Notes on Public Debt

Public Debt: Meaning, Classification and Method of Redemption

Meaning of Public Debt:

Modern governments need to borrow from different sources when current revenue falls short of public expenditures. Thus, public debt refers to loans incurred by the government to finance its activities when other sources of public income fail to meet the requirements. Public debt is incurred when the government floats loans and borrows either internally or externally from banks, individuals or countries or international loan-giving institutions.

Classification of Public Debt:

The structure of public debt is not uniform in any country on account of factors such as categories of markets in which loans are floated, the conditions for repayment, the rate of interest offered on bonds, purposes of borrowing, etc.

In view of these differences in criteria, public debt is classified into various categories:

i. Internal and external debt

ii. Short term and long term loans

iii. Funded and unfunded debt

iv. Voluntary and compulsory loans

v. Redeemable and irredeemable debt

vi. Productive or reproductive and unpro­ductive debt/deadweight debt

i. Internal and External Debt:

Sums borrowed from market loans through bonds and treasury bills from banks including RBI, LIC and institutions are called internal debt and sums borrowed from foreigners comprise the external debt. Internal debt refers to the government loans floated in the capital markets within the country. Such debt is subscribed by individuals and institutions of the country.

On the other hand, if a public loan is floated in the foreign capital markets, i.e., outside the country, by the government from foreign nationals, foreign governments, international financial institutions, it is called external debt.

ii. Short term and Long Term Loans:

Loans are classified according to the duration of loans taken. Most government debt is held in short term interest-bearing securities, such as Treasury Bills or Ways and Means Advances (WMA) or  91 days/181 days Treasury bill is usually 90 days.

Government borrows money for such period from the central bank of the country to cover temporary deficits in the budget. Only for long term loans, government comes to the public. For development purposes, long period loans are raised by the government usually for a period exceeding five years or more.

iii. Funded and Unfunded or Floating Debt:

Funded debt is the loan repayable after a long period of time, usually more than a year. Thus, funded debt is long term debt. Further, since for the repayment of such debt government maintains a separate fund, the debt is called funded debt. Floating or unfunded loans are those which are repayable within a short period, usually less than a year.

It is unfunded because no separate fund is maintained by the government for the debt repayment. Since repayment of unfunded debt is made out of public revenue, it is referred to as a floating debt. Thus, unfunded debt is a short term debt.

iv. Voluntary and Compulsory Loans:

A democratic government raises loans for the nationals on a voluntary basis. Thus, loans given to the government by the people on their own will and ability are called voluntary loans. Normally, public debt, by nature, is voluntary. But during emergencies (e.g., war, natural calamities, etc.,) government may force the nationals to lend it. Such loans are called forced or compulsory loans.

v. Redeemable and Irredeemable Debt:

Redeemable public debt refers to that debt which the government promises to pay off at some future date. After the maturity period, the government pays the amount to the lenders. Thus, redeemable loans are called terminable loans.

In the case of irredeemable debt, government does not make any promise about the payment of the principal amount, although interest is paid regularly to the lenders. For the most obvious reasons, redeemable public debt is preferred. If irredeemable loans are taken by the government, the society will have to face the consequence of burden of perpetual debt.

vi. Productive (or Reproductive) and Unproductive (or Deadweight) Debt:

On the criteria of purposes of loans, public debt may be classified as productive or reproductive and unproductive or deadweight debt. Public debt is productive when it is used in income-earning enterprises. Or productive debt refers to that loan which is raised by the government for increasing the productive power of the economy.

A productive debt creates sufficient assets by which it is eventually repaid. If loans taken by the government are spent on the building of railways, development of mines and industries, irrigation works, education, etc., income of the government will increase ultimately.

Productive loans thus add to the total productive capacity of the country.

In the words of Findlay Shirras: “Productive or reproductive loans which are fully covered by assets of equal or greater value, the source of the interest is the income from the ownership of these as railways and irrigation works.”

Public debt is unproductive when it is spent on purposes which do not yield any income to the government, e.g., refugee rehabilitation or famine relief work. Loans for financing war may be regarded as unproductive loans. Instead of creating any productive assets in the economy, unproductive loans do not add to the productive capacity of the economy. That is why unproductive debts are called dead­weight debts.

