Is Public Sector Wage Growth Moderating?

Three months ago, I wrote that it was time for a public employee wage freeze, to offset three years of much stronger compensation growth in the public sector than the private sector. One quarter on, what has happened?

First, the good news: in the first quarter of 2010, private employee compensation growth outpaced state and local government employee compensation growth. This happened both because private sector compensation grew faster (0.6%) than any quarter in 2009, and because public sector compensation growth moderated to 0.4%. (These figures, and all employment cost figures cited here, are seasonally adjusted.)

But we have seen blips before (as in the third quarter of 2009) with public employee compensation growth taking a brief break and then coming back the following quarter. Indeed, over the last four quarters, public employee compensation growth outpaced private growth, as it has for every period of four consecutive quarters since 2005. More quarters of private sector outperformance will be needed before we can call this a shift in the trend.

And there is still much more to be done to bring compensation back into balance. Even including this quarter, employee compensation has grown 38% faster in the public sector than the private sector since the end of 2006. At last quarter's pace, it would take several years for the private sector to catch up with the public sector's compensation growth during the recession.

So, what should state lawmakers do? First, they should take steps to ensure this quarter's modest growth in employee compensation costs continues for an extended period. Wage freezes were a good idea three months ago and are still a good idea now.

They should also particularly take steps to ensure that the cost of employee benefits is contained. Public employees receive a relatively large share of their income as benefits (34%, compared to 29% in the private sector) in part because of their unusually generous health care and pension benefits. As for total compensation, the new figures on benefit cost growth are an improvement over last year - the employment cost index for public employee benefits rose just 0.3% last quarter, versus an average of 0.8% per quarter last year.

But the gap between public and private sector benefits remains massive. In the first quarter, the average public employee earned $4.45 worth of health benefits per hour, compared to $2.01 in the private sector. In general, public employees have more generous health plans and pay a smaller portion of their insurance premiums.

The difference is partly explained by differences in job mix - public employees tend to be more highly skilled and educated. But even comparing employees in similar job types, the differential remains. For managerial, professional and related workers, health benefits average $4.90 per hour in the public sector, versus $2.94 in the private sector. Sales and office workers: $4.11 public, $1.80 private. Service workers: $3.62 public, $0.90 private.

This gap is not new: since the start of 2004, health benefit costs rose 31% for private sector workers and 32% for public sector workers. But as health care costs continue to soar and health insurance makes up a larger share of most employees' compensation, public employees' richer benefit packages push up their total compensation relative to the private sector.

Earlier this year, New Jersey passed bipartisan legislation that will require all employees to pay at least 1.5% of salary toward health benefits. Previously, many local employees (including nearly all schoolteachers) made no contribution toward premiums. Other states should take similar steps, and should ideally link the contribution to benefit value (not salary amount) so employees share employers' incentive to contain growth in health benefit costs.

Steps to rein in health benefit cost growth are particularly important because of the "Cadillac Tax" that is scheduled to come into law in 2018. The tax, a 40% excise on insurance premiums over a designated threshold, will disproportionately hit government employees because of their relatively generous health benefits.

Retirement benefits are another area of hidden cost. Again, there is a wide sector gap: private sector employees average $0.92 per hour in retirement benefits, against $3.19 for state and local government employees. And the government figure is likely understated, because aggressive accounting strategies in public pension plans underestimate the present cost of providing future benefits.

Several states (including Colorado, Illinois, New Jersey and New York) have enacted reforms in the last six months that will cut the cost of public pensions for new hires, and over time these should slow pension benefit growth. Unfortunately, in previous cycles similar reforms have often been undone after an economic rebound. States should do more to rein in pension costs by moving employees to defined-contribution pension plans, as is typical in the private sector.

Because of the recession and the weak private job market, the superior job security enjoyed by public employees is more valuable than ever. That means that instead of rising, there should be room for public employee compensation to fall relative to the private sector, as generous wage and benefit increases are not necessary to attract and retain qualified talent.

This quarter's numbers mean that might be starting to happen, in a small way. Perhaps state and local lawmakers are realizing, as stimulus funds run out, that public employee wage trends are unsustainable. But it will take affirmative steps in state capitals - including legislation that reins in employee benefits - to ensure that the trend continues for quarters to come.