Happy new year folks: The govt has increased excise duty on petrol and diesel again!

light-diesel-oil-250x250Dear Reader,

While you, me and everybody else was busy celebrating the new year, the government quietly increased the excise duty on petrol and diesel, again. This increase was announced on January 1, 2016 and came into effect from the next day.

This is the seventh increase in the excise duty on petrol and diesel since November 2014. Also, the government has increased the excise duty thrice in quick succession over the last two months (between November 6, 2015 and now). Since November 2014, the excise duty on unbranded petrol has gone up by Rs 6.53 per litre, with latest increase being of 37 paisa per litre. This is a massive jump of 544%.

During the same period the excise duty on unbranded diesel has gone up by Rs 6.37 per litre or 436%, with the latest increase of Rs 2 per litre. In the process, the government has captured a major part of the fall in oil prices.

On November 11, 2014, when the excise duty on petrol and diesel was increased by the Narendra Modi government for the first time, the price of the Indian basket of crude oil was at $79.11 per barrel. As on December 31, 2015, the price of the Indian basket of crude oil stood at $32.9 per barrel, a massive fall of 58.4% since November 2014.

In the same period the price of petrol and diesel in Mumbai has fallen by only 3.6% and 9.9% respectively. What this tells us loud and clear is that the government has captured most of the fall in oil prices, without passing on the benefit to end consumers. The surprising thing here is that there has been no protest on this, either from the opposition parties or the citizens.

There are a number of issues that crop up here. First comes the question, why is the government doing this? In fact, there is a clear trend in the government increases of the excise duty on petrol and diesel. In 2014-2015, the last financial year, the increases came on November 11, 2014, December 2, 2014 and January 1, 2015. These increases were in the period close to the annual budget which is presented in end February.

The same trend is playing out this time as well. The three recent increases have come on November 6, 2015, December 16, 2015 and January 1, 2016. In the run up to the budget which will be presented in end February 2016, the government is sprucing up its finances. Estimates suggest that the three recent increases will bring in an extra Rs 10,000 crore into the coffers of the government.

In the budget presented in February 2015, the government had targeted a fiscal deficit of Rs 5,55,649 crore or 3.9% of the gross domestic product(GDP). Fiscal deficit is the difference between what a government earns and what it spends.

It is important to figure out how this calculation was carried out. In 2014-2015, the nominal GDP was at Rs 12,653,762 crore. Nominal GDP is essentially GDP which hasn’t been adjusted for inflation. It was assumed that during 2015-2016, the nominal GDP would increase by 11.5% to Rs 14,108,945 crore. A fiscal deficit of Rs 5,55,649 crore amounts to 3.9% of this projected GDP of Rs 14,108,945 crore.

So there are two things that the government needs to keep track of here. The absolute fiscal deficit as well as the nominal GDP. The trouble is that the nominal GDP hasn’t grown at the projected rate. The nominal GDP for the first six months of the financial year (April to September 2015) has grown by only 8.2% instead of the projected 11.5%. And this has thrown the fiscal deficit calculations of the government for a toss.

As the Mid-Year Economic Analysis released in December 2015 points out: “It is true that the decline in nominal GDP growth relative to the budget assumption will pose a challenge for meeting the fiscal deficit target of 3.9 per cent of GDP. Slower-than-anticipated nominal GDP growth (8.2 percent versus budget estimate of 11.5) will itself raise the deficit target by 0.2 percent of GDP.”

In order to ensure that it meets the fiscal deficit target, the government has increased the excise duty on petrol and diesel thrice in the last three months. On November 6, 2015, when the first of the three increases came in, the price of the Indian basket of crude oil was at $45.07 per barrel. Since then it has fallen to $32.9 per barrel, a fall of 27%. Hence, every time there has been a fall in oil prices, the government has moved in and increased the excise duty.

What this tells us is that on the finance front, the government has essentially turned out to be a one-trick pony. The easy money that the government has managed to raise from falling oil prices has led to a situation where it has totally given up on all other measures to spruce up its revenues as well as cut its expenditure.

