Reforming the Public Sector’s Wage Policy

Abstract

I propose a reform of public sector wages consisting of: i) a review of pay of all public sector workers to align the distribution of public sector wages with the private sector and ii) stipulating up a rule to determine the yearly growth rate of public sector wages. I use a model with search and matching frictions and heterogeneous workers to evaluate this reform in the steady-state and over the business cycle. The model was calibrated to the UK economy based on Labour Force Survey data. A review of the pay received by all public sector workers to align the distribution of wages with the private sector reduces steady-state unemployment by 3 percentage points. Implementing a procyclical simple rule to determine the yearly growth rate of public sector wages reduces the volatility of unemployment by 3 to 8 percent and of private consumption by 4 to 12 percent. I show that, in a sample of 29 developed countries for the pre-crisis period of 1995-2006, countries that deviated more from the rule had a larger increase in the unemployment rate and higher volatility of unemployment relative to GDP.