Public sector workers might not be overpaid after all

Public sector workers might not be overpaid after all

In April, 2013, the Fraser Institute released a report comparing the compensation of public and private sector workers in Canada[1]. Using data from the 2011 Labour Force Survey, the report concluded that public sector workers in similar jobs and with similar characteristics to their private sector counterparts enjoyed a 12% wage advantage.

In March, 2015, the Canadian Federation of Independent Business (CFIB) released a similar report, calculating from the 2011 National Household Survey that the public sector wage advantage in Canada is between 18% and 37%.[2] These are significant percentages, and with a view of reducing Canada's budget deficit, it's tempting to suggest, as both the Fraser Institute and the CFIB did, that public sector compensation ought to be pulled, kicking and screaming, into line with wages in the private sector. It's hard to find a reason to disagree. After all, why should two otherwise identical workers receive different wages just because one of them is on the government's payroll?

Although it seems natural to plough ahead with this line of reasoning, we are missing a step between calculating the wage advantage and proposing a way to reduce it: finding out what's causing it! Broadly speaking, the wage advantage can be decomposed into two distinct parts: a “pure wage premium”, which is caused by differences in pay structures, and an “endowment advantage”, which is caused by differences in workers' wage-generating characteristics, such as education or experience. According to University of Toronto economics professor Morley Gunderson in his 1979 paper Earnings Differentials between the Public and Private Sectors, this latter component is “considered a ‘legitimate’ differential”, since it “reflects either the returns to the acquisition of human capital such as education or training, compensating differentials or short-run earnings advantages”. [3], [4] In other words, the endowment advantage is not caused by an unfair government pay structure, but by a wage-generating composition of worker skills and job types.

To add concreteness to the discussion above, in this blog the ICP builds on its existing research by calculating the public sector wage advantage for Canada in 2015, and then breaking it down into the pure wage premium and the endowment advantage. [5] As in the ICP's Working Paper 19, we depart from the Fraser Institute's choice of data by only comparing workers in a number of selected occupations. We do this because there are many jobs in the private sector that do not exist or are defined very differently in the public sector, such as salespeople or teachers, and these distinctions would not be captured in our data, potentially throwing off our results. [6] To begin, we calculate the raw wage advantage to be 9.37%. That is, the weekly earnings of the average worker in the public sector are 9.37% higher than the weekly earnings of the average worker in the private sector. This is smaller than the Fraser Institute's and CFIB's figures, likely because the ICP's selected occupations are more comparable. Even so, the raw public sector wage advantage is a composite of many distinct and interwoven effects, such as differences in endowments, pay structures, and job types. These need to be disentangled before we can say anything interesting about the nature of the public sector wage advantage in Canada.

In addition, workers in the public and private sectors are not directly comparable. After all, our data does not describe everything about the workers in our sample, and some of the unknown information may be correlated both with a worker's earnings potential and their likelihood of choosing to work in the public sector. This could really skew our findings if we're not careful. Using the methodology in Raaj Tiagi's 2010 paper Public Sector Wage Premium in Canada: Evidence from Labour Force Survey, we adjust our calculations to account for this potential selection bias. [7], [8] The corrected raw wage advantage is now 0.3%. The reason for this drop is that, on average, current public sector workers would earn more in the private sector than current private sector workers. Raaj Tiagi came across a similar finding, describing public sector workers in his 2008 Labour Force Survey sample as the “cream of the crop”.

With selection bias accounted for, we can now disentangle the pure wage premium and the endowment advantage discussed above. [9] The results are truly surprising. For the average public sector worker, the pure wage premium in Canada in 2015 is -20.4%. That is, the average public sector worker earns 20.4% less in the public sector than they would earn in the private sector doing the same job with the same set of skills. On the flip side, the average private sector worker earns 2.3% more in the private sector than they would earn in the public sector. What we can take from these findings is that, although the absolute difference in earnings is small - only 0.3% -, public sector workers are underpaid relative to the endowment advantages that they have over their private sector counterparts. Previous studies, such as those performed by the Fraser Institute and CFIB, have not explicitly separated the endowment advantage and the pure wage premium, nor have they controlled for selection bias.

These results lead us to an entirely different line of reasoning than that taken by the Fraser Institute and the CFIB. Artificially deflating the wages of these public sector workers won't substantively resolve the underlying questions: Why are Canada's “cream of the crop” workers consistently choosing the public sector over the private sector? Could it be because, as the Canadian Centre for Policy Alternatives asserted in October 2014, lower workplace discrimination in the public sector is attracting skilled workers from minority groups, such as women or aboriginal people?[10] Or could it be that skilled workers are less attracted to Canada's unproductive and slow-growing businesses, as discussed in the ICP's Working Paper 15?[11] Is the Government of Ontario taking the right approach by continuing to freeze the wages of OPSEU workers? More research will be needed to pinpoint the narrower causes and implications of the public sector wage advantage, but what's clear is that there's more to this issue than meets the eye.

For more information on the methodology used to get the results discussed in this post, click here.

[1] Palacios, M.; Clemens, J. (2013). Comparing public and private sector compensation in Canada. Vancouver, B.C.: Fraser Institute.

[2] Mallett, T. (2015). A Comparison of Public-sector and Private-sector Salaries and Benefits. Canadian Federation of Independent Business.

[3] A compensating differential is defined as the additional compensation needed to motivate a worker to perform a riskier or more unpleasant job. Rosen, Sherwin (1986). The theory of equalising differences. The Handbook of Labour Economics. New York: Elsevier. pp. 641 - 692.

[4] Gunderson, M. (1978). Earnings differentials between the public and private sectors. Toronto: Faculty of Management Studies, University of Toronto.

[5] Data is from the first four months of the 2015 Labour Force Survey.

[6] For a list of the selected occupations, see The Institute for Competitiveness and Prosperity, Working Paper 19, The Realities of Ontario's Public Sector Compensation, February 2014. pp. 12

[7] Tiagi, R. (2010). Public Sector Wage Premium in Canada: Evidence from Labour Force Survey. Review of Labour Economics and Industrial Relations.

[8] We use a structural endogenous switching model to control for the likelihood of selection on earnings.

[9] A Blinder-Oaxaca decomposition was used to isolate the pure wage premium.

[10] McInturff, K. ; Tulloch, P. (2014). Narrowing the Gap: The Difference That Public Sector Wages Make. Canadian Centre for Policy Alternatives.

[11] The Institute for Competitiveness and Prosperity, Working Paper 15, Small Business, Entrepreneurship, and Innovation, February 2012.

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Category: Employment, Productivity, Public Policy