The loss making public sector units continue to operate as they had in the past. The government continues to own stakes in companies like ITC, Axis Bank and L&T, worth thousands of crore.

The irony is that the government spends a lot of money in telling people that consumption of tobacco is injurious to health and at the same owns a 11.17% stake in ITC through the Specified Undertaking of the Unit Trust of India. How do the finance minister Arun Jaitley and prime minister Narendra Modi explain this dichotomy? (Like P Chidambaram and Manmohan Singh before them).

Jaitley has also talked about a stable tax regime in the past to woo foreign investors to invest in India. How about offering the same stable tax regime to the Indian consumer as well?

The Indian economy as well as the government finances have benefitted a lot during the course of this year due to falling oil prices. Sajjid Chinoy, chief economist at JP Morgan India, has estimated that lower oil prices gave a 1.3 percentage points boost to growth in the last four quarters.

The question is will this continue? If it doesn’t, does the government have a Plan B in place?

What will happen once oil prices start to rise? How will the government finance its expenditure? Will the government be able to maintain the excise duty that it is currently charging on petrol and diesel and allow their respective prices to rise? If the government raised excise duty in an era of falling oil prices, it is only fair that it cuts excise duty when oil prices are going up?

To conclude, falling oil prices have made the Modi government lazy on the revenue raising front. And that is clearly not a good sign as we enter 2016.

The column originally appeared on The Daily Reckoning on January 4, 2016.

Arun Jaitley will abandon fiscal consolidation in next year’s budget

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It’s too early to be writing about the next year’s budget as it’s more than two months away. But given the way things stand as of now a few things can be safely said.

The finance minister Arun Jaitley during the course of the budget speech in February earlier this year, had said: “I want to underscore that my government still remains firm on achieving the medium term target of 3% of GDP…I will complete the journey to a fiscal deficit of 3% in 3 years, rather than the two years envisaged previously.  Thus, for the next three years, my targets are: 3.9%, for 2015-16; 3.5% for 2016-17; and, 3.0% for 2017-18.” Fiscal deficit is essentially the difference between what a government earns and what it spends.

The way things stand as of now there is no way that the finance minister can work with a fiscal deficit target of 3.5% of the gross domestic product(GDP) for 2016-2017, which is the next financial year.

Why do I say that? The Mid-Year Economic Analysis released by the ministry of finance last week hints towards the same. The nominal GDP growth for the first six months of the year came in only at 8.2%. It had been assumed to grow at 11.5% in the budget. Nominal GDP is essentially GDP which hasn’t been adjusted for inflation.

This lower than expected economic growth has led to the ministry revising the expected nominal growth for 2015-2016 to 8.2%. “Unless oil prices decline further this annual estimate of 8.2 percent would represent two successive years of substantial declines in nominal GDP growth…We estimate that real GDP for the year as a whole will lie in the 7-7.5 per cent range.,” the Mid-Year Economic Review pointed out. The real GDP is essentially GDP which has been adjusted for inflation.

In this scenario of lower than expected economic growth (as measured by the real/nominal GDP growth) “if the government sticks to the path for fiscal consolidation, that would further detract from demand,” the Review points out. Further, “consolidation of the magnitude contemplated by the government… could weaken a softening economy”. Fiscal consolidation is essentially the reduction of fiscal deficit, along the lines Jaitley had talked about in his budget speech.

What the Review is essentially saying here is that if the government continues to cut its fiscal deficit, it will have to cut down on its expenditure. And in an environment where the consumer and industrial demand isn’t really robust this may not be the best way to go about it. With overall demand not in best shape if the government also cuts its expenditure there will be a further fall in demand and in the process economic growth will slow down further.

Hence, enough hints have been dropped in the Mid-Year Economic Review to suggest that the government doesn’t plan to stick to the fiscal deficit target of 3.5% of the GDP in 2016-2017, as it had talked about at the time it presented the budget for 2015-2016.

In fact, even without taking what the Mid-Year Economic Review has to say, the numbers clearly suggest that there is no way the government can work with a fiscal deficit target of 3.5% of the GDP.

