By contrast, while Pay Commission awards are often presented as purely political in nature, there is an important economic consideration to their recommendations. In an economy which is integrating with the global economy especially at the level of the organised formal sector, and where therefore salaries of certain professionals in the private sector grow sharply even as other wages stagnate in real terms, it is unrealistic to expect the public sector to attract professionals without offering at least comparable salaries. The explosive growth of public sector salaries is therefore a reflection of the economic liberalisation process, along with the political factors that influence the outcome.
 
This point is not mentioned at all in the Report, which instead castigates both increased wage bills and increased spending on overt and covert subsidies as undesirable, but does not see the rise in interest rates as another way of subsidising rentiers. This underlying acceptance of the basic economic strategy of the 1990s, which characterises the EFC's whole approach, is problematic because it also informs the attitude to how to resolve the problem of fiscal imbalance, and leads to some suggestions which are actually contradictory with others.
 
The fiscal context that the EFC describes is indeed one marked by large imbalances. Chart 1 shows the fiscal deficits of the Centre and States over the 1990s as per cent of GDP (Old Series). It should be noted that the figure for the Central fiscal deficit for 1999-2000 appears lower only because it excludes the States' share of small savings, which were earlier included. The problem is not with the size of these deficits so much as that they have been increasingly composed of revenue deficit rather than capital expenditure, as evident from Chart 2.

Chart 1 >> Click to Enlarge

Chart 2 >> Click to Enlarge
 
Here the deterioration of State finances appears to have been faster than that of the Centre in the 1990s, but this is not due to any worse performance in terms of raising tax revenues. In fact, as shown in Chart 3, while tax buoyancy (per cent changes in tax receipts divided by per cent changes in GDP) has declined for both Centre and States over the decades, the decline in the 1990s has been sharper for the Centre. This has gone to the point where tax buoyancy for the Centre has fallen below 1 in the 1990s. This is clearly the result of falling tax rates, which despite the grandiose claims of successive Finance Ministers, have not yielded better compliance at all.

Chart 3 >> Click to Enlarge

The EFC is clearly correct to argue that there should be a much more systematic attempt to increase the tax-GDP ratio, and it includes such an increase in its proposed fiscal adjustment scenario which is detailed in Chart 4. Overall, the fiscal adjustment that the EFC asks for over the next five years is quite substantial. As Chart 5 illustrates, tax revenues of Centre and States are to go up by nearly 3 percentage points of GDP, and total revenue receipts by more than 3 percentage points.

Chart 4 >> Click to Enlarge

Chart 5 >> Click to Enlarge

Chart 6>> Click to Enlarge

Meanwhile, revenue expenditure is also to be cut by nearly 3 percentage points, bringing the revenue deficit down from nearly 7 per cent of GDP at present to a highly respectable 1 per cent. This would be associated with an aggregate fiscal deficit of 6.5 per cent of GDP, implying 5.5 per cent of GDP for capital expenditure by both Centre and States. This is not particularly ambitious but still substantially more than at present.
 
How is such a dramatic turnaround to be achieved ? One mechanism is increasing tax revenues, of course. What is interesting, however, is the EFC's expectation that a very large part of this increased tax revenue (around 45 per cent of it) will come from enhanced tax effort by the States. This is intriguing, given that the States' ability to impose taxes is far more constrained than that of the Central government, and that the Centre has shown much poorer performance in the recent past in this regard and therefore has much more scope for improvement.