11. Fiscal Implications arising out of the Implementation of The Fifth and Sixth Central Pay Commissions

Note: How babus get nicely worded reports from reputed institutions to justify the heavy pay packets for themselves and others.The development expenditure is the only causality. Somewhere I read that it is only in India, government employees serving as well as retired get their wage hike with price indexation as well as periodic pay hikes resulting in huge burden on government funds

Excerpts from:

A Study on Fiscal Implications arising out of the Implementation of The Fifth and Sixth Central Pay Commissions on the Finances of The Union and The State Governments for the Seventh Central Pay Commission

                                                        by

                              A Team of Economists from IIM Calcutta1

 Partha Ray, Soumyendranath Sikdar, Anup Sinha

                                            April 13, 2015

                                                        Executive Summary

1. This study aims at assessing the fiscal and macroeconomic impacts of the Fifth and Sixth Central Pay Commissions (CPC). The analysis is based primarily on the detection of trends and breaks in the fiscal data of the Union and the State Governments. The macroeconomic impact is assessed using an econometric model.

Impact of the Fifth CPC

2. As a result of implementing the Fifth CPC, committed liability of the Union Government (i.e., pay and allowances plus pensions) registered a very sharp rise, growing by 30.7 per cent and a further 17.0 per cent year on year for the following two years, viz., 1997-98 and 1998-99. There is no evidence to suggest that the Union Government made any cuts in other items of expenditures (both on revenue and capital accounts). The tax and non-tax revenue growth was not adequate enough to soften the impact on the gross fiscal deficit (GFD) and the revenue deficit (RD).

3. While State Governments are under no compulsion to follow the CPC recommendations, once the Union Government announces and accepts pay revisions there emerge inevitable political and social pressures to follow suit for their own (state government) employees. Some states take a modified version of the CPC recommendations. Others set up their own Pay Commissions and decide according to their own specific set of criteria for the revisions. As the timing, as well as the magnitude of the revisions varied across the states, the time period 1996-97 to 1999-2000 emerged as the ‘shock years’ for the combined liability of the State Governments.
4. Following the implementation of the Fifth Pay Commission, committed liability grew on an average at an annual rate of over 20 per cent. Revenue expenditure grew during this time at around 15 per cent per annum during the shock years. While in the first year of the increases in committed liability there was no significant change in the fiscal deficit, in the second year the change in the gross fiscal deficit was to the tune of 68.6 per cent followed in the next year by a further 22.9 per cent. The revenue deficits also increased in the second year by an astonishing 154.2 per cent followed by another 22.7 per cent in the following year. It was during 2000-01, the last year under consideration that the deficits were brought under control. Thus, the 5th CPC Commission seems to have led to considerable fiscal stress.

5. Three major inferences may be drawn from the state-wise analysis of 18 major (i.e., excepting the special category states) states. First, it appears that for the major states, the 5th CPC has led to enhanced fiscal stress. This was indicated by worsening of both the GFD and RD for all these 18 states. Second, while some states tried to soften the blow by curtailing revenue expenditure, others resorted to reduction in capital expenditure. There were a few states which took neither of these softening measures. Some states (e.g., Gujarat) tried to smooth the stress by spreading the burden over a number of years. Third, most of the states exhibited varying degrees of recovery in terms of fiscal indicators within two years, mostly by additional tax efforts and partially by expenditure management. Even the special category states (i.e., seven North-East states plus Himachal Pradesh, J & K, and Sikkim), despite their cushion of non-tax revenue in terms of grants from the centre, could not escape fiscal stress caused by the CPC awards.

Impact of the Sixth CPC

6. As a result of the implementation of the 6th CPC recommendations pay and allowances increased substantially from Rs.452.75 billion in 2007-08 to Rs.880.73 billion in 2009-10. Committed liability too grew significantly. It was perhaps fortuitous that in the year when the Sixth CPC was being implemented, the global financial crisis changed the macroeconomic scenario drastically. The impact on the fiscal and revenue deficits were quite significant. GFD rose from 2.54 per cent of GDP in 2007-08 to 6.46 per cent of GDP by 2009-10, while the corresponding measures for RD during the same period of time were 1.05 per cent and 5.23 per cent. Only in the subsequent year of 2010-11 the deficits (both in absolute measures, as well as a per cent of GDP) improved. However, it may be noted that the improvement was possibly to a large extent due to the one-off increase in non-tax revenues coming out of the sale of telecom spectrum. Thus, the 6th CPC undoubtedly contributed to fiscal stress through a very large increase in committed liability. The immediate efforts of resource mobilization had not been productive enough to offset the impact on deficits and borrowing needs. In fact, the two latest Central Pay Commission awards have undoubtedly contributed to fiscal stress due to very large increases in committed liability. The magnitude of the stress might have compelled the Government to curtail expenditures in other (possibly socially important) areas.

7. To put the states’ finances in perspectives, at the outset it may be noted that there has been significant improvement in the consolidated fiscal position of the State Governments since the mid 2000’s. In particular, the period 2004-05 through 2007-08 witnessed almost zero revenue deficits for all the states on a consolidated basis. However, in the aftermath of the financial crisis as some states adopted fiscal stimulus packages to counter the adverse impact by initiating or stepping up various developmental and welfare programmes, since 2008-09 there have been some interruptions in the progress on fiscal consolidation at the states’ level. GFD of all the states increased from 1.5 per cent of GDP in 2007-08 to 2.4 per cent in 2008-09 and further to 3.2 per cent of GDP in 2009-10, reflecting inter alia slowdown in growth of revenues and the implementation of the Sixth Central/State Pay Commissions on expenditures. The pattern that was discernible immediately following the Sixth CPC awards by the union government was for the period 2008-09 to 2011-12. The total pay and allowances for all the states during 2007-08 was Rs.1359.40 billion, which rose to Rs.3237.60 billion by 2011-12. It may be noted that by this time all the states of the Indian Union had been brought under the discipline of the Fiscal Responsibility and Budgetary Management (FRBM) provisions.

