Jeremy Peat, chief economist with The Royal Bank

of Scotland, looks at how the proposed minimum

wage would affect the economy of Scotland

WE have been analysing how the minimum wage might affect the Scottish economy and our business customers. By examining the structure of earnings and business costs, we are able to estimate its impact across more than 50 separate industries.

At #3.60 per hour, with a reduced rate for younger employees, the initial impact of the minimum wage on business costs is, on average, really quite small. The worst affected sector is hotels and restaurants, with some 40% of employees involved, although we estimate the overall increase in costs at little more than 2%. For individual businesses, the cost may be higher. If profit margins are tight, this could be critical to their survival.

However, the initial impact is only part one of the story. The big impact on costs will depend on the extent to which other employees demand higher wages to restore the differential between their own earnings and those of the people who have benefited from the minimum wage.

A national minimum wage can be targeted at either reducing the relative disadvantage of the lower paid, as compared to those higher up the earning scale, or increasing the absolute ''ability to purchase'' position of the low-paid group. In terms of tackling relative low pay, the policy succeeds only to the extent that differentials are not restored. If everyone simply gets paid more then the poorest have not caught up. Indeed, in absolute terms we could also be back to square one, if prices rise to compensate for the higher money wages. Any real wealth gain for the lower paid could be illusory. Differential restoration is therefore crucial, both to the success of the policy as a welfare initiative, and to minimise the impact on business costs, competitiveness, and jobs. The interests of industry and of those wishing to promote the policy for social reasons coincide.

Our analysis raises another interesting issue. While only a small proportion of public sector employees earn less than #3.60, the sector is highly unionised, with a significant amount of pay awards bargained at a national level. It is quite possible that the unions will seek to restore differentials, adding significantly to government costs.

There is a potential Scottish angle to this. The annual change in Scottish Office spending is determined by the much discussed ''Barnett Formula''. Contrary to popular misconception, this gives Scotland a population share of changes in spending in England. Given our more than proportionate share of public sector employment, even if the budgets of UK departments were increased to allow for higher wage costs, Scotland would receive insufficient additional funds to meet the extra costs.

There are a range of broader economic issues which must also be discussed. Is it optimal to the economy for this welfare objective to be achieved at the cost of employers, via a minimum wage, rather than taxpayers, via the tax and benefit system? What about the impact in inflation and hence monetary policy?

But so far as more direct effects are concerned, the key lies in what might happen to differentials.