Thursday, September 27, 2007

Tenth anniversary of Fifth Pay commission

This month is the tenth anniversary of the United Front (UF) government’s profligate decisions on the report of the Fifth Pay Commission (FPC). It’s an event worth recalling (though not celebrating) for at least two reasons. First, these decisions had serious adverse consequences for India’s economy and public finances lasting through most of the Ninth Plan period (1997-2002). Second, with the Sixth Pay Commission (SPC) launched last year and its report expected in late 2008 or early 2009, it is interesting to speculate about the possible outcome, which could impact significantly on India’s future development trajectory.

Back in 2001 I wrote “the FPC effects constitute the single largest adverse shock to India’s strained public finances in the last decade, with corresponding negative consequences for aggregate savings and investment in the economy”. Six years later I stand by that assessment. The September 1997 decisions resulted in pay and pension increases of 40 per cent and higher to central government employees, which were soon emulated by state governments. Importantly, the pay and pension increases decided by the government were much higher than those recommended by the FPC for the vast majority of employees. The sociology of the decision-making was simple. The FPC had recommended the large increases of 40 per cent plus for the executive grades of the government system (exemplified by the IAS/IFS/IPS, etc) and much lower increases for the vast majority of lower rank employees (even by the most liberal definitions the “executive grades” account for less than 5 per cent of government employees). This is because the FPC judged government executives to be underpaid relative to comparators in the private sector but deemed this not to be the case for the vast majority of government employees (such as clerks, peons, service workers, teachers, etc).

Confronted by union pressure the UF government succumbed and accorded the large increases to virtually all government employees, with the unfortunate consequences that reverberated for several years. At the macro level, the combined fiscal deficit of the Centre and states rose from 6.4 per cent of GDP in 1996/7 to 9.9 per cent in 2001/2, while the revenue deficit (a close approximation of government dissavings) doubled from 3.6 per cent of GDP in 1996/7 to 7 per cent in 2001/2. About half of this fiscal deterioration was directly attributable to the FPC decisions. As I have pointed out elsewhere (Business Standard, November 30, 2006), the marked worsening of the fiscal position was a notable cause behind the deceleration of economic growth in the period 1997-2002 , following the post-reforms boom of 1992-97. Conversely, the growth surge of 2002-07 has been helped significantly by the fiscal consolidation of recent years. 

Source: RBI, Handbook of Statistics on Indian Economy, September, 2006 and Annual Report, 2006/7.

There were other major adverse effects of the FPC decisions. The perennially stressed finances of state governments became much worse. Rising pay and pension obligations preempted spending on material and investment inputs for education, health, roads and other basic infrastructure. Thus, the actual public service provision and development capacities of state governments suffered enormously during these years and it is doubtful whether they have recovered fully in the present decade. Second, the FPC-driven pay increases worsened the dualism in India’s labour markets. For example, it widened the gap between the pay of government school teachers and those appointed by local communities and private institutions, thus stunting the incentives for non-government initiatives for provision of social services. Third, by transferring about 1.5 per cent of GDP to about 3 per cent of the country’s labour force (government employees and all in the “formal sector”) the FPC decisions probably worsened income inequality in India and were no help to the poor. Fourth, government pay increases led to similar increases in public sector units and probably strengthened the vested interests against the policies of disinvestment and privatisation. 

Alright, the FPC decisions took a substantial toll of India’s development momentum and fiscal health for several years. What of the future? What can we expect from the SPC and the decisions on their recommendations? As regards the latter, that is, the government’s decisions on prospective SPC recommendations, the only thing it may be safe to conclude is that the government of the day (most likely another unwieldy coalition) is very likely to decide pay increases in excess of whatever recommendations the SPC makes. And what might those be? Obviously, we will only know when the SPC report becomes available. Till then we can only speculate. Let me voice my main concern.

It seems to me that the main new factor that has emerged in the past decade, and especially in the last six or seven years, is the dynamism of India’s private corporate sector and the sharp increases in corporate executive remuneration. Never mind that the corporate world in India is highly diverse and there are a huge number of small struggling companies with ill-paid executives. The dominant impression, fanned by the press and TV, is one of super salaries in large, fast-growing companies. Against this background the SPC will be under heavy pressure to recommend large pay increases for executive grades of government employees, probably even more so than in 1996. If that happens, it’s hard to see how India can avoid another large fiscal shock with the kind of unfortunate chain of economic consequences that resulted from the FPC. Even if the recommended pay increases for the 95 per cent plus of “non-executive” government employees are modest, the sociology of decision-making that occurred with the FPC recommendations is quite likely to prevail again. If government “executives” get X per cent increase, then that is likely to be the realistic increment for all employees. And then we shall see a rerun of the negative economic and public finance consequences that were triggered by the FPC decisions.

At least, that’s my worry. I hope the esteemed members of the SPC will prove me wrong with their report.