in the labor input (and employment) shares of low-wage industries. Consequently, the mean wage, which doesn’t control for these changes, is a downward-biased measure of the composition-adjusted mean wage. The economic magnitude of this bias is, however, quite small and, as shown by the growth rates of the two measures, not crucial for understanding wage growth in the mid–1990s.

41. The last two panels of this figure show the effects of changes in the regional composition of labor inputs. As in the case of the industry results, the downward bias in the unadjusted mean wage relative to the composition-adjusted mean wage is quite small.

42. Figure 16B repeats the analysis for weekly earnings. For this part of the analysis, the adjustment is for relative employment (rather than labor input) shares. The differences compared to the results for the hourly wage are small. The only significant difference is the larger downward bias in unadjusted mean earnings when compared with a measure that adjusts for changes in the inter-industry composition of employment (middle panel).

Figure 16B.
Figure 16B.

United Kingdom: Composition Effects Earnings

Citation: IMF Staff Country Reports 2001, 124; 10.5089/9781451981445.002.A001

43. Extending the decomposition analysis, the total change in mean wages (or earnings) can be split into components attributable to within-group mean wage changes and to changes in the employment or labor input shares of different groups. Using the notation described above, one can write this arithmetical decomposition as follows:

ΔW¯=ΣiΔSi·Wi0+ΣiΔWi·Si0

44. The results of this decomposition, for the total change in mean hourly wages and mean earnings from 1992 to 1999, are shown in Table 2. It is clear that a substantial fraction of the change in mean wages is attributable to changes in within-group mean wages, irrespective of whether these groups are defined on the basis of occupational classification, industry or region. Similar results are obtained with the weekly earnings measure. This confirms the graphical analysis showing that composition effects have had little effect on measurements of mean changes in labor compensation during this expansion.

Table 2.

Decomposition of Real Wage Growth

article image
Notes: The first column shows the total percentage change in the mean real wage from 1992 to 1999. The second column shows the change in the mean real wage resulting from the chansge in within-group mean real wages, holding fixed the employment (or labor input) shares of each group at its 1992 levels.

F. Discussion

45. The stylized facts presented in this paper do not provide any indication of imminent or latent wage pressures in the U.K. economy. Quantity measures of labor demand such as average and overtime hours show little evidence of constraints on labor input growth. Nor do measures of wage growth, even those that account for changes in the skill or industry composition of employment, show much evidence of labor market tightness. In short, it is difficult to detect evidence of clouds gathering on the horizon.

46. And yet, the ointment is not without its proverbial fly. One troubling feature of the current expansion is that, after strong growth in the first half of the 1990s, labor productivity has since risen at anemic rates. In fact, if one considers labor input measures adjusted for compositional changes in skill levels of employed workers, labor productivity growth during the latter half of the 1990s was, if anything, marginally lower than suggested by unadjusted measures. And this despite the remarkable and sustained surge in business fixed investment since the mid–1990s.

47. One way of reconciling at least some of these facts is to argue that the surge in investment can be explained by the decline in the relative price of capital. Indeed, this relative price decline is particularly striking in the context of information and communication technology (ICT) related capital goods.17 Given capital-skill complementarity, this would imply an increase in the demand for skilled labor. The labor supply response resulting from labor market reforms over the last two decades would, however, have held down the wage growth, both in absolute and relative terms, that would otherwise have resulted from this shift in labor demand. This interpretation of the data suggests a shift in relative factor proportions in the aggregate production function but with few obvious implications for productivity growth in the future.

48. An alternative story that could account for the stylized facts described in this paper is that employers are responding to a permanent country-specific shock.18 Consequently, their desired levels of capital and other inputs, including labor, would have increased. Given capital-skill complementarity, employment levels for skilled workers would be expected to continue rising at a relatively faster rate. This would also be consistent with the high rates of business fixed investment observed recently, particularly since the mid–1990s. The permanent productivity shock interpretation would also explain the employment growth in the mid–1990s that has coincided with little change in average hours or overtime work. In response to such a shock, employers would have an incentive to adjust labor inputs at the extensive margin (employment) rather than at the intensive margin (hours).