The recommendations of the Seventh Pay Commission are expected to add Rs 73,650 crore or 0.65% of the GDP in the first year, to the government’s expenditure. In line with the recommendations of the Commission, the government will pay higher salaries as well as pensions.

Also, the recommendations of the Commission come into effect from January 1, 2016.  They will be implemented from April 1, 2016. Hence, arrears for the three months of January to March 2016 will also have to be paid. This is likely to amount to Rs 18,412.5 crore (Rs 73,650 divided by 4). This pushes up the total extra expenditure due to the recommendations of the Seventh Pay Commission to Rs 92,062.5 crore (Rs 73,650 crore plus Rs 18,412.5 crore).

Over and above this, The Financial Express reports that the Railways has requested the government to fund the extra money it would have to spend in order to meet the recommendations of the Seventh Pay Commission. This is estimated to be Rs 28,450 crore. The Pay Commission in its reports expected the Railways to meet this extra expenditure out of its own revenues. But with the revenues of the Railways not growing as fast as they were expected to, this may not happen now.

Further, arrears of the first three months of 2016 will also have to be paid by the Railways and this will push the total extra expenditure of the Railways to be funded by the government to Rs 35,562.5 crore (Rs 28,450 crore plus Rs28,450 crore divided by 4).

Hence, the total extra expenditure of the government due to the recommendations of the Seventh Pay Commission will come to Rs 1,27,625 crore (Rs 92,062.5 crore plus Rs 35,562.5 crore). Add to this the extra expenditure due to the implementation of one rank one pension which is expected to come to Rs 10,000 crore and we are looking at an extra expenditure of close to Rs 1,40,000 crore.

Also, as I had pointed out in yesterday’s column food and fertilizer subsidies of greater than Rs 1,00,000 crore have not been paid. Once all these factors are taken into account it becomes very clear that there is no way the government can come up with a fiscal deficit number of 3.5% of the GDP.

So, what is the solution for the government, given that this is big money being talked about here? Rest assured some accounting shenanigans will be resorted to with some expenditures (like the payment of subsidies) being postponed. Over and above this, the government needs to shut down loss making public sector enterprises and sell the assets these public sector enterprises have been sitting on for many years now.

The Business Standard reports that the government is planning to raise the rate of service tax from the current 14% to 16%. This is line with the recommendations of the Arvind Subramnian committee which has proposed a standard goods and services tax in the range of 16.9-18.9%. As an editorial in The Financial Express points out: “Based on this year’s budgeted collections for service taxes, a 2-percentage-point hike can yield around R30,000-35,000 crore extra.” And this clearly won’t be enough.

The column was originally published in The Daily Reckoning on December 23, 2015

Mr Jaitley, what is India’s ‘real’ fiscal deficit?

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The ministry of finance released the Mid-Year Economic Analysis for 2015-2016(April 2015 to March 2016) last week. One of the worrying things that it pointed out in the report was regarding India’s fiscal deficit. Fiscal deficit is the difference between what a government earns and what it spends.

In the annual budget for 2015-2016, it was projected that the fiscal deficit for the year would work out to Rs 5,55,649 crore or 3.9% of the gross domestic product (GDP). From the way things stand as of now it is highly unlikely that this number will be achieved.

Why is that? It is all about the way the GDP number has been calculated. When the government says that it expects the fiscal deficit to be at 3.9% of the GDP, it is talking about the GDP in nominal terms. Nominal GDP is essentially GDP which hasn’t been adjusted for inflation. The GDP for 2015-2016 has been projected at Rs 14,108,945 crore by assuming an 11.5% growth over the GDP of Rs 12,653,762 crore for 2014-2015 (April 2014 to March 2015).

Hence, the projected fiscal deficit of Rs 5,55,649 crore expressed as a proportion of the projected nominal GDP of Rs 14,108,945 crore is 3.9%. So far so good.
The trouble is that 11.5% growth is turning out to be an extremely optimistic assumption. The Mid-Year Economic Analysis points out that the GDP growth during the first six months of 2015-2016, has been at 8.2% instead of the assumed 11.5%. And this is a huge gap.

