[quote=EconProf]This meaty article will prompt many pro and con contributions by Piggs. It is a healthy debate to have, since our fiscal future and our state’s economy depends upon it.
The question is whether state employees are overcompensated or not compared to similar private sector occupations. While many dueling statistics can be brought forth by both sides, I’d like to pose one question: What is the quit rate for public sector workers compared to similar private sector workers?
I’ve heard that the public sector workers almost never quit, suggesting that they know they have a good deal. But that’s only anecdotal. Any Piggs have any statistics?[/quote]
This has some data, I think the gap has become much wider in the last few years…
Heritage Foundation Working Paper (comments welcome)
Jason Richwine (jason.richwine@heritage.org)
Andrew Biggs (andrew.biggs@aei.org)
Introduction
Public-private pay comparability has become a major political issue in the past year, with some claiming that public workers are overpaid and others claiming they are paid too little. An important aspect of this debate is the difference between federal workers on the one hand and state and local workers on the other. Although federal workers earn higher wages and benefits than comparable private workers, the state-local situation is more complicated. Compared to private workers, state-local workers tend to earn less in wages but more in benefits. The net impact on overall pay is controversial.
The Center on State and Local Government Excellence, the Center for Economic and Policy Research, the Economic Policy Institute, and the Center on Wage and Employment Dynamics (CWED) have all released similar studies arguing that the wage penalty and benefit premium for state-local workers either cancel out or tilt in favor of private workers.
While these studies more or less properly measure wage differences, none of them considers the full benefit premium enjoyed by state-local workers. A full accounting of benefits needs to include retirement healthcare, job security, and pension funding using the proper private sector discount rate. After including these missing pieces of the benefits pictures, we find that state-local compensation is substantially higher than previous estimates.
Because state-level data varies widely in quality and availability, it is still difficult to say whether state-local workers are overpaid on a national level. This paper focuses exclusively on public workers in California, a large state with reasonably good benefits data. Because the authors of the CWED report also focus on California, we contrast our methods and results with theirs throughout this paper.
CWED concluded that California public workers are not overpaid. However, we find that CWED’s analysis of benefits leads to a substantial understatement of state-local compensation in California. With a more complete accounting of benefits, public employees in California in fact earn up to 30 percent more in total compensation than comparable private sector workers.
Wages
Our public-private wage comparison is very similar to CWED’s. We use the same dataset and the same basic regression analysis.
Data and Methods. We averaged the 2006 through 2010 years of the Current Population Survey. The five-year average is more representative of recent trends in government pay, and the larger sample size allows us to add more detailed control variables.
We used the Annual Demographic Supplement of the CPS, which contains information on annual earnings. The analysis is limited to adult civilians working full-time for a wage or a salary during the whole previous year.
We dropped workers with imputed earnings, since the imputation process does not take government status into account. People with annual earnings less than $9,000 were also dropped.
In addition to dummy variables for federal, state, and local government employment, we used the following controls: usual hours worked per week, experience (age – education – 6), experience-squared, years of education, firm size (6 categories), broad occupation (10 categories), immigration status, race, gender, marital status, and year dummies to account for inflation. We also included interaction terms: experience x education, experience-squared x education, marital status x gender, and gender x race.
Choice of Controls. Most control variables in wage regressions are uncontroversial, but there is some debate among economists over whether to include certain ones. For example, our inclusion of firm size means that California state workers are compared only to workers at large firms (1,000+ employees), which tend to pay higher salaries than smaller firms.
Since firm size is a characteristic of employers rather than employees, this is controversial. Some argue that larger firms tend to pay higher wages because they are more successful, that a state government cannot be “successful” in any market sense, and therefore that a firm size control is inappropriate. However, working at a large firm reflects to some extent an employee’s preferences for whatever characteristics large firms tend to exhibit. If state-local workers quit in favor of private sector jobs, they would likely choose a private firm that is above-average in size. For that reason, we believe controlling for firm size is the better choice for both wages and benefits. Excluding the firm size control would make the observed state and local wage penalties substantially smaller than what we are reporting here.
Some economists also control for union status, but we do not feel that is appropriate. Collective bargaining drives up wages, and California’s decision to allow state workers to unionize is essentially another means of boosting compensation. One could argue that union membership, like firm size, is also a state worker’s revealed preference that he would continue to seek in the private sector. Unlike firm size, however, this preference could be driven mainly by the higher wages and benefits of unionized labor, which should be included in the state-local premium. Controlling for union status would likely raise our estimate of the wage penalty but would not change any of our conclusions.