8. The rise in revenue expenditure called for by the pay revisions was moderated by possible expenditure-switching (reduction in some other items of revenue expenditure) as well as, a slowing of growth in capital expenditure. On the resource mobilization side, tax as well as non-tax revenue appear to have grown steadily over this period. Even as a percentage of GDP tax revenue increased while non-tax revenue did not decline. As a result of all these, the fiscal deficit of all the states combined grew in the first year (2007-08) but then moderated and actually fell subsequently. The revenue deficit worsened in the first year, but then moderated quite substantially.

9. Analysis seems to indicate that the states on the whole were able to manage their finances and absorb the shock better after the 6th CPC than after the 5th a decade ago. At the risk of some oversimplification the following broad conclusions may be drawn. First, all the states have embraced some versions of FRBM Legislations during 2008-2010 (putting some cap on GFD and / or RD) which followed the 6th CPC. Therefore the stress of implementation of the 6th CPC did not show up as strongly in terms of higher GFD or RD as under the 5th CPC. So, the burden of adjustment must have fallen on capital expenditure to a larger extent. And when revenue expenditure did take a hit, the possibility of adverse social and economic consequences is hard to rule out. These would depend upon the scale and item of expenditure that was affected. Second, faced with the fiscal discipline of FRBM there might have been a tendency among some of the states to stagger the pay commission benefits over a number of years – often three to four. Despite this, fiscal stress could not be averted completely because of the difficulty in generating adequate tax and non-tax revenue to counter the enlarged burden of committed liability. The difficulty is likely to be a mix of socio-political compulsions and lack of tax buoyancy at the state’s level.

Macroeconomic Impact

10. The study made an attempt to assess the macroeconomic impact of the Fifth and Sixth Pay Commission Awards using the well-known econometric tool of ‘Vector Auto-regression’ (VAR) model, estimated over the period 1990-91 through 2013-14 (i.e., 24 years). In the first VAR model, we have taken the following variables: (a) Committed liability (i.e., pay and allowances plus pensions) of the Union Government; (b) Aggregate Government Expenditure of the Union Government (G); (c) Private Consumption Expenditure; (d) real GDP Growth; and (e) WPI inflation. The first three are measured as ratio to GDP. To capture the macroeconomic impact of the Pay Commission’s awards we have considered a unit standard deviation shock in the committed liability of the Union Government. The impulse responses derived from the VAR model (over a horizon of five years) tend to indicate that in response to a Pay Commission shock (in terms of committed liability of the Union Government): (a) government expenditure increases over a period of two years (followed by decline thereafter); (b) growth rises over three years; and (c) inflation tends to stabilize after two years. Private consumption expenditure (as proportion of GDP) tends to go down over the first three years. This is consistent with the consumption behavior postulated in macroeconomic theory, viz., consumption-income ratio declines with a rise in income. Also, the benefits of the CPC awards have mostly accrued to Central Government employees who have relatively high saving propensities. Finally, the impulse responses indicate that the time taken for the macroeconomic impacts (arising out of the Pay Commission’s recommendations of the Union Government) to taper off is mostly two years.

11. In order to gauge the impact of implementation of the CPC recommendations at the state level (either following the Central Government directly or implementing their own pay commissions), we have run another VAR with “combined pay and allowances of the state governments” as an additional variable. While the results of this VAR are more or less unchanged for inflation, government expenditure and private consumption for the next three years, for growth the behaviour is somewhat different with the impact dying down immediately after a year. This result suggests that the growth impact of Pay Commission’s recommendations is not long-lived.

 Sum-up

12. To sum-up our findings to the questions / issues raised in the study is as follows:   a)Did the Union Government and various State Governments accept the recommendations of the 5th and 6th Central Pay Commissions (CPCs)?

• Yes.
• The Union Government implemented them almost immediately.
• In case of State Governments there was a time lag of one to three years.
• Some States had their own Pay Commissions (e.g., Karnataka) while others adopted variants of CPC recommendations.

           b) How did they implement it?

• Tax as well as non-tax revenue appeared to have grown steadily.
• The impact of the CPC was moderated by
•  reduction in some other revenue spending
• moderation in capital expenditure growth.
• For some of the special category States, grants-in-aid from centre helped moderate the impact of the CPC .

c)  Did implementation of pay commission recommendations lead to deterioration of fiscal         health of the Union and various State Governments? In specific terms, did these pay commission    recommendations affect fiscal sustainability of the Union and various State Governments?

• The pay Commissions caused fiscal stress in the sense that most of the deficit indicators deteriorated immediately after adoption of the recommendations.
• However, fiscal sustainability did not get out of control as within a few years (usually two) the States could absorb the initial impact.

        d) What was the macroeconomic impact on the following variables?

• Growth – Growth rises mildly for three years
• Private consumption spending – Aggregate private consumption-GDP ratio declines.
• Government spending – Government expenditure-GDP ratio increases over a period of two years, followed by decline thereafter.
• Inflation – Inflation tends to stabilize after two years.

       e) How much time did the Union Government and the State Governments (those implementing            the recommendations) take for mobilizing additional revenues for absorbing the impact of      such implementation?

• The impulse responses tend to indicate that the time taken for the macroeconomic impacts to taper off is two years in most cases.