If the GDP is to grow by 11.2% during the course of the year, then it needs to grow by 13.6% during the second half of the year. i.e. between October 2015 and March 2016.

The way things stand as of now that seems highly unlikely. So how will the fiscal deficit look if the GDP grows by only 8.2% during the course of the year? In that case, the fiscal deficit will work out to 4.1% of the GDP, assuming that the absolute number of Rs 5,55,649 crore, does not change. Hence, the fiscal deficit will see a jump of 20 basis points from the expected 3.9% to the actual 4.1%. One basis point equals one hundredth of a percentage.

As the Mid-Year Economic Analysis points out: “It is true that the decline in nominal GDP growth relative to the budget assumption will pose a challenge for meeting the fiscal deficit target of 3.9 per cent of GDP. Slower-than-anticipated nominal GDP growth (8.2 percent versus budget estimate of 11.5) will itself raise the deficit target by 0.2 percent of GDP. The anticipated shortfall in disinvestment receipts, owing to adverse market conditions for a portfolio that largely comprises commodity stocks, will add to the challenge.”

So how does the government plan to tackle this challenge? As the Mid-Year Economic Analysis points out: “Tax collections have been buoyant. That plus the additional revenue measures (the Swachh Bharat cess and recent increases in excise) will ensure that central government’s target will be met.”

Last week the government raised the excise duty on petrol and diesel again by Rs 0.30 per litre and Rs 1.17 per litre respectively. This will add Rs 2,500 crore to the government kitty during the remaining part of the year. The total excise duty on petrol and diesel currently stands at Rs 19.36 and Rs 11.83 per litre.

Excise duty on diesel and petrol has been a major source of finance for the government. As Harsh Damodaran writes in The Indian Express: “Since June 2014, the specific excise duty on diesel has been hiked from Rs 3.56 to Rs 11.83 per litre, and from Rs 9.48 to Rs 19.36 per litre for petrol. The annual revenue gain to it from these increases would add up to Rs 95,000 crore or so — Rs 68,000 crore from diesel, and Rs 27,000 crore from petrol.” The excise duty has been hiked seven times since November 2014.

Getting back to the fiscal deficit—it is more than likely that the government will meet the fiscal deficit target of 3.9% of the GDP. This will be achieved through higher excise duty collections. Don’t be surprised if the excise duty on petrol and diesel is increased further, if the price of oil falls any further (let’s say it goes below $30 per barrel). Along with that some expenditure cuts will also have to be made. As the Mid-Year Economic Analysis points out: “If the typical pattern of revenue collection and spending is taken into account, the first half outturn is well in line with meeting the year’s target.”

Nevertheless, it needs to be pointed out here that the government has been postponing the payment of fertilizer as well as food subsidies. As the economist Ashok Gulati writes in The Indian Express: “Fertiliser policy is in a mess. Unpaid fertiliser subsidy bills to the industry have crossed Rs 40,000 crore, and will likely reach Rs 48,000 crore by the end of this fiscal year, as per industry estimates…The finance minister may be smart enough to show that the fiscal deficit is under control, but unpaid fertiliser and food subsidy bills have together already crossed Rs 1,00,000 crore.”

Over and above this, a report in The Financial Express points out that the unpaid subsidy of the Food Corporation of India (FCI) was at an all-time high of Rs 73,650 crore as of March 2015. What this tells us very clearly is that the fiscal deficit number of 3.9% of the GDP is incorrect. It has been achieved by the government postponing the payment of subsidies.

This is not a good practice given that the aim of any accounting should be to put forward the correct financial picture. By postponing the payment of bills, the government beats that very purpose.

It needs to be pointed out here that this isn’t something that the Narendra Modi government started. It was something that they have inherited from the previous Congress led United Progressive Alliance government.

