Public Safety Economics
Is the Public Sector at War with the Private Sector?
The labor movement has been losing steam in the U.S. for decades, with the unionization rate having declined from a high of one third of the private-sector workforce in the late 1950s to under 7 percent today. yet, unions have been, until recently, gaining strength in one part of the economy: government.
Federal and state reforms legitimized collective bargaining for government employees beginning in the 1960s. As a result, public-sector unionization rates moved in precisely the opposite direction, from nonexistent in the post-WWII years to 36 percent of government workers today. These changes have transformed the public sector into the last bastion of organized labor in the U.S., with the number of unionized government workers recently eclipsing that of private-sector union members. This trend is likely to continue into the future as private sector unionization wanes.
Unions can affect both unionized and non-unionized workers and entire industries for good and ill. It is not my purpose here to pass wholesale judgment on labor unions per se, but to address the economic impact of a unionized workforce on government finances. While much research has found beneficial effects of unions in terms of improving workers’ standing in the workplace (the “voice” effect), the most obvious economic effect of powerful unions is to significantly raise unionized workers’ compensation relative to non-unionized workers in a particular industry (the “monopoly” effect). Not infrequently does this imposition of a higher cost structure bring about the collapse of unionized firms or even entire industries.
Government-employee unions have the same basic effect of imposing higher costs on the governments that employ them. Government entities, however, face a completely different set of incentives and constraints than do private entities. While the permanence and coercive fiscal powers of governments can obscure the economic effects of a unionized workforce, the fundamental process operates with perhaps greater power: Unionized labor exerts evergrowing upward pressure on government budgets. Eventually the process comes to a head in the form of escalating budget crises, pitched tax battles and a hollowing out of government services.
States and municipalities have different policies regarding public-sector collective bargaining, and thus are at various stages of union-imposed fiscal decay. It is hoped that an awareness of the economics of public employee unions can help concerned Indiana citizens and policymakers make the needed reforms before union budget demands erode the capabilities of our local governments and generate a never-ending fiscal nightmare of municipal budget crises, bankruptcies and a reduced capacity for public-goods provision.
Basic Union Economics
As mentioned, there is more to unions than just maximizing compensation for their members. However, the most economically relevant aspect of unions, especially regarding their budget impact, is their effect on labor costs. The singular fact about unions in this light is their use of collective bargaining to increase their own members’ compensation.
The standard economic model conceives of unions as monopoly suppliers of labor. Just like monopoly suppliers of goods are able to raise prices above the competitive level by withholding supply, unions are able to raise member worker wages above the competitive labor market equilibrium through their monopoly control of a business or government entity’s labor supply. The standard supply-and-demand representation of this effect is shown in the diagram below:
Economic theory thus indicates that we should expect to see higher wages for union workers over nonunion workers in a given industry. But how significant is this “union wage premium?” A durable finding in the academic literature on this question is that union workers earn, on average over all industries, at least 15 percent more than their non-union counterparts.
With unions imposing higher per-worker labor costs on companies, one would expect unionized companies to employ fewer union workers in a bid to keep costs down. This is often the case, wherein firms in unionized industries cut back on employment numbers due to unions’ very success in making workers more expensive to hire. However, it is also common for unions to seek to preserve their workers’ jobs by inserting so-called “featherbedding” language into collective-bargaining agreements that mandate minimum staffing numbers, stringent work rules and other gimmicks aimed at maintaining high levels of union employment. The success of such measures can offset what we might term the pure labor-demand effect of unionization, thus making the overall impact of unions on employment somewhat ambiguous.
What is not ambiguous, though, is the impact of unionization on corporate profits. By increasing unionized firms’ per-worker compensation costs, unions erode businesses profits. A large body of economic research finds that unionization reduces corporate profit rates by a factor of 10 to 20 percent — a phenomenon
termed the “union tax” in the academic literature. In this regard, unions have been quite successful in transferring corporate income from “capital” (i.e., the firm’s ultimate owners) to labor. Worthy as this goal might be in the eyes of union organizers and labormovement ideologues, this has a depressing effect on long-term capital investment and overall employment growth in heavily unionized industries. Not surprisingly, over the long run unionized industries see reductions in capital investment and research and development spending versus their non-unionized peers on the order of 13 to 15 percent. The reduced profitability and investment, in turn, imply lower overall long-run growth in unionized industries. This, in turn, entails lower job growth if not lower outright employment levels in unionized industries. From this perspective, it is not difficult to understand the long-run decline in overall unionization rates — a perverse but predictable effect of initial union strength. Examples of companies and entire industries that have been hollowed out in this fashion by powerful, unyielding unions are too numerous to mention here. one recent, newsworthy example was the liquidation of Hostess Brands — maker of the well loved Twinkie and other snacks — brought on by excessive compensation demands from a recalcitrant Bakers Union.
