A proposed increase in government salaries could threaten New Delhi's fiscal deficit target and limit overall capital spending, overshadowing potential gains to consumption.
In India, a government-appointed panel known as the Pay Commission meets every 10 years or so to revise the salaries of central government employees. This year, the Seventh Commission recommended Asia's third-largest economy adopt a 23.5 percent increase in wages and pensions for the 2016-2017 financial year.
The financial impact of implementing these measures is estimated at 1 trillion rupees ($15 billion), the bulk of which will be absorbed by the next federal budget, according to the panel.
But that spells trouble for the government's 2016-2017 fiscal target, which is 3.5 percent of gross domestic product (GDP), compared to 3.9 for the current year.
If the wage increases are implemented, Morgan Stanley expects the 2016-2017 deficit to widen to 3.9 percent.
"With the Pay Commission recommendations to be likely taken up, the trend of fiscal consolidation is likely to be delayed - we expect the central government to see slippage in the deficit vs. target levels," the bank said in a Friday report.
While there is a bright side to higher government salaries in the form of increased private consumption, the impact could be moderate for a number of reasons, Morgan Stanley warned.
Firstly, civilian public sector employment accounts for only 3.9 percent of India's total work force.
Moreover, rural households, which account 50 percent of overall consumption, will see a limited reaction since only 5 percent of the sector is dependent on government jobs.
Lastly, higher income rates may give households incentive to increase their saving rate rather than spend, the bank said.
Though the Commission's recommendations are not binding for state governments, most states tend to adopt them, it added. "If that is the case again, the states' wages and pension expenditure will also go up and put pressure on the national fiscal deficit level as well."
Asia's third-largest economy successfully lowered its deficit to 4 percent of GDP in 2014-2015 from 5.8 percent in 2011-2012 but now, the Commission's measures could bring India's recent progress to a screeching halt.
Moreover, "the higher spending costs come just as other commitments are on the rise, including additional capital infusion into banks, weak divestment proceeds and importantly, absence of the additional windfall from low oil prices," noted DBS economist Radhika Rao.
Not only is the deficit target at risk, spending elsewhere is likely to be restrained.
"If the [Commission's] targets are adhered to, allotments towards capital expenditure are likely to fall. This means that a budgeted 25 percent jump in capital expenditure in FY15/16 might follow with a less [than] 10 percent increase next year," Rao said.
That's problematic for an economy betting on capital spending to boost economic growth. Prime Minister Modi is betting on higher public expenditure, especially in infrastructure, to achieve a growth target of 8-8.5 percent for the year ending March 2016, from 7.3 percent a year ago.
"Combining these headwinds, there is a risk that next year's fiscal target is raised modestly, limiting the room for additional monetary stimulus," Rao added.