Having said that it is now their problem and it needs to be tackled, instead of just being postponed. As Gulati writes: “Clear the arrears…If not in one go, the finance minister could commit to doing this over two years. Blaming the previous government for the mess will not help.

Indeed, that is a sensible suggestion which the finance minister Arun Jaitley should implement when he presents the next budget in February 2016. Also, a part of the finance for these payments could be raised through shutting of loss making public sector enterprises and selling off their assets (primarily land in cities which is in perennial short supply).

The question is will Jaitley choose to clean up the government accounts or postpone the problem again? My bet is on the latter. How about yours?

The column originally appeared on The Daily Reckoning on December 22, 2015

 

What the media did not tell you about the economic growth number

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In yesterday’s column I had explained why the gross domestic product (GDP) growth number of 7.4% is more of a statistical quirk. The GDP is essentially the measure of the size of an economy.

The coverage of the GDP news in the media talked about the 7.4% economic growth, without really getting into the details of how that number was arrived at. The GDP growth of 7.4% that everyone from the politicians to the media seem to be talking about is essentially the real GDP growth.

Neither the media nor the economists and the politicians talked about the nominal GDP, which came in at 6%. The nominal GDP is calculated at the current price levels. Once this is adjusted for the prevailing inflation, we arrive at the real GDP.

Hence, nominal GDP growth minus inflation equals the real GDP growth. In this case, the nominal GDP growth came in at 6% and was lower than the real GDP growth of 7.4%. This meant that the inflation was negative. The inflation in this case is referred to as GDP deflator and came in at – 1.4%.

This as I had explained yesterday is because the GDP deflator is a sort of a combination of inflation as measured by the consumer price index and inflation as measured by the wholesale price index. The wholesale price index has been in negative territory for some time now. And this has led the GDP deflator into negative territory as well. Hence, the deflator instead of deflating the nominal GDP number is inflating it.

This is a point that the experts and the media missed out on. There was another important point that the media missed out on and was brought to my notice by Anindya Banerjee, Analyst, Kotak Securities, FX and interest rate desk.

Nominal GDP Growth

Earlier this year, the ministry of statistics and programme implementation moved to a new way of measuring the gross domestic product. They also produced some backdated data for the last few years. The red curve shows the nominal GDP growth rate as per the new method of calculating the GDP. The blue curve, on the other hand, shows the GDP growth as per the old method of calculating the GDP.

What the table clearly tells us is that the nominal GDP growth has collapsed. In fact, as the table clearly shows the nominal GDP growth has never been as low as it is now, in the last ten years. I know I am committing a sin here by mixing data from two different GDP series but the trend has been clearly downward. And this is a reason to worry.

As I had mentioned in yesterday’s column, negative wholesale price inflation has had a huge role to play in inflating the economic growth number. India is seeing a negative wholesale price inflation because of several reasons. Commodity prices have crashed and that is the good bit, because we import a huge amount of important commodities like oil.

On the flip side, negative wholesale price inflation is also a reflection of weak industrial and consumer demand, low capacity utilisation by factories as well as low private investment and falling exports.

These factors are a negative for the economy. But they have ended up adding to the calculation of the GDP in a positive way. The negative wholesale price inflation has led to a negative GDP deflator which has in turn inflated the real GDP growth number. And this has meant that even though the real GDP growth number is strong, the economic growth doesn’t really seem strong.

What all this tells us is that for economic growth to really recover, the nominal GDP number needs to start to move up. Also, it is worth highlighting here that nominal growth really matters.

Corporate earnings are not adjusted for inflation through the GDP deflator. Neither are wages given by companies both private and government, as well as entrepreneurs. And this has an impact on the psychology of private consumption. The corporate earnings for the period of three months between July and September 2015 grew by less than 1%. In this scenario wage increments will be low.

Let’s say the companies are generous and give around 3% wage increments to their employees in the coming year. The employee will look at it as a 3% increment in wages, which is not huge. He will not look at it as a 7.5% ‘real’ increase in wages (3% nominal wages minus the wholesale price inflation of around – 4.5%). This tendency to look at money in nominal rather than real terms is referred to as the money illusion. Given this, higher wages will not lead to a higher consumption.

