Public Debt: Meaning, Forms and Effects

After reading this article you will learn about:- 1. Meaning of Public Debt 2. Occasions of Public Debt 3. Different Forms 4. Redemption 5. Effects.

Meaning of Public Debt:

Borrowing by public authorities is of recent origin. This practice of revenue raising was not prevalent prior to the eighteenth century. In the middle ages, borrowing was a rare event. Whenever there was urgency, usually a war, the Monarch relied on his hoarded wealth, or borrowed on his own credit.

However, such borrowing was not recognized by the society. It was considered as a ‘dead-weight’ debt.

However, from nineteenth century onwards, borrowing was con­sidered as an important source of revenue to almost all democratic governments. In the nineteenth century, public credit replaced pri­vate credit.

Today, an average citizen has greater sense of security and confidence and his willingness and ability to lend have increased. This contributed towards the development of solid foundation of a system of public debt.

For governments, borrowing is essentially an alternative means of raising revenue to cover expenditures. Borrowing that is the cre­ation of public debt is a means through which governments may finance public services, without reducing the real wealth of private individuals during the period when the funds are acquired.

Hence, in modern times, borrowing by the governments has become a normal method of government finance along with other sources like taxa­tion. Public debt refers to borrowing by a government from within the country or from abroad.

The government may borrow from banks, business houses, individuals and other organizations within the coun­try. It also relies on international agencies and foreign nations during times of emergency. Public debt is the income of the government. This is generally in the form of bonds.

It carries with them the prom­ises of the government to pay interest to the holders of these bonds at stipulated rates at regular intervals or in lump sum at the end of the period, in addition to the principal amount.

According to Prof. Taylor “government debt arises out of borrowing by the treasury, from banks, business organizations and individuals. The debt is in the form of promises by the treasury to pay to the holders of these promises a principal sum and in most instances interest on that principal”.

Pub­lic credit as Prof. Adams points out is the source of anticipatory revenue as contrasted with direct or derivative revenue and so every question of public credit should be judged in the light of this fact.

Occasions of Public Debt:

Public debt is an important source of revenue to a modern govern­ment. A modern government can borrow from individuals, financial institutions, commercial banks and from the central bank of the coun­try.

Usually the government borrows from within the country. It is called as internal debt. The government can borrow from outside the country. It is called as external debt.

The resources raised by way of public debt may be used on various occasions. Usually the government raises loans for the fol­lowing purposes.

In the first place, public borrowing is usually done to tide over the budget deficits. Modern governments do not have large accumu­lated cash balances to overcome budgetary deficits. Fiscal man­agement principle insists that the annual expenditure of the govern­ment should be met out of annual income. But owing to different circumstances, the yield from tax and non-tax sources may not be equal to the actual expenditure to be incurred.

Coupled with these unplanned and unexpected emergency situations like flood, famine, natural calamities etc. may create imbalance in revenue expendi­ture pattern of government.

During this situation it may not be pos­sible to secure funds through taxation. In such circumstances short term borrowing in anticipation of tax collection is used by the govern­ment to tide over this budget deficit.

Secondly, extra ordinary situations like war necessitate bor­rowing. Modern war is an expensive affair. During war time, all the resources at the disposal of the government may not be adequate to meet the huge war expenditure.

Moreover, imposition of additional taxation beyond certain limits has disastrous consequences on the productive activities of the economy. Hence, the government relies on borrowing to meet war expenditure.

Thirdly, public borrowing is considered as the strongest weapon to fight depression and unemployment situation. Depression and unemployment are generally due to deficiency of effective demand, resulting from low economic activity.

Increased public expenditure, financed through borrowing is used for the creation and maintenance of development projects to mitigate the evils of depression and un­employment. J.M. Keynes advocated increased public expenditure financed through borrowing and not through taxation as the best anti-dot to fight depression.

Fourthly, in modern times public borrowing is used as a tool of development finance. Developing economics, experiencing capital shortage, usually depend upon borrowed money to finance various development projects. Hence, developing economies like India uti­lizes borrowed money for accelerating the pace of economic devel­opment.

Fifthly, public debt is used to finance the creation and develop­ment of social overhead capital like education and health care facili­ties.

These basic facilities require huge investments, which cannot be met by ordinary source like taxation. Hence modern governments utilize borrowed money to finance these projects.

Different Forms of Public Debt:

Borrowing of the government differs from one another on several grounds. On the basis of duration, purpose, origin, use etc., Public debt can be classified into different categories.

