7th Pay Commission recommendations will hit govt finances hard

The Seventh Pay Commission has recommended a 23.6 percent increase in salaries of Central government employees, as well as pensions of retired Central government employees. This largesse will cost the government Rs 1,02,100 crore in 2016-2017, the report estimates. The report estimates that this increase will work out to 0.65 percent of the gross domestic product (GDP) in 2016-17. In comparison, the awards of the Sixth Pay Commission had worked out to 0.77 percent of the GDP. The report points out that "while projecting the GDP for 2016-17, we assumed that the real growth rate of GDP will be 7.5 percent and inflation will be 4 percent in 2016-17." This is perhaps a little overoptimistic, but let me not nit-pick. Also, the 0.65 percent of the GDP number may be lower than what the number might eventually turn out to be because it does not take into account the impact of recommending one rank one pension for Central government employees as well as paramilitary personnel. Further, the trouble with expressing amounts as a percentage of the GDP is that it does not always show the correct picture. It is important to understand what will be the impact of the 'extra' Rs 1,02,100 crore on government finances. In 2005-06, the total government expenditure had stood at Rs 5,06,123 crore. A decade later in 2015-16, the total government expenditure is projected to be at Rs 17,77,477 crore. This means an increase in expenditure at around 13.4 percent per year. In 2005-06, the total receipts of the government (less its borrowings) or what it earned, stood at Rs 3,59,688 crore. Ten years later in 2015-16, the total receipts of the government (less its borrowing) is expected to be at Rs 12,21,828 crore. This means an increase in earnings at around 13 percent per year. I am calculating these numbers so as to be make a rough projection for the receipts as well as the expenditure of the government in 2016-2017, the next financial year. Looking at the long-term trend we will assume that for 2016-17, the receipts of the government will go up by 13 percent, whereas its expenditure will go up by 13.4 percent. While the chances of things playing out exactly like this are low, but please indulge me, in order to understand the broader point I am trying to make. Hence, the government receipts for the year 2016-17 are likely to be at Rs 13,80,666 crore (1.13 times Rs 12,21,828 crore, the projected receipts for 2015-16). The government expenditure for the year is likely to be around Rs 20,15,389 crore (1.134 times Rs 17,774,77 crore, the projected expenditure for 2015-16). This expenditure for 2016-2017 does not include the Rs 1,02,100 crore cost of the recommendations of the Seventh Pay Commission. We need to add this. Hence, the total expenditure is likely to be at Rs 21,17,489 crore. Against this, the government will earn Rs 13,80,666 crore as receipts. This means that the government will run a fiscal deficit of around Rs 7,36,823 crore. Fiscal deficit is the difference between what a government earns and what it spends. In 2015-16, the fiscal deficit is projected to be around Rs 5,55,649 crore or 3.9 percent of the GDP. So what will the fiscal deficit work out to be in 2016-17 as a proportion of the GDP? For 2015-16, the nominal GDP (i.e. not adjusted for inflation) is assumed to be at Rs 14,108,945 crore. The Seventh Pay Commission assumed a real GDP growth of 7.5 percent and an inflation of 4 percent in 2016-17. We will stick to the same numbers and hence assume a nominal GDP growth of 11.5 percent (7.5 percent real GDP growth plus 4 percent inflation). This would mean the nominal GDP in 2016-17 would be Rs 15,731,474 crore (1.115 times Rs 14,108,945 crore, the GDP projected for 2015-2016). Hence, the fiscal deficit as a proportion of GDP for 2016-2017 would work out at 4.7 percent (Rs 7,36,823 crore expressed as a proportion of Rs 15,731,474 crore). This means the Seventh Pay Commission recommendations if accepted, will push up the fiscal deficit to 4.7 percent of the GDP from this year's 3.9 percent. And this isn't a good thing, given that the government is trying to achieve a fiscal deficit of 3.5 percent of the GDP by 2016-17 and 3 percent of the GDP by 2017-18. The broader lesson here is that if things continue in the way they are now the Seventh Pay Commission recommendations are likely to screw up the government finances big time by pushing up the fiscal deficit. The way to avoid this situation is by increasing receipts or cutting down on expenditure. If salary expenditure goes up, then other productive expenditure like capital expenditure may have to be cut. And that can't be good news for the economy. Further, if the government believes in good economics it needs to shut down loss-making public sector enterprises, but that is unlikely to happen. On the receipt side the option to raise income tax rates is always there. But that will be a very unpopular move. Finance Minister Arun Jaitley in his last budget speech had said: "I therefore, propose to reduce the rate of Corporate Tax from 30 percent to 25 percent over the next four years." So if corporate tax rate is likely to be brought down, that doesn't leave the government with many options in order to increase its receipts. Perhaps, we may see the service tax rate being raised further in the next budget. We may also see the government resorting to more standalone surcharges and cesses, like it already has in the form of Swacch Bharat cess. The government will also have to fasten the pace of disinvestment, something most governments haven't shown interest in doing up until now. Also, this year the government benefitted substantially from lower oil prices. It captured a major part of the gains by raising excise duty and not passing on the gain to consumers. Next year, any incremental help from falling oil prices may not be available. All in all, the recommendations of the Seventh Pay Commission, if accepted, will not work out well for the government finances, unless it chooses to change the current way of doing things. Further, it is best that the government instead of accepting an increase of 23.6 percent, settles at a lower number between 12-15 percent, to control the damage on its finances. The government as expected remains optimistic. As the finance secretary Ratan Watal put it: "We will handle this." I really hope it does. (Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)