Public Debt: Classification, Growth and Method of Debt Redemption

Read this article to learn about Classification, Growth and Method of Public Debt Redemption.

Public debt refers to borrowing by a government from within the country or from abroad, from private individuals or association of individuals or from banking and non-banking financial institutions.

Classification of Public Debt:

Public debt may be classified as under:

(1) Internal and External:

Internal debt is raised from within the country and external debt is owed to foreigners or foreign governments or institutions.

(2) Productive and Unproductive:

The productive debt is expected to create assets which will yield income sufficient to pay the principal and interest on the loan. In other words, they are expected to pay their way; they are self-liquidat­ing. On the other hand, loans raised for war do not create any asset; they are a deadweight and are regarded as unproductive.

(3) Short-term and Long-term:

Short-term loans are repayable after short interval of time, e.g. Treasury Bills payable after three months, ways and means advances from the Central Bank. They are intended to bridge the gap temporarily between current revenue and current expenditure. It is called floating debt. Long-term loans are payable after a long time covering several years. They are also called funded debt.

Growth of Public Debt:

Borrowing by public authority is a modern practice. In the past, whenever there was an emergency, usually a war, the monarch relied on the hoarded wealth or borrowed on his own personal credit. Books on history abound in instances of fabulous hoards and accounts of loots and sacks of hoarded wealth either from king’s treasuries or from temples and churches. But this method of finance is not suited to modern conditions. It will be inadequate and unecono­mical.

The system of public credit, making it easy for the state to borrow, has led to tremendous increase in the indebtedness of modern states. Take the case of India. While the total public debt of the country at the end of march 1951 stood at Rs. 2,054 crores, it was expected to shoot up to Rs. 87,062 crores by the end of March 1986 (B.E.— Budget Estimates), i.e., more than 42 times in 35 years.

Causes of Increase in Public debt:

Besides war, there are several other causes which have brought about great increase in the size of public debt:

(i) The most important cause of increase in public debt is war of war-preparedness. Nations attach a great importance to their territorial integrity and they consider no sacrifice too much to defend their country. Every war, therefore, leaves the country under greater debt.

(ii) The increase is also due to fairly frequent budget deficits or current account. The deficits arise from the necessity of maintaining full economic activity in the economies which may have ceased to expand.

(iii) Increase in public debt is also due to the undertaking of welfare schemes by governments in modern times.

(iv) In Public utilities, where there is no convenient profit check, no right control over cost can be maintained and there are more losses than gains. They also add to the weight of public debt.

(v) In recent years, urge for economic growth has induced the under­developed countries to contract debts both internally and externally. The volume of public debt has consequently swollen.

Purposes or Public Debt:

The following are the principal purposes for raising public loans:

(i) Bridging Gap between Revenues and Expenditure:

It often happens that towards the end of the financial year, government experiences shortage of funds. To cover this gap between revenue and expenditure, the government raises temporary loans or gets ‘ways and means, advance from the Central Bank. In India, the government issues what are called ‘Treasury Bills’ which are repay­able after three months.

(ii) Financing Public Works Programme:

During depression, the govern­ment has to launch public works programme to provide employment. In this way, money is injected into the economy to lift the depression. For this purpose, it becomes necessary to raise public loans to ensure economic stability.

(iii) Gurbing Inflation:

When inflation is rampant and it is desired to bring down the prices, the government issues public loans. In this way, money or purchasing power is drawn from the public. Reduction in money supply will bring down prices.

(iv) Financing Economic Development:

The underdeveloped countries are now very keen on speedy economic development, which involves huge invest­ment. They are unable to raise adequate finances through taxation. Hence resort to public borrowing becomes necessary.

(v) Financing the Public Sector:

Economic system, which is becoming increasingly popular, is that of mixed economy. For several reasons, economic, political and social, there has to be a rapidly expanding public sector. The financing of this sector is not possible without resort to public borrowing.

(vi) War Finance:

A modern war is a very costly affair. To prosecute a modern war by taxation is simply out of the question. Public borrowing becomes essential. Thus, public borrowing is necessitated by the requirements of filling the gap between revenue and expenditure, public programme, economic development and war finance.

Methods of Debt Redemption:

Modern governments make it a point of honour to repay their debts. Debt repayment maintains and strengthens the national credit. If a national emergency arises later, it will be easy to raise funds. Repayment of loans also releases funds for trade and industry.

The following are some of the methods adopted:

(i) Utilization of Surplus Revenue:

This is an old method and badly out of tune with the modern conditions. Budget surplus is not a common phenome­non. Even when there is a surplus, it is so insignificant that it cannot be used for making any substantial reduction in the public debt.

(ii) Purchase of Government Bonds:

The government may buy its own stock in the market, thus wiping off its obligation to that extent. This may be done by the application of surplus revenues or by borrowing at low rates, if the condi­tions are favourable.

(iii) Terminable Annuities:

When it is intended completely to wipe off a permanent debt, it may be arranged to pay the creditors a certain fixed amount for a number of years. These annual payments are called annuities. It will appear that, during the time these annuities are being paid, there will be much greater strain on the government finances than when only interest has to be paid.

(iv) Conversion:

This is a method for reducing the burden of the debt. A government may have borrowed when the rate of interest was high. Now, if the rate of interest falls, it can convert a high-rated loan into a low-rated one.

The government gives notice to the creditors that they should either agree to reduce the interest rate for future payments or it will exercise the option of repaying the loan, in case the bond-holders do not accept the lower rate, then the government will raise a new loan at lower rate of interest and, with the proceeds, pay off the old debt. The effect is to convert a high-rated loan into a low-rated one. The financial burden is consequently reduced.

(v) Sinking Fund:

This is the most important method. A fund is created for the repayment of every loan by setting aside a certain amount every year out of the current revenue. The sum to be set aside is so calculated that over a certain period, the total sum accumulated, together with the interest thereon, is enough to pay off the loan.

Burden of Public Debt:

In order to assess the burden of public debt, we shall have to consider the nature and the purpose of the public debt. If the debt is taken for productive purposes, e.g., for irrigation and railways, it will not mean any burden. On the other hand, it will confer a benefit, provided the scheme has been successfully executed. But if the debt is unproductive, it will impose both money burden and real burden on the community. The measure of the burden will depend on whether the debt is internal or external.

Burden of Internal Debt:

Internal debt involves a series of transfers of wealth within the community. For example, when the loan is raised, money is transferred from the lenders to the government. The government then makes payments to contractors, govern­ment servants or to those people from whom it buys goods and services.

Money is, thus transferred from some sections of the community to the other sections. In this case, there is obviously no direct money burden of the debt on the community as a whole. But there will be a direct real burden (i.e., sacrifice, hardship or loss of economic welfare) on the community depending on the nature of these transfers of wealth.

If by these transfers, wealth comes to be more evenly distributed i.e., wealth is transferred from the rich to the poor, then public debt will be considered beneficial instead of being burdensome. If, on the other hand, the public debt enriches the rich at the expense of the poor, it imposes a real burden.

Let us analyse carefully the nature of the transfer. In order to repay the interest and the principal of the debt, the Government must levy taxes. What the tax-payers pay, the bond-holders receive. The bond-holders are generally rich people. But the tax burden does not exclusively fall on the rich, unless it is very sharply progressive which is seldom the case.

The tax burden falls ion the rich and the poor both, and, in the case of indirect taxes, it may be more on the poor than on the rich. The net result many be that the wealth is transferred from the poor to the rich. This means a net loss of economic welfare.

This burden is accentuated by the fact that the transfer is from the young to the old (the bond-holders, the creditors of the government, are generally advanced in age) and from the active to the Passive members of the community. “Here”, says Dr. Dalton, “If nowhere else in the sphere of public finance, the voice of equity rings loud and clear. There is also a general presumption, on grounds of production (besides those on grounds of distribu­tion) against the enrichment of the passive at the expense of the active, whereby work and productive risk-taking are penalized for the benefit of accumulated wealth.” Thus, internal debt has adverse repercussions both on production and distri­bution of wealth. Thus is its direct real burden.

Its indirect real burden will lie in the check it imposes on production. The production is likely to be checked, if the desire and ability to work and save are reduced. If the repayment of debt involves very heavy taxation, it is likely to reduce the ability and the willingness to work and save.

Burden of external Debt:

The external debt also involves a series of transfers of wealth but not within the same country like the internal debt. This makes all the difference. When the loan is raised, wealth is transferred from the lending to the borrowing country, and when it is repaid the transfer is in the opposite direction.

The account of money paid by the debtor country towards interest and the principal is the measure of the direct money burden on the community. But if we want to know the direct real burden (i.e. loss of economic welfare), we shall have to consider the proportions in which the rich and the poor contribute to these payments. The government will raise the required money by taxes. If the taxes fall largely on the rich, the direct real burden will be less than it would be if the incidence is largely on the poor.