The major types of classification are listed below:

1. Internal and External Debt:

Internal public debt refers to the public loans floated within the coun­try, whereas external debt refers to the obligations of a country to foreign countries or international institutions. Internally the govern­ment borrows from private individuals, institutions, commercial banks etc.

External loans may help the government in difficult times, when internal resources are not sufficient to meet the financial require­ments. Prof. Dalton made a distinction between internal and exter­nal debt as “a loan is internal, if subscribed by persons or institu­tions within the area controlled by the public authority which raises the loan; external if subscribed by persons or institutions outside the area”.

2. Voluntary and Compulsory Debt:

If the case of voluntary debt, people are free to buy public debt at their sweet will. Voluntary loans are provided by the people, willfully. In this case there is no compulsion to lend money to the govern­ment. No legal enforcement or compulsion is involved in it.

Whereas, compulsory debt involves force. It includes those loans which are taken by the government, by using its coercive authority arising out of its sovereign powers. The government compels the public to subscribe to these loans.

It is obvious that in the case of compulsory loans, the terms of borrowing are such that the govern­ment would not be able to raise the debt if it was a voluntary loan. In this case compulsory loan is similar to a tax.

The tax element consists of the difference between the terms of a voluntary and compul­sory loan. Compulsory loans create inconvenience, oppression and lack of confidence in the government. It has all the disadvantages of a tax.

3. Productive and Unproductive Debt:

Productive debts are those loans which are raised by the govern­ment for financing projects which yield income to the government. For example, loans raised for the development of railways, irrigation projects etc., are productive loans.

The income generated form these projects may be used to repay the loan amount with interest. In short, loans raised for the creation of remunerative capital assets that yield revenue to the government can be called as productive debt.

On the other hand, public debt incurred to cover budgetary defi­cits on revenue account or for purposes which do not yield any direct income to the government is classified as unproductive debt. It is also called dead-weight debt.

According to Prof. Findlay Shirras “dead weight or unproductive debts are those which have no existing as­sets”. Productive debts are fully covered by assets of equal or greater value, whereas unproductive debts neither create any asset nor any income to the government.

They do not add to the productive capac­ity of the economy. They impose a net burden on the community. For example, war finance can be classified into this group. War debt is unproductive because it does not create an asset; it is a dead­weight debt which generates a net burden on the community without any matching asset creation.

4. Redeemable and Irredeemable Debt:

Public debt may be redeemable or irredeemable. Redeemable debts are those which the government undertakes to pay back after a fixed period. This classification is done on the basis of maturity.

Redeem­able debts are otherwise known as ‘terminable debt’. Irredeemable debts are not paid back or redeemed and they are not intended to be paid back. But on such debts regular interest is paid by the govern­ment. It is a permanent interest yielding asset. These loans are also known as ‘perpetual debts’.

5. Funded and Unfunded Debts:

Funded debts are long term debt created by the government, for generating a permanent capital asset. It is repayable after a speci­fied period of time. The mode and means of repayment and the time of repayment are indicated clearly when the loan is floated. Usually when a loan of this type is issued, the government’s options to repay cannot be exercised till after a stipulated period, during which the lenders will receive the interest undiminished.

Unfunded debt is a short term fund. It is also called floating debt. Unfunded debts are those that are paid off within a year. Treasury bonds are unfunded debts because they are for three to six months.

In this form of debt government assumes an obligation to pay at a due date with interest at an agreed rate payable during its continu­ance. In a sense floating debt is a temporary debt, which is in the form of an advance to the government on the demand of the creditor, or within a comparatively short period. Therefore, unfunded debts are for purpose of filling temporary gaps in the budget.

6. Marketable and Non-Marketable Debt:

A marketable debt is one in which the debt instruments are nego­tiable. That is it can be freely bought and sold in the market. Most of the government debts belong to this category. Non-marketable debts are those debts such as savings bonds which cannot be bought and sold in stock-exchange markets.

7. Callable and Non-Callable Debt:

Callable debts are those debts which the government can repay even before the period of maturity, whenever it is found convenient for the government to do so. The government can pay back these types of debts, whenever it enjoys surplus funds, or when the prevailing interest rates are low. Non-callable debts cannot be repaid in this manner. It can be repaid only at the time of maturity.

8. Short-Term, Medium-Term and Long-Term Debt:

Based on the duration of the loan, public debt can be classified into short term, medium term and long term debt. Short term debts are those debts which mature within a period of three to six months. These loans are drawn from the central bank by using the credit instrument of treasury bills.

