The crisis was brought on by a ballooning wage bill which has been exacerbated by Israel’s refusal to unblock tax revenues.
International donors have threatened to cut aid if Hamas fails to renounce violence and refuses to recognize Israel.
A report by the World Bank underlines the implications for a Hamas-led government if Western powers curtailed aid payments.
It said government spending was to blame for a budget deficit which reached US$800m (A$1.06bn) in 2005.
Nearly half of the deficit was financed by foreign donors.
"The PA's fiscal situation has become increasingly unsustainable mainly as a result of uncontained government consumption, in particular a rapidly increasing public sector wage bill, expanding social transfer schemes and rising net lending," said the report.
Former finance minister Salam Fayad won widespread praise for implementing a package of reforms but he was infuriated when big pay rises for the security services were approved behind his back.
The World Bank said the budget deficit had the potential to destabilise the government.
Immediate action needed
The report said that a rapid recovery will be compromised unless the problem is addressed promptly.
It could not only destabilise the Palestinian Authority’s operations but reduce the public and private resources otherwise available for productive investments."
Outgoing Palestinian economy minister Mazen Sunukrot acknowledged "some technical problems" but said the World Bank had been assured of the government’s continued "commitment to the basic fundamentals of international finance."
Israel has given the Palestinian government an added headache by blocking US$50m (A$66.13m) in customs duties.
The funds should normally be paid on the first of the month but wages for the month of January have not been paid.
Israel has held up the money claiming it wants to ensure that it does not end up in the hands of "terrorists."
Foreign Minister Tzipi Livni said Wednesday Israel would take "a few days" to screen the funds.
The stance flies in the face of a demand by US State Department to unblock the funds.
Washington wants continued support for moderate president Mahmoud Abbas who is highly regarded in the United States.
"The issue here is: How do you support President Abbas in his efforts in this interim period, which ... could last anywhere from two to three months?" said State Department spokesman Sean McCormack.
"The Palestinian Authority has certain needs in terms of budget support, paying salaries."
A senior Israeli government official however maintained its refusal to hand over the cash immediately.
"We will not unblock these funds until we can be sure that they will not be used to finance a government made up of terrorist elements," a senior official in the prime minister's office told AFP.
’Collective Punishment’
Outgoing Palestinian Prime Minister, Ahmed Qurie, has accused Israel of collective punishment.
Mr Qurie is hopeful that an alternative source can be found to meet the budget shortfall needed to pay public sector workers.
“We hope that Israel will release this money because it is our right,” said Mr Qurie.
“We are now trying to get money from other sources. We are in contact with Saudi Arabia, Qatar and the Gulf states. We hope we will soon get the necessary funds to pay the public workers as this money is not for factions but for the Palestinian Authority,” he said.