7th Pay Commission: Consumption boost, higher fiscal deficit and inflationary pressures
While pay hikes will boost consumer discretionary demand, do not forget the extremely adverse financial impact of implementing these recommendations
The 7th Pay Commission has recommended a 16% hike in salary for central government servants. This will benefit an estimated 47 lakh serving central government employees and 52 lakh pensioners. While this will boost consumer discretionary demand, it will increase government's fiscal burden and also raise inflation, feel brokerages and ratings agencies.
"Since the pay hikes are a boost to government employees’ disposable income, they have historically boosted consumer discretionary demand. A category wise breakdown of consumption shows discretionary spending on automobiles, clothing and footwear and expenditure on education have historically risen in the years following
previous pay commissions," says Nomura in a research note.
The brokerages and ratings agencies also agree that the recommendations of the 7th Pay Commission, if accepted, would increase fiscal burden of the government and also raise economy's inflation profile.
"If (the recommendations of 7th Pay Commission are) adopted, bulk of the impact will be absorbed by the FY2016-2017 Budget and are scheduled to be implemented from January 2016 onwards. Historically, Pay Commission’s rollouts have been positive for consumption trends but negative for fiscal balances. The Panel estimates the financial impact of implementing these recommendations at Rs1.02 lakh crore, of which 72% will be borne by the central government’s Budget and rest by the Railway Budget. In absolute terms, the additional expenditure is expected to be in the tune of 0.65%-0.7% of GDP, slightly less than 0.77% arising from the 6th Pay Commission," says DBS Bank Ltd in a research note.
A pay commission is constituted every decade to revise the pay scale of government employees. Although government employee salaries are adjusted for inflation every year (dearness allowance), the pay and pension component is revised only once every 10 years based on the recommendations of the pay commission. Since Independence, there have been six pay commissions. In the past, the fiscal stimulus resulting from the one-time salary revisions has led to a consumption boost, overshooting of the fiscal deficit target and inflationary pressures.
According to Nomura, this time, the tasks of the 7th Pay Commission was much tougher for two reasons. "One, the government’s fiscal consolidation targets are quite aggressive for the next two years from 3.9% of GDP in FY16 to 3.5% in FY17 and 3% in FY18, leaving little scope for sharp increases in its wage and pension bill, and second, a fiscal stimulus not linked with commensurate productivity increases could spur inflation, countering the Reserve Bank of India (RBI)’s medium term target of lowering CPI inflation to 4% by March 2018," it said.
The suggested wage increase by the 7th Pay Commission would come into effect at the beginning of the 2016 calendar year. The recommended increase is less than the 40% that was implemented after the last Commission in 2008. On its own, the pay rises would increase the central government's wage bill by around 0.5% of GDP. It is important to note though that this would also likely affect state government finances as they would be inclined to follow suit.
Terming the recommendations of 7th Pay Commission as a challenge to India's fiscal consolidation plans, Fitch Ratings says, "A recommended 23.55% increase in remuneration for India's central government employees, if fully implemented, would have a significant impact on the government's wage bill, and add to challenges the government faces in achieving fiscal consolidation targets."
"The central government has earlier indicated a target fiscal consolidation of 0.4% of GDP for a deficit of 3.5% in the fiscal year ending 31 March 2017 (FY17), down from 3.9% in FY16. As such, the planned wage increase is sufficient to add substantive challenges to achieving the planned medium-term consolidation targets. The government could seek to cut expenditures in other areas. There may be some room to rein in the subsidy bill, for example. But the government may find cuts in capital expenditures undesirable, especially as investments are planned to play a key role in its efforts to stimulate the economy," the ratings agency added.
Echoing similar views, DBS Bank said, the likely options for next year’s fiscal math point are to restrain spending elsewhere, source additional tax revenues or renege on the fiscal deficit targets. It said, "If the targets are adhered to, allotments towards capital expenditure are likely to fall. This means that a budgeted 25% jump in capital expenditure in FY2015-16 might follow with a less 10% increase next year, while revenue spending rebounds from the small 3% rise this year. Combining these headwinds, there is a risk that next year’s fiscal target is raised modestly, limiting the room for additional monetary stimulus."
Nomura also sees the 7th Pay Commission as helping boost demand for four wheelers across India. "In our view, a 15-20% pay hike for central government employees is likely to benefit four-wheeler demand by a FY17-18F CAGR of about 5-7%. We believe that the penetration of two-wheelers is already high with government employees, and thus the benefits may be more limited to a FY17-18F CAGR of around 1.5%-2.5%. Over a two-year period, car sales could benefit by 14% as the state and central government pay hikes come through," it added.
The last few pay commissions suggest some important implications for the economy. First, the previous three pay commissions (fourth, fifth and sixth) hurt India’s fiscal position. The Fifth Pay Commission implemented in FY98, resulted in a rise in the central government’s wage and pension bill from 2.6% of GDP in FY97 to 3.2% in FY98/FY99.