These loans are also called ‘ways and means’ advances. Medium term loans are those loans which mature within a period of one to ten years. Whereas long term loans are obtained for longer period, say for example, ten years or more. Such loans are usually raised for financing development projects. It usu­ally carries a high rate of interest.

Gross debt refers to the total debt obligation of a government out­standing at a particular time. Whereas net debt is gross debt minus sinking fund or other assets created for the repayment of loans.

Mrs. Hicks have given a different type of classification of public debt. She classifies public debt into three categories namely dead weight debt, passive debt and active debt. Dead weight debt is one which is incurred to meet expenditures which do not in any manner increase the productive power of the community.

It will yield neither money revenue nor a future flow of utilities. Mrs. Hicks gives the example of war expenditure. Passive debt is one incurred for expenditure which yields utilities, but will not yield a return in money income nor increase the efficiency and productivity of labour and capital.

For example, construction of public parks. An active public debt is incurred in connection with capital expenditure on self-liquidating projects, which will directly or indirectly increase the pro­ductive power of the community. For instance, expenditure on public health, education etc.

Redemption of Public Debt:

Redemption of debt implies repayment of public debt. The very need to repay public debt exercises a sort of check on the reckless and unplanned nature of government expenditure.

Just as an individual have the responsibility to pay back his personal debt, the govern­ments too have the obligation to repay the loans taken by them. Hence the government must find the necessary resources to repay its debt obligation.

Accumulated large volume of public debt has a demoralizing effect on the people, in addition to the tax burden imposed upon them on account of repayment of public debt. Different methods are adopted by the government for the redemption of public debt.

The important methods are explained below:

1. Repudiation of Public Debt:

One simple way of throwing of the burden of debt is to repudiate it. It means that the government refuses to pay the interest as well as the principle. In a sense repudiation means destroying a debt rather than repaying it.

However, this is undesirable and normally not prac­ticed. Repudiation will shake the confidence of the general public in the government. Repudiating countries credit worthiness will be lost and it will be very difficult for the country to raise loan in future at reasonable rate of interest.

It is also immoral, since the loan would have come from funds mobilized from all classes of income earners in a society. However, in extreme cases a government may be forced to repudiate its internal or external debt obligations.

For instance, in 1917, Soviet Russia repudiated all the internal and external obliga­tions of the state. Repudiation disables a state from raising future loans. Of all the methods of redeeming debt, repudiation is the most extreme.

2. Refunding:

It is a method in which an old debt is repaid through fresh loans, when a bond matures for payment; the government issues a new bond to the bond holders, under the same terms governing the old bonds.

Sometimes the government may find it inconvenient to re­deem the debt obligations at the time of maturity. On such occa­sions it may issue new securities and pay back the old debts, from the funds thus obtained.

Hence refunding is not repayment, as it is only a substitution of a new loan for an old one. But it gives a tempo­rary relief from its obligation of repayment.

3. Conversion:

Conversion is also a method of refunding. It means the process of changing the old debt obligations into new debt obligations, under­taken usually by the government, in order to take the advantage of a fall in the rate of interest.

The process of conversion consists gener­ally in converting or altering a loan bearing a given rate of interest into a loan at a lower rate of interest. Conversion is not repayment; it is only exchange of new debts for old.

The two terms conversion and refunding are interchangeable. Yet there is a distinction between them. Refunding means the repayment of a loan by taking fresh loans. Conversion involves a change in the rate of interest and other details.

Conversion is actually a method of reducing the amount of interest obligations. Conversion is usually practiced to obtain a number of advantages like reduction of interest obligations, readjustment of maturity structure of the debts etc.,

4. Buying Up Loans:

It is otherwise known as redemption by purchase or open market operations. Under this method, the government may redeem its debt through buying up loans from the market.

When the government possesses surplus income, it will spend them to purchase government bonds from the lenders who hold them. These bonds are purchased and sold in the open market. If the government possesses surplus income, this is a good method of practice, even though it is not sys­tematic.

5. Inflation or Currency Expansion:

The government may also repay the debt by the creation of fresh currency. But this method involves a fall in the value of the monetary standards of the country. It will generate inflationary situation in the economy. The confidence of the public in the financial capacity of the government will be shaken when this method is practiced.

When the government resorts to this method of liquidating its public debt, the credit of the government suffers. In such a situation it may be difficult for the government to borrow funds from the public in future.

6. Serial Bond Redemption:

It is a method under which a part of debt is repaid every year from the budget revenues so that the total debt is paid off during a specified period.

Under this method the government makes provision for the retiring of a small portion of the debt every year. This method is made possible only if government has a surplus budget. For the execution of this process of repayment, the loans outstanding are arranged according to the dates of their maturity.

