labels: crisil, economy - general
Pay Commission may reverse states' fiscal improvementnews
12 September 2006

Primary deficit levels could reach 3.1 per cent of gross state domestic product, thrice the current target, by 2011-12, say CRISIL's Sreenivasa Prasanna, head, rating criteria and product development and Subodh Rai, manager, rating criteria and product development.

A study by CRISIL reveals that the steady fiscal gains state governments have made since 2000, and expects to make going ahead, are under threat. The constitution of the Sixth Pay Commission for Central Government employees has the potential to impact state government finances: state governments generally follow the Central Government pay hikes with increases of a similar magnitude. CRISIL estimates that if state governments implement pay and pension increases similar to those following the Fifth Pay Commission, the aggregate primary deficit levels of 21 large states would rise to as much as 3.1 per cent of their aggregate gross state domestic product (GSDP) by 2011-12 (refers to financial year, April 1 to March 31). This level is higher than the 2.6 per cent recorded in 1999-2000, the first year in which the full impact of salary and pension hikes was felt in the wake of the Fifth Pay Commission. This is also more than thrice the figure of 1 per cent targeted by the Twelfth Finance Commission (TFC). In such a scenario, the fiscal gains that the Finance Commission envisages by 2010 will likely not materialise.

CRISIL's study is based on the assumption that annual salary and pension growth caused by the Sixth Pay Commission will be similar to that caused by the fifth, and that state governments will implement the recommendations with effect from April 2009. Further, the study assumes that the current growth rates in the economy will continue and that, in the normal course, states will be able to meet the deficit targets set by TFC. However, given the negligible flexibility states have in curtailing expenditure, the limited impact that the current effort to rationalise their workforce has had on their cumulative salary and pension bills, and the tendency of the states to overspend when revenues increase, CRISIL's assumptions may be considered optimistic. In fact, the actual deficits could eventually turn out to be larger than the estimates under the CRISIL study.

CRISIL thus believes that, before implementing pay revisions on the basis of the Sixth Pay Commission's recommendations, states should clearly identify the revenue sources to fund the incremental salary and pension burdens. The state governments should thoroughly analyse the fiscal implication of the pay revision and take prudent measures to contain the adverse impact, upfront. Unless this is done, states' credit profile may undergo stress similar to that witnessed in the late 1990s.

This commentary analyses the potential impact of salary and pension increases on the fiscal position of state governments.

Another pay commission: is the alarm justified?
Salaries and pensions constitute the largest component of state governments' expenses: they make up between 30 and 45 per cent of individual states' revenue expenditure. In the late 1990s, states' deficit indicators worsened dramatically due to the implementation of the Fifth Pay Commission's recommendations. Keeping this fiscal shock in mind, the Eleventh and Twelfth Finance Commissions recommended that there was no need to appoint a pay commission every ten years; TFC targeted a reduction of the share of salaries in total revenue expenditure to 35 per cent. However, despite these recommendations, the Government of India (GoI) in September 2006 constituted the Sixth Pay Commission. Though the pay commission has only been constituted for central government employees, experience shows that state governments tend to implement similar salary and pension revisions at the state level. CRISIL therefore expects that this time, too, there will be pressure on the state governments to follow the Sixth Pay Commission's recommendations, considerations of fiscal prudence notwithstanding.

Potential outcome: more delay in fiscal improvements

CRISIL has estimated the potential impact of the Sixth Pay Commission on the aggregate deficit indicators of the governments of 21 large states. For this analysis it is assumed that:

1. State governments will implement the recommendations of the Sixth Pay Commission with effect from April 2009
2. The financial impact will be felt fully from the first year of implementation i.e. 2009-10
3. Without the impact of the Sixth Pay Commission, states will achieve the deficit indicators (Revenue Deficit [RD], Primary Deficit [PD], and Gross Fiscal Deficit [GFD]), targeted by TFC for 2009-10. Although experience indicates that this may be an optimistic assumption, they are the best estimates available today
4. In the absence of pay commission-triggered salary and pension increases, the deficit indicators in 2010-11 and 2011-12 would remain at the same levels as in 2009-10
5. Without Sixth Pay Commission-related pay increases, salary and pension will grow at 5 per cent and 10 per cent per annum respectively
6. Aggregate nominal GSDP will grow at the rates mentioned in Table 1

Table 1: GSDP growth rates assumed for this study

Source : a) Handbook of statistics on state government finances
b) State Finances A Study of Budgets of 2004-05
c) State Finances A Study of Budgets of 2005-06

Out of 25 years (1980-81 to 2004-05) GFD declined in only three years. Even these declines were nullified in the subsequent years. It is therefore highly unlikely that GFD in absolute terms will undergo any substantial permanent decline in the medium to long term.

The tendency to overspend will be exacerbated by a sudden increase in salary and pension expenses, if the recommendations of the pay commission take the shape that CRISIL has assumed. Thus, we may see even larger deficits than this study projects.

In the context of the growth rates assumed by CRISIL, the possibility of a downturn in growth rates, and the tendency of states to spend more when revenue growth is buoyant, indicate that CRISIL's estimates are in themselves optimistic. Therefore it is likely that the credit profiles of the state governments may come under severe pressure, and that they will find it very difficult to generate revenues to meet large incremental expenditures on pensions and salaries.

The implementation of recommendations to significantly increase salaries and pensions could severely impact the credit profiles of state governments. Therefore, it would be prudent for the central and state governments to thoroughly debate the fiscal implications before implementing any recommendations of the Sixth Pay Commission. The incremental salary and pension burden as a result of the recommendations should be calibrated such that it is well within the resources of the state governments; state governments should be careful not to implement recommendations that could weaken their fiscal situations.

The Fifth Pay Commission had recommended a significant reduction in staffing levels as a means of overcoming the increased expenditure burden due to salary increases. Subsequent experience has demonstrated that such recommendations are more difficult to implement than salary and pension increases. Since the strategy of increasing salary levels without actually increasing the salary bill has clearly failed, the state governments will need to have more imaginative ideas to finance anticipated increases in salaries.

CRISIL believes that a paradigm shift in public finance management is needed. In general, governments have shown a tendency to commit expenditure first, and think of the resources to fund the same later. When these expenditures are inflexible and recurring in nature, they cause a severe strain on resources. Hence, as a fiscally prudent step, it is important for state governments to clearly identify revenue resources, estimate likely buoyancy, and project overall revenues. Subsequently, states should estimate the likely surplus to be generated, and new expenditure commitments should be based on the surplus alone. Such an approach will help ensure fiscal sustainability.

CRISIL thus believes that, before implementing pay revisions on the basis of the Sixth Pay Commission's recommendations, states should identify the revenue sources to fund the incremental salary and pension burdens. Since the expenditure is recurring in nature, the revenue sources should also be of a similar nature. Any ad-hoc decision to implement the recommendations could jeopardise the states' fiscal profiles and credit quality, a familiar situation for those who remember the late 1990s.

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Pay Commission may reverse states' fiscal improvement