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Are Government Workers Underpaid? No

Wednesday, June 9, 2010

Once all promised benefits are included, government employees at all levels—local, state, and federal—receive significantly greater total compensation than private-sector workers.

A recent research paper released by the Center for State and Local Government Excellence argues that employees of state and local governments earn salaries and benefits significantly less than similar private-sector workers. But this study omits unfunded pension and retiree health benefits for public-sector workers. Once unfunded promises are included, state and local employees may receive significantly greater total compensation than private-sector workers.

Study authors Keith Bender and John Heywood of the University of Wisconsin-Milwaukee analyzed differences in salaries between private-sector workers and state and local employees using the Current Population Survey (CPS). Even when controlling for differences in age, education, race, marital status, and other factors, they found that state and local workers received salaries around 11 percent lower than otherwise identical private-sector employees.

As far as this goes, it’s fine. My former AEI colleague Jason Richwine (now ensconced at the Heritage Foundation) and I used the same data and methods to analyze the pay of federal employees (who, we found, received around a 12 percent pay premium relative to similar private-sector workers). Our figures regarding state and local salaries match those of Bender and Heywood. It’s quite possible that state and local workers are underpaid even as federal workers extract a premium.

In addition to health coverage and other benefits that are consumed today, most state and local employees also become eligible for defined benefit pension and health benefits in retirement.

But Bender and Heywood’s result holds only if public and private workers receive similar benefits, as the authors believe. Since the CPS doesn’t report benefits directly, Bender and Heywood use data from the National Compensation Survey (NCS), which reports how much employers spend on a variety of non-wage benefits. According to the NCS, both state and local governments and large private-sector employers pay fringe benefits equal to around one-third of their total compensation. Put another way, for each dollar of salary they receive, their employer devotes around 50 cents toward benefits. If these data are dispositive, then state and local workers receive total pay around 11 percent below private employees.

But here’s the problem. In the private sector, the amount employers spend on workers’ benefits is a good measure of what the employees themselves will receive. Most private-sector employers pay matching contributions into 401(k)-type pension plans, premiums for health coverage, and other similar benefits. Once employers have paid these costs, their obligation ends.

Not so in the public sector. In addition to health coverage and other benefits that are consumed today, most state and local employees also become eligible for defined-benefit pensions and health benefits in retirement. But state and local governments haven’t come close to fully funding these obligations. That means that the amount government employers spend today may be well less than what employees will actually receive when they retire. (Just because these benefits are underfunded doesn’t mean they won’t be paid; in most cases, payment is required by law or state constitutions.)

Biggs 6.8.10

Given the data available, it’s not easy to precisely calculate the effect of unfunded benefits on public-sector compensation. But here’s an initial attempt to shake the numbers out, starting with defined-benefit pensions.

As of 2006, pensions were funding only around 9 of the required 11 percent, leaving a gap of 2 percent of pay that is unfunded.

State governments need to set aside around 11 percent of workers’ pay each year to cover existing pension costs and the additional benefits generated by workers in that year, according to 2006 data compiled by the Center for Retirement Research at Boston College. Due to rising costs and declining pension assets, today that required contribution rate is likely higher. But, as of 2006, pensions were funding only around 9 of the required 11 percent, leaving a gap of 2 percent of pay that is unfunded.

That doesn’t sound like much. But it’s also increasingly understood these figures are a significant underestimate of what pensions truly should be funding. As I’ve written elsewhere, if pension funding were calculated using private-sector accounting methods—which is in any case a good approach, since we’re trying to compare public- and private-sector benefits—public pensions’ reported funding shortfall of $438 billion (as of 2008) rises to slightly over $3 trillion. To fully fund these pension promises would require annual government contributions not of 11 percent of workers’ wages, but of around 75 percent. But since these benefits will be paid, it makes sense to focus on what governments should fund, not on what they’re currently funding.

It’s a similar story with retiree health benefits, which generally provide full health coverage for public employees from the time they retire until they become eligible for Medicare and so-called “Medigap” coverage thereafter. Overall retiree health liabilities are smaller than for pensions—around one-fifth the size, according to a recent Pew Foundation report. The problem is that they’re almost entirely unfunded.

To fully fund these pension promises would require annual government contributions not of 11 percent of workers’ wages, but of around 75 percent.

A study by the Center for State and Local Government Excellence showed that states should devote an amount equal to around 13 percent of public employees’ pay to funding their retiree health benefits. But as a recent Pew Foundation report showed, most states fund only around one-third this much. In other words, state and local workers are promised unfunded retiree health benefits worth around 9 percent of pay, but this value isn’t reflected in compensation data.

I’m hesitant to put a total value on these unfunded promises, given the multiple moving parts and haphazard state of the data. But if public-sector workers are promised pension benefits that should require another 60 percent of wages to cover and retiree health benefits that should require an additional 9 percent of wages, then total effective compensation is almost 50 percent higher than you would conclude based solely on what government currently pays its employees. That’s more than enough to make up for Bender and Heywood’s 11 percent gap in what government employers currently pay relative to the private sector, and would leave state and local workers almost one-third better paid overall.

Now, there may be some reasons to scale these estimates back a bit. But the generosity of public-sector pension and retiree health benefits and the degree of underfunding mean that looking only at what government employers currently pay toward benefits isn’t representative of what government employers—and the taxpayers—ultimately will pay for these benefits.

Andrew G. Biggs is a resident scholar at the American Enterprise Institute. From 2008 to 2009 he served as principal deputy commissioner of the Social Security Administration and as secretary of the Social Security Board of Trustees.

FURTHER READING: Biggs explained how “Spending, Not Tax Cuts, Is the Real Driver of the Fiscal Mess,” “Why Immigration Can’t Save Social Security,” “Obama Budget Rigs Healthcare Numbers,” and “How Different Is Grandma’s Spending?” He decried “Shooting the Messenger: CBO in the Crosshairs” and warned of the “Entitlement Apocalypse.” His scholarly work includes a recent dive into “The Market Value of Public-Sector Pension Deficits.”

Image by Rob Green/Bergman Group.

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