The effect known as Baumol’s cost disease describes how salaries in sectors which has experienced no or low productivity gains still follow the general increase in salaries in the economy as a whole. The theory breaks with the traditional notion that wage growth is facilitated by labour productivity growth, pointing out that the general level of wages will influence all industries.
On a macro level, productivity is measure by GDP per worked hour. GDP itself is the market value of all final goods and services produced within a country in a given time period. Of course, in the public sector there is no market value, as public services per definition are not sold in the market. Public sector GDP is therefore measure by cost, not by value. This creates a problem when measuring productivity. Indeed, how do you measure the productivity of a librarian, a bureaucrat in the state department or a Sergeant in the Royal Air Force when no-one is paying them for their services? How do you encourage productivity increases when the measure for output is the cost, not the value? Claiming that increased costs are necessarily a reflection of increased productivity is clearly nonsensical. In the UK, the Office for National Statistics (ONS) attempts to ‘use data from administrative sources that records the amount of certain activities which make up the service output’ but admits that measuring the quality of the output is tricky. In private sectors of the economy, higher quality is reflected in a higher price, but the ONS’s attempt as ‘quality adjustments’ for public services is only applied to healthcare and education. Productivity in other public services is measured simply by cost.
Of course, some parts of the public sector will claim that productivity increases are unfeasible; looking after the sick and elderly requires time and demanding increased productivity will inevitably lead to a poorer service – and of course, more output of a poorer service may mean no or even negative productivity growth. Best to leave well enough alone. But this of course does not mean that such sectors recognise that real wage increases may be difficult to come by. Wages in the public sector largely follow wage increases in the economy as a whole. As such, the public sector is a prime candidate for a case of Baumol’s disease.
UK productivity gains have famously plummeted post the financial crisis; the so-called productivity puzzle. Before 2008 GDP per worked hour rose at around 2.3% per year. In the last decade this has dropped to an abysmal 0.4% per year. But the public sector has fared worse. In the period from 1997 to 2013, productivity barely increased, according to the ONS.
This should maybe not surprise us. One of the key drivers of productivity increases is of course competition; the pressure to keep innovating, improving quality and lowering prices to satisfy discerning and fickly consumers. No such pressures exist in the provision of public services.
So, productivity in the public sector has not kept up with the private sector. What abut pay? Historically, state employees have enjoyed higher wages than private employees (after adjusting for worker characteristics). After the global financial crisis, private sector pay growth dropped sharply but recently the private sector has caught up.
As chancellor, Goerge Osborne introduced a freeze on public sector pay in 2010 and in 2012 introduced a 1% cap on pay increases, in response to the sharp drop in private sector pay growth in the preceding years. This meant some meagre years for public employees until the cap was lifted in 2017, during which the private sector caught up with and even slightly overtook pay in the public sector.
So, private sector pay growth has outperformed the state recently. Ironically, this happened in a period with notoriously low private sector productivity growth and has of course only been facilitated by the controversial public sector pay cap.
Overall, the picture is clear: the public sector struggles to deliver (ill defined) productivity increases but overall this is not reflected in lower pay. The public sector is indeed afflicted by Baumol’s disease. But this is a disease the patient doesn’t mind having; in fact, getting rewarded with salary increases because others are working more efficiently, with few pressures to increase one’s own productivity, can seem an enviable position. And the nature of public services – no market price – makes it difficult to incentivise better results. There is more currency in arguing that productivity increases are inherently alien to public services while freeriding on the gains in the economy as a whole. Of course – as always – the tax payer picks up the bill.