The fiscal problem this year at the Centre is difficult, yes, but looking beyond into the middle distance, there is a boulder up ahead which needs to be stopped from rolling down the hill. For the current year, more even than moving the fiscal deficit at the Centre below 4.5 per cent, what is needed is identification of expenditure and tax reforms that will be put in place over the next two years. Even at 4.5 per cent, the consolidated deficit across the Centre and states (which is what matters), will amount to no more than seven per cent, since the aggregate state-level deficit is capped at 2.5 per cent of gross domestic product (GDP) at market prices (states are held to a maximum of three per cent of state domestic product at factor cost, which sums to less than the market price aggregate). The widely accepted consolidated target is six per cent of GDP.
So what is the boulder up ahead we have to worry about? I have to backtrack all the way to 1997-98, when the pay scales recommended by the Fifth Pay Commission were given to central civil servants retrospectively from calendar year 1996. By 1999-2000, all state-level employees had won parity in pay scales and pensions with their central counterparts, there were equivalent arrears payable, and the aggregate fiscal deficit of states had climbed to 4.5 per cent of GDP. The two major borrowing avenues for state government were securities; or alternatively small savings, which were at that time collected by the Centre and loaned back to states. Either way, interest rates shot up (small savings deposit rates were actually administered, but had to be raised in order to collect more). States found themselves saddled with a ballooning interest bill to go with their salary and pension bills.
That story is acutely relevant today because one of the last acts of the outgoing government in 2014 was to appoint a Seventh Pay Commission, three years before it was due. So we have to go back to see how that earlier pay hike played out in the system.
In a commendable reform in 1999-2000, the central government ceased its intermediary role in the small savings fund flow, and moved it to a separate fund in the public account. The separation made it transparently clear that if lending rates on loans to states were to be reduced, small savings deposit rates would have to come down too. In this way, state acquiescence was sought and (reluctantly) granted for a steady reduction in small savings deposit rates, which had always acted as a floor to bank deposit rates.
Over the three years from 2000 to 2003, with dwindling inflows into small savings, and the heavy backlog of interest dues on loans taken to cover the pay hike and arrears, states were forced to engage in strenuous primary fiscal correction. The payoff was that interest rates fell all round, private investment leapt up, growth hummed. The National Democratic Alliance government went to the 2004 polls with their India Shining campaign. And they lost.
Many constructions have been placed upon that electoral defeat, but there is no question that state governments' unhappiness with the brutal fiscal correction forced upon them played into it. The fiscal reform by itself was absolutely the right thing to have done. It set the groundwork for the high growth rates and tax revenue inflows enjoyed by the successor United Progressive Alliance government right across their first term, surviving even the global crash of September 2008. The public policy error lay in the manner in which the Fifth Pay Commission scales were accepted at central level in 1997, with no thought to the fiscal implications for states.
Discrete ramp-ups of civil servant pay every 10 years or so are not a good way to go. No attempt is made at these decadal points to examine the structure of the civil service, using the term in the sense of government employees rather than in the Indian sense of an elite cadre sitting at the top of the governmental pyramid. (In international usage, a postman is as much as a civil servant as the postmaster general.)
The Indian civil service in that sense, aggregating across central and state government employees, is not large by international standards. There is no consolidated database on public servants employed across the Centre and states, but the last reported estimate places it at 1.2 per cent of the population (excluding military personnel), implying an absolute number today of around 14 million. The corresponding estimate for China is 2.4 per cent, the most appropriate large-population federal comparator country.
The problem in India is not the large size of the service but its structure. The elite layer, consisting of A- and B-level officers, accounts for five per cent of the total. Level C accounts for 70 per cent and level D for 25 per cent (these figures are from a study that is now 25 years old, but I suspect the percentages would not have changed substantially). Within each of these levels there is a very wide range in terms of competence. Without highly skilled C-level employees, the Budget documents at the Centre (and states), for example, simply could not be produced. There are highly skilled drivers and gardeners in level D, too. But there are also large numbers, with no apparent duties to perform, visible in the corridors of government offices.
The Sixth Pay Commission scales were accommodated within the fiscal stimulus sanctioned after the global crash in 2008-09, but the difficulty of applying the brakes on that stimulus is what we are seeing right now. The 13th Finance Commission recommended that Centre and states make annual contributions towards a fund to cover decadal pay scale revisions. There is still time. The Seventh Pay Commission was not due to be appointed until 2016-17, and its report is not due until 2017-18. With the forthcoming Budget, the Centre could make a start on a fund build-up. States will have to be brought in on the feasible increase in civil service pay, and the fiscal challenge it will pose.