Luxembourg: Impact of wage indexation on pay

Luxembourg is one of four EU Member States where wages are index-linked to inflation. Recently, the government reinstated the pre-crisis process of quarterly rather than annual indexing. A new study shows that the criticisms often levelled at such systems   that they are likely to increase wage rigidity and reduce competitiveness appear to be unfounded.

Introduction

In the context of the longstanding debate on wage indexation, the tripartite Observatory for Competitiveness (ODC)  commissioned the University of Luxembourg to study the impact of wage indexation on wage formation. Existing research, notably a 2011 study on Labour market developments in Europe, published by the European Commission’s Directorate-General for Economic and Financial Affairs (DG ECFIN), has found that indexation mechanisms lead to more rigid wage formation. The European Commission, the OECD and the IMF have used these results to issue recommendations to the government of Luxembourg to abandon automatic wage indexation. The ODC, however, identified a need for more information in order to make a more informed assessment. A new study, Salary formation: A comparative analysis of four European countries (in French, 4.7 MB PDF), was carried out by researchers at the University of Luxembourg in 2014.

Research methodology

In a first step, the authors of the new study replicated the results of the DG ECFIN study, which sampled data across the EU27, and found a range of weaknesses. In particular, they found that the estimates do not seem to be robust and that the results change once newer data are added. The new study also criticises some conceptual points, in particular the fact that the data used for the DG EFIN study include the entire economy and do not focus exclusively on the private sector, where international competition clearly has a stronger impact. Moreover, the original study did not take actual working time into account and researchers also identified problems with endogeneity.

To eliminate these weaknesses, the authors of the study chose a smaller sample. They compared two countries with wage indexation mechanisms (Belgium and Luxembourg) with two neighbouring countries that do not have indexation (France and Germany). (In France, however, the national minimum wage is linked to inflation.) For the period 1976 to 2011, the researchers estimated Vector Autoregressive (VAR) models for each country separately. In addition, each model is calculated according to different levels of aggregation: total economy, private sector, and, for Luxembourg, a disaggregation into the manufacturing industry and business services sectors. The models estimate the following factors:

  • impact of inflation
  • unemployment
  • productivity per hour worked
  • competitiveness of companies
  • openness of the economy
  • tax wedges

The coefficients of each specification can then be compared between countries with and without wage indexation.

Main findings

Patterns of productivity and wage growth

A descriptive data analysis reveals a strong relationship between real hourly wages and productivity per hour in the private sector. The lines follow very similar patterns up to the mid-1980s in all countries. Thereafter, the relationships are strongest in France, Luxembourg and Belgium, while in Germany the difference between wage increases and productivity is most strongly marked.

Effect of indexation on wage-setting

The VAR estimations allow for some more in-depth analysis. Over time, it is found that hourly remuneration figures have an elasticity which is not significantly different with respect to the consumer price index (CPI). Unemployment, on the other hand, shows the expected negative impact on wages, which is statistically significant across all specifications and all countries. Other regressors that capture productivity and competitiveness also produce the expected significantly positive results. Overall, the authors suggest that all coefficients show more similarities than differences across countries. The researchers argue that this finding suggests that wage indexation has no effect on the development of wages over a long period of time.

Using VAR estimations also allows for a comparative analysis of the impact of exogenous economic shocks in countries with and without automatic indexation. The researchers thus calculate the short-term impacts of increases in consumer prices on hourly wages. It is found that price–wage dynamics are similar in Belgium and Luxembourg, weaker in Germany and stronger in France. Hence, the labour market in Belgium and Luxembourg was not shown to have more rigid wage adjustments.

This study suggests that although there are differences in wage flexibility between the countriest, there is no evidence that wage-indexation is a factor in this.

Social partner reactions

Employers did not wish to comment on the study. However, the trade unions interpreted its findings as arguing in favour of social peace but without having a negative impact on the economy’s competitiveness. Véronique Eischen, a member of the executive committee of the Luxembourg Confederation of Independent Trade Unions (OGB-L), said that the abolition of the indexation mechanism would have a negative impact on collective bargaining and union demands in negotiations.

At the same time, the government of Luxembourg announced that it would return to full wage indexation in 20154 as stipulated by national law. For a period of three years (2012–2014), wages, pensions and unemployment benefits were adjusted just once a year instead of once a quarter, in response to the impact of the economic crisis. The Luxembourg Business Federation (FEDIL) issued a press release expressing its concern that the decision will negatively affect the country’s economic situation (in French). The organisation is opposed to indexation and calls for its complete abolition.

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