Pay Commission may reverse states fiscal improvement

Transcription

1 Pay Commission may reverse states fiscal improvement Primary deficit levels could reach 3.1 per cent of GSDP, thrice the current target Analytical contact: Sreenivasa Prasanna Head Rating Criteria & Product Development Tel.: (+91 22) Subodh Rai Manager - Rating Criteria & Product Development Tel.: (+91 11) srai@crisil.com Executive Summary The steady fiscal gains state governments have made since 2000, and expect to make going ahead, are under threat. A study by CRISIL shows that state governments may find it difficult to implement the recommendations of the proposed Sixth Pay Commission if these recommendations result in salary and pension increases similar to those recommended by its predecessor, the Fifth Pay Commission. CRISIL estimates that if implemented, such pay and pension increases would drive the aggregate primary deficit levels of 21 large states to as much as 3.1 per cent of their aggregate gross state domestic product (GSDP) by (refers to financial year, April 1 to March 31). This level is higher than the 2.6 per cent recorded in , 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 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 rationalize their workforce has had on their cumulative salary and pension bills, and the tendency of the states to overspend when revenues increase, CRISIL s

2 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 The financial impact will be felt fully from the first year of implementation i.e 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 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 and would remain at the same levels as in 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 Year Growth rate (%) For , and , salary expenses will grow by 15 per cent, 24 per cent and 19 per cent, and pension expenses by 18 per cent, 38 per cent and 41 per cent respectively. This assumption mirrors the year-onyear percentage increase experienced in salary and pension in , and respectively due to implementation of the Fifth Pay Commission s recommendations. Though most states implemented salary revisions with effect from early 1996, the impact became evident only in during , the period in which salary arrears were cleared. Therefore, the year-on-year growth in salary and pensions during reflects most of the impact of the Fifth Pay Commission

3 CRISIL has assumed that in the normal course, the buoyancy in revenues, if accompanied by expenditure rationalisation measures, would help the state governments to meet the tough deficit targets set by TFC. To carry out its analysis CRISIL has projected Gross State Domestic Product (GSDP) growth for the next five years, and has estimated salary and pension expenses both with and without the pay commission impact. These projections have been used to estimate the change in states deficit indicators due to the implementation of the pay commission s recommendations; these estimates are presented in Table 2. It should be noted here that these are optimistic estimates; even under normal circumstances state governments rarely meet the improvements expected by finance commissions. Therefore, it is quite likely that the actual deficit indicators will significantly overshoot CRISIL s estimates. Table 2: Projected deterioration in deficit indicators (Rs. Billion) Year Salaries without Pay Commission impact (C) 1,090 1,144 1,202 Salaries with Pay Commission impact (D) 1,195 1,483 1,764 Increase in Salaries due to Pay Commission (E=D-C) Pension without Pay Commission impact (F) Pension with Pay Commission impact (G) Increase in Pensions due to Pay Commission (H=G-F) Aggregate impact of Pay Commission (I) = (E+H) Targets set by TFC (Before Pay Commission recommendations) Revenue deficit as %age of aggregate GSDP (J) 0.0% 0.0% 0.0% Primary deficit as %age of aggregate GSDP (K) 1.0% 1.0% 1.0% Gross fiscal deficit as % of aggregate GSDP (L) 3.0% 3.0% 3.0% Projected aggregate GSDP (CRISIL Estimates) (M) 40,827 45,727 51,214 Revenue deficit (N) = (J)*(M) Primary deficit (O) = (K)*(M) Gross fiscal deficit (P) = (L)*(M) 1,225 1,372 1,536 Factoring in implementation of Pay Commission recommendations Revenue deficit (Q) = (N) + (I) ,052 Primary deficit (R) = (O) + (I) 553 1,010 1,564 Gross fiscal deficit (S) = (P) + (I) 1,369 1,924 2,588 Revenue deficit as %age of aggregate GSDP (Q/M) 0.4% 1.2% 2.1% Primary deficit as %age of aggregate GSDP (R/M) 1.4% 2.2% 3.1% Gross fiscal deficit as % of aggregate GSDP (S/M) 3.4% 4.2% 5.1% Source: a) CRISIL estimates b) TFC c) Handbook of statistics on state government finances d) State Finances A Study of Budgets of

