The Budget proposals on pensions are consistent with the strategy of long-term fiscal correction

In the last decade the central government has seen persistent fiscal deficits of over 5 per cent of GDP. This is an unprecedented situation by world standards. But, surprisingly, there has as yet been no visible adverse impact of these deficits.

The possibility of higher inflation, higher interest rates and a banking sector crisis as a consequence of large fiscal deficits are not issues that are uppermost in the minds of the people or perhaps of the government. Yet, the problem can assume very real proportions.

One of the ways in which the problem of fiscal deficits has started hurting people in recent years has been by reducing the ability of the Centre to help out states when they face fiscal constraints. It is today not uncommon for teachers, whether in colleges or schools run by state governments to expect their salaries to be delayed by months.

Reports of retired teachers demonstrating in West Bengal against non-payment of pensions indicates where the next most painful pressure point may be. It is clearly bad to be unable to pay employees. But able-bodied individuals in employable age could, in principle, get alternative or additional work.

When the state reneges on its commitment to pay pensions to those who are old and dependent on their pensions for their livelihood as they are no longer employable, it is a much more inhuman scenario.

The 2002-03 Budget estimates for pension payments to civil servants for the Centre and states add up to Rs 45,431 crore or around 2 per cent of GDP. Civil servants are promised a clearly defined pension benefit, but the government makes no plans for the future, and when pensions have to be paid, taxes are used to fund the pension outgo.

Governments all over the world have run into problems on a variety of promises made with respect to defined benefit pensions.

We are used to thinking that the promises of a government are inviolable, but even governments in OECD countries have violated promises made on account of pensions. The amounts that are required to be paid out, based on poorly thought out pension policies, simply overwhelm the exchequer.

Pension policies which may have been fine a few decades ago, when the typical civil servant lived for only a few years after retirement, require a rethink in a world where longevity has increased significantly.

Pension reforms which have been undertaken in many countries generally involve phasing out defined benefits, and moving to individual accounts with an NAV based system, where each individual chooses pension fund managers and gets an investment return based on his decisions.

To his credit, Jaswant Singh, for all his apparent short-sightedness on the fisc, has been surprisingly thoughtful on this issue. The new scheme announced by the Finance Minister will not have a fiscal reduction impact right away, but over the years it will reduce the fiscal burden of government employees pensions on the exchequer.

The scheme moves new recruits of the government into a ‘defined contribution’ pension system. Under such a system, each individual contributes a certain amount of his income to a pension fund, matched by contribution by the government (instead of the government committing to pay him when he retires) which then earns a return and builds up to an amount available to him when he retires. This is like the PF system, where money is paid into the pension account every month, but no promises are made about future investment returns.

Even though it does not apply to the defence forces, whose pensions pose a huge burden to State expenditure as retirement ages are lower, the system applies to other new entrants in government. The new pension system will be available not only to civil servants but also to anyone in the country.

From the view point of the civil servant, the key difference in the new system will be a personal pension account which transparently shows an account balance. The civil servant will not need to worry about the solvency of a government in the future. The new recruits into the civil service will be free of the risk that rising fiscal deficits could mean that the government will not have the money to pay their pensions. They will have their own pension wealth to protect themselves in old age.

An additional positive feature in the Budget is the merger of the civil servants pension system with the voluntary unorganised sector pension system. This clearly fosters labour market mobility. A person who joins the civil service can leave, and continue to hold his pension account when in the private sector. This is progress when compared with the existing regime, where pension provisions often generate strong incentives to not leave a government job.

Also, the linking up of government employees pensions with that available to the public has other beneficial fall-outs. A pension system for civil servants is likely to be one which the bureaucracy does a good job of building and running. If there were two pension systems, one for the civil service and another for the unorganised sector, then the bureaucracy is more likely to make the first work, and cut corners in building the second.

Whenever countries attempt the replacement of defined benefit pension systems by defined contribution pension systems, for one generation, there are additional costs. For one generation, the government will be paying pensions to the staff that exist today, and paying contributions to the newcomers. Hence, at first, it looks like such reform only serves to increase the costs of government. Yet, it is a key structural reform that is required for obtaining fiscal stability.

In sharp contrast with the hopes raised by the Kelkar committees, the latest Budget has not attempted serious fiscal reforms in taxation. We are still in the ‘exemption raj’. But at least in the area of pensions, the Budget proposals are consistent with the strategy of long-term fiscal correction.

What has been unveiled so far, in the Budget speech, seems to be on the right track. But the devil is in the details, and what matters now is execution. If done correctly, Mr Jaswant Singh will leave his mark on history. While the new scheme appears to be only for central government employees for the time being, hopefully in the future it will be adopted by the states whose finances are much more precarious, and who do not have the power to print money.

State government employees would be far more fearful of accepting promises of money in the future as against receiving money in their pension accounts today. Not only will it impact the nation’s finances, many generations of government employees would be thankful to Jaswant Singh. We hope he gets this one right.

ila@icrier.res.in

(The author is at ICRIER. These are her personal views.)