The CWED report includes firm size but excludes union status, just as we do.
Results and Conclusion. Results of the regression are displayed in Table 1. The first column lists key independent variables, and the second column shows the percentage increase in wages associated with a one unit increase in each variable. For example, an additional year of education leads to a 9.9 percent increase in wages, all else equal.
Table 1: Wage Regression Results, 2006-2010.
Control Variable Coefficient (%)
hours worked per week 1.7
experience (in years) 3.9
education (in years) 9.9
foreign-born -11.4
married 18.0
black -16.6
Hispanic -10.7
woman -14.0
federal worker 4.8
state worker -10.2
local worker -0.6
Observations 25,576
Adjusted r-squared 0.506
Note: All coefficients significant at the 95 percent level or higher, except local worker. Additional controls not shown; see text for details.
Source: Authors’ calculation from Current Population Survey.
The most important variables in the list for our purposes are state and local government status. After controlling for observable skills and a detailed list of personal characteristics, state workers in California earn about 10.2 percent less in wages than private sector workers. Local workers see a much smaller, statistically insignificant penalty of 0.6 percent. Combining state and local workers together yields a significant penalty of 3.7 percent (not shown in the table).
Benefits
Our results for wages are similar to CWED’s, but we begin to diverge with benefits. We first review the “standard” benefit calculations used by CWED and other groups, and then we describe the omitted or undercounted portions.
“Standard” Benefit Calculation. The Bureau of Labor Statistics (BLS) publishes benefit/wage ratios for private and state-local workers collected through the Employer Costs for Employee Compensation (ECEC) survey. These figures include: paid leave, such as vacation, holiday or sick pay; supplemental pay, such as overtime and bonuses; insurance, such as life and health coverage; retirement and savings, which includes employer contributions to defined benefit and defined contribution pension plans; and legally required benefits, such as Social Security and Medicare payroll taxes.
In the Pacific Census region, which includes California, benefits for state-local employees were 55.5 percent of wages (or 37.5 percent of total compensation). For private sector workers in large firms, benefits equaled 50.3 percent of wages or (33.5 percent of compensation). BLS does not release state-specific data due to small sample sizes. If California has more generous public sector benefits than other states in the region, which is likely given our review of the pension and retiree health data, then the BLS Pacific Region figures may slightly understate total California compensation.
Omitted or Undercounted Benefits. We possess employee benefit data at nowhere near the level of detail that we have for salaries with the CPS. Given the limitations of BLS data on employee benefits, the CWED and other studies do a reasonable job of approximating total employee compensation. However, the CWED and other studies omit or understate two important benefits for public sector employees: retiree health care and defined benefit pensions.
Retiree Health Benefits. The existing studies omit retiree health benefits, which are not included in BLS compensation data as there are no payments to active employees. For private sector workers this omission is generally unimportant—private workers retire later, relatively few private workers receive retiree health coverage, and eligibility has been tightened and premiums increased for those who do. In contrast, almost 90 percent of state and local governments offer retiree health benefits to employees who retire in their 50s, with the government paying much of their costs, often including Medicare premiums and deductibles. State actuarial reports show the annual accruing costs of California retiree health benefits equal approximately 6.5 percent of total compensation.
Moreover, even these actuarial figures will understate the true value of retiree health coverage. The reason is that that the costs of coverage are calculated as the amount by which retiree coverage increases costs to the employer plan by increasing the average age of the covered population. However, there is an additional subsidy to the retiree as he otherwise would have to purchase coverage in the individual health market, which is approximately 25 percent more expensive for a given policy than group coverage. Thus, the true subsidy to the individual is the employer cost plus the cost difference between individual and group health coverage. In this case, the total subsidy would equal approximately 8.125 percent of total compensation.
Controlling for Pension Discount Rates. An important difference between public and private sector employment is the predominance of traditional defined benefit (DB) pensions in the public sector versus 401(k)-type defined contribution (DC) plans in the private sector. All pay comparisons to date have failed to accurately capture certain important distinctions between the two.
Employer contributions to pensions are only a proxy by which we infer the value of an actual future pension benefit. To accurately infer that value, we must consider both the size of the employer contribution and the implicit rate of return paid on it from the time of payment through the time the benefit is received.
For DC pensions, the return on contributions is straightforward. Individuals may invest employer contributions as they choose, in assets with a mix of risk and return they find optimal. For comparability with DB pensions, which are generally riskless to the employee, we assume that individuals invest DC assets in guaranteed U.S. Treasury securities, currently yielding around 4 percent annually over 20 years.
