The following points highlight top nine methods used for the redemption of public debt. The methods are: 1. Refunding 2. Use of Budgetary Surplus 3. Terminal Annuity 4. Sinking Fund 5. Debt Conversion 6. Statutory Reduction in the Rate of Interest 7. Additional Taxation 8. Capital Levy 9. Using Trade Surplus.
Method # 1. Refunding:
The government often issues new bonds for raising new loans in order to pay-off the matured loans (i.e., an old debt). Thus, the government takes a fresh loan in order to repay an old debt. When the government uses this method of refunding there is no liquidation of the money burden of the public debt. Instead, the debt-servicing (i.e., repayment of the interest along with the principal) burden gets accumulated on account of the postponement of the debt-repayment to some future date.
Method # 2. Use of Budgetary Surplus:
Sometimes, a government is able to generate a surplus in the budget. In such a situation, the government is left with two options. It can either reduce taxes or repay some of its old debt. In general, the government makes use of the budgetary surplus to buy back from the market (the people) its own bonds and securities. As a result, there is an automatic liquidation of the debt liability of the government.
Method # 3. Terminal Annuity:
In some countries, the government follows the practice of paying-off the debt on the basis of terminal annuity. By using this method, the government pays-off its debt (which includes both interest and the principal) in equal annual instalments.
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This method often finds favour with the planners and policymakers in developing countries like India because it leads to a fall in the burden of public debt every year. The government is not required to repay the entire debt at a time (i.e., it is not required to make one huge lump-sum payment in order to repay the debt).
Method # 4. Sinking Fund:
Sometimes, this government of a country establishes a separate fund known as the ‘Sinking Fund’ for the purpose of repaying its debt. Under this system, the government goes on crediting a fixed amount of money to this fund every year.
By the time the debt matures, sufficient money gets accumulated in the fund so as to enable the government to repay the debt along with interest. In general, there are, in fact, two alternative ways of crediting sums to this fund.
The usual procedure is to deposit a certain (fixed) percentage of its annual income to the fund. A preferable alternative for the government is to raise a new loan and credit the proceeds to the sinking fund. However, some economists do not treat the second method with favour. For example, Dalton has opined that it is in the Tightness of thing to accumulate a sinking fund out of the current revenue of the government, not out of new loans.
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Modern economists like J.F. Due, Richard Musgrave and others look at this sinking fund method as a systematic method of debt repayment. Under this system the-burden of debt is spread evenly over an extended period of time (10 – 15 years). Furthermore, this normal method adds to the creditworthiness of the government. Critics, however, argue that this method is a slow process of debt repayment.
Method # 5. Debt Conversion:
Sometimes, a high interest debt is converted into a low-interest one. The question here is: when is this possible? Let us suppose the government contracts the debt when the existing rate of interest is quite high. But after some time the market rate of interest may fall.
This gives the government an opportunity to convert its high-interest debt into a low-interest one. And, the government is enabled to reduce the burden of public debt. If the interest burden of public debt falls the government is not required to raise huge revenue through taxes to service the debt.
Instead, the government can reduce taxes and provide relief to the taxpayers in the event of a fall in the rate of interest payable on public debt. Since most taxpayers are poor people and bondholders are rich, such debt conversion is likely to improve the pattern of income distribution. If this happens there is an automatic reduction in the degree of inequality in the distribution of income.
Method # 6. Statutory Reduction in the Rate of Interest:
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Sometimes, the government passes ordinances to reduce the rate of interest payable on its debt. This happens when the government suffers from financial crisis and when there is a huge deficit in its budget. There are so many instances of such compulsory reduction in the rate of interest. However, this practice is not followed under normal circumstances. Instead, the government is forced to adopt this method of debt management (repayment) only when the situation so demands.
Method # 7. Additional Taxation:
Sometimes, the government imposes additional taxes on people to pay interest on public debt. By levying new taxes, both direct and indirect, the government can collect the necessary revenue so as to be able to pay-off its old debt.
However, this method is often criticised on the ground that it creates inequality in the distribution of income by redistribution (transferring) income from taxpayers to the bondholders. This is why it is said that if income-tax revenue is used to pay interest on public debt there is a net burden on the community.
Method # 8. Capital Levy:
In times of war or emergency most governments follow the usual practice of repaying its debt by imposing a capital levy on its citizens. Keynes also agreed to this method when he discussed the different methods of paying for a war. A capital levy is just like a wealth tax inasmuch as it is imposed on capital assets.
This method serves a two-fold purpose:
(1) Prima facie, it enables to the government to repay its wartime debt by collecting additional tax revenues from the rich people (i.e., people who have huge private property and wealth);
(2) Secondly, such capital levy, imposed at progressive rates in capital assets, also helps reduce the degree of inequality in the distribution of income and wealth.
Method # 9. Using Trade Surplus:
The methods discussed above are used to repay internal debt. However, when the government borrows from other countries, it has to service the debt in foreign exchange. The burden of country’s external debt is measured by its debt-service ratio, which is a country’s repayment obligations of principal and interest for a particular year on its external debt as a percentage of its exports of goods and services (i.e., its current receipts) in that year.
An external debt is usually repaid in foreign currencies or gold. If a country is unable to repay the debt it has to export goods abroad. For this, it has to generate an export surplus, i.e., it has to raise exports and reduce imports and make net export or the balance of trade favourable.
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If a country is able to generate export surplus or balance of trade surplus there will be net inflow of foreign exchange into the country. This will enable the debtor country to repay its external (foreign) trade.
In this context, the following quote from Paul Samuelson and W.D. Nordhaus is highly relevant:
“An external debt, one owed by a nation to foreigners, does involve a subtraction from the goods and services available to people in the debtor nation. Many nations in the 1980s — Poland, Brazil and Mexico — laboured under severe economic hardships after they incurred large external debts. They were forced to export more than they imported — to run trade surpluses — in order to service their external debts, that is, to pay the interest and principal on their past borrowings”.
In fact, in the mid-1980s some countries needed to pay 25% to 35% of their export earnings to service their external debt. The debt-service burden on an external debt leads to a loss of social welfare because it reduces society’s consumption possibilities.