Public sector wages: what’s the right level?

After the Global Crisis, some European countries reduced their public sector wages to ensure fiscal sustainability. In Japan, after the Great East Japan Earthquake, the wages of the central government officials were cut for two years to finance the reconstruction expenses. Even in normal times, the appropriate level of public sector wages is debated frequently in every country. Because wages are an important incentive for workers, appropriate wage levels and their structure in the public sector are essential for ensuring the quality and efficiency of public services. In this column, I present a comparison of the wage structure between the public and private sectors in Japan by focusing on the wage differentials among regions.

Public-sector wages and agglomeration economies

It is general practice in advanced countries to determine public sector wages by the principle of ‘equal pay’ with the private sector, i.e., the wage level of the public sector should be balanced with that of the private sector (see, for example, Linneman and Wachter 1990, Bender 2003, and Belman and Heywood 2004). Similar to other advanced countries, wages for government officials in Japan are determined by the equal pay principle with those of the private sector. One reason behind the equal pay principle is the perception of fairness from the viewpoint of nationals and citizens, although equal pay is important also for efficiency in the labour market. In practice, however, the wage structure of the public sector often diverges from that of the private sector (see Gregory and Borland 1999 for a survey).

Regional wage differentials for private sector workers have been analysed frequently for the purpose of finding evidence on agglomeration economies. These studies generally have shown that wages are higher in densely populated regions even after accounting for individual characteristics and the sorting of individuals across regions (see Combes et al. 2011 and Moretti 2011 for surveys). The theoretical background of the observed regional wage differentials is essentially the different productivity arising from agglomeration economies. However, studies that compare the regional wage structure between public and private sectors are scarce. Although past studies on public–private wage differentials often employed regional dummies as explanatory variables, they typically treated them as control variables and did not pay particular attention to their coefficients.[1]

Regional wage differentials in the public sector

In order to find evidence on the regional wage differential in the public sector, I estimate standard wage functions for full-time regular employees separately for the public and private sectors using micro data from the 2007 Employment Status Survey (ESS).[2] The ESS is a representative official statistical survey conducted in Japan every five years, and approximately one million people participated in the 2007 survey. Public sector employees are identified as those who are employed by the central or local governments and their affiliated organisations. Although I cannot differentiate between employees of the central government and those of local governments in the ESS, approximately 80% of public sector employees belong to local governments in Japan.

The dependent variable is log annual income and the explanatory variables are gender (female dummy), age group dummies (five years interval), tenure and its square, dummies for educational attainment, occupation dummies, weekly working hours, and regional (prefecture) dummies. There are 47 prefectures in Japan, and Tokyo is used as the reference category in the estimation. As an alternative specification, I replaced the prefecture dummies with the population density of the prefectures in order to see the elasticity of wages with respect to population density.

Figure 1 indicates the regional wage differentials for public and private sectors drawing from the estimated coefficients for the prefecture dummies. It is obvious that the regional wage differentials are smaller in the public sector than in the private sector after controlling for the various observable employee characteristics. For example, in Okinawa, Akita, and Aomori prefectures, where the private sector wages are more than 40% lower than those in Tokyo, the public sector’s regional wage discounts relative to Tokyo are only around 20%. As a result, the overall regional dispersions (standard deviations) of the estimated coefficients are 0.050 and 0.110 for the public and private sectors, respectively.

Figure 1. Wage differentials by region (relative to Tokyo)

Notes: Estimated from micro data of the 2007 ESS. The vertical axis (log annual income) indicates the coefficients for the prefecture dummies (relative to Tokyo). Control variables include gender (female dummy), education, age classes, tenure and its square, occupation, and weekly working hours.

Deviation from the spatial equilibrium

When replacing the prefecture dummies with the population density of the prefectures as the explanatory variable, the estimated elasticity for the public sector is less than half of that for the private sector (see Figure 2). According to the estimation result, when the population density of the prefecture doubles, wages in the public and private sectors increase by 2.9% and 6.0%, respectively. In less populated regions, where private sector wages are lower, the tendency is for relatively higher wages in the public sector and vice versa, suggesting that wages in the public sector may deviate from the ‘spatial equilibrium’.

Figure 2. Elasticity of wages with respect to population density

Notes: Estimated from micro data of the 2007 ESS. Explanatory variables are gender, education, age classes, tenure and its square, occupation, weekly working hours, and population density. The vertical axis indicates the estimated coefficients for the log population density.

The smaller regional wage differential may cause skilled individuals in rural regions to self-select into public sector jobs. At the same time, public sector employers in metropolitan regions such as Tokyo may have difficulty in hiring high quality employees. To restore the spatial equilibrium, adjustment of regional wage differentials for public sector employees is necessary.

Published in collaboration with VoxEU

Author: Masayuki Morikawa is Vice President of the Research Institute of Economy, Trade and Industry (RIETI)

Image: Participants from government ministries and agencies take part in the Cyber Defense Exercise with Recurrence (CYDER) in Tokyo. REUTERS/Toru Hanai