Impact of sixth pay commission on fiscal

This is one of the most important questions being asked  in the Indian economy- What is going to be the impact of sixth pay commission on India’s fiscal deficit.

I was reading the recent speech by Dr. Rakesh Mohan (Deputy Governor, RBI) , where some analysis has been done. He compares the payout in fifth pay commission (implemented in 1997-98) and the sixth pay commission. See this table for details.

• The liability of the Central Government as a result of implementing the FPC award was estimated at Rs.18,500 crore up to the end of February 1998.
• The impact was spread over the period from 1997-98 to 2000-01, rather than being a mere one off impact in 1997-98 .
• The proportion of wages, salaries and pensions of the Central Government, as a proportion of GDP, which had increased from 2.7 per cent in 1996-97 to 3.3 per cent for three years up to 2000-01, tapered-off back to about 2.7 per cent by 2003-04.
• Thus, the impact of the FPC approximately amounted to about 0.6 per cent of GDP per annum over a four-year period – a cumulative impact of 2.4 per cent – for the Central Government.
• In respect of the State Governments, in the absence of budgetary data on salary expenditure, the impact of FPC can be ascertained from its proxy taken as the non-plan revenue expenditure in social, economic and administrative services.
• The impact was visible from the year 1999-2000 when the proxy indicator as a proportion to GDP rose from 6.6 per cent in 1998-99 to 7.0 per cent in 1999-2000 and 7.2 per cent in 2000-01, before declining back to 6.7 per cent in 2001-02. Thus, the impact of FPC for the States amounted to approximately 0.4-0.6 per cent of GDP (a cumulative impact of 1.0 per cent over the two-year period).
• The combined impact of the Centre and States, thus, approximated to around 1.0 per cent of GDP (a cumulative impact of 3.4 per cent).
• In order to absorb the impact of FPC, the Government envisaged to bear it through a combination of additional resource mobilisation and expenditure reducing measures. However, as alluded to above, there was a decline in the tax-GDP ratio in the late 1990s, which exacerbated impact on the Government finances. 
• Looking forward, assuming that the scale of the impact of the SPC to be similar to FPC in proportionate terms, the pressures on expenditures may amount to about 1.0 per cent of GDP per annum for the Centre and States combined, spread over a 3-4 year period.

This means it would add about 1% to the total expenditure for the 3-4 years when it is implemented. This is a pretty big figure. But the situation isn’t as bad as it was in the time of FPC.

Unlike the prevailing situation during the FPC, the SPC implementation would be undertaken when the economy is witnessing high tax buoyancy – the tax-GDP ratio of the Centre has increased by 2.6 percentage points to 11.3 per cent in 2006-07(RE) from 8.8 per cent in 2002-03.

It all depends on tax revenues. If they decline, there could be a problem.

Addendum:

BS reports that according to Finance Secretary D Subbarao, 6th pay commission expenditure would be within 0.4% of GDP. Here is an interview of the Finance Secretary on the same.

Do we see similar housing demand in Mumbai?

Bob Shiller (of Yale) has written a wonderful articleexplaining the recent Housing Bubbles. Shiller is an expert on matters pertaining to housing markets. He applies the principles of psychology really well to understand the developments in financial and other asset markets.

What struck me was the way in which the concept can be applied to understand housing markets worldwide.

 The failure to recognize the housing bubble is the core reason for the collapsing house of cards we are seeing in financial markets in the United States and around the world. If people do not see any risk, and see only the prospect of outsized investment returns, they will pursue those returns with disregard for the risks.

Were all these people stupid? It can’t be. We have to consider the possibility that perfectly rational people can get caught up in a bubble. In this connection, it is helpful to refer to an important bit of economic theory about herd behavior.

Precisely. We have to consider the fact that even rational people can make poor decisions. Then he points to a paper which helps us understand the process:

Three economists, Sushil Bikhchandani, David Hirshleifer and Ivo Welch, in a classic 1992 article, defined what they call “information cascades” that can lead people into serious error. They found that these cascades can affect even perfectly rational people and cause bubblelike phenomena. Why? Ultimately, people sometimes need to rely on the judgment of others, and therein lies the problem. The theory provides a framework for understanding the real estate turbulence we are now observing.

Mr. Bikhchandani and his co-authors present this example: Suppose that a group of individuals must make an important decision, based on useful but incomplete information. Each one of them has received some information relevant to the decision, but the information is incomplete and “noisy” and does not always point to the right conclusion.

The main issue he tries to address is that best people in the business are bound to have incomplete information. So they rely on others who also have incomplete information leading to a cascade of poor decisions and what the authors call as “wrong collective action”. The finding is quite surprising:

Mr. Bikhchandani and his co-authors worked out this rational herding story carefully, and their results show that the probability of the cascade leading to an incorrect assumption is 37 percent. In other words, more than one-third of the time, rational individuals, each given information that is 60 percent accurate, will reach the wrong collective conclusion.

37% !! That is a big number. So, even if we assume rationality, there are bound to be huge errors.

The same concept can be applied to the other asset markets even in other parts of the world.

Like, we continue to see the housing prices rise (and rise and rise) in Mumbai. I have explained previously the demand curve has actually become an upward sloping curve with hardly any effect of rising prices showing on demand. The main reasons given are pretty rational ones- increase in demand for housing due to rising incomes, migration etc.

Though, I am sure large part of the rise is also because of the information cascade effect explained above. Just because someone else has bought, the other person feels it is the right time. And if he is a leader in the peer group/family, the cascade effect is bound to be larger.

Addendum:

I couldn’t find the original paper, but here is a similar kind of research paper from the same authors. It looks like an updated version as well.

Assorted Links

1. A research paper presented in US Monetary Policy Forumis being widely discussed - It estimates Banks losses in subprime around $ 2 trillion!! Trillion!. WSJ Blog summarises the paper.

More summarise of the event are here (Bill Poole’s speech) and here

2. Ajay Shah on Budget 2008-09.

3. EPSA Blog on building political support for development programs 

4. JRV points how vulture funds are buying default mortgages.

5. Prof TTR is a contrarian at most times. He sayswe shouldn’t bother too much about fiscal consolidation and rather relax the FRBM target in order to increase infrastructure spending.

6. Though he shares the same belief as others on actual fiscal numbers.

7. MR pointsto a Ed Glaesar thought. It also pointsto a new paper from Krugman. So, this is what Krugman has been working on. He acknowledges as well.

8. I wish we had such an education program in India.