Which factors shape the relationship between manufacturing and government wages?

Benedicta Marzinotto, Alessandro Turrini 05 September 2014



During the crisis, numerous Eurozone countries have introduced public wage freezes or cuts as part of an attempt to contain rising fiscal deficits and debts. Some of these countries also had to rebalance their economies, and improve price competitiveness. The relevant question is therefore whether government wages, whilst relevant for fiscal outcomes, may also exert some impact on private-sector labour costs and price competitiveness.

There is an established literature looking at the potential for types of fiscal consolidation to have competitiveness-enhancing effects by reducing unit labour costs in the exposed sector (e.g. Alesina and Perotti 1997, Ardagna 2004). Another strand of research looks at the relationship between public and private wage-setting – notably whether there is merely co-movement, or instead wage leadership by one of the two sectors (e.g. Perez and Sanchez 2011, Lamo et al. 2012, 2013).

Two aspects seem generally neglected in the available literature. One is whether the size of the public sector matters. This is surprising because any market-driven transmission going from the public to the private sector is likely to be affected by size.

The other is whether the way in which government wages are set – through collective bargaining or government decision – also matters. Whilst fully unexplored, the wage-setting mode in the government sector is a crucial issue because it is an indication of the extent to which changes in government wages are mostly the result of fiscal policy decisions, or are rather part of the broader economy-wide wage-setting process.

Manufacturing and government wages: estimating the links

We test the relationship between manufacturing and government wages on a sample of EU countries for which general government employment data are available for 1980–2012. The analysis of public employment and wages is typically impaired by issues of cross-country comparability because the boundaries of the public sector vary from one country to the other. We use OECD data to compute nominal compensation per employee for the general government, as this is the public sector definition that better permits cross-country comparisons.1 Nevertheless, we remain confronted with problems of country and time coverage, which is why the sample is limited to 17 EU countries.

We adopt a co-integration framework that allows us to assess both the long-run and the short-run relationship between manufacturing and government wages and other standard explanatory variables. The full exercise and the results are reported in a recent Commission Report (European Commission 2014). It is found that, on average, every 1% rise (fall) in government wages leads on to a 0.3/0.4% rise (fall) in manufacturing wages – a result broadly in line with analogous studies (e.g. Afonso and Gomes 2008). Manufacturing wages are related not only to general government wages, but also to the standard variables used in wage equations, namely the inflation rate, productivity, and unemployment.

Government size

By splitting the sample into groups of countries that share common features, we are able to assess whether the strength of the relationship between manufacturing and government wages varies from one group of countries to the other. We split the sample according to the size of the government sector, distinguishing between countries where general government to total employment is above the sample’s mean and countries where it is below.

Interestingly enough, when the general government is a relatively important employer, the long-run relationship between manufacturing and government wages is fundamentally different from what it is when the government employs only a small share of the labour force. Each 1% rise (fall) in government wages leads to a 0.7% rise (fall) in manufacturing wages compared to just 0.2% when the government sector is small. Their short-run relationship is instead unaffected by size.2

Fiscal consolidation episodes

The evolution of labour costs in the public sector was among the factors that contributed to debt growth and in some instances to competitiveness losses ahead of the crisis in a number of Eurozone countries (e.g. Blanchard 2007). Yet, the crisis marked a watershed in the relative behaviour of government wages. Whilst before the crisis government wages were growing well above those in the manufacturing sector, including at times of fiscal consolidation, this pattern was in some cases reversed after 2007, when government wages actually fell in years of fiscal adjustment (Figure 1).

It is possible that, in periods of fiscal stress, the interplay between manufacturing and government wages differs from normal times. To test this hypothesis, it is not possible to proceed by means of a sample split in the estimation of the co-integration framework discussed above, as consolidation episodes have concerned most countries, and for limited time periods only. We proceed then by simply measuring the correlation between manufacturing and government wage growth across the whole panel, isolating time periods with and without fiscal consolidation.

We find that government and manufacturing wages are generally less correlated in periods of fiscal consolidation, which indicates that government compensation is mostly driven by deficit reduction objectives rather than by the state of the labour market. The correlation between manufacturing and government wages, however, holds strong for countries with a large government sector even during fiscal consolidation episodes, which may allude to the presence of spillovers running from the government sector to the rest of the economy (Table 1).