Then the repay­ments are made as and when the loan matures. An alternative method is to earn-mark a portion of the revenue each year for debt retirement. This system enables portion of debt being paid off every year.

7. Terminal Annuity:

Under this method public debt is repaid in equal installments which include both the interest and the principal, it is done annually. Under this method a part of the debt is repaid every year. This is also called Annual Repayment method.

8. Sinking Fund Method:

A sinking fund is a fund for retirement or repayment of funded debt. It is the process of creation of a special fund for the purpose of repay­ment of debt. The income of the sinking fund must be provided out of general government revenue. That is dedication of certain portion of revenues to the sinking funds.

Normally the government save a certain part of its current rev­enue and set it aside in the form of a sinking fund.

The amount accumulated therein is used for debt retirement. It is the most sys­tematic and best method of debt redemption. In simple terms it means the creation and gradual accumulation of a fund which will be suffi­cient to pay-off public debt.

Suppose the government floats a debt of Rs. 20/- crores, redeemable in ten years for road construction. At the time of floating itself, the government may levy a tax on petrol and the proceeds therein will be credited to a fund known as sinking fund. Year after year the tax proceeds with interest will make the fund grow and after 20 years it becomes sufficient enough to pay off the original debt.

The principle of sinking fund is built upon the idea of planned repayment of public debt. Prof. Taylor has rightly defined sinking fund “as a fund for retirement of funded debt. It had a theoretical justification in the belief that government should impose upon itself requirements for orderly debt retirement”.

This method is commonly practiced in many countries of the world. One short coming of this method is that during times of finan­cial stringency, the government may not hesitate to draw from the accumulated fund to spend for other purposes, than for which the fund is originally constituted.

Therefore, in modern days, the fund does not accumulate or continue from year to year as explained earlier. Instead a part of the revenue is earmarked for the repay­ment of the part of the debt in the same year.

9. Capital Levy:

It is an extra-ordinary method adopted to repay the huge debt accu­mulated during war period. Debt redemption by the imposition of a heavy tax on property and other assets has been advocated by Ricardo and Mill. Prof. A.C. Pigou also supported capital levy. This levy has been proposed to repay the whole or greater part of the enormous war debt by means of a big levy on capital.

Hence capital levy is a levy on capital or assets of individuals. The purpose of this levy is to wipe out the entire war debt, by impos­ing a once for all tax on capital assets, whose value has appreciated greatly on account of war time situation.

The justification of capital levy is that during war time, inflation and prosperity, the owners of capital assets, business men, speculators and producers amaze large fortunes. Hence they should be made liable to bear a large cost of war debt.

Moreover capital levy is a special levy imposed only on the rich people; the poor will not be affected in the course of retirement of public debt. War debt as such is unproductive and is a dead weight on the community necessitating heavy taxation year after year. Hence it will be better to impose it out once for all by a special levy.

Ricardo and Mill advocated such a levy immediately after Napoleonic war to wipe out war debt. Prof. A.C. Pigou another staunch supporter of this levy even suggested the inclusion of per­sonal ability or mental ability for such a levy, though he admitted the difficulty involved in such an inclusion.

Prof. Pigou advocated a steep levy on all forms of wealth including estates, machinery, stocks, bonds etc., owned by individuals.

Effects of Public Debt:

A peculiar profile of public borrowing is its voluntary nature, as con­trasted to the compulsory features of taxation. When the govern­ment offers its securities to the public, persons are free to purchase them.

If they subscribe government bonds, they suffer no net dimi­nution in their wealth, as occurs when they pay taxes. In exchange for liquid cash, they receive bonds or other securities which bear interest and which will ultimately be paid off.

The government in turn receives money for meeting its expenditure, but incurs a liability for the payment of interest and the repayment of principal in the future.

The economic effects of a government programme financed by borrowing are different from the effect of a similar programme financed by taxation. This is partly because the lending of money to the gov­ernment is purely voluntary and partly because the making of such loans does not reduce the personal wealth of the lenders but merely changes its form.

A major consequence of these types of fund mobi­lization is that borrowing, on the whole, is likely to have a less contractionary effect upon aggregate demand, than raising an equiva­lent amount by way of taxation.

Hence a programme of expenditure financed by borrowing is likely to have a greater net expansionary effect upon the economy than a programme of the same magnitude financed by taxation.

1. Effect of Borrowing upon Consumption:

In the case of borrowing, curtailment of consumption spending is likely to be slight, except in wartime borrowing programmes in which substantial pressure is applied to individuals to reduce consumption and buy bonds.