Similar patterns of union strength, followed by union stubbornness in the face of declining profitability and industry growth, followed again by a reduction in union numbers as the industry declines and shifts assets out of union strongholds, have occurred in the U.S. auto, textiles and steel industries, to name but a few.
These effects of successful unionization within private-sector companies and industries can be summarized in what I term the “union cycle”:
The Private-Sector Union cycle
1. Unionize the labor force in a profitable industry
2. “Redistribute” profits from capital (ownermanagers) to labor (union members)
3. Erode industry investment and growth over time
4. observe dwindling long-run unionization as “the parasite kills the host”
Public-sector unions undoubtedly share the same basic goals and generally employ the same tactics (i.e., legally imposed collective bargaining) as their privatesector union cousins. Not surprisingly, economists have similarly found a durable wage premium for unionized (versus non-union) government workers. Studies repeatedly find that unionized government workers consistently earn, on average, at least 10 percent higher wages than non-unionized government workers. yet, unlike private-sector union effects, the research on public-sector unions has found that, in addition to raising compensation costs, they also increase employment in unionized government departments by an amount ranging from 5 to 10 percent of average employment levels for both unionized and non-unionized government departments. Scholars explain this positive employment effect of government-worker unions by referring to the fundamental difference between government entities and private companies. First off is the fact that, unlike private firms subject to the “market test” of profit and loss, government entities are tax-financed monopoly public goods providers. Note that in the private sector excessive union demands will erode a company’s profits, eventually driving it into bankruptcy. Excessive public sector union demands, on the other hand, often will simply be met with larger government budgets, even if that necessitates higher taxes and lower spending levels on non-union personnel budget items.
Perhaps more important to explaining the great success public employee unions have in raising both compensation and employment numbers is to realize that government-worker unions operate as powerful special interest groups within the government. As Public choice economics indicates, interest groups lobby hard to preserve the benefits they accrue from particular government programs and policies. Unions have always been notoriously politically active; public-sector unions in particular are well known for mobilizing their members and tapping large funding sources — including dues automatically deducted from workers’ paychecks — for political advertising and campaign contributions. In other words, public-sector unions exert strong political pull, which can give them bargaining power above and beyond that gained through collective-bargaining privileges alone.
Public-sector unions’ political clout therefore generates a uniquely perverse set of incentives for the bureaucrats and politicians who manage government budgets. In a striking contrast to private-sector union dynamics, public-sector unions face a situation in which the interests of “management” are strangely aligned with those of the workers.
As scholar Daniel DiSalvo explains, “Through their extensive political activity, these government-workers’ unions help elect the very politicians who will act as ‘management’ in their contract negotiations — in effect handpicking those who will sit across the bargaining table from them, in a way that workers in a private corporation cannot.” Thus the political influence public employee unions exert on their employers ensures them a powerful ability to obtain generous concessions at the bargaining table.
Finally, note that while public-sector unions have been found to raise government worker wages and increase government employment, economists have found that they do not increase total spending for unionized government entities, but only spending within the unionized departments. The implication here is that, in the long run, one major effect of publicsector unions will be to divert resources from within government to themselves, away from various non-labor, non-unionized government spending outlets.
Public-Sector Pension Pains
As we’ve seen, the political strength of public sector unions gives them a powerful ability to divert government resources towards their own members. Indeed, with the lock these unions have on many state and municipal governments, it’s surprising that their wage premium is not even greater than that of private sector unions. But, as many news-savvy Americans are beginning to learn, the wage premium is not half of the story here. The real strength of public-sector unions — and thus the real public budget impact — must be found by examining their entire compensation package, including wages and benefits.
Researcher Chris Edwards, using data from the Bureau of labor Statistics, finds that unionized government workers across the U.S. earn about 30 percent higher wages than non-union government workers, but 68 percent higher benefits. Among benefit items (such as insurance, paid sick leave, pensions, etc.), the union advantage is over 100 percent greater in one particular category: defined-benefit pension contributions. In other words, public-sector union members are taking much of their union wage premium in the form of extremely rich retirement benefits rather than as current wages.
