Raising the floor: scenarios for the minimum wage in the next parliament

The National Minimum Wage (NMW) for those aged 21 and over – the ‘adult rate’ – is increasing to £6.50 from 1 October 2014. The 19p increase represents the first real-terms rise in the NMW in six years, but will leave the rate some 4.1 per cent lower in real-terms than its peak in October 2008, returning it only to its 2005 level. This highlights the scale of lost ground in the wage floor – ground that is unlikely to be made up – particularly when you consider the rises that might have been expected in the NMW in the absence of an economic downturn.

In response to the real-terms falls experienced over recent years, a number of politicians and others have suggested potential increases in the NMW. Some have questioned the merit of such interventions, arguing that it risks undermining the independence and autonomy of the Low Pay Commission (LPC). We do not comment on that debate in this briefing note. Instead, given that a variety of numbers and paths of recovery for the NMW have been advanced in recent months, we explore a range of scenarios designed to help interpret and contextualise these different suggestions.

With the economy recovering and employment growth in particular proving strong, there appears to be new political interest in recovering some of the ground lost by the NMW over the course of the downturn. For example, prior to the LPC’s recommendation for this year’s rate, the Chancellor stated that he favoured an above-inflation increase:

The exact figure has to be set by the Low Pay Commission, which talks to business, talks to other bodies in our economy, but if, for example, the minimum wage had kept pace with inflation, it would be £7 by 2015-16 – it’s £6.31 at the moment – so that’s an increase.

Similarly, Vince Cable has called for a restoration of the real value of the NMW over a period of two to four years. Last week, Ed Miliband set a cash target for the medium-term, promising that a future Labour government would aim to increase the NMW by £1.50 (to £8) by the end of the next parliament (which means October 2019, given that this is the last point at which the rate will be increased during the parliament). The move is reportedly designed to raise its value relative to median pay, though clearly whether or not this is achieved will depend on the – still uncertain – trajectory for median pay over the coming years.

Earlier this year, the Resolution Foundation’s review of the future of the NMW (the Bain Review) set out a strategy for reducing the incidence and persistence of low pay. Among a series of recommendations, it called for the establishment of a clear political ambition for the NMW over the medium-term. More specifically, it argued that it would be “reasonable” to set a medium-term ambition of raising the NMW ‘bite’ – its value as a share of median hourly pay. The focus on a relative measure of ‘bite’, rather than an absolute cash target, was very deliberate and designed to account for the inherent uncertainty associated with making projections and to avoid presenting inflation-driven measures as real gains. It argued that, based on international evidence, a bite of 60 per cent is probably as high as could be achieved over the medium-term.

This approach reflects the fact that assessing the relative ambition and plausibility of any given cash target for the NMW rests on consideration of three things:

• How quickly inflation rises (i.e. how much of any given increase is absorbed by rising prices?);
• How quickly median pay grows (i.e. how high would the NMW need to increase simply to keep pace with median pay?); and
• How much the bite relative to median pay increases (i.e. what proportion of any given increase is driven by a narrowing of the gap between the minimum and the median?).

To help us interpret these different aspirations for the NMW, we can consider five scenarios for the wage floor over the course of the next parliament. All are based on highly uncertain assumptions about the future path of prices and wages and should be considered as indicative – and liable to change – rather than definitive. Nevertheless, starting with the October 2014 rate as given, we can speculate about the nominal path of the NMW where:

• It rises in line with the OBR’s projection for CPI inflation in every year from October 2015;
• It returns to its pre-crisis real-terms peak (as measured by CPI) over the parliament (which means by October 2019);
• The ‘bite’ of the NMW in 2014-15 relative to our projections for median hourly pay (which are based in turn on the Bank of England’s and the OBR’s projections for average pay) is held constant over the period. This effectively means that the NMW moves in line with median pay;
• The annual rate of growth in the NMW returns to that recorded during the pre-crisis years from October 2015. Specifically, we use the real-terms rate of growth (in order to control for differences in inflation before and after the crisis) recorded between October 2002 and October 2007. We have chosen to remove the effect of the very sizeable increases in evidence in the first few years of the NMW, on the basis that they are unlikely to be replicable over the coming period. Similarly, we have focused on the pre-crisis years as representative of what is achievable alongside a strongly performing labour market. Even having removed these years, it is worth noting that the NMW was growing at around 3 per cent a year above CPI inflation;
• Finally, and most ambitiously, it reaches the level it might have stood at in October 2019 in the absence of any economic downturn. This is calculated by again applying the 3 per cent average annual rate of real-terms growth recorded pre-crisis, but this time assuming that such growth had continued uninterrupted after 2007-08.

Figure 1 sets out what each of these scenarios would imply for the nominal level of the NMW by October 2019.

Figure 1:         Selected scenarios for the NMW by the end of the next parliament: 2000-2020

Notes:          Figures to 2015-16 are outturn/plans. In all instances we use OBR projections for CPI through to 2018-19 and assume it remains at 2 per cent thereafter. In estimating the future path of median pay, we apply an adjustment to the projections for average pay from the Bank of England and the OBR based on the historic ratio of median pay growth to mean pay growth.

Sources:      RF analysis of ONS & OBR

It shows that keeping pace with CPI inflation would take the NMW to £7.18 over the course of the parliament (with a higher level required if we were to use RPI inflation instead). This suggests that, of the £1.50 increase favoured by Labour over this period, close to half arises simply due to inflation.

Restoring the October 2008 real-terms peak would imply a cash value of £7.48 by October 2019. Clearly, the value by the end of the parliament would be higher if the aim of restoration was achieved more quickly, as Vince Cable argued for. If we instead assume that the real-terms peak is restored by October 2017 and thereafter maintain the bite relative to median pay, the NMW would stand at £7.69 in October 2019.

In practice, this is broadly equivalent to our third scenario, in which the NMW rises in line with median pay, thereby maintaining its bite at 54 per cent. Under this approach, our estimate is that the NMW would reach £7.70 by the end of the parliament – a figure close to one reported to have been calculated by HM Treasury for the position in 2019-20.

Restoring the pre-crisis rate of growth in the NMW from October 2015 would push the level somewhat higher – to £8.31 – by October 2019.

By way of illustration, our fifth scenario describes how far short each of the other scenarios would fall relative to a world in which there had been no economic downturn and no slowdown in the pace of growth of the NMW. The nominal value of £10.83 is in stark contrast to all of the other figures presented – and is unlikely to be considered a reasonable target over the course of a single parliament – but it highlights just how much of a permanent hole the downturn has punched in earnings. This is true not just at the minimum, but across much of the distribution.

Table 1 sets out the real-term NMW values in October 2019 associated with each of these scenarios, along with the implied bite relative to median pay. It shows that restoration of the pre-crisis growth in the NMW from October 2015 would imply a bite by October 2019 that approaches the 60 per cent lodestar set out in the Bain Review.

Table 1:           2019-20 outcomes associated with selected scenarios for the NMW

Notes:          See notes to Figure 1

Sources:      RF analysis of ONS & OBR

The arrival of the first real-terms increase in the NMW since October 2008 is very welcome. But its future path – and the debate about the role that politicians might play in setting the appropriate course – remains uncertain. Our analysis suggests that the NMW in October 2019 might reasonably be expected to sit somewhere between £7.18 (as implied by simply keeping pace with inflation) and £8.31 (as implied by returning to the historic rate of growth) by the end of the next parliament.

Tellingly, all of these potential outcomes remain a long way below the level the NMW might have stood at in the absence of economic downturn. But equally, the differences between them will strike some as relatively small – in real-terms the spread between them is around £1. Bearing in mind the inherent uncertainty surrounding the projections for inflation and median pay that underpin each of them, they should be considered to provide nothing more than an indication of the potential spread between different approaches. Clearly though, relatively small differences in these approaches will have very material effects on outcomes for those paid at or close to the NMW.