Putting the direct costs of the pay cap to public services aside, there is also the so-called multiplier effect to consider. This means when you give someone a pay rise, there are larger positive implications for the economy because it can stimulate further rounds of spending. For example, if there is a £2bn increase in wages for NHS workers and they spend just half of this in shops, then shopkeepers will also receive income.
In turn, this increase in income will mean shopkeepers are more likely to employ more people and increase salaries themselves. The treasury would then not just receive more taxes from higher wages among NHS staff, but also the VAT on extra goods sold, and on higher income taxes from jobs created elsewhere.
The multiplier effect is thought to be higher for those on low-middle incomes, as they are much more likely to spend it than save it or put it in a tax haven. According to a Unison study based on International Monetary Fund figures, every 1% increase in public sector pay would generate between £710m and £820m for the government in increased income tax. Of course, there are debates about just how big these multiplier effects are – but we must stop thinking about a pay rise as purely negative for the public purse. We all know that our public service workers are worth every penny – but these pennies go well beyond their pay packets.
It’s not economics unless you consider opportunity costs. That money has come from someone. Might be tax, might be borrowing, but those who had it would have also spent some portion of it into the economy. Even if we say that borrowing means it is obviously only coming from savings if those savings weren’t put into gilts then it would have been invested elsewhere instead.
What we actually want to know is what is the effect after this? This is known as the marginal propensity to spend (or save, the inverse). If we take tax off low paid people and give it to low paid people then the net effect is nothing. Because whatever the marginal propensity to spend of the poor is, it’ll be the same or those who lose money as those who gain it. If we take money off the rich then there will be a change. But that change is not the amount of money itself. It’s the difference between what the rich would have spent and the poor do spend. A useful rule ot thumb here is some 15%. Upper middle classes might save 15% of any marginal income, the poor 0%, that’s the amount that spending rises by.
Do also note that this only applies to tax funded increases in such wages. If it’s from what is already being saved well, those savings would have been used to invest in some other thing if not borrowed by government.
The argument is true but it’s a very, very, weak one, with nothing like the power attributed to it.