Why do unionized government work forces choose to defer the gains from unionization in this manner? As I’ve noted, the higher costs imposed by unionized workers on state and local governments necessitates either larger budgets and higher taxes or, barring those options, a larger share of existing budgets devoted to satisfying union demands. Politicians need union support to win and retain office, yet they also face some degree of accountability to the public over the provision of public goods for which they are responsible such as police protection, road and sewer maintenance, public parks and so on. An attractive compromise is to keep current budgets in line and therefore maintain expected levels of public-goods provision yet also appease the powerful union interest groups’ demands by awarding much of the union’s premium in the form of deferred compensation. Thus unionized government workers, while still enjoying a significant current wage premium, have wielded their political influence to win themselves generous — in some cases lavish — future benefits in the form of pension and health insurance employee benefits.
This “buy now, pay later” pattern of political behavior comes as no surprise to those steeped in Public choice economics. Indeed, there’s a name for it: “political myopia” or “shortsightedness bias.” It’s not that politicians are inherently more shortsighted than regular citizens or corporate executives, but simply that they face strong incentives to appease the current demands of powerful constituencies by imposing large burdens on future budgets and future taxpayers. Incentive is the name of the game in economics, and perhaps nowhere is the incentive difference between private, market-based decision-making and government decision-making more evident than in these matters of determining present versus future compensation for employees.
Private companies are ultimately managed by their owners — directly in the case of small proprietorships or indirectly in the case of publicly held large corporations. In either case, what the owners own is the present value of the ongoing net income of the business. committing to large future costs that do not pay off in terms of larger future revenues erodes the present capital value of the company. Therefore business owners have strong incentives to carefully scrutinize expenses, both current and projected.
Politicians and bureaucrats, on the other hand, have no such “stake” in the company. Not only is there no owner of government enterprises (other than some nebulous concept of “the public”); there is no net income to be gained.
Politicians are, at best, temporary stewards of public-goods providing government enterprises whose compensation is based on fixed formulas, rather than the market performance of the enterprise. Even assuming noble, public-spirited motives on the part of elected state or municipal leaders, their planning horizons are often attenuated by the electoral process. Facing reelection at two- or four-year intervals, and heavily dependent on the donations and campaigning of interest groups, foremost among which is often government-employee unions, elected leaders face pressure to sacrifice sound long-term fiscal management to appease the short-term pressure of powerful government labor monopoly interests.
How does the policymaker balance the government services needs of the public against the budget appetites of unionized workers? Daniel DiSalvo, again, captures the essence of how the political incentives play out: “. . . many lawmakers found that increasing pensions was good politics. They placated unions with future pension commitments, and then turned around, borrowed the money appropriated for the pensions, and spent it paying for public services in the here and now. Politicians liked this scheme because they could satisfy the unions, provide generous public services without raising taxes to pay for them, and even sometimes get around balanced-budget requirements.”
Thus the presence of a unionized workforce, in combination with the unique political incentives facing governmental budget-crafters, leads to a specific incarnation of the union cycle in the public sector:
The Public-Sector Union cycle
1. Unionize state or local government departments
2. Redistribute tax revenue from “capital” budgets to “labor,” especially in the form of healthcare and pension benefits (generating large future liabilities for governments)
3. Precipitate eventual budget crisis, leading to:
• Increase in state/local tax burden (Illinois model)
• limits on public-sector bargaining (Wisconsin model)
• Municipal bankruptcy or restructuring (california model)
• Federal bailouts for financially strapped states and localities unable or unwilling to trim their public employee pension obligations through any of the other options
4. Union retiree benefits crowd out other government spending priorities
In this paper I have presented substantiated, noncontroversial findings of a large body of academic research on the effects of both private- and public sector unions. I have made inferences based on those findings that are corroborated by several recurring real-world examples. Whether or not one views the economic effects of unions, private or public sector, as troublesome is of course a matter of individual values and preferences.
At any rate, there’s no denying that public-sector unions are putting large, growing, unsustainable cost pressures on all levels of government. In an era of fiscal concern and budget austerity, it’s not surprising that public-sector unions, with their increasingly wellpublicized “union premium” pay and benefit packages, have drawn much political heat.