Methods of Redemption of Public Debt:

Redemption of debt refers to the repayment of a public loan. Although public debt should be paid, debt redemption is desirable too. In order to save the government from bank­ruptcy and to raise the confidence of lenders, the government has to redeem its debts from time to time.

Sometimes, the government may resort to an extreme step, such as repudiation of debt. This extreme step is, of course, violation of the contract. Use of repudiation of debt by the government is economically unsound.

Here, instead of concentrating on the repudiation of debt, we discuss below other important methods for the retirement or redemption of public debt:

i. Refunding:

Refunding of debt implies issue of new bonds and securities for raising new loans in order to pay off the matured loans (i.e., old debts).

When the government uses this method of refunding, there is no liquidation of the money burden of public debt. Instead, the debt servicing (i.e., repayment of the interest along with the principal) burden gets accumulated on account of postponement of the debt- repayment to save future debt.

ii. Conversion:

By debt conversion we mean reduction of interest burden by converting old but high interest-bearing loans into new but low interest-bearing loans. This method tends to reduce the burden of interest on the taxpayers. As the government is enabled to reduce the burden of debt which falls, it is not required to raise huge revenue through taxes to service the debt.

Instead, the government can cut down the tax liability and provide relief to the taxpayers in the event of a reduction in the rate of interest payable on public debt. It is assumed that since most taxpayers are poor people while lenders are rich people, such conversion of public debt results in a less unequal distribution of income.

iii. Sinking Fund:

One of the best methods of redemption of public debt is sinking fund. It is the fund into which certain portion of revenue is put every year in such a way that it would be sufficient to pay off the debt from the fund at the time of maturity. In general, there are, in fact, two ways of crediting a portion of revenue to this fund.

The usual procedure is to deposit a certain (fixed) percentage of its annual income to the fund. Another procedure is to raise a new loan and credit the proceeds to the sinking fund. However, there are some reservations against the second method.

Dalton has opined that it is in the Tightness of things to accumulate sinking fund out of the current revenue of the government, not out of new loans. Although convenient, it is one of the slowest methods of redemption of debt. That is why capital levy as a form of debt repudiation is often recommended by economists.

iv. Capital Levy:

In times of war or emergencies, most governments follow the practice of raising money necessary for the redemption of the public debt by imposing a special tax on capital.

A capital levy is just like a wealth tax in as much as it is imposed on capital assets. This method has certain decisive advantages. Firstly, it enables a government to repay its (emergency) debt by collecting additional tax revenues from the rich people (i.e., people who have huge properties).

This then reduces consumption spending of these people and the severity of inflation is weakened. Secondly, progressive levy on capital helps to reduce inequalities in income and wealth. But it has certain clear-cut disadvantages too. Firstly, it hampers capital formation. Secondly, during normal time this method is not suggested.

v. Terminal Annuity:

It is something similar to sinking fund. Under this method, the government pays off its debt on the basis of terminal annuity. By using this method, the government pays off the debt in equal annual instalments.

This method enables government to reduce the burden of debt annually and at the time of maturity it is fully paid off. It is the method of redeeming debts in instalments since the government is not required to make one huge lump sum payment.

vi. Budget Surplus:

By making a surplus budget, the government can pay off its debt to the people. As a general rule, the government makes use of the budgetary surplus to buy back from the market its own bonds and securities. This method is of little use since modern governments resort to deficit budget. A surplus budget is usually not made.

vii. 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. Although an easier means of repudiation, this method has certain advantages since taxes have large distortionary effects.

viii. Compulsory Reduction in the Rate of Interest:

The government may pass an ordinance 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 statutory reductions in the rate of interest. However, such practice is not followed under normal situations. Instead, the government is forced to adopt this method of debt repayment when situation so demands.

Public Debt: Meaning, Objectives and Problems

Meaning:

In India, public debt refers to a part of the total borrowings by the Union Government which includes such items as market loans, special bearer bonds, treasury bills and special loans and securities issued by the Reserve Bank. It also includes the outstanding external debt.

