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In the debate over public sector compensation, it’s often noted that – in addition to generous salaries and better fringe benefits – federal employees have far greater job security than private sector workers. While a private sector worker has an approximately 20 percent chance of being fired or laid off in a given year, for federal employees it’s only 6 percent. This effectively gives federal employees an insurance policy against being discharged. My goal here is to assign a dollar value to that insurance.
To understand the value of job security, imagine that you were offered a job where you would be well-paid but would also have a good chance of being fired or laid off. What salary reduction would you accept to hold the same position but with zero possibility of losing your job? One answer is to look at the expected pay of the job – that is, the annual salary after accounting for the probability of being laid off and the time it would take you to find a new job. But since most people dislike risk they will accept less than the expected pay – often far less – in order to have greater job security.
The question is, how much less? To arrive at a rough estimate, we’ll work from a chart that resembles what you might see in an economics textbook. 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. That’s what economists call the declining marginal utility of income – in other words, your first dollar buys you more happiness than your ten thousandth dollar.
To begin, let’s assume a position pays $40,000 annually. That produces a combination of income and utility shown at Point A on the chart. However, this is a typical private-sector job, and the employee has a 20 percent chance of losing his job involuntarily this year. If the employee were to lose his job, his annual income would be reduced. Here we assume it takes an average of 20 weeks to find a new job, which is at the same salary. So if he were to lose his job, his annual income would fall to $24,615. The income and utility associated with the job-loss scenario is shown at Point B.
We can take a weighted average of those two figures to find the employee’s expected annual income: $36,923. We can also take a weighted average of the utility the employee derives under the scenario that he keeps his job or that he loses it. This is represented on the chart at Point C, showing the employee’s expected combination of income and utility from taking a private-sector job with a $40,000 salary.
But now draw a line from Point C going to the left to meet the utility curve, at Point D. Point D has the same utility as Point C, but is based on a certain income without any prospect of job loss. The income at Point D, $32,500, is called the “certainty equivalent” of income at Point C. In other words, an individual would be equally happy with a salary of $40,000, with a 20 percent chance of being fired, or a guaranteed income of $32,500.
In calculating the implicit pay premium for federal workers, we don’t calculate the salary they would accept for a zero possibility of being fired, but merely what they’d be willing to take to reduce the 20 percent private sector possibility to the 6 percent annual discharge rate enjoyed by federal employees. The certainty equivalent wage under those circumstances is $34,000.
In other words, even if federal employees receive the same salaries as similarly qualified private sector workers, they’re actually receiving a pay premium of around 18 percent due to their greater job security. And, since most academic research shows that federal employees receive salaries 10 to 20 percent higher than similar private sector workers even before job security is factored in, the total federal pay premium could be a lot larger than we’d previously thought. This suggests that even if Congress decided to reduce federal pay significantly, it’s not likely that many federal employees will quit.
An individual’s risk aversion comes into the picture through the shape of the curve. A more risk-averse person’s utility function would flatten out more quickly. This means that the certainty equivalent income would be further below the expected income than for a less risk-averse person.
Now, to isolate the job security pay premium precisely, we’d need to get better estimates of the parameters. For each individual, these could include:
• The probability of being discharged in the federal government: it’s not clear what demographic characteristics distinguish workers who are discharged from federal employment;
• The probability of being discharged in the private sector: federal workers tend to have high education levels, and better educated workers may have a lower discharge rate than less skilled employees;
• Length of unemployment: Better educated federal workers may have an easier time finding a new job;
• Effects of unemployment benefits: Unemployment insurance would cushion the loss of income due to being discharged from federal employment, but because unemployment benefits are capped the effects would be largest for low-income workers;
• Salary of new job: Federal workers who lost their jobs may not find new ones at the same salary; in particular, the federal pay premium for lower-skilled workers is very large, meaning they may be unemployed longer and have to accept lower wages once they do find a new position;
• Risk-aversion: Several studies have found that public employees are significantly more risk-averse than other Americans, meaning that they’ll give up a lot of salary in exchange for job security. But I suspect that for lower-skilled individuals the attraction of federal employment is principally better pay and benefits, while for higher-skilled workers job security may be more important.
So while more empirical work needs to be done, we can see the general direction of things: job security is very valuable, particularly to people who are unusually risk-averse, and federal employees have much more job security than private sector workers. Given that there’s already solid evidence of a federal pay premium even without considering job security, it’s likely that true overpayments to federal employees are even larger than previously thought.
Andrew G. Biggs is a resident scholar at the AEI.
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