If public-sector union excesses are left unchecked, the effects we can expect to see are clear: public unions can only maintain their take of government funds by diverting an ever larger chunk of resources away from other government functions such as capital expenditures on infrastructure, parks and other amenities. In this there is a striking similarity between budget-busting public-sector unions at the state and local government levels and the budget-busting old age “entitlement” programs of the federal government. In both cases elite interest groups eat up an increasing share of tax receipts (or generate increasing government debt). Robert Samuelson, writing in the Washington Post, recently noted this phenomenon in federal government finances, stating, “In fiscal 2012, Social Security, Medicare, Medicaid and civil service and military retirement cost $1.7 trillion, about half the budget. If they’re off-limits, the burdens on other programs and tax increases grow ever greater… Almost everything is being subordinated to protect retirees. Solicitude for government’s largest constituency undermines the rest of government… Government is being slowly transformed into a vast old-age home, with everything else devalued and degraded.”
Governments, though, eventually run up against hard budget constraints, whether in the form of practical balanced-budget constraints for states and municipalities or a bona fide debt crisis in the case of the federal government. Budget problems must eventually come to a head and be resolved by one means or another. While national governments with monetary sovereignty often resort to the expedient of inflationary finance to “solve” their budget problems, this option is, fortunately, off limits to state and local governments within the U.S.
The question before us, then, is what will Indiana and its municipalities that are facing the budget strain of unionized public-employee benefits do? Will they cave to the political force of the unions and choose tax hikes and intragovernmental redistribution from capital to labor until their states tax bases are hollowed out in the manner of unionized U.S. manufacturing? or will they choose to resist union pressures and endure the difficult medicine of austerity now, knowing that this policy offers the best hope of creating the sound, reliable fiscal environment crucial to restoring long-run economic growth?
We have already seen some strong, proactive leadership on this front with a governor who took steps to check public-union excesses. But of course we can and must do better to remain competitive as a good place to live and do business.
Other states can offer equal, if not better, fiscal environments (and better weather). To remain competitive in an increasingly globalized economy, Indiana policy leaders must be proactive in maintaining a sound fiscal environment and preventing union-imposed public finance debacles from happening here.
About the Author: Tyler Watts, Ph.D., is an adjunct scholar of the Indiana Policy Review Foundation, and teaches economics at Ball State University. This study originally appeared in the Spring 2013 edition of the Indiana Policy Review, and is republished here with permission.
3. David Blanchflower and Alex Bryson. “What Effect Do Unions Have on Wages Now and Would Freeman and Medoff be Surprised?” In Bennett & Kaufman, eds. What Do Unions Do: a Twenty-Year Perspective. Transaction Publishers, 2007.
4. Barry Hirsch. “What Do Unions Do for Economic Performance?” In Bennett & Kaufman, eds. What Do Unions Do: a Twenty-Year Perspective, p. 212. Transaction Publishers, 2007.
5. Ibid., p. 216
6. See, for example, Gregg Lewis. “Union/Nonunion Wage Gaps in the Public Sector” in Freeman and Ichniowski, eds.,. When Public Sector Workers Unionize. University of Chicago Press, 1988.
7. Jeffrey Zax, Casey Ichniowski. “The Effects of Public Sector Unionism on Pay, Employment, Department Budgets, and Municipal Expenditures.” in Freeman and Ichniowski, eds., When Public Sector Workers Unionize. University of Chicago Press, 1988.
9. Op. cit. Zax and Ichniowski.
12. This has not happened to date, of course, but some experts on the topic — notably Northwestern University Finance Professor Joshua Rauh — are worried that the magnitude of unfunded state pension liabilities will necessitate this outcome as the least painful solution to the coming state pension crisis. See Joshua Rauh, “Are State Public Pensions Sustainable? Why the Federal Government Should Worry About State Pension Liabilities” available at http://ssrn.com/abstract=1596679
14. According to the Pew Center on the States, Indiana’s state pension funds are currently 65% funded, but
state retiree health care programs are only 5% funded. Source:
Assets/2012/Pew_Pensions_Update.pdf . According to an analysis of state pension funding by the Morningstar
company, Indiana ranked 27th in terms of unfunded state retiree benefit liabilities per capita, at $2,284. The worst
performing state, Illinois, by comparison, was reported to have per capita unfunded liabilities of $6,505. Source: