Why is the UK short of workers and what should be done about it?

In the good old days, economists could gauge the health of the UK labour market simply by glancing at the unemployment rate. The latest official figure is still just 3.7 per cent, which suggests all is well. Unemployment has not been this low since the early 1970s.

Put another way, the vast majority of people who want a job are able to find one quickly, which is clearly a ‘good thing’.

However, this partly reflects a significant increase in the number of people who are no longer looking or available for work. These people are classified in the official statistics – rather brutally – as ‘economically inactive’.

The ranks of the ‘missing workers’ aged between 16 and 64 have grown by more than half a million since the start of the Covid pandemic. On top of this, many older workers, defined as those over 64, have chosen to retire earlier than they would otherwise have done.

Getting most of these people back into work could boost total employment – and hence economic activity – by at least one percent. In turn, this could make the difference between recession and growth over the coming years.

What’s more, the UK appears to be an outlier here. The increases in inactivity in most other major economies during the pandemic have now largely reversed. A shortage of workers could therefore be one factor contributing to the relatively weak economic recovery in the UK, where total employment and quarterly GDP are both still below their pre-Covid levels.

So what’s going on? It is always worth considering the possibility that the official data are wrong. The headline figures for employment and inactivity are drawn from the Labour Force Survey (LFS), which only samples a small proportion of the total population. It also weights the results in ways that may not be reliable.

In contrast, hard data drawn from PAYE submissions to HMRC suggest that the number of people on UK payrolls is more than 900,000 higher than it was before the pandemic.

Another possibility is that the problem is a lack of demand for labour, rather than a lack of supply. We may be looking at this the wrong way around. Instead of the recovery being held back by a shortage of workers, the UK economy might still be too weak to create enough decent jobs.

But neither of these alternative explanations fits what almost every other piece of evidence is telling us. In particular, the level of unfilled vacancies is still high, and many business surveys report  difficulties in hiring. There are certainly plenty of ‘staff wanted’ signs on display in my neighbourhood.

The jump in payroll employment should be regarded with suspicion too. This is because it has been flattered by a shift out of self-employment, partly due to new tax rules (known as IR35) which make off-payroll working less attractive. The additional problems faced by the self-employed during the pandemic may also have encouraged some to seek the relative security of payrolled employment.

The ‘missing workers’ problem is therefore real. Digging deeper, the official surveys suggest that the increase in the number of ‘economically inactive’ people has been driven by two main factors.

The most important is a sharp rise in the number of people reporting as ‘long-term sick’. This covers a multitude of problems, including long Covid and the backlog of NHS care built up during the pandemic. It also includes problems such as workplace stress and difficulties with the menopause.

There is no easy answer here. It is certainly not just a question of resources: the NHS has more money and more staff than it had before Covid, and yet is treating fewer patients. Dare I say it, the organisation itself may be part of the problem.

The second largest contribution to the increase in inactivity is less worrying – a sharp rise in the number of mainly young people choosing to become students during the pandemic rather than work. This at least should fix itself as they complete their courses and rejoin the labour market, hopefully with more skills than they had before.

It is important too not to lose sight of the bigger picture. One important trend is the natural ageing of the population. This is only partly adjusted by looking at particular age groups – such at those between 50 and 64 – because the average age within each group will be increasing.

Another is that many people have simply decided that it is not worth working any more, because high inflation and the rising tax burden have reduced real take-home pay.

Of course, not everyone has this choice. Some people might actually have to take on more work in order to cover their soaring bills. But there are others for whom work will no longer pay, including those close to normal retirement, single parents worried about the rising cost of childcare, and those who might lose benefits if they work more hours.

The obvious solution is to make sure that work does indeed pay. This is partly about ensuring that the tax and benefit system does not discourage work.

A good example is the perverse incentive for people to retire early to avoid paying more tax on their pension pots. The case for an increase in the lifetime allowance is strong. I would go further and look again at the entire tax treatment of pensions.

It is also right that employers should be expected to pay their staff more. This is a surprisingly controversial point. Some worry that this would trigger a ‘wage-price spiral’ and keep inflation higher for longer. But it is hard to see this as a serious threat when wages are still rising much more slowly than prices.

It makes more sense to view wages as a relative price just like any other and one which should respond freely to the forces of supply and demand. Indeed, one of the silver linings of labour shortages is that wages appear to be rising more quickly in the UK than in the European Union, or at least falling by less after adjusting for inflation.

So far I’ve managed to avoid mentioning the ‘B-word’. This is because Brexit does not explain why economic inactivity has risen. Overall migration to the UK has also remained high. Allowing more EU workers to come here might help to fill some of the gaps, but this could only be a temporary fix.

In short, there are some things that the government could do to ease labour shortages. Fixing the healthcare crisis should be a priority, which requires fundamental reform and not just more cash. It is also essential to tackle high marginal tax rates and distortions caused by the benefit system.

But in general, this is about allowing labour markets to work properly. Businesses may simply have to accept that scarce labour is more expensive, and invest more themselves in training and equipment to make the most of what they have.

This piece was first published in the Daily Telegraph on 26 December 2022

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