Hamish McRae: Pay attention: this is a stupid idea

The cost of pay freezes and high taxes was a culture of duplicity, envy and hypocrisy

The Chancellor was right yesterday to dismiss the idea of a High Pay Commission. His phraseology was characteristically mild: he was "not persuaded" of his merits. He might have put the point more strongly, for this is one of the most seriously stupid ideas that has come out of Britain's liberal/left establishment since the £6-a-week pay limit in 1975.

It is not going to happen, but what is worrying is that people have so little memory of the 1970s that even some apparently sensible ones are prepared to sign up for it. It was not just that the pay policies of the 1970s led to the winter of discontent and a middle-class revolution. It was that they reinforced a culture of duplicity and corruption over pay. High tax rates and pay freezes led to a situation where people were instead rewarded in all sorts of under-the-table ways. It was the parliamentary expenses scandal on a national scale.

Because an employer could not increase people's pay they had to find other ways of retaining them when another company tried to bid them away. I worked for The Guardian then and its particular wheeze was giving its staff cars supplied with free petrol. Journalist salaries were relatively modest but the management revealed in some negotiation that the paper had more editorial cars than the Times, Telegraph and FT put together.

Of course there was only modest tax on this benefit, so it suited both sides to do it – at the cost of distortion, envy and hypocrisy. That was the culture that pay curbs, coupled with a top tax rate of 83 per cent on earned income (and 98 per cent on income from savings), created. It has taken a generation and more to wean the country away from the culture of the company car.

There is a similar distortion now, though it is not over expenses so much as over pensions. It is not possible for anyone in the private sector to save for a pension pot as large as that accumulated by senior people in the public sector – the huge pensions of the failed bankers are under past legislation. There is now an effective cap of some £1.8m on the size of any private-sector pension pot. Permanent secretaries by contrast retire with pots worth around £2.5m and the Prime Minister will have one of some £3m. I note that most of the signatories calling for a High Pay Commission will also have their pensions paid for by the taxpayer.

To say all this is not to justify very large pay differentials, which trouble a lot of us. I try to subscribe to the tenth commandment (it's the one about coveting for those who don't know or don't remember) when it comes to such matters, but as an economist our task is to try to explain what is happening rather than make moral judgements about it. Only when you understand the forces at work can you begin to figure out what might be done about this situation.

There are at least half a dozen reasons why pay differentials have widened over the past generation. The first four seem to me to be reasonable and legitimate, the final two more questionable.

First, they have become more open. That is a function of lower nominal tax rates. The tax take in the 2000s in terms of a percentage of GDP is roughly the same as in the 1970s but the nominal top rates are lower. So people are paid in salary and pay tax on it, rather than be paid in cars, free travel, allowances for parties they gave at home and so on – and not pay tax (or very little) on these.

Second, there is much more movement of professionals and managers. There is more movement internationally. The UK has been particularly open in attracting talented people from abroad, and not just to play football. Some one-third of the heads of the FT 100 companies are non-nationals. There is a global market for talent whereas a generation ago there were merely a series of national markets.

There is also more movement within countries. Typically half a firm's staff will change every three to five years. So national markets are more competitive too.

Third, the demands on executives are higher, the hours are longer, the travel greater and career patters more risky. The days of long lunches are long gone. At the top level not many people have the combination of skills, personality and stamina and companies have to bid up for those that do. Even further down the pay scales, the skill levels needed have become very specialised. About three-quarters of the new jobs created in the past decade in the developed world require at least a first degree but only about one-third of job entrants have one.

Fourth, it is possible in some jobs – not all – to measure the added value a person brings quite precisely. If you are a top City dealer you will consistently earn money for your employer – if you don't, you are sacked. While you earn that money, a proportion will be paid to you in some form of bonus or commission. If it isn't, you take your skills elsewhere. Salespeople everywhere are generally paid on commission.

In many other types of job it is harder to ascribe profit directly to individuals but the fact that banks bid for whole teams shows that employers at least think they can reasonably identify which people will make money for them. A generation ago, performance pay was pretty much in its infancy except in sales. The effect of its growth has inevitably been to increase differentials.

If those are the four "good" reasons, now the two "bad" ones. One is that there has been a corruption of the bonus culture to include occupations where commission or bonuses are inappropriate. As someone who has never received a bonus in my life, maybe I am falling to observe the tenth commandment but it seems ridiculous that civil servants are paid extra for simply doing an OK job or MPs for losing their seats.

And finally there has been a corruption of the celebrity system, where people achieve unwarranted star status – be they managers, lawyers, bankers or sports celebrities – thanks to clever PR rather than genuine merit.

The way forward, of course, is more openness about everything: straightforward taxation, acceptance that some people have rare skills or work harder than others, better education and training, more honesty about the need for bonuses and the corruption of the system when applied inappropriately. But please let's not try and go back to the 1970s and please let's remember the tenth commandment.

h.mcrae@independent.co.uk