The government revenue and the fiscal deficit are not adjusted for inflation either. Also, the fiscal deficit of the government is expressed as a percentage of nominal GDP and not real GDP. Fiscal deficit is the difference between what a government earns and what it spends. Let’s take a closer look at the fiscal deficit number projected by the government for the current financial year, 2015-2016. The fiscal deficit has been projected at Rs 5,55,649 crore or 3.9% of the GDP.

The GDP has been assumed to be at Rs 14,108,945 crore for 2015-2016. The GDP under consideration is nominal GDP. The nominal GDP number for 2015-2016 was arrived at by assuming a growth of 11.5% over the nominal GDP number for 2014-2015.

The nominal GDP growth number between April and June 2015 had stood at 8.8%. Between July and September 2015 it came in at 6%. Hence, for the six months of this financial year, the nominal GDP growth has been nowhere near the assumed 11.5%.

Let’s assume that the nominal GDP growth improves during the second half of the year, and the final nominal GDP growth number comes in at 9%. What happens to the fiscal deficit? Assuming the absolute fiscal deficit stays the same, the fiscal deficit as a proportion of the GDP will cross 4%, against the targeted 3.9%. In order to ensure that this does not happen, the government will have to cut down on its expenditure. In an economy where private expenditure and investment is slow that is not the best thing that can happen.

Further, the government wants to reduce the fiscal deficit to 3% of the GDP by 2017-2018. For that to happen, the nominal GDP has to start to go up at a higher rate. It also needs to be pointed out here that the Raghuram Rajan, the governor of the Reserve Bank of India, in the latest monetary policy statement said that he expects the government to continue maintaining the fiscal deficit in the years to come, despite the increased expenditure due to the implantation of the recommendations of the Seventh Pay Commission.

The column was originally published on December 3, 2015 on The Daily Reckoning

Will damages of the 7th Pay Commission be as bad as the Sixth?

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This is the third time this week I am writing a column around the Seventh Pay Commission recommendations. In this column I would like to address the total financial impact of the recommendations of the Seventh Pay Commission.

As I have mentioned in the earlier columns, the Commission has recommended an overall increase of 23.6% in the salary of the central government employees and the pensions of those who have retired from central government jobs. This is likely to cost the government Rs 1,02,100 crore in 2016-2017, the Commission has estimated.

The report estimates that this increase will work out to 0.65% of the gross domestic product (GDP) in 2016-2017.  In comparison, the awards of the Sixth Pay Commission had worked out to 0.77% of the GDP.

The question is how much will it impact the finances of the central government, if the recommendations where to be accepted. First and foremost Pay Commission recommendations are usually accepted. And there is no reason that they won’t be accepted this time around as well.

Further, it is very difficult to estimate by exactly how much the government finances will be affected , given that there is no way of figuring out what the budget makers of the government are thinking. Nevertheless, it is safe to say that the government will have to figure out a way of either increasing its earnings or cutting down on its expenditure, in order to be able to finance this expenditure (as we saw in yesterday’s edition of The Daily Reckoning).

If we look at the budget numbers between 2005-2006 and 2015-2016, the government expenditure has gone up at the rate of 13.4% per year. The government receipts (i.e. the tax and the non-tax revenue of the government less its borrowings) have gone up at the rate of 13% per year. The government expenditure has been going up on a larger base at a faster rate.

Of the extra Rs 1,02,100 crore the government will have to spend, Rs 73,650 crore will have to be borne on the general budget and the remaining on the railway budget. Assuming that the trend of the last ten years will continue in 2016-2017, with an extra expenditure of Rs 73,650 crore, the fiscal deficit of the government is likely to jump to 4.5% of the gross domestic product (GDP) (I will spare you the Maths here).

In 2015-2016, the government has targeted a fiscal deficit of 3.9% of the GDP. Fiscal deficit is the difference between what a government earns and what it spends. And this isn’t a good thing, given that the government is trying to achieve a fiscal deficit of 3.5% of the GDP by 2016-2017 and 3% of the GDP by 2017-2018.