49. During the transition to a new steady state with a larger scale of production, however, labor productivity growth rates could be temporarily lower if there were significant costs to adjusting the scale of production.19 Indeed, further support for this notion comes from the marked change in production structures implied by the fact that the recent surge in investment has been largely concentrated in ICT goods. In addition to traditional time-to-build considerations, time-to-learn factors could also be important as workers and firms adapt to the new technologies. A production structure that formalizes the notion of adjustment costs and also builds in capital-skill complementarity (necessary to explain the increase in the relative wage and relative employment share of skilled workers) is presented in the appendix.

50. But, as noted above, increases in employment rates across all categories of workers without commensurate wage growth suggests that other forces are at work. In particular, the labor market reforms introduced in the 1980s, by reducing the bargaining powers of unions and by eliciting strong labor supply responses by increasing the incentives for acquiring and maintaining employment, may have played an important role. These labor market reforms were reinforced by additional policy measures during the 1990s. There is a fairly extensive literature arguing that major reforms affect the functioning of labor markets only with a significant lag. Furthermore, a more recent literature has argued that a favorable macroeconomic environment is required for the full effects of the labor market reforms to blossom forth.20 Thus, the persistence of non-inflationary growth in the United Kingdom may be the result of a fortuitous interaction of earlier labor market reforms and favorable macroeconomic shocks. In fact, the effects of such an interaction, which results from a set of circumstances particular to the United Kingdom, might in fact constitute the country-specific “shock” that this story relies on.

51. Is there evidence that the labor market reforms instituted over the last two decades could have had a delayed effect of the sort posited here? The volume edited by Ray Barrell (1994) provides an interesting set of perspectives in this context. For instance, in their contribution, Blanchflower and Freeman conclude that “…the Thatcher reforms succeeded in reducing union power and increasing the incentive to work—and may have increased the responsiveness of wages and employment at the micro level.” But “…there is no strong evidence that the British labor market experienced a deep microeconomic change.” They mention the possibility that more time might be required for the reforms to have their full effects and note skeptically “Just wait until the mid–1990s, and we will all be praising the labor market reforms for setting the precondition for the British economic miracle.” Minford and Riley observe that “…micro problems have been substantially diminished by the supply-side reforms of the 1980s…” and conclude more optimistically that “…we see promising scope for bringing unemployment down sharply without risks of re-igniting inflation.”

52. In short, the favorable macroeconomic performance of the U.K. economy in the mid to late 1990s might in fact have served as the catalyst for the effects of the labor market reforms to blossom forth. Under at least one interpretation of the U.K. data suggested here, significant gains in labor productivity are likely in the next few years. Indeed, the pickup in labor productivity growth in 1999–2000 is consistent with this interpretation. Whether this increase in labor productivity growth will be sustained and validate this story remains to be seen. It should also be noted that a pickup relative to the second half of the 1990s would still imply a fairly moderate rate of labor productivity (and TFP) growth, perhaps only to the trend level witnessed after the productivity slowdown in the 1970s. This would still leave productivity growth rates (and levels) in the United Kingdom well below those of most other industrial countries.

53. Thus, for a more sustained and durable increase in productivity, more fundamental reforms to the education and training system to improve both the general and technical skills of the workforce are required. In addition, although the labor market reforms of the last two decades have created a well-functioning labor market, residual concerns like the declining participation rates for men (especially low-skilled men) need to be addressed.

Appendix I: A Production Function with Capital-Skill Complementarity

54. This appendix describes a production structure that allows for capital-skill complementarity and formalizes the notions discussed in the concluding section of the paper on the relationship between the rate of capital accumulation and measured labor productivity growth.21

55. Krusell et al. (2000) propose the following production function with four inputs—capital structures, capital equipment, skilled labor and unskilled labor.22 The production function is Cobb-Douglas over capital structures (Ks) and a constant elasticity of substitution (CES) aggregate of the three remaining inputs. The specification they find to be consistent with U.S. data is as follows:

F(Tt,Kst,Ket,Ut,St)TtKstDPUtv(1⁢     P)(OKetU(1⁢      O)StU⁢VU|1⁢ασ(A1)

56. The parameters a and p determine the elasticities of substitution among capital equipment (Ke), skilled labor (S) and unskilled labor (U). This production function is also flexible enough to incorporate changes in relative efficiency of different skill categories. Inputs of skilled and unskilled labor may be considered as the products of aggregate hours (h;) and an efficiency index (Ψi), where i is an index for skill type. Exogenous factor neutral productivity is represented by θt.