4 As Table 2 illustrates, if such recommendations are implemented, states deficit indicators will deteriorate sharply. In fact the sharp deterioration is very similar to the effect witnessed in the second half of the 1990s due to the Fifth Pay Commission. The deficit indicators for all states on an aggregate basis, after the implementation of the Fifth Pay Commission s recommendations, deteriorated significantly. This is shown in Table 3 below: Table 3: Deterioration in deficit indicators Year Revenue deficit/revenue receipt 6.0% 10.5% 9.6% 24.7% 26.0% Primary deficit/gsdp 0.9% 0.9% 1.0% 2.4% 2.6% GFD/GSDP 2.9% 3.0% 3.2% 4.6% 5.1% Source: CRISIL estimates, Handbook of statistics on state government finances As can be observed from Tables 2 and 3, the deficit indicators that are projected by CRISIL for would be the same or higher than those of , completely undoing the fiscal improvements targeted by TFC. States credit risk profiles will deteriorate again Large borrowings will be required to bridge these potential deficits. In the past, between 2002 and 2005, states took on market borrowings in excess of Rs.500 billion to refinance high-cost debt from GoI; this debt matures between 2012 and These too will now have to be refinanced by further borrowings. Since the states will be borrowing from a position of fiscal weakness and therefore lower creditworthiness, their cost of borrowing will increase; this in turn would further delay correction in their fiscal positions. Will ongoing rationalisation of states workforces moderate the impact? Some state governments have consciously tried to contain the size of their workforce to control wage bills, and are therefore not filling non-critical vacancies. Though natural attrition helps, albeit slowly, in containing employee strength, such efforts do not have a significant impact on the cumulative salary and pension expenditure because of the concomitant increase in pension expenses. Moreover, since employment is a sensitive issue, states positions on the same do not remain consistent over time. There have been numerous instances when, after a brief period of rationalisation, state governments have gone ahead with recruitment on a large scale. Overall, it is unlikely that aggregate salary and pension expense would remain stagnant in the medium to long term. To cite a parallel example from the centre, although the strength of central government employees has declined from 3.9 million in 2001 to 3.4 million in 2005, the wage bills increased from Rs billion in to Rs billion in A part of the increase in the wage bills can be attributed to merging of 50 per cent of the dearness allowance with basic salaries. Even after adjusting the impact of the same, the aggregate wage bills have increased. In fact, cumulative salaries and pension bills have increased in all but one of the last 25 years. Though comparable data for state governments is not available, CRISIL believes that trends in their wage bills would not be very different. Overall, CRISIL concludes that measures to contain the size of the workforce may have only marginal potential to contain the impact of Sixth Pay Commission-related expenditure increases. Can states curtail expenses to fund increased salary and pension bills? CRISIL believes that states expenditure is largely inflexible, limiting the ability to cut expenses. Aggregated, salary, pension, and interest payments account for nearly two-thirds of states total expenditure. Since these expenses are inflexible in nature, curtailing them is not possible. The remainder of states revenue expenditure largely comprises expenditure on social (education, water supply and sanitation, public health) and economic (energy, irrigation, agriculture) services.

5 Expenses on social services would be difficult to curtail given India s very poor social indicators, reflected in a low human development index (HDI) ranking (India is ranked 127 th in the world 1 ). Similarly, capital outlays both for the upkeep of existing infrastructure as well as for new projects also cannot be curtailed, as overall infrastructure availability, critical for economic growth, is inadequate. Increasing user charges would be one good way of reducing overall expenditure, but would call for political resolve at the state government level. Overall, CRISIL believes that states have very limited manoeuvring space in their expenditure; hence, it is likely that any incremental expenditure will be funded by debt, straining their debt position even more. Will the current economic growth mitigate the impact? In the ongoing debate on the new pay commission, it has been argued that expected buoyancy in revenues due to rapid economic growth would help in meeting the incremental salary and pension expenses. CRISIL s study is based on the achievability of TFC target indicators; these indicators factor in, to a large extent, the benefits of rapid economic growth. CRISIL s assumed economic growth rates are even higher than that assumed by TFC. Moreover, there is a possibility that the current buoyancy in economic growth may not continue. In 1997, when the Fifth Pay Commission s recommendations were accepted, the economy was growing rapidly, and there was a case for believing that economic growth and the consequent revenue buoyancy would make it easy to finance salary and pension increases. However, the subsequent slowdown in the economy constrained state governments ability to meet incremental expenses. (Refer Table 4). If such slowdown were to reoccur, the deficit levels would be worse than estimated in this study. Table 4: Gross Domestic Product (GDP) growth rates at times of Fifth and Sixth Pay Commissions 5th Pay Commission Post 5th Pay Commission 6th Pay Commission Year Growth in % 7.3% 7.3% 7.8% 4.8% 6.5% 6.1% 8.4% Source: Central Statistical Organisation Further, states tend to spend more when revenues increase. This natural tendency is demonstrated by Chart 1 below, which captures the steady increase in GFD numbers, at the aggregate level, over the last 25 years. Chart 1: Secular rise in GFD over last 25 years Trends in aggregate GFD for all Indian states GFD (Rs. billion) GFD Year Source : a) Handbook of statistics on state government finances b) State Finances A Study of Budgets of c) State Finances A Study of Budgets of (RE) 1 Source: Human Development Report 2005, United Nations Development Programme

6 Out of 25 years ( to ) 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. Conclusion 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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