Figure 1. Average annual percentage change in government and manufacturing compensation under alternative fiscal conditions, EU countries, 1999–2007 and 2008–2012

Table 1. Correlation between government and manufacturing compensations’ growth under alternative fiscal conditions, EU 1980–2012

Source: Own calculations based on OECD and DG ECFIN AMECO Database.

Notes: Pearson correlation coefficients. Fiscal consolidations are defined as a change in the structural balance of at least 1.5% of GDP in one year or of at least 3% of GDP over a three-year period, with at least 0.5% improvement in each year. Sample: EU countries (excluding AT, BG, CY, DE, EL, LT, LV, MT, RO, SI) over 1980–2012 (1995–2012 in the case of CZ, EE, HU, SK).

Government wage-setting mode

To take into account the way in which government wages are set, we split the sample into two groups of countries depending on whether government wages are mainly set by collective bargaining or by government decision (for details on the information used for such a classification, see European Commission 2014). We find that while the relation between manufacturing and government wages is similar irrespective of the wage-setting modality, how wages in the government sector are determined appears to matter instead for the link between manufacturing wages and productivity, with manufacturing wages poorly aligned with productivity in countries where government wages are set by decision. The interpretation is as follows. When government wages are unilaterally set by the government, they are less likely to be aligned with productivity developments. If they also influence manufacturing wage dynamics, misalignment between pay and productivity may emerge also in the manufacturing sector.3

Concluding remarks

Our analysis confirms that there is in general a significant relationship between manufacturing and government wages, and adds that such a relationship appears much stronger in countries with a large government sector. The fact that in large-government countries the link is strong also during fiscal consolidation periods suggests an interpretation of the relationship in terms of a spillover going from the government to the export sector, as during major fiscal retrenchment periods government wage dynamics mostly respond to budgetary objectives. The wage-setting mode in the government sector also plays a role on wages in the tradable sector, albeit an indirect one, by affecting the alignment between pay and productivity in that sector. Going forward, looking into the institutional environment in which decisions on government wages are taken seems like a promising research avenue, which would require more information on government wages and wage-setting modalities than available at present.

Authors’ note: the views expressed in this column represent those of the authors and not necessarily those of the European Commission.


Afonso, A and P Gomes (2008), “Interactions between private and public sector wages”, ECB Working Paper 971. 

Alesina, A and R Perotti (1997), “The welfare state and competitiveness”, American Economic Review 87(5): 921–939.

Ardagna, S (2004), “Fiscal stabilizations: when do they work and why”, European Economic Review 48(5): 1047–1074.

Blanchard, O (2007), “Adjustment within the euro. The difficult case of Portugal”, Portuguese Economic Journal 6(1): 1–21.

European Commission (2014), “Government wages and labour market outcomes”, Occasional Paper 190. 

Forni, L and N Novta (forthcoming), “Public employment and compensation reform during times of fiscal consolidation”, IMF Working Paper.

Lamo, A, J J Perez and L Schuknecht (2012), “Public or private sector wage leadership? An international perspective”, Scandinavian Journal of Economics 114(1): 228–244.

Lamo, A, J J Perez and A Sanchez-Fuentes (2013), “Institutional determinants of public-private sector wages’ linkages”, Applied Economics Letters 20(12): 1165–1169.

Perez, J J and A J Sanchez (2011), “Is there a signalling role for public wages? Evidence of the euro area based on macro data”, Empirical Economics 41(2): 421–445.


1 The general government includes central government, local governments, and social security, and comprises only non-market entities (e.g., hospitals and schools) classified according to common statistical guidelines across EU countries. Nominal compensation per employee is calculated as general government final wage consumption expenditure divided by general government employment available from the OECD.

2 Such a difference in the long-run response is not found when splitting the sample according to country openness instead.

3 Forni and Novta (forthcoming) find that government wage cuts are more likely to lead to a permanent reduction in the wage bill if supported by a social dialogue.




Topics:  Labour markets

Tags:  wages, government, public-sector pay, collective bargaining, manufacturing, Public sector, private sector, competitiveness

Policy Analyst, Economist, European Commission DG ECFIN

Head of Unit, DG Economic and Financial Affairs, European Commission