57. There are a couple of reasons for splitting capital into two types. First, the phenomenon of capital deepening in many industrial economies in recent years is largely attributable to equipment investment (including computers) rather than investment in structures. Second, it is not obvious that skilled and unskilled labor would have different degrees of substitutability with structures, while differences in substitutability with capital equipment are more plausible.

58. Note that this production function specification implies that the elasticity of substitution between equipment and unskilled labor is the same as that between skilled and unskilled labor. This restriction follows from the symmetry property of the CES aggregation and is consistent with empirical estimates of these elasticities. The elasticity of substitution between capital equipment and unskilled labor is l/(l-σ) and that between capital and skilled labor is 1/(1-ρ). Hence, setting σ > ρ implies capital-skill complementarity.

59. The notion of adjustment costs could be most relevant for equipment investment in the second half of the 1990s. In particular, the surge in investment in information and communication technologies (ICT) during this period has been enormous and unprecedented. Indeed, as shown in another paper in this volume23, this increase could be even larger, in real terms, at correctly measured prices. In addition to standard time-to-build considerations, the adjustment costs at such high levels of investment could be rationalized on a number of grounds. As firms change the nature of their production processes and their mix of different vintages of capital, there could be significant lags in optimizing production processes. In addition, the use of new high-tech capital could imply higher depreciation and obsolescence rates for older vintages of equipment. Further, there could be a substantial lag in training even relatively-skilled workers in the use of new capital goods.

60. In terms of modeling, these adjustment costs could easily be added to the production function as a quadratic of the change in the stock of equipment investment. This would yield a modified version of equation (Al):

F(θt,Kst,Ket,Ut,St)=θtKstα[μUtσ+(1-μ)(λKetρ)+(1-λ)Stρ)σρ]1-ασ(A2)-d2(Ket-Ket-1)2

61. This modification would not add any state variables to the model; hence, calibrating and simulating such a model would impose no additional computational constraints. Intuitively, it is clear that periods with high levels of equipment investment would then have lower levels of output and labor productivity, compared to a steady state with a higher level of equipment capital. In other words, the transition path to a new steady state with higher productivity (both in terms of labor productivity and TFP) might in fact be one with lower measured productivity growth.

References

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*

This chapter was prepared by Eswar Prasad (Research Department).

1

See Prasad (1996) for a review of the empirical literature and a discussion of the implications of this type of aggregation bias for matching moments from theoretical models to moments of actual data. Using U. K. data, Blundell, Reed and Stoker (1999) argue that composition effects arising from endogenous labor force participation decisions create an additional source of bias.

2

See Dickens (2000) for more details on the NES dataset and for a comparison of this dataset with Labour Force Survey data on low-wage workers.

3

The use of the RPI-X or the private consumption deflator made little difference to the results reported in this paper.

4

Note that, since the dataset used in this paper ends in 1999, this analysis may not fully capture the effects of the National Minimum Wage (which was introduced in April 1999) on wage inequality. There is some evidence that, in 2000, hourly wage rates of workers in the bottom decile of the bottom decile of the wage distribution rose significantly faster than those of workers in the top decile.

5

The downward level shift after 1991 in between-group inequality across occupational groups is the artifact of a change in occupational coding that occurred in that year. It has not yet been possible to consistently match the pre- and post–1991 occupational codes. This does not affect any of the results shown below that are restricted to the post–1990 period.

6

To abstract from year-to-year variation, the percentile differentials reported in this table are 3-year averages, centered on the years shown.

7

This approach was popularized by Juhn, Murphy and Pierce (1993). Using this technique, these authors show that, in the U.S., both within- and between-group inequality rose sharply among men during the 1980s.

8

See Prasad (2000) for more discussion of this point and for an interesting contrast provided by the German experience.

9

This weighting procedure is similar to that employed by Fortin and Lemieux (2000). The kernel density estimates for log hourly wages were computed using an Epanechnikov kernel with bandwidth set to 0.05. These density estimates were also computed using optimal bandwidths computed separately for each year—these bandwidths were typically in the range of 0.04–0.06. Using optimal bandwidths had little effect on the shape of the distributions. The use of a fixed bandwidth is solely to maintain consistency when comparing distributions across different years.

10

Fortin and Lemieux (2000) document a similar phenomenon in the U.S. They argue that this reconciles two findings. One is that male wage inequality has increased sharply in the U.S. in the 1980s and, although at a slower rate, also in the 1990s, with both within- and between-group inequality among men contributing to this increase (see, e.g., Juhn, Murphy and Pierce, 1993). The second result, documented by Lee (1999), is that the overall wage distribution in the U.S., including both men and women, was in fact quite stable in the 1980s and 1990s once the effects of the decline in the real value of the minimum wage are excluded.

