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Government Employees: Still Overpaid

Saturday, October 23, 2010

Several studies from left-leaning research groups claim that state and local government employees are underpaid. All of the studies are seriously flawed.

A new study from the Center on Wage and Employment Dynamics at the University of California-Berkeley has garnered significant press attention with its claim to show authoritatively that California government employees are not overpaid relative to similar private sector workers. The report received press coverage by CNBC, the San Francisco Chronicle, and other outlets. The CWED study follows three nearly identical recent studies making the same claim for state and local government workers nationwide, coming from the Center on State and Local Government Excellence, the Center for Economic and Policy Research, and the Economic Policy Institute. All three studies share the same errors in underestimating the value of public employees’ pension and retiree health benefits. Correcting these errors shows a strong probability that state and local government employees are overpaid.

The CWED and the other three reports use nearly identical methods in calculating the “pay gap” between public and private sector employees. In the first step, the studies use detailed data from the Current Population Survey to compare salaries for public and private sector employees while controlling for differences in age, education, experience, and a number of other relevant factors. Then, the studies use Bureau of Labor Statistics (BLS) compensation data to estimate the generosity of fringe benefits, such as health coverage and pensions, since it is only by including benefits that we can know if public employees are truly overpaid. It is in this second stage that all these studies fall down.

The studies use Bureau of Labor Statistics compensation data to estimate the generosity of fringe benefits. It is in this second stage that all these studies fall down.

The CWED study finds that state and local employees in California receive hourly wages 6.4 percent below those of otherwise similar private sector employees. Let’s assume that these results are reasonable. The study then goes on to compare the value of fringe benefits. Data from BLS show how different fringe benefits make up total employee compensation. Private sector workers in large firms receive around 67 percent of their total compensation as wages, with the remaining 33 percent as fringe benefits. Public sector workers receive 64 percent of their total compensation as wages, with 36 percent coming from benefits. CWED argues that these slightly more generous public sector benefits combine with 6.4 percent lower salaries to produce total public sector hourly compensation—benefits plus salaries—that is 2.3 percent higher than that of similar private sector employees, a difference that isn’t statistically significant. Overall, the study concludes, California public sector workers receive total pay almost exactly the same as that of private sector employees.

The basic problem with CWED’s treatment of benefits is that it assumes data showing what employers currently pay toward benefits is equal to what employees will actually receive. In the short-term, this assumption is fine, since many employee benefits are consumed today. But in the public sector, a large share of compensation is deferred to retirement in the form of pension benefits and retiree health benefits. The CWED study significantly underestimates the value of deferred benefits.

The basic problem with CWED’s treatment of benefits is that it assumes data showing what employers currently pay toward benefits is equal to what employees will actually receive.

As many people are aware, public sector defined-benefit pension plans are significantly underfunded. Using private sector accounting standards, which is necessary to make apples-to-apples comparisons, the typical public pension is less than 50 percent funded. When pensions are underfunded, compensation from pensions is underestimated.

Thus, although the CWED study argues that California’s public sector employees receive pension benefits equal to 8.2 percent of their total compensation, that’s not exactly true. Their data actually shows that California public employers are paying 8.2 percent of employee compensation toward pensions, but that is only around half what employers should be paying. And since public pension benefits are guaranteed, that extra amount will be paid sooner or later. A good guess of true public pension compensation is to divide the reported pension contribution of 8.2 percent by the 50 percent funding level of California pensions, producing a value for promised pension benefits of 16 percent of compensation. This increases the 2 percent pay advantage that the CWED study already acknowledges to a public sector pay premium of around 10 percent.

The retiree health coverage obviously is a form of deferred compensation to workers and should be counted as such for public-private pay comparisons.

There’s also another factor contributing to the flawed interpretation of data: Retiree health benefits aren’t counted as worker compensation. Most public employees receive free or subsidized health coverage after they retiree, a benefit that most private sector workers do not get. Given how early most public employees retire and the high cost of health insurance for older individuals, this retiree health coverage can be worth several hundred thousands of dollars over the course of their lifetimes. But because these payments are made to retirees, not to workers, the BLS excludes them in their employee compensation data. Yet retiree health coverage obviously is a form of deferred compensation to workers and should be counted as such for public-private pay comparisons.

How much is this coverage worth? Using data from the Pew Foundation, I calculated how much each state would need to put aside each year, as a percentage of workers’ wages, to fully fund their retiree healthcare. For California, the answer is around 12 percent of pay, among the highest in the country. Accounting for retiree health coverage would increase total compensation by around 8 percent, pushing the total California public pay advantage to around 18 percent.

Judging from the number of studies on public sector pay emerging from left-leaning policy groups, these groups must have concluded that they have a persuasive case to make. But that case depends crucially on a flawed approach for estimating the value of pension and retiree health benefits. Once those errors are corrected, it is difficult to conclude that state and local government employees are not overpaid. 

Andrew G. Biggs is a resident scholar at the American Enterprise Institute.

FURTHER READING: Biggs asks, “Why Does Government Grow and Grow and Grow?” smells “New Blood for Social Security,” and, with Jason Richwine, reports that "Federal Employees Are Not Underpaid 22 Percent." Biggs also warns that "Personal Accounts Are No Cure-All" and offers "A Conservative's Take on Social Security Reform."

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