However, it does not include the following items of borrowings:

 (i) small savings,

(ii) provident funds,

(iii) other accounts, res­erve funds and deposits.

The aggregate borro­wings by the Union Government—comprising the public debt and these other borrowings — are generally known as ‘net liabilities of the Government’.

Objectives:

In India, most government debt is held in long-term interest bearing securities such as national savings certificates, rural development bonds, capital development bonds, etc. In indus­trially advanced countries like the U.S.A., the term government or public debt refers to the accumulated amount of what government has borrowed to finance past deficits.

In such countries the government debt has a very simple relationship to the government deficit the increase in debt over a period (say one year) is equal to its current budgetary deficit. But, in India, the term is used in a different sense.

The State generally borrows from the people to meet three kinds of expenditure:

(a) to meet budget deficit,

(b) to meet the expenses of war and other extraordinary situations and

(c) to finance development activity.

(a) Public Debt to Meet Budget Deficit:

It is not always proper to effect a change in the tax system whenever the public expenditure exceeds the public revenue. It is to be seen whether the transaction is casual or regular. If the budget deficit is casual, then it is proper to raise loans to meet the deficit. But if the deficit happens to be a regular feature every year, then the proper course for the State would be to raise further revenue by taxation or reduce its expenditure.

(b) Public Debt to Meet Emergencies like War:

In many countries, the existing public debt is, to a great extent, on account of war expenses. Especially after World War II, this type of public debt had considerably increased. A large portion of public debt in India has been incurred to defray the expenses of the last war.

(c) Public Debt for Development Purposes:

During British rule in India public debt had to be raised to construct railways, irrigation projects and other works. In the post-independence era, the government borrows from the public to meet the costs of development work under the Five Year Plans and other projects. As a result the volume of public debt is increasing day by day.

The Burden of Public Debt:

When a country borrows money from other countries (or foreigners) an external debt is created and it has to pay interest on such debt along with the principal. This payment is to be made in foreign exchange (or in gold). If the debtor nation does not have sufficient stock of foreign exchange (accumulated in the past) it will be forced to export its goods to the creditor nation. To be able to export goods a debtor nation has to generate sufficient exportable surplus by curtailing its domestic consumption.

Thus an external debt reduces society’s consumption possibilities since it involves a net subtraction from the resources available to people in the debtor nation to meet their current consumption needs. In the 1990s, many developing countries such as Poland, Brazil, and Mexico faced severe economic hardships after incurring large external debt. They were forced to curtail domestic consumption to be able to generate export surplus (i.e., export more than they imported) in order to service their external debts, i.e., to pay the interest and principal on their past borrowings.

The burden of external debt is measured by the debt-service ratio which returns to 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 receipt) in that year. In India it was 24% in 1999. An external debt imposes a burden on society because it represents a reduction in the consumption possibilities of a nation. It causes an inward shift of the society’s pro­duction possibilities curve.

Three Problems:

When we shift attention from external to internal debt we observe that the story is different.

It creates three problems:

(1) Distorting effects on incentives due to extra tax burden,

(2) Diversion of society’s limited capital from the productive private sector to unproductive capital sector, and

(3) Showing the rate of growth of the economy.

These three problems may now be briefly discussed:

1. Efficiency and Welfare Losses from Taxation:

When the government borrows money from its own citizens, it has to pay interest on such debt. Interest is paid by imposing tax on people. If people are required to pay more taxes simply because the government has to pay interest on debt, there is likely to be adverse effects on incentives to work and to save. It may be a happy coincidence if the same individual were tax-payer and a bond-holder at the same time.

But even in this case one cannot avoid the distorting effects on incentives that are ines­capably present in the case of any taxes. If the government imposes additional tax on Mr. X to pay him interest, he might work less and save less. Either of the outcomes — or both — must be reckoned a distortion from efficiency and well-being. Moreover, if most bond­holders are rich people and most tax-payers are people of modest means repaying the debt money redistributes income (welfare) from the poor to the rich.

2. Capital Displacement (Crowding-Out) Effect:

Secondly, if the government borrows money from the people by selling bonds, there is diversion of society’s limited capital from the productive private to unproductive public sector. The shortage of capital in the private sector will push up the rate of interest.

