Pay is Above Market
10 March 1996 . Number 3
Subcommittee on Civil Service, Committee on Government Reform and Oversight
United States House of Representatives
My name is Wendell Cox. I am principal of Wendell Cox Consultancy in Belleville, Illinois and have served for three years as Director of State Legislation and Policy and Principal Policy Consultant for the American Legislative Exchange Council. I am also principal author of the America's Protected Class series (co-authored with Samuel A. Brunelli), which documents the comparative advantages of public employment in the United States. Thank you for the opportunity to share our research with you.
In his letter of invitation, Chairman Mica asked that I deal with a number of issues. Most of my testimony will relate to the first general issue: comparison of public and private sector compensation and benefits.
1. Comparing Public and Private Sector Compensation and Benefits
Market rate compensation can only be determined by the market. Market prices, including the price of labor, cannot be reliably determined through administrative processes. Nobel Laureate Frederik Hayek cautioned that the competitive price cannot be known until there is competition. This is vividly illustrated by the inability of Soviet planners to reliably establish market prices despite 70 years of trying. The resulting gross economic misallocation was a major factor contributing to the collapse of that economy.
Even so, administrative methods for estimating market compensation will be even less reliable if they fail to account for readily quantifiable elements of value. This is the case of the federal government, which bases its non-military employee compensation determination entirely on wages and salaries, and excludes. other significant elements of compensation such as employer paid benefits and paid time off, and superior job security. (Federal non-military employees include federal civilian employees and federal government enterprise employees [primarily US Postal Service employees].)
There is more to employee compensation than wages and salaries. The federal Office of Personnel Management (OPM) has estimated that, on average, federal civilian wages and salaries are 22.3 percent below that of comparable private employees this is referred to as a "pay gap." But wages and salaries represent less than 75 percent of federal non-military employee compensation. Moreover, academic studies often find federal pay premiums rather than a pay gap.
There is considerable inherent excess value in federal employment. I reviewed our research before your subcommittee on April 5, 1995. This was published by the American Legislative Exchange Council under the title America's Protected Class: The Excess Value of Public Employment. The research developed an "excess value factor," which when applied to assumed level of federal wage and salary comparability provides a reasonable estimate of the total compensation value for federal non-military employees compared to that of comparable private employees.
Using a hypothetical case, we estimated the extent to which inherent differences between private and federal non-military employment impacted the value of total compensation (wages and employer paid benefits adjusted for hours worked). The elements analyzed included employer paid benefits; paid holidays, vacation days, and sick days; the federal income tax free value of the higher employee benefits; larger annual compensation increases; and the relative value of job security over a 40 year employment career. The resulting excess value factor in 1993 was 50.8 percent --- in the favor of federal employees.
Our excess value estimate is consistent with previous research. A 1982 study estimated the extent to which federal employee wages and salaries would need to be reduced to achieve balance between the supply and the demand for federal jobs (Venti). Applying federal employee composition-weighted relative compensation increases (1982 to 1991) to this study yields an excess value factor of 55.0 percent somewhat above our original estimate of 50.8 percent.
Applying the original excess value factor of 50.8 percent, the following can be concluded:
1. If it is assumed that a federal employee's starting salary is 22.3 percent below that of a comparable private employee (based upon the President's Pay Agent "pay gap"), the value of the federal employee's compensation would exceed that of the private employee by $261,000 over a career (base: federal wages and salaries).
2. If it is assumed that a federal employee starting salary is equal to that of a comparable private employee, the value of the federal employee's compensation would exceed that of a comparable private employee by $586,000 over a career (base: private wages and salaries).
3. If it is assumed that a federal employee starting salary is 11 percent above that of a comparable private employee (Krueger), the value of the federal employee's compensation would exceed that of a the private employee by $777,000 over a career.
Only if it is assumed that a federal employee's starting salary is 33.7 percent or more below that of a comparable private employee would there be no excess value for the federal employee. And, if federal employee compensation were truly below market rates, the federal government would, frankly, be unable to retain its employees. This is not the case.
Federal pay determination mechanisms yield untenable results. If federal pay systems were reliable --- that is, if they produced results consistent with labor market outcomes, then average employee tenure (period of employment with the current employer) among federal non-military employees would be similar to that of comparable employees in the private sector. Average federal employee tenure has been estimated at three times that of private employees. This is a strong indicator that federal non-military employee compensation is well above market rates.