The payment that we make to the foreign creditor gives him a control over our goods and services. He does not take away our money it is of no use to him. He buys with those money goods in our country. An external loan thus sets up a drain of goods from our country. In the absence of debt payments, these goods would have been enjoyed by ourselves. This means a diminution of economic welfare; hence a direct real burden.

The indirect burden of the foreign debt lies in the check to production of wealth in the economy. Taxes imposed, in order to raise funds for debt payment, may reduce public expenditure in the directions which would have stimulated production. Hence, production may be checked.

International payments can be made only by exporting goods. For this purpose, a country must produce more. Hence, it is said that production is stimulated. But production is stimulated only in certain directions. There is no general increase in production and employment. Factors of production are limited.

If they are needed in the export industries, they will have to be drawn from the other industries which must consequently shrink. Thus, there is only a diversion of resources and no net increase in production and employment.

Role of Public Borrowing in a Developing Economy:

A developing economy has to tap all possible sources to mobilise sufficient financial resources for the implementation of its economic development plans. It has to utilise revenue surplus for the purpose, seek external aid, pitch up its level of taxation and public borrowing are the two major instruments of resource mobilisation.

Public borrowing has one advantage over taxation. Taxation, beyond a certain limit, tends to affect economic activity adversely owing to its disincen­tive effect. There is no such danger in public borrowing. It does not have any unfavorable repercussions on economic activity by being disincentive, partly because of its voluntary nature and partly because of expectation of return and repayment.

According to expert opinion, taxation should cover at least current expenditure on normal government services, and borrowing should be resorted to finance government expenditure which results in creation of capital assets. In that case, growing public debt will not be a burden on the economy, because such a debt is self-liquidating. But there is a limit to public borrowing, which is considered safe. Additional taxation is also necessary to implement the development plans.

The classical theory frowned upon public borrowing. It was thought that the use of resources by the government was less productive than their use in private hands. But the classical reasoning was based on the assumptions of full employ­ment, inelasticity of money supplies and unproductiveness of public expendi­ture. These assumptions, we know, are not valid today.

Public borrowing for financing productive investment generates additional productive capacity in the economy, which otherwise would not have been possible. It is used as an instrument to mobilise resources which, in an underdeveloped economy, would otherwise have gone into hoards or invested in real estate or jewellery. Public debt would thus divert the flow of resources into the right channels.

Thus, in an underdeveloped economy public borrowing, if prudently managed and skillfully operated, can become a powerful instrument of economic development. Besides, growing public debt provides the people opportunities to hold their wealth in the form of safe and stable income-yielding assets, i.e. government bonds.

Growth and composition of public debt provides the monetary authorities with assets which they can manipulate to give effect to a monetary policy consi­dered desirable in the context of economic development. Thus, monetary policy, which is considered essential for achieving the objectives of economic policy, becomes vitally related to public debt management. The management of public debt is used as a method to influence the structure of interest rates. This, a growing public debt, in an underdeveloped economy, has become a powerful tool of developmental monetary policy.

There are two important ways in which the governments of underdeveloped economies raise resources through public loans:

(a) Market borrowing, i.e., sales to the public of government bonds (long-term loans) and treasury bills (short- term loans) in the capital market,

(b) Non-market borrowing, i.e., issue to the public of debt which is not negotiable and is not bought and sold in the capital market, e.g., issue of national savings certificates and national plan bonds and accepting deposits in the government post office.

Voluntary or Forced Loans:

Most of the types of public loans are voluntary. But, if the voluntary loans do not prove sufficient for the purpose, forced loans become necessary and are resorted to. An important example of forced loans familiar in India is that of Compulsory Deposit Scheme (CDS). Compulsory borrowing is a compromise between taxation and borrowing. Like a tax it is a compulsory contribution to the government but like a loan, it is to be repaid with interest.

Compulsory loans have a special advantage in the context of an inflationary situation and are superior to voluntary public borrowing. They sterilize funds, whereas voluntary public loans result in the creation of readily cashable bonds.

They are monetized to increase liquid assets in the community which produce an inflationary effect. Also, lower rate of interest can be paid on compulsory loans, thus reducing the cost of public debt. But a continuous policy of compul­sory borrowing may arouse public resentment. Normally, it is the voluntary public borrowing programmes which should be chiefly relied upon.