Long story short—the government cannot continue operating the way it currently is. It will have to find out ways to cut its expenditure on other fronts as well increase its revenues. If it does not do that there is no way it will be able to finance the extra spending on salaries and pensions without managing to increase its expenditure as well as the fiscal deficit in the process. And that won’t be a good thing for the Indian economy.

A higher fiscal deficit will have to be financed out of higher borrowing by the government. This will leave lesser amount of money for the private sector to borrow and in effect push up interest rates. And that is something the government won’t want to do.

In fact, the impact of the recommendations of the Seventh Pay Commission don’t end at the central government level. As soon as the central government accepts the recommendations of the Seventh Pay Commission, demands will start for the state governments to increase their salary and pension payouts as well.

That is how things had played out after Sixth Pay Commission recommendations were accepted. The Sixth Pay Commission was due from 2006 onwards, but the Pay Commission report was submitted only in March 2008. The recommendations were accepted in August 2008. Given this, the government had to pay arrears to the employees.

These arrears were paid in 2008-2009 and 2009-2010, with a split of 40:60. This pushed up the fiscal deficit of the central government big time. The fiscal deficit in the year 2007-2008 had stood at 2.54% of the GDP. In 2008-2009, it hit 5.99% and then climbed to 6.46% of the GDP in 2009-2010 (as can be seen from the accompanying table).

There were other reasons as well for this massive jump in the fiscal deficit, from debt of farmers being waived off, to the United Progressive Alliance government getting into the pump priming mode in the aftermath of the financial crisis which started in mid-September 2008, to the expansion of the Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA) to all districts of the country from the original 200 districts.

YearFiscal deficit of the central govt(% of GDP)Combined fiscal deficit of the state govts (% of GDP)Total
2007-20082.541.514.05
2008-20095.992.398.38
2009-20106.462.919.37
Source: http://planningcommission.nic.in/data/datatable/1203/table_27.pdf

 

After the central government, the state governments also had to start raising salaries as well as pensions. The Seventh Pay Commission had commissioned a study by IIM Calcutta to “ascertain the fiscal impact of the previous Commissions’ awards on the states”.

The study found that: “that a significant number of States follow the recommendations of the Central Pay Commission. Equally, there is significant plurality of States that design their own pay awards based on the recommendations of their own State Pay Commissions, which of course do consider the recommendations the Central Pay Commission.”

Hence, the salaries of the employees of the state government employees also went up after the Sixth Finance Commission recommendations were accepted by the central government. This led to the combined fiscal deficit of the states jumping from 1.51% of the GDP in 2007-2008 to 2.91% of the GDP in 2009-2010.

The combined fiscal deficit of the centre as well as the states jumped from 4.05% of the GDP to 9.37% of the GDP. Things started to improve from 2010-2011 onwards. As the Seventh Finance Commission report points out: “The empirical analysis conducted indicates that the macroeconomic impact on States’ finances tends to taper off in two years in most cases.” So, government finances were impacted for two years.

Will a similar scenario play out this time around as well? While the fiscal deficits of the centre as well as the states are likely to jump up, the quantum of the jump may not be as much, because this time the chances of arrears having to be paid are low (at least in case of the central government).

As the Seventh Pay Commission report points out: “The awards of the previous Pay Commissions, both V as well as the VI, involved payment of arrears…However, Seventh Central Pay Commission recommendations entail, at best, payments of marginal arrears.”

This time around the chances are that the recommendations of the Commission will be implemented from April 1, 2016, onwards, and hence will involve payment of marginal arrears. In case of state governments, the arrears will depend on how soon the state governments agree to salary increases.

So can we safely say that the damages of the Seventh Pay Commission will not be as bad as the damages of the Sixth Pay Commission, which screwed government finances for two years? The fact is that the Seventh Pay Commission has recommended one rank one pension for central government employees as well. And that remains the joker in the pack.

The column originally appeared on The Daily Reckoning on Nov 26, 2015