Whenever contrasts between federal employment are highlighted, objections are raised that there are significant differences between the two sectors --- that there is a higher concentration of white collar employment in the federal government than in the private sector. But a higher white collar work force composition does not necessarily justify substantially higher federal compensation. One category of white collar employment, administrative support and clerical workers, is paid less than in the market than the private sector average. Approximately half of federal non-military white collar employment consists of administrative support and clerical workers.
Differences in the composition of federal non-military employment relative to private employment are not sufficient to account for the much higher compensation received by federal employees. Average employee tenure is an indicator of the value of particular types of employment to employees. The composition of the federal work force justifies a difference in average tenure of not more than 10 percent --- a small fraction of the actual difference.
Federal employee benefit costs are excessively high and have escalated unreasonably. It is important to consider not only the design of federal employee benefits from the "bottom up," but also the overall impacts of any package of benefits from the "top down." Most of the testimony you hear is likely to be "micro" in its approach, while mine will be "macro" ("top-down").
The average cost of federal employee benefits as a percentage compared to wage and salary expense is nearly double that of private employees. Yet the composition of the federal work force justifies only a small differential from the private sector average.
Federal employee benefits were not always so far out of reconciliation with the market. Indeed, in 1980, federal employee benefits were similar to the private sector average. Since that time, federal employee benefits have increased by 105 percent --- 13 times that of the average private employee. The federal employee increase has been 3.5 times that of state and local government employees. No conceivable work force composition could justify this extent of federal advantage.
If employer paid benefits for federal non-military employees had reflected the changes in the market from 1980 to 1993, the taxpayers and consumers of government enterprise services would have paid $18 billion less in 1993. The above market escalation in employer paid benefits widened the average federal non-military employee's compensation advantage over that of the average private employee by $6,400 --- $9,000 in tax free equivalent income. Federal employment is more lucrative than private employment. The result is that average federal employee compensation increased 22.5 percent from 1980 to 1993, more than 3.5 times the private sector average of 6.1 percent. Federal non-military compensation increased 268.9 percent relative to private employee compensation over the period. The federal increase is more than double the rate justified by the composition of federal employment.
In 1993, total compensation wages and paid benefits were 53 percent more than average private compensation, an increase from the 1980 differential of 32.2 percent. The federal non-military compensation advantage over the average private employee increased from $10,500 in 1980 to $18,200 in 1993. The 1993 differential is approximately four times the level justified by the federal work force composition.
But there's more. Federal employees are granted paid leave of at least 10 days more annually than can be justified by the federal work force composition. When applied to the 53 percent differential above, the federal compensation advantage becomes 62 percent.
Then there is the nearly $1 trillion in unfunded federal civilian pension liabilities. These are payroll expenses that do not show up in federal compensation figures but which must be paid. OPM estimates that a 40 year amortization of unfunded federal civilian pension would add another 20 percent to federal compensation costs relative to wages and salaries. There are other advantages of federal employment. For example:
1. Virtually all federal employees are eligible for severance pay compared to less than 40 percent of private sector "white collar" workers.
2. In the 40 states with income taxes which comprise more than 80 percent of the population the excess employer paid benefits represent a further tax free value to federal employees.
3. In states comprising more than 25 percent of the population, federal (and state) employee pensions are exempt from state income taxes unlike private pensions.
4. Federal employee pensions are of the more lucrative "defined benefit" type and provide annual cost of living increases. Private employees are much less likely to be covered by pensions. Further, private pensions are more typically of the less lucrative "defined contribution" type and generally do no provide cost of living increases.
The causes: deficient pay determination methods and failure to apply administrative tests of results against the market. Why is the federal non-military compensation system producing results that are so at odds with the market? Obviously, as has been noted above, a major contributing factor has been the design deficiencies of the federal pay determination systems. But there is another factor that the federal pay determination system results are not modified to reflect actual labor market outcomes. It is not enough to categorize jobs as comparable in the federal and private sectors. Job categorization is a difficult and subjective process. If the comparability determination process is reliable, then labor market outcomes will be similar average turnover rates will be similar. If the comparability determination process is unreliable, then there will be substantial differences in turnover rates between the two sectors. And, as noted above, that is the case average federal employee tenure is substantially greater than that of the private sector even after adjusting for the federal work force composition. This huge difference indicates that the value of federal jobs is well above the market.
The federal government is not subject to the competitive market. It does not have to compete for revenues against other entities offering the same products to consumers. It cannot be challenged by new entrants, nor does it face liquidation as a penalty for failure in the market. Unlike firms in the competitive market, the federal government can afford to pay above market employee compensation, because it can compel taxpayers to pay, unlike private entities. The public is paying more than necessary for federal non-military employee compensation.
