The federal government of Ethiopia has recently announced a 160 billion birr salary increase for public servants, a significant step aimed at alleviating the financial strain employees face due to the soaring cost of living and persistent inflation. However, experiences from other countries indicate that such measures can have drawbacks. In future policy formulation, decision-makers should thoroughly examine existing alternatives and evaluate their specific pros and cons before implementation.

As previously mentioned, public sector wage policy serves as a key tool for the government to address cost-of-living challenges, enhance employee motivation, and promote social equity. The salary increment introduced by the government last August will likely alleviate some pressure from high inflation and low real wages. Nevertheless, the author believes that other viable alternatives should also be explored. For instance, the government could consider reducing personal income tax by introducing or expanding tax-free allowances for essential expenses such as housing, transportation, education, and healthcare. A combination of both approaches may be even more effective. This article aims to compare the benefits of salary increases with tax-free allowances within Ethiopia’s financial and inflationary context.

Ethiopia currently faces two primary issues. Firstly, there is the rising cost of living that demands attention. Inflation diminishes real income, making it difficult for employees to afford basic necessities. Secondly, the government grapples with fiscal and inflationary challenges, as limited budgetary resources could mean that increased wage expenditures might further escalate inflation.

The central policy question, therefore, is whether salary increases are more effective in enhancing employee welfare without compromising macroeconomic stability.

Let’s first consider direct salary increments as the first policy option. By implementing this measure, the government adds 160 billion birr to the wage bill, resulting in immediate increases in employees’ take-home pay.

Ghana provides an illustrative example of this model. In 2010, Ghana introduced a major salary reform known as the Single Spine Salary Structure, which significantly raised cash pay for public sector workers. This initiative caused the wage bill to surge by approximately 50% based on base pay estimates at its inception, eventually consuming a substantial share of national revenues. The IMF and World Bank subsequently urged Ghana to reduce the wage bill’s share of GDP and revenue to restore fiscal balance.

Several studies have linked Ghana’s rising wage bill to macroeconomic strain and pressures on inflation and exchange rates, partly due to deficits and financing issues.

For Ethiopia, substantial increases in cash pay can quickly enhance employee welfare and morale, but they may also lead to fiscal challenges. If these salary increments outpace productivity or revenue growth, they could hinder investment and social spending.

In the United Kingdom, limited public-sector pay was implemented during the 2010s, followed by selective increases in recent years. The UK relied heavily on tax-advantaged “salary sacrifice” schemes for pensions and specific benefits, alongside targeted family programs, such as Tax-Free Childcare, which replaced older employer vouchers.

As a result, HMRC’s salary-sacrifice framework enables workers to exchange cash for non-cash benefits (primarily pensions), thereby reducing income tax and National Insurance contributions. This approach is widely utilized by both mid- to high-income earners and their employers, who also benefit from savings on National Insurance.

Tax-Free Childcare has largely replaced employer childcare vouchers for new participants since 2018, enhancing access but remaining under-utilized due to its complexity. Recent data indicates growth in participation, yet many eligible families still do not take advantage of the program. Effective design and communication are critical issues.

Implications for Ethiopia: Well-designed allowance or sacrifice schemes can enhance take-home pay without triggering cash-demand inflation. However, these schemes tend to benefit taxpayers above the threshold (notably, the Birr 6,000 personal income tax floor) and require robust administration and user education to effectively target the intended groups.

Japan serves as a relevant case study. The country has implemented two approaches: longstanding non-taxable commuting allowances (up to certain caps) and sustained cash wage increases through the Shuntō spring negotiations, aimed at breaking the cycle of low inflation and wage stagnation.

Commuting allowances in Japan are non-taxable up to specified caps (e.g., reasonable public transport fares up to ¥150,000 per month and distance-based caps for car use), exemplifying targeted, rule-based allowances.

From 2023 to 2025, Japan experienced its largest pay increases in over 30 years (approximately 5–5.5% at large firms), intended to stimulate consumption and normalize monetary policy. However, the impact on real wages depends on inflation rates and the participation of small and medium-sized enterprises.

Implications for Ethiopia: Targeted, capped, non-taxable allowances (like transportation) can provide welfare benefits with minimal inflationary effects. However, if broader economic objectives (such as boosting demand) take precedence, significant cash pay may be justified—assuming GDP and productivity trends are favorable and inflation is controlled.

South Africa has also employed a combination of pensionable salary increases through multi-year public-sector negotiations and a clear allowance and fringe-benefit tax code (e.g., travel allowances with identifiable taxable portions).

As a result, a 2023 public-sector agreement converted cash allowances into pensionable salaries and included raises (approximately 7.5% headline), with the National Treasury noting ongoing costs to the wage bill.

SARS provided detailed guidelines on allowances and fringe benefits (such as travel and reimbursable kilometers), which reduced misuse and clarified tax treatment. While the system requires significant administration, it is rule-based.

Implications for Ethiopia: The success of tax-free or partially taxed allowances depends on clear rules and enforcement similar to SARS’s approach. Without this, there is a risk of leakage and inequity. Converting cash pay to pensionable salaries results in long-term fiscal commitments.

Cross-country lessons related to these two policy levers reveal their respective advantages and disadvantages.

Large cash salary increases offer immediate gains for morale and welfare, provide visible benefits, and support demand during economic downturns. However, the primary risk is fiscal sustainability, as evidenced by Ghana and South Africa, where wage agreements can inflate costs and limit fiscal space if not aligned with revenue or productivity. Inflation may erode real benefits.

This approach is most effective when GDP and revenues are growing, and productivity reforms are credible. Your government’s focus on GDP growth mirrors Japan’s macroeconomic strategy, which combined pay increases with structural changes and stringent rules in other areas.

On the other hand, tax-free or partially taxed allowances (for housing, transport, education, and health) tend to be less inflationary, target specific expenses, and can be adjusted annually (following practices in the UK and Japan). However, these benefits often favor taxpayers above the threshold (in Ethiopia, above Birr 6,000). The risk of evasion or misclassification exists without clear guidance, and the complexity can reduce participation rates, as seen with UK childcare. Tax administration is most effective when it can verify documentation and caps, especially when the goal is to protect specific household costs rather than increase overall demand.

Considering the advantages and disadvantages of the two policy options discussed, the writer of this article recommends a balanced approach for Ethiopia—a hybrid model. This model provides modest salary increments to support low-income employees who do not benefit from tax allowances. It also introduces selective tax-free allowances for housing, education, and health, targeting middle- and higher-income employees who face significant living costs and currently pay income tax.

This combined strategy promotes equity, controls inflation, and supports fiscal sustainability while delivering meaningful relief to all employee categories.