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21 December 2022

Do pay rises cause inflation?

Rishi Sunak claims higher pay for public sector workers would lead to prices rising. He’s wrong.

By Anoosh Chakelian

Another strike, another excuse. Rishi Sunak has claimed to MPs that he cannot give in to public sector workers’ demands for pay rises because doing so would add to inflation.

“The best way to help them and help everyone else in the country is for us to get a grip and reduce inflation as quickly as possible,” the Prime Minister said on 20 December. “We need to make sure that the decisions that we make can bring about that outcome. Because if we get it wrong and we’re still dealing with high inflation in a year’s time, that’s not going to help anybody.”

Refusing to raise public sector pay is not a way to bring down inflation, however. Here’s why.

Do higher salaries cause prices to rise?

Wages have not caused the inflation Britain is currently experiencing, which is why we must be sceptical of politicians warning of a “wage-price spiral”. It’s a misleading phrase, because this period of inflation actually follows a long period of wage stagnation rather than wage rises. Factors that have nothing to do with wages, such as rising energy costs and a sudden spike in demand after the pandemic, are to blame.

If workers get pay rises, don’t things become more expensive?

The argument goes that if employers are paying out more in wages then they will have to charge customers more, causing prices to rise. Yet this cannot be true of the public sector. Public bodies cannot increase their costs for consumers to make up for paying higher wages, because they don’t sell their services.

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As the Institute for Fiscal Studies (IFS) notes: “Higher wages for teachers would not increase the ‘price’ of schooling facing households with children, nor would higher pay for midwives increase the ‘price’ of giving birth in an NHS hospital.”

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When it comes to the private sector, there is the risk that if employers pay higher wages then they will put the prices of their goods and services up for customers. This is why Andrew Bailey, governor of the Bank of England, controversially told the public not to ask for big pay rises this year. This is also not straightforward, however. There are companies that make huge profits for their shareholders, and they could decide to pay their staff more and take a hit to those profits rather than putting prices up.

Won’t higher public sector pay cause private companies to compete?

There is also no risk of public sector pay rises leading to the need for more generous packages in the private sector. This is because public sector pay is rising far slower than private sector pay. According to the Office for National Statistics public sector workers’ wages rose 2.7 per cent in August to October this year, compared with a 6.9 per cent rise for their private sector counterparts. So there is no danger of public pay setting a benchmark or precedent for private companies to compete with.

If people have more money won’t they spend more, leading to price rises?

Another common contention is that if people have more money they will spend more, therefore fuelling economic demand and meaning prices will go up.

There are many reasons that this a weak argument. The first is that, as people are paid more, they are taxed more, which would dampen any impact on inflation. Also, if given a pay rise, those workers on strike will probably be spending most of their extra pay on essentials, like food and energy, the prices of which are at the whims of global markets anyway. When Sunak was chancellor he made the same argument against giving welfare claimants higher benefits – that it would add to inflation. I was told by one Bank of England economist at the time that this was “bollocks” for that reason.

The second point is that even if more spending money in the economy does add to demand, this is not a reason to oppose pay rises. Any inflationary impact could be offset by dampening demand elsewhere, like tax rises for wealthier citizens, for example. Ultimately, keeping people poorly paid is not a method of mitigating inflation. There is already an accepted mechanism for this: the Bank of England raising interest rates.

[See also: Why is the Bank of England raising interest rates when inflation has peaked?]

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