In its mid-year economic review released in December, the central government hinted that achieving the target of keeping the fiscal deficit to 3.5% of gross domestic product in 2016-17 might be difficult, given the need to increase investment in the economy. While the central government’s budget accounts receive a lot of attention, policymakers would do well to look at state government finances, which can add significantly to government deficits over the next couple of years. This could happen due to the twin burdens of taking over huge loans of power utilities, which stood at 4.3 trillion in 2014-15, under the Ujwal Discom Assurance Yojna (UDAY), and implementation of pay hikes in keeping with the Seventh Pay Commission recommendations.

Is it possible to predict what is in store for state finances in the future?

Peer pressure for paying more

To be sure, there is nothing in the statutes that compels states to also implement the hikes announced by each Pay Commission. However, not doing so might make them susceptible to the ire of employees who want a hike when their peers in the centre/other states get it. It is not surprising that four of the five states—West Bengal, Tamil Nadu, Punjab and Uttar Pradesh—which approached the centre to delay pay hikes, are set for polls in the next two years.

How much do states spend on wages and salaries?

The share of money spent on wages and salaries for all states taken together (29 states, Delhi and Puducherry) has declined by around seven percentage points in comparison to what it was at the beginning of the millennium. In absolute terms, this amount was 4.73 trillion for 2014-15 (Budget Estimates). However, the weight of wages and salaries expenditure in total expenditure varies significantly among states. Punjab’s share is the highest, more than 35%, while Uttar Pradesh’s is the lowest, just 16%.

How will the Seventh Pay Commission change things?

As has been discussed earlier, nothing binds the states to follow the Pay Commission recommendations. Since no state has declared its hikes yet, it is difficult to predict what exactly would be the financial impact of such hikes. Rather, it is better to look at how state finances fared when the Fifth and Sixth Pay Commission recommendations came into place. A study for the Seventh Pay Commission by economists from the Indian Institute of Management Calcutta looked at the implications of the Fifth and Sixth Pay Commissions on central and state finances. Its findings suggest that when states implement pay hikes, they either suffer a strain on the fiscal front or cut back other expenditure—both revenue and capital—which can have adverse development and welfare consequences. In the long term, however, many states manage to normalize the fiscal situation, the study found. The study also shows better results for the sixth Pay Commission than its predecessor, probably a result of better expenditure management.

Time to pay the ‘bijli’ bill

While launching the UDAY scheme, the central government noted that outstanding debts of power distribution companies had mounted to 4.3 trillion in 2014-15. Reiterating the received wisdom that state governments must own up what are actually their liabilities, UDAY proposes to convert 75% of the existing debt into state government bonds with 50% conversions in 2015-16, and remaining 25% in 2016-17. Using the debt figures provided by the government, this comes out to 2.1 trillion and 1.075 trillion in 2015-16 and 2016-17, respectively. The total gross fiscal deficit of states in 2014-15 (according to budget estimates) is 2.95 trillion. Technically speaking, all new debt should be treated as expenditure and hence added to the fiscal deficit of states. This would mean a massive increase in fiscal deficit of states. Since the bulk of the debt-laden discoms is concentrated in a few states, the impact on fiscal deficit would also vary.

There is little surprise that the centre has agreed to exempt all UDAY participant states from their Fiscal Responsibility and Budgetary Management obligations for these two years. In addition, there is also the additional carrot of funds under two central schemes—Deendayal Upadhyaya Gram Jyoti Yojana and Integrated Power Development Scheme—which involve spending of 4,500 crore and 2,500 crore respectively. Non-participants would not get funds under these two schemes.

What after the bailout?

UDAY’s success is premised on the fact that once cleared of their huge debts, discoms would embrace efficiency and cut down on losses. If they fail to do so, states would foot the bill. The percentage share of discoms’ previous year losses to be taken over by states would increase to 5%, 10%, 25% and 50% in 2017-18, 2018-19, 2019-20 and 2020-21 respectively.

A wide gamut of technological, economic and political issues has been leading to discoms making losses. In case a turnaround does not happen, there is bound to be significant stress on state finances beginning 2017-18.

A ticking time bomb?

As has been explained earlier, the bulk of the Pay Commission burden is felt in the states with a time lag of one to two years after the centre implements it, owing to delayed or staggered implementation.

As things stand now, it is highly likely that beginning 2017, both Pay Commission and discom losses might come back to haunt state finances.

The IIM Calcutta study concludes that states have managed to recover from the strain of increased salaries for Fifth and Sixth Pay Commissions, although at a cost to development and welfare activities. In that case, the question is whether UDAY would be a classic case of a bad bailout or genuine uday (dawn) of a cost-efficient power sector in the country.

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