Hence compared with taxation, public debt do not have any serious effect on the level of current consumption. In the case of individuals, their consumption pattern is set by their current income. Loans are advanced out of saving, whereas taxes are paid out of income.

Under certain conditions, there is greater possibility of an increase in the spending on consumption, due to government borrowing. The bond holders regard their bonds as wealth and a source of income.

Moreover, by holding government bond, their li­quidity position is not very much effected because bonds can be converted into cash at any time. Hence there will be a tendency to increase spending on consumption.

2. Effect of Borrowing on Saving and Investment:

The floating of public debt influences saving and investment through the interest rate mechanism. Floating of public debt will raise the rate of interest. Since savings are interest elastic, creation of public debt will raise savings.

Investment expenditure of the bond holders are influenced through the claim effect on investment. That is through increase or decrease in interest rate. When bonds are issued, the ratio of money supply to debt supply will be reduced and as a result rate of interest will increase.

As a result the effect of public debt will be, reduced investment expenditure. On the other hand when bonds are purchased by the government from the open market, or when government repay public debt, the ratio of money supply to debt supply increases and the rate of interest declines.

This will lead to an increase in investment. The overall effect on the economy de­pends largely on the way in which the investment is made in the public sector, compared with what could have been achieved in the private sector.

The effect of public debt on investment also depends on the method of raising loans. Suppose if the government borrows from commercial banks and central bank of a country, it will increase the money supply or purchasing power and hence the funds available for investment will not be reduced.

However, if the government bonds are subscribed by the public and financial institutions, out of funds meant for investment, then automatically investment expenditure will be curtailed.

3. Effect of Borrowing on Production:

In general, government borrowing results in enhancing the productive capacity of the economy. If the borrowed money is used by the government to finance developmental projects, it will generate in­come and employment opportunities.

Such investments strengthen the capital base of the economy and help to increase the production of goods and services. Moreover, the government will be able to re­pay the debt and interest charges in future without much difficulty.

Whereas, if the public purchases government bonds, by selling their shares or debentures, invested in private industrial concerns, it will create an adverse effect on private investment.

However, when the borrowed money, as stated above is used for highly productive activities, overall production is not affected badly. Likewise, if the public subscribe government bonds by withdrawing their bank de­posits, it will adversely affect the lending capacity of commercial banks and thereby private investment activities.

However, if public debt is purchased by the individuals, utilizing their idle funds, it will not adversely affect private investment. Whereas borrowing resorted to meeting current expenditure or for financing a war, would result in the diversion of resources from productive activities to wasteful ex­penditure flows.

4. Effect of Public Debt on Distribution:

Borrowing leads to transfer of resources from one section of the community to another section. If this transfer takes place from the rich to the poor, the inequality in the distribution of income and wealth would be reduced and as a result the economic welfare of the com­munity will be enhanced.

On the other hand if the transfer of wealth takes place from the poor to the rich, the disparity in the income distribution will be aggravated.

Usually, government bonds are subscribed by the richer income group. Whereas, the burden of taxation imposed for financing debt service and repayment of public debt, falls on the poor section. There­fore generally public debt has a tendency to increase economic in­equality.

Whereas suppose the public debt is mobilized through the small savings of lower income group. Correspondingly debts are serviced and repaid through taxation imposed on the richer income group.

Then public debt will not result in increased income inequality. Hence, loan finance can be used as a means to redistribute income be­tween different segments of the society.

5. Other Effects of Public Debt:

(a) Public debts in the form of government bonds are negotiable credit instruments. They are highly liquid form of assets. The investors can freely convert them into liquid cash at any time to meet their demand for money.

Moreover, as far as financial insti­tutions are concerned, it adds to the liquidity position of these institutions, because of its transparency in convertibility.

(b) During times of inflation, when the government borrows from the people, the purchasing power in the hands of the public will be reduced. As a result inflationary pressure in the economy will be reduced.

On the contrary, during depression, when the borrowed funds are utilized for development projects, it will generate addi­tional purchasing power, employment and income. Hence, dur­ing depression, public debt can be utilized as an effective instru­ment to curb deflationary fluctuations in economic activity.

Hence, in modern times, public debt is used as an important instrument to bring about economic stability in the economy. In fact, one of the major objectives of government borrowing today is to strengthen the economy by freeing it from the evils of depres­sions and also to build up the economy and stable economic growth. Owing to this reason, rapid increase in public debt need not be viewed with concern.

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