For DB plans, however, the implicit rate of return on contributions is a function of the plan’s benefit formula. This return can differ from person to person, but on average it will equal the discount rate or assumed investment return for the program as a whole.
In private sector DB plans, the discount rate equals the interest rate on a portfolio of high quality corporate bonds. Currently, such a portfolio yields approximately 5.5 percent. State and local pensions generally assume a discount rate of 8 percent, based on the expected return on assets held by the fund. This means that the employer contribution today is equal to the eventual benefit discounted back to the present at a 5.5 or 8 percent interest rate. Put another way, it means that public sector employees receive a guaranteed return of 8 percent on their employers’ pension contributions.
If we compare only the size of employer contributions while excluding the implicit return, we will understate true compensation delivered through DB pensions. To account for this, we calculate an adjustment factor to defined benefit pension contributions to account for how different annual rates of return compound over time. Most participants in defined benefits plans do not have a full career under such plans prior to retirement. In the state-local sector, it is common for employees to have approximately 25 years of service prior to retirement. We will assume the same length of service for all employees with DB pensions. We estimate the effect of different implicit rates of return by compounding over one-half the assumed number of service years for the employee.
The adjustment factor equals:
,
where the expected return equals 5.5 percent (private) or 8.0 percent (state-local) and the riskless return is 4 percent. This factor, which is greater than 1 so long as the expected return exceeds the riskless return, is multiplied by each sector’s employer contribution to DB pensions. The resulting value equals the equivalent employer contribution were all workers to hold defined contribution pensions.
These factors are multiplied by the normal cost of California pension plans, which is the cost (as a percent of salaries) of benefits accruing in a given year. Based on a weighted average of normal costs for California’s major pension funds—CalPERS, CalSTRS, the University of California pension, and the pensions of city employees in Los Angeles, San Francisco and San Diego—we calculate that the higher implicit return on public defined-benefit pensions increases the compensation of California’s government workers by approximately 4 percent.
Job Security
The final factor we consider is job security. According to the BLS Job Openings and Labor Turnover Survey (JOLTS), a private sector worker has an approximately 20 percent chance of being fired or laid off in a given year while for state-local employees the probability is only 6 percent. This effectively gives federal employees an insurance policy against being discharged. Here we attempt to ascribe a value to that insurance.
Adam Smith in The Wealth of Nations originated the idea of what are today called “compensating wage differentials,” that is, changes to wages to balance the positive or negative characteristics of jobs. Smith explains how this applies to the risk of unemployment:
Employment is much more constant in some trades than in others. In the greater part of manufactures, a journeyman may be pretty sure of employment almost every day in the year that he is able to work. A mason or a bricklayer, on the contrary, can work neither in hard frost nor in foul weather, and his employment at all other times depends on the occasional calls of his customers. He is liable, in consequence, to be frequently without any. What he earns, therefore, while he is employed must not only maintain him while he is idle, but make him some compensation for those anxious and desponding moments which the thought of so precarious a situation must sometimes occasion…. The high wages of those workmen, therefore, are not so much the recompense of their skill as the compensation for the inconsistency of their employment.
Just as positions with a high incidence and duration of unemployment should pay a compensation premium, positions with greater job security – such as public sector employment – should pay less than otherwise similar jobs.
Theory. To estimate the value of job security on effective compensation, we calculate what in financial economics is termed a “certainty equivalent,” which represents a guaranteed payment which individuals would find equally attractive to a higher but uncertain payment. For instance, an individual might be willing to accept a guaranteed payment of $45,000 in lieu of a 50 percent chance of winning $100,000. The more risk averse individuals are, the lower the certainty equivalent is relative to the probability-weighed expected value of the risky payment.
In this case, we effectively ask how much lower salary a private sector worker would accept to have the job security of a public sector employee. To calculate this value, we begin with an isoelastic/CRRA utility function of the form
where u is the utility derived from consumption c, and ρ is the coefficient of constant relative risk aversion (CRRA). What this indicates is that the welfare generated by income will rise as income rises, but at a decreasing rate. Moreover, the rate at which the marginal utility of consumption declines increases with the risk aversion of the individual. A more risk averse individual will be willing to accept a lower certainty equivalent income, because the increase in expected utility by accepting employment risk is lower.
Data. Using this utility function, we first calculate the utility of total compensation for a worker assuming he retains his job full time, assuming total compensation of $85,000. We then calculate utility in the case the worker becomes unemployed, which involves assumptions regarding the duration of unemployment, the level of unemployment benefits, and the compensation of the new job the individual may find. For the baseline case, we assume a duration of unemployment of 19 weeks, unemployment benefits of $450 per week (the California maximum) and a current position pay premium of 15 percent, which is approximately the amount by which we calculate that California public sector compensation exceeds that paid to similar private sector workers. Using these assumptions, annual compensation in the event of unemployment is $54,400, for which we also calculate a utility value.
The expected utility is the weighted average of utility if the individual remains employed throughout the year and utility if the individual is discharged. In this exercise, we do not wish to calculate the salary reduction an individual would accept to have a zero probability of being discharged, but merely the difference between the private sector rate (20 percent) and the public sector probability (6 percent). Thus, we approximate by assigning a probability of discharge equal to the difference between the two (14 percent). Expected utility is equal to the weighted utilities of consumption assuming the individual is discharged (14 percent probability) or remains employed throughout the year (86 percent probability).
To calculate the utility of consumption we require a value for the risk aversion of public sector employees. We obtain this from Munnell et al (2007). Based on data from the Panel Study of Income Dynamics, they estimate a CRRA for public employees of 5.4, which is significantly higher than the estimate for private sector workers of 2.8. Other studies have concluded that public employees are more risk averse than private sector workers.
We derive the certainty equivalent compensation by calculating the riskless compensation whose utility would equal the expected utility of compensation under the risk of unemployment. This value is $73,840. The base compensation of $85,000 exceeds this value by approximately 15 percent, thereby generating our estimate of the job security compensation premium. Using a more conservative assumption that California workers, were they to work in the private sector, would have half the probability of becoming unemployed (perhaps due to their higher average education) the job security pay premium is around 5 percent.
Graphical Illustration. The intuition of the calculations may be more understandable using a simple chart. Figure 1 shows a stylized utility function, where the curved line shows the relationship between income (on the horizontal axis) and utility (on the vertical axis). Higher income generates more happiness, but at an ever-declining rate. Point A represents the income/utility if the individual keeps his job throughout the year, while Point B represents the income/utility should he lose his job. Point C, which lies between the two, represents the individual’s expected utility from his employment – that is, the probability weighted average of the utilities at Points A and B.
Point D lies to the left of Point C and represents the certainty equivalent income, that is, the compensation with zero probability of discharge that that would generate the same utility as the non-guaranteed compensation the individual currently receives.
Summary
Whether public sector employees receive greater or lesser compensation than similar private sector workers is an empirical question that demands analysis of salaries, benefits, and job security. In the case of California public employees, we find that salaries are slightly lower in the public sector. Initially, benefits appear only slightly higher, implying rough parity in public and private compensation. However, properly accounting for retiree health benefits and DB pensions 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 compensation, meaning that the total public sector pay premium in California may be as high as 30 percent.
Sylvia A. Allegretto and Jeffrey Keefe,“The Truth about Public Employees in California,” Center on Wage and Employment Dynamics, Institute for Research on Labor and Employment, University of California Berkeley, October 2010, at http://www.irle.berkeley.edu/cwed/wp/2010-03.pdf (February 23, 2011).
An interesting compromise position on firm size, which we may incorporate into future drafts, is used in: “The Economic Policy Institute is Wrong: Public Workers are Overpaid,” Center for Union Facts, February 22, 2011, at http://www.unionfacts.com/downloads/Public_Sector_UnionsBrief.pdf (February 23, 2011).
The overstatement would be small because of the size of California’s population relative to that of other states.
Melinda Beeuwkes Buntin, José S. Escarce, Kanika Kapur, Jill M. Yegian, and M. Susan, “Trends and Variability in Individual Insurance Products,” Health Affairs, September 24, 2003.
Alicia H. Munnell, Kelly Haverstick, and Mauricio Soto, “Why Have Defined Benefit Plans Survived in the Public Sector?” State and Local Pension Plans Brief 2.Chestnut Hill, MA: Center for Retirement Research at Boston College, 2007.
Don Bellante and Albert N. Link, “Are Public Sector Workers More Risk Averse Than Private Sector Workers?”
Industrial and Labor Relations Review. Vol. 34, No. 3 (Apr., 1981), pp. 408-412.
At this point it is difficult to estimate probabilities and durations of unemployment for public sector workers, though we are investigating possible methods to do so.