11

Arguably, even in the case of a permanent shock, hours would be adjusted before, or in tandem with, employment. However, the discussion later in the paper notes that capital accumulation is a relatively slow process. Hence, there would be little incentive, given the gradual increase in the requirement of labor inputs in concert with slow changes in the scale of production, to adjust labor at the intensive margin.

12

In addition, the dispersion of annual earnings could differ from that of monthly earnings. However, the NES does not have information on annual earnings (or on the number of months of employment per year).

13

A variety of human capital and implicit contracting theories have been developed to explain this stylized fact. Keane and Prasad (1993) review this literature and provide some empirical evidence for the United State on the cyclical variability of employment, hours and wages for workers of different skill types.

14

This 4-group classification is based on 1 -digit industry codes as follows: Manufacturing (metal manufacturing; textiles, leather, clothing; other manufacturing); Construction, utilities and transportation (construction; gas, electricity and water; transport and communications); Services (retail and wholesale trade; financial and professional services; other services). Excluded from this classification are agriculture, forestry and fishing; mining and quarrying; and food, drink and tobacco. Together, these 3 industries account for only about 6 percent of total employment during the 1990s.

15

This 4-group classification is based on regional codes as follows: North (North East, North West, Merseyside); Midlands, Eastern (East Midlands, West Midlands, Eastern); London, South (London, South East, South West); and Wales and Scotland.

16

As emphasized earlier, the exercise conducted here is purely an accounting one and sets aside some general equilibrium considerations. Changes in the observed levels of employment and wages for different skill groups are the result of shifts in relative demands and supplies for different types of labor. The sort of conditional exercise conducted here ignores behavioral responses of workers and firms to these shifts.

17

See the paper “The ’New Economy’ in the United Kingdom” in this volume.

18

The mechanism discussed here requires a country-specific productivity shock in an open economy, which the United Kingdom clearly is.

19

Cotis and Rignols (1998) make a similar point in the context of France, although the circumstances there, and the mechanism suggested by these authors, are rather different.

20

On the former, see, e.g., the papers in the Barrell (1994) volume and references therein. Olivier Blanchard is one of the principal proponents of the latter argument. Blanchard and Wolfers (2000), for instance, argue for that interactions of institutions and shocks are important for explaining cross-country differences in labor market performance.

21

For direct evidence on capital-skill complementarity, see, e.g., Griliches (1969) and Goldin and Katz (1998). Keane and Prasad (1996) provide more references and a discussion of substitutability/complementarity in an extended production function that includes physical capital, energy, and skilled and unskilled labor.

22

These authors use this framework to examine the effects of relative demand shifts (for different types of skill) and capital-skill complementarity on the equilibrium skill premium. In an analysis of the West German labor market, Prasad (2000) adapts this model to study the potential employment effects of rigidities that prevent adjustment in the skill premium in response to different shocks.

23

See the paper “The ’New Economy’ in the United Kingdom” in this volume.

Same Series

Other IMF Content

Other Publishers

Cover IMF Staff Country Reports
United Kingdom: Selected Issues
Author: International Monetary Fund
Volume/Issue:
Volume 2001: Issue 124
Publisher:
International Monetary Fund
ISBN:
9781451981445
ISSN:
1934-7685
Pages:
89
DOI:
https://doi.org/10.5089/9781451981445.002

United Kingdom: Evolution of Wages and Earnings

Employment and Real Wage Growth

United Kingdom: Percentile Differentials for Hourly Wages

United Kingdom: Wages Growth Across Percentiles, All

United Kingdom: Wage Growth Across Percentiles, Women

United Kingdom: Wage Growth Across Percentiles, Men

Labor Force Status by Gender

United Kingdom: Kernel Density Estimates, All

United Kingdom: Kernel Density Estimates, Full-Time Workers

United Kingdom: Average Weekly Hours—Total and Overtime

United Kingdom: Average Weekly Hours by Gender

United Kingdom: Variance Decomposition for Earnings

United Kingdom: Employment and Earnings by Occupation Group

United Kingdom: Employment and Earnings by Industry Group

United Kingdom: Employment and Earnings by Region

United Kingdom: Composition Effects: Wages

United Kingdom: Composition Effects Earnings