Impact on economy

The practice of panel recommending pay hikes every 10 years needs to be replaced by a formula based adjustment done annually.

What would be the impact on the economy if the government accepts the recently submitted Seventh Central Pay Commission (SPC) recommendation of a 23.5 per cent hike in pay, allowances and pensions (increase of Rs 1.02 lakh crore) for Central government employees, to be effective from January 01, 2016? The answer, as economists are fond of saying, is: “It depends” on what we assume about “other things”


The additional government expenditure has to be financed. There are basically four options. First, a part (about 15-20 per cent) of the expenditure will be automatically covered by additional income tax revenue from the enhanced incomes. If the remaining gap is covered by raising tax rates, the fiscal deficit would remain the same. Peoples’ disposable income would go down by the amount of taxes paid.

As a result, their expenditures would fall, though not exactly by the full amount of taxes as their savings would also fall. In any case, even if there is some net increase in (government plus private) total expenditure in the economy, the effect would be rather small. There would be no big bonanza for the consumer goods industries, as is being assumed by some analysts.

The second option is to finance the fiscal deficit by borrowing from the market. That means less funds available for private sector investment. So, along with the rise in consumption expenditure, there will be some fall in investment expenditure. Again, there could very well be a net increase in total expenditure. Some industries (like cars, two-wheelers, real estate) would get a boost while the demand for capital goods like machinery would be squeezed.

However, this option implies a rise in fiscal deficit which is estimated to be around 0.65 per cent of GDP for the fiscal year 2016-17. Given that the finance minister (and international credit rating agencies) would not like a reversal of the promised reduction in fiscal deficit by 0.4 to 3.5 per cent for the year, this option is unlikely to be pursued.

The third possibility is to print notes to cover the deficit. Here, apart from the finance minister, the RBI governor (known for his tough anti-inflation stand) would be highly unlikely to agree. Speeding up growth of money supply would be considered inflationary. Already, the consumer price index inflation is moving up (though wholesale price index inflation is still in the negative territory) and is likely to go up further, following two consecutive bad monsoons. So, this option, too, is highly unlikely.

This leaves us with the fourth option where the additional salary expenses would be financed by cutting other expenditures. The fiscal deficit target would be met. The axe would have to fall on ca-pital expenditures as interest payments on past loans and defence spending can not be reduced. Total expenditures for the economy would remain the same.

No overall demand stimulus but additional consumption expenditure would have a positive effect on the consumer goods sector while falling capital expenditures would have an adverse impact on the capital goods sector. To the extent future growth of GDP depends on more investment expenditure, growth would suffer.

Therefore, the most likely scenario would be a combination of options one and four. There will be some rise in taxes and some cut in capital expenditure. The stimulus to the economy would be negligible. The fiscal deficit targets would be adhered to. The effect on overall inflation rate would be small.

However, food inflation is likely to rise as the supply of non-grain food articles would not keep pace with the rise in consumer demand. Given that there is excess capacity in the auto and housing sectors, the rise in prices, if any, in these areas would not be significant. Public investment expenditures would suffer.   

Additional taxes
The best possible scenario for the finance minister would be if global oil and commodity prices (like metals and minerals) continue to fall. This would mean a further fall in oil subsidy bill and a downward push on inflation. Moreover, he can levy some additional taxes on oil (as he has been doing) while keeping rupee price of oil the same. This additional non-inflationary tax revenue would cushion the required fall in the government capital expenditure.

Finally, a question that is often raised: Is the periodic hike in salaries of government employees, over and above regular DA increases, through the pay commission route   justified? The argument for the hike is based on parity with employees in the private sector where either unions successfully negotiate regular pay increases, or the companies, in order to attract and retain talent, have to pay competitive market compensation.

Since that option is not available to government employees, there has to be some mechanism for maintaining pay parity. The argument against is that, unlike in the private sector, there is no market test whether salary hikes for government employees are justified by corres-ponding productivity/ profit increases.

Moreover, there is widespread dissatisfaction over the quality of service that government employees provide which does not necessarily go up with pay hikes. Job security, irrespective of performance, is the biggest benefit for public sector employees.

Hence, even if they do not get salaries comparable to private sector, most of them would not like to take up jobs in the private sector. So, the argument that the government would lose talent to the private sector unless pay parity is maintained may not be valid in most cases.

Economic considerations alone cannot settle this debate. However, most analysts that the practice of pay commission recommending pay hikes after an interval of 10 years or so needs to be replaced by a more automatic formula based adjustment done annually or  every couple of years. This would reduce the sudden big strain on government finances while easing the build-up of expectations about big pay hikes from the pay panel.

(The writer is a former professor of economics, IIM-Calcutta)

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