Workers earning more while producing less is affordable thanks to falling import prices and pension deficits – but it won’t last

Falling pension costs and import prices have temporarily severed the link between productivity and wage growth in the UK, allowing real wages to rise without putting further pressure on inflation. But this ‘unproductive wage growth’ won’t last, according to new research published today (Monday) by the Resolution Foundation.

The Foundation’s latest Macroeconomic Policy Outlook examines what lies behind the UK’s recent pay recovery, in which real average weekly regular earnings have grown by a healthy 2.1 per cent in the 12 months to February 2024. This has helped to recover some of the ground lost from the sharp pay squeeze in recent years – real average weekly earnings fell by 2.7 per cent in the 12 months to October 2022 for example.

In fact, real wages have grown as much over the past 12 months as they have over the previous 16 years (2.1 per cent between February 2008 and February 2024) – highlighting the scale of Britain’s long-term pay depression.

This welcome real wage recovery is all the more unlikely given that productivity – measured by output per worker – actually fell by 0.6 per cent over this period (Q4 2022 – Q4 2023).

Over the long term, real wage rises are driven by productivity growth. However, real wage growth can outpace (or fall behind) productivity rises over the short term. Such periods often result in firms being forced to pass on higher wage costs via higher prices, which is why unproductive wage growth is a huge inflation worry for monetary policy makers. However, the report sets out two key reasons why the UK’s unproductive wage growth is affordable for firms, and isn’t fuelling inflation.

First, employer social contributions – such as payroll taxes and pension contributions – add a fifth, on average, to a firm’s wage bill. Changes to these contributions can affect how much of a firm’s wage expenditure actually reaches an employee’s pay packet.

These contributions fell by the equivalent of 2.4 per cent of wages between Q3 2020 and Q4 2024, or £20 billion, driven by reduced contributions into firms’ Defined Benefit (DB) pension schemes. This is because rising interest rates have helped to reduce or even close many firms’ pension deficits, allowing them to redirect those contributions back into wage packets.

Second, the terms of trade shock that the UK experienced during the cost of living crisis, where surging import prices fuelled inflation and reduced our purchasing power, has started to unwind.

Over the past year import prices have fallen by 2.9 per cent, compared to a 0.1 per cent fall in export prices. This terms of trade boost has given importing firms and consumers more ‘bang for their buck’ in terms of the real value of their wages. The Foundation notes that just as the terms of trade shock made Britain poorer beyond its control during the cost of living crisis, its partial unwinding is now making us richer without the need for productivity rises.

But while this welcome pay recovery has been affordable, the Foundation cautions that it is unlikely to last. Further improving terms of trade cannot be counted on, pension contributions cannot continue to fall indefinitely, and in any case they may be offset by the freeze in employer National Insurance thresholds, which is pushing up employer social contributions.

Ultimately, unless productivity growth returns, the current level of wage growth will need to fall, or it will simply be passed on through higher inflation – as firms won’t be able to absorb higher wages without raising prices too.

Greg Thwaites, Research Director at the Resolution Foundation, said:

“After 16 years of wage stagnation, real pay packets in Britain are growing again at a healthy two per cent. This welcome turnaround is all the more remarkable given that output per worker – the ultimate driver of rising wages – has actually fallen.

“Britain’s recent real wage recovery is largely down to the unwinding of trends that caused pay packets to shrink during the cost of living crisis. Falling import prices have boosted our purchasing power, while rising interest rates have allowed firms to redirect pension deficit contributions into pay packets.

“But while this welcome real wage recovery has been affordable so far, it won’t be in the future. Unless productivity picks up, wage growth will peter out, or pay rises will simply be passed on through higher prices and prolong our inflation problems.”