2. Effect of Excess Federal Benefits on the Private Sector
As was indicated above, federal employer paid benefits are considerably higher than employee benefits in the market. The excess amount taken from the private sector has impacted the private sector and probably by more than the direct amount taken (which is estimated at $18 billion for 1993). Research has indicated that each excess dollar in federal taxation destroys economic growth in the amount of $1.39 (Jorgerson & Kun)--- this is referred to as a "deadweight tax loss" or "excess burden of taxation." Based upon this finding, the excess burden of taxation related to excess federal employee benefits would be $25 billion annually. Based upon overall economic factors, this could translate into a loss of 425,000 private sector jobs, which would have otherwise been created (and which would have reduced the unemployment rate by 0.5 percentage points).
3. Tax Treatment of Employee Benefits
Any time government intervenes in the market, there will be misallocation of resources. It is for this reason that government intervention should be kept to a minimum. For example, government intervention in the employee compensation market was a major contributor to misallocation in health care markets. Health care arose as an employee benefit as employers and employees sought to increase employee compensation without violating federal wage and price controls in the 1940s. Many experts believe that the escalation in health care expenditures is a direct result of separating the responsibility for payment from the health care recipient. As Nobel Laureate Milton Friedman noted, people are more careful with their own money than with other people's money. From an economic perspective, it would be best to treat all employee compensation as taxable income. And, of course, there should be no difference with respect to the treatment of benefits or taxation of benefits between the public and private sectors.
Conclusion: Federal Pay Determination Must be Reformed
The evidence is overwhelming. Federal non-military employee compensation is above market rates it is higher than necessary. The differences in the composition of federal non-miliary employment relative to private employment are not sufficient to account for the much higher compensation received by federal employees.
Administrative pay determination mechanisms are inherently flawed. But these flaws do not justify a federal system that is neither complete in the elements it considers nor credible in the results that it produces. The federal pay determination systems need to be reformed. The following principles should be followed.
Wherever possible, employee compensation should be determined directly by the market. Federal services and programs should be converted to market mechanisms such as competitive contracting and privatization to the greatest extent feasible.
Where federal employee compensation is determined administratively, the methodology should include all quantifiable elements of compensation. At a minimum this should include wages and salaries, employer paid benefits, the tax free value of excess employer paid benefits (including the fully funded value of employer pension contributions), the value of excess paid leave, and relative compensation increases.
But, as a Concord Coalition report puts it, job description comparisons are notoriously unreliable, since federal agencies (unlike most private employers) face strong incentives to inflate them. A better approach to the entire comparability question a market test that weighs the total attractiveness of a job to everyone who might fill it is to look at job turnover rates (Howe & Jackson). Routine and comprehensive reference checks should be established to ensure that federal non-military labor outcomes balance with labor market outcomes. Administratively determined compensation should be adjusted (generally downward) to achieve turnover rate parity with that of comparable private positions.
And, it must be recognized that even if these reforms were implemented, employment in federal functions not competitively contracted or otherwise privatized would still be determined by inherently flawed administrative mechanisms. The market rate can only be established by the market.
Academic research routinely produces estimates of federal pay comparability that imply considerable underestimation by federal systems. It is safe to say that a large portion of the public perceives that federal employees are comparatively well paid. Only "inside the beltway" is there an broadly held view that federal employees are underpaid.
Government has a responsibility to exercise stewardship over the funds that it compels from taxpayers a moral duty to spend no more than necessary to produce the services it has determined are necessary. The federal government appears to be failing in this duty with respect to employee compensation.
It is imperative that federal pay determination systems be reformed to eliminate wasteful excess spending for federal employee compensation. Fairness to taxpayers requires reform. And reform is required for fairness to future generations, who are already obligated by the burdensome federal debt.
Neil Howe and Richard Jackson, The Facts About Federal Pensions, The Concord Coalition (Washington: May 1995).
Dale W. Jorgerson & Kun-Young Kun, "The Excess Burden of Taxation in the United States," Journal of Accounting, Auditing and Finance (September 1990).
Alan B. Kreuger, "Are Public Sector Workers Paid More than their Alternative Wage? Evidence from Longitudinal Data and Jobe Queues," Richard B. Freeman and Casey Ichniowski (editors), When Public Sector Workers Unionize, University of Chicago Press (Chicago: 1988).
Steven F. Venti, "Wages in the Federal and Private Sectors," David A. Wise (editor), Public Sector Payrolls, University of Chicago Press (Chicago: 1987).