Elephant in the Room: Public vs. Private Employee Pay

by: Ronald Rutherford

This year has brought forth the meme that public sector employees are paid more than their counterparts in the private sector. The center of this debate has concentrated on Wisconsin and, of course, the Governor Scott Walker. The Economist sums up some of the points at Wisconsin public unions: Don't join the government to get rich. The most obvious point is that some career choices have monetary consequences. For example, top corporate lawyers can earn an income vastly larger than district attorneys. But I think most people consider a lot of the non-monetary aspects of jobs also when deciding which career to pursue, such as working environment, job security, stress levels, safety, job turnover, and the constraints of individual's innate abilities and interests.

The Economist links to a study by Jeff Keefe at the Economic Policy Institue that defends public sector employees and their salaries. Instead of comparing similar jobs, these types of studies compare workers across education levels, experience, hours of work, organizational size, gender, race, ethnicity and disability. Aside from education levels, the rest of the factors are not mentioned as being significant.

This raises two issues with education levels of public employees. First, as the studies themselves point out, there is not equality in job titles and responsibilities. The pay scales for education majors in like music, history, English, etc. are indeterminate but not likely to be at the same level as public employees. Second, there are various reasons to believe that the government relies more heavily on education as requirements for a job than the private sector would. In the desire to be non-discriminatory, it is easier to use education credentials during recruitment to weed out the possible candidates to a reasonable pool than it is to use more subjective requirements and tests.

If in fact people are over-educated for the jobs they receive through the government, then this is not simply a matter of government budgets paying for those unneeded levels of education but also a dead-weight loss to society. Instead of resources (human resources) going to the most productive sectors of the economy, they get diverted to bureaucracy. For example, foreign aid often diverts skilled, educated labor away from creating an entrepreneurial class towards administering aid.

The Economist magazine goes on to make another important point. Government employees feel entitled to the pensions plans that the unions and government agreed to and reneging on that is grossly unfair. We should feel sympathetic to their plight, but is the bargaining between two diametriaclly oppsed interests as in traditional worker/management arrangements. A good way to describe this relationship is from Mark Perry at Carpe Diem who quotes Katherine Kersten (The Vicious Cycle of Government Unions).

Here's the vicious cycle: Union leaders take money from union dues and pass it to Democratic candidates. Once elected, the politicians "negotiate" with the unions that helped elect them. In essence, the unions hire their own bosses who face them across the bargaining table.

Politicians repay unions' financial support by doling out hefty pensions and benefits. It's easy to be generous when you're spending taxpayers' money, not your own. Elected officials aren't accountable to a board of directors or shareholders, and they don't have to worry about going bankrupt, as private companies do.

There is a tendency for the government to push benefits into the future. Most of the reports seem to overlook what the discount rate is for calculating net present value of benefits. It's conceivable that public employees might have a lower discount rate than the general population. This means that future payments have more value than presently counted. The government should use that lower rate to calculate present benefits, which would lead to lower benefits for the present.

Paul Krugman also sides with the unions (surprise, surprise, surprise). In his post The Contribution Scam, he quotes David Cay Johnston. They both feel that pensions and the benefits package come out of the workers "pay", as that was negotiated in the contracts, and supposedly the government workers earn less than they could have if benefits were lower. The difference is whether public employees are judged by their productivity to society. In a private firm, there can be overpaid employees, but unlike in the fairy tales of Dilbert, competition pushes inefficient producers out. What mechanism will push government to use its resources (human capital) in the most efficient manner?

The Economist article ends with a discussion about unions being a form of monopoly market power and questions why they don't earn even more than their counter-parts in private institutions. From the discussion above and some data below, there is in fact some questions as to whether public employees are being taken advantage of. One reason the Economist gives is that government is a "monopoly employer" especially concerning specialized jobs that do not have equals in the private sectors. This may be just a blog post at the Economist, but the correct term is that the government is a monopsonist employer. Monopsonist is a market participant that is the sole or nearly sole buyer of a product or service. Since the government is in that position, it could extract higher levels of productivity and thus create more social good, but that has not happened. Inefficiencies in government have persisted. When a monopolist sells to a monopsonist, then who captures the rents is indeterminate and falls mostly to the one that that can capture political influence.

So What is the Elephant in the Room?

Entrepreneurs and risk takers in society, for the most part, are not concerned about job stability, but for most workers it is an important consideration. One of the best ways to determine what people want most, is to see how they "vote with their feet". This does not tell us the benefits from moving to a new location like the US or another state or just a new job, but it does tell us that the benefits exceed the opportunity costs from staying at present location.

So what data points might tell us how people are voting with their feet? Job openings do not tell us how the prospective employee is reacting in the market, but quits and separations tell us the rate of employees leaving the job. Ideally, we would want to see the number of applicants per job announcement compared with the interest of prospective employees for each position. The graph below is the rate of total separations for private and government employees, and the second is the rate of quits for both sectors. Both are from the Federal Reserve Bank of St. Louis over the last ten years. (Job Openings and Labor Turnover (JOLTS) - FRED - St. Louis Fed)
Just for comparison, I also include the two sets of data with the origin at zero and included the mean and one standard deviation for all four series.

Some things to note on the graphs are: since the last recession started separations and quits have been declining for both private and public employees as more are staying on the job longer; total separations for government employees spiked up because of the census workers being laid off, but still maintained its below average rate; volatility, as measured by standard deviation, is much greater for private employees and most dramatic for quits, and private employees always face higher rates of separation and always quit at higher rates than public employees even with the massive separations from the census workers the difference was only marginally reduced. Even though the evidence clearly shows that government employees have the lowest turnover rates, we must be cognizant that there may be a selection bias happening here. That is, those that desire jobs that have less turnover would also have the ability to fit into an organization for the long-term. Those that desire long-term job stability would also have traits that allow them to stay on the job long-term.

Clearly, government workers stay much longer at their job and have the lowest turnover rates. They feel very content at their jobs and are not leaving or quitting, which tells us that the job benefits are of greater value to them than the alternatives. A priori reasoning suggests that the benefit package that government employees get is greater than what the private sector provides. These benefits go beyond just pay checks and benefits to stability of their jobs and overall work and working conditions. At a House meeting on public employee compensation shown on CSPAN, it was calculated that this lower turnover rate amounts to around a 12% pay raise. That would be a subjective determination from each individual employee as to the value of this factor along with what the individual's discount rate would be. The Heritage Foundation uses utility functions to calculate this additional benefit for increased job security and conclude that it could be as high as 15% of pay for California Public Employees. (Are California Public Employees Overpaid? | The Heritage Foundation).

However, properly accounting for retiree health benefits and defined-benefit pension plans generates a public compensation premium of around 15 percent. The additional job security granted to public-sector employees is equivalent to an approximately 15 percent increase in public compensation, meaning that the total public-sector pay premium in California may be as high as 30 percent.

Maybe whether they are overpaid or not is immaterial, as they are benefiting more than others that are suffering in this economic recession. Governments could be using their monopsonist market powers to extract either higher rates of productivity or lower rates of pay/benefits or both.

If state and local governments are to balance their budgets then the pay of public employees must be considered as it consumes about 44% of state and local spending. At some time, productivity of public workers must be considered. Education is the biggest single category of public employees and thus productivity of teachers will have to be addressed also.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: No positions mentioned.