In fact, while selling bonds, the government competes for borrowed funds in financial markets, driving up interest rates for all borro­wers. With the large deficits of recent years, many economists have been concerned in the competition for funds; also higher interest rates have discouraged borrowing for private investment, an effect known as crowding out.

This, in its turn, will lead to fall in the rate of growth of the economy. So, decline in living standards is inevitable. This seems to be the most serious consequence of a large public debt. As Paul Samuelson has put it; “Perhaps the most serious consequence of a large public debt is that it displaces capital from the nation’s Stock of wealth. As a result, the pace of economic growth slows and future living standards will decline.”

3. Public Debt and Growth:

By diverting society’s limited capital from productive private to unproductive public sector public debt acts as a growth-retarding factor. Thus an economy grows much faster without public debt than with debt.

When we consider all the effects of government debt on the economy, we observe that a large public debt can be detrimental to long-run economic growth. Fig. 22.3 shows the relation between growth and debt. Let us suppose an economy were to operate over time with no debt, in which case the capital stock and potential output would follow the hypothetical path indicated by the solid lines in the diagram.

Now suppose the government increase a huge deficit and debt; with the accumulation of debt over time, more and more capital is displaced, as shown by the dashed capital line in the bottom of Fig. 22.3. As the government imposes additional taxes on people to pay interest on debt, there are greater inefficiencies and distortions — which reduce output further.

What is more serious is that an increase in external debt lowers national income and raises the proportion of GNP that has to be set aside every year for servicing the external debt. If we now consider all the effects of public debt together, we see that output and consumption will grow more slowly than in the absence of large government debt and deficit as is shown by comparing the top lines in Fig. 22.3.

This seems to be the most important point about the long-run impact of huge amount of public debt on economic growth. To conclude with Paul Samuelson and W. D. Nordhaus: “A large government debt tends to reduce a nation’s growth in potential output because it displaces private capital, increases the ineffi­ciency from taxation, and forces a nation to service the external portion of the debt.”

Conclusion:

There is no doubt a feeling among some people that interest payment on the national debt repayment is a drain on the nation’s limited economic resources. It is pure waste of our resources to use them to pay interest on the debt.

This argument is wrong because interest payment on the debt — if domestically held —do not prevent a use of economic resources at all. It is, of course, true that if our debt is held by foreigners, we will suffer a loss of resources.

In the case of domestically held (internal) debt, internal payment on the debt involves a transfer of income from Indian taxpayers to Indian bondholders of the same generation. Since, in most cases, taxpayers and bond­holders are different entities, a large national debt inevitably involves income redistri­bution effects. But internal debt does not involve any using up of the nation’s real economic resources.

Limit to Public Debt:

Though there is no clear end limit to internal debt there should be a definite limit to external debt. Moreover the upper limit to internal debt should be set by the annual rate of growth of per capita GNP.

Assessing the Debt (Optional):

What kind of burden does the national debt impose on taxpayers and on future gene­rations?

One of the most obvious and significant burdens of the national debt is the interest that must be paid to borrow and maintain a debt of this magnitude. The interest burden of the national debt cumulates as additional debt is incurred each year. Because the debt is not being retired, interest must be paid year after year.

The rising burden of the debt service — or interest cost of maintaining the debt — will be passed on to future generations who will have to pay the interest on the current debt. At the same time, however, many of those to whom interest will be paid will be Indian citizens who own government securities.

Should we pay off the debt? First of all, it would be a huge, probably impossible, burden, even over several years, to raise, through taxes and other revenues, the amount needed to pay off the debt. Second, with repayment of the debt, a significant income redistribution would occur as the average taxpayer became poorer due to the increased tax burden and the holders of government securities became richer with their newly redeemed funds.

Also, some portion of the debt is external, or foreign-owned. While, under normal conditions, this is not a serious concern, in a period of accelerated repayment it would mean a sizable outflow of rupees from the India. Finally, in order to pay off the public debt, a series of surplus budgets would be needed.

However, as Keynes pointed out, a surplus budget has a contractionary impact on the economy. While the debt was being paid off, economic activity would decline. In short, the opportunity cost of lowering the national debt would be a slowing down of the economic activities.