Public Debt:

Now a day public expenditure has increased in the view of increasing activities of the government. It is not possible to meet the large public expenditure through the the traditional sources of revenue, like taxes. Therefore the government is required to obtain additional revenue through borrowing. Borrowing by the government leads to the public debt. The total outstanding loans by the government go by the name of government debt or public debt.

“Public debt is the debt which the government owes to its subjects or to the nationals of the other countries.”

Public debt refers to the loans raised by the government from within the country or from outside the country.

The government may borrow from individuals, business enterprises and banks etc. from within the country and from outside the country.

Types of Public Debt:

Public debts can be classified into various categories on the basis of the market in which the loans are floated, the rate of interest offered, the condition of repayment of loans or purpose for which loans are taken. The main forms of public debt are:

1. Internals and External Public Debt:

On the basis of the location of the market in which the loan is floated the loan may be internal or external :

a. Internal Debt :

Internal debt refers to the public loans floated with in the country, i.e., the government borrows funds from the individuals and institutions located within the country.

The central government of the country raises loans from within the country by raising market loans, selling government bonds, borrowing from RBI, raising small saving and through provident funds etc.

The payment of interest on internal debt does not pose much of a problem because it only causes redistribution of income within the country.

Example, Government of India sells government bonds to its subjects to finance its activities.

b. External Debt:

External debt refers to the loans taken by the government from the individuals, institutions and government of foreign countries as well as the loans taken from the international financial institutions like World Bank, IMF etc.

The payment of interest on external debt and repayment of these loans may cause great hardships to the economy because the payment has to be made in terms of foreign currency and this results in transferring a part of the income and wealth abroad.

Therefore a large amount of country’s limited foreign exchange earnings from exports is not available for its economic development.

2. Productive and Unproductive Debt:

On the basis of the purpose for which the loans are taken by the government the loans may be productive or unproductive :

a. Productive Debt:

Productive debt is the debt which is used by the government for directly productive purposes.

This type of debt is used for the projects which yield an income, like development of railways, power projects, irrigation projects establishment of industries etc.

It adds to the total production capacity of the economy.

The productive debt can be repaid out of the government revenues generated by the projects financed by this debt.

For this reason the productive debt do not constitute a burden upon the government and the taxpayers.

b. Unproductive Debt:

Unproductive debt is the debt which is used for undertaking projects which are not directly productive.

This debt is incurred on those projects which do not yield any income such as financing war, controlling floods, epidemic etc.

Since these debts do not add to the productive capacity of the economy thus these debts constitutes a burden upon the government and repaying these debts becomes difficult.

Question : Why unproductive debt is known as dead weight debt ?

Answer:

unproductive debts are the debts taken by the government to incur on those purposes which do not yield any income to the government.
Loans taken for financing war, controlling floods, epidemic, refugee rehabilitation famine relief funds, etc.
Since these debts do not add to the productive capacity of the economy but constitute a burden upon the government and repaying these debts is difficult for the government.
Therefore for above all reasons unproductive debts are called dead weight debts.

3. Short term and Long term Debt:

On the basis of the period for which the debt is taken by the government, public debts may be short term and long term:

a. Short term debt:

Short term debt is the debt which is raised by the government for short period of three to nine months.

The interest on such loans is generally low.

Treasury bills and advances from the central bank are the example of short term loans.

b. Long term debt:

Long term debts are those debts, taken by the government and repayable after a long period, say five years or more.

These debts carry a higher rate of interest.

These debts are taken largely for development purposes.

4. Funded and Unfunded or Floating Debt:

a. Funded 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.

For the repayment of such debt, the government maintains a separate fund, thus this debt is called funded debt.

b. Unfunded or Floating Debt:

Unfunded or floating loans are those which are repayable within a short period, usually less than a year.

Since no separate fund is maintained by the government for the debt repayment, these debts are called unfunded debt.

Since repayment of unfunded debt is made out of public revenue, it is referred to as a floating debt.

Unfunded debt is a short term debt.

5. Voluntary and Compulsory loans:

a. Voluntary loans:

The loans given to the government by the people on their own will and ability are called voluntary loans.

All the public debts, in a democratic country are by nature voluntary.

b. Compulsory or Forced loans:

During emergencies for example, war, natural calamities like flood, earthquake, tsunami or epidemic etc., government may force the nationals to lend it, such loans are called forced or compulsory loans.

These loans are rare.

6. Redeemable and Irredeemable Debt:

a. Redeemable debt:

Redeemable debts are referred 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. Hence these loans are also called terminable loans.

b. Irredeemable debt:

These are the debts which government does not make any promise about the payment of the principal amount, although interest is paid regularly to the lenders.

For this reason redeemable public debt is preferred.

If irredeemable loans are taken by the government the society will have to face the consequences of burden of perpetual debt.

Reasons for Borrowing by the Government :

These are various reasons for public borrowing, some are as follows :

1. To Meet Budgetary Deficit

2.To Finance War

3. Financing Development Plans

4. To Provide Foreign Exchange

5. To Check Recession

6. Meeting Unforeseen Expenses

7. To Finance Public Enterprises

8.:Soft Revenue Option

1. To Meet Budgetary Deficit :

Some times the government borrows to meet its current revenue expenditure.

Some times, the revenue from taxes and other sources of revenue may fall short of its current expenditure.

In this case, the government requires short period loans to cover the gap between the current revenue and expenditure.

2. To Finance War:

The government may borrow for defence of the country.

Since defence expenditure and warfare is very expensive and it can not be financed by taxation alone.
Public loan is an easier method of collecting revenue than taxation.

Government may use public borrowing on a large scale to meet large expenditure arising out of war.

3. Financing Development Plans:

The government in the underdeveloped countries have to incur a huge expenditure in promoting economic development projects.

The government in these countries can not resort to heavy taxation because of the low taxable capacity of the people.

In this conditions public loans are the only way out.

Example, the Indian government had to borrow heavily to finance its five year plans.

4. To Provide Foreign Exchange:

The government of underdeveloped countries usually take loans to provide foreign exchange.

Underdeveloped countries need foreign exchange during the early stages of economic development, to purchase capital equipments and raw material from abroad and to cover the balance of payments deficit.

Therefore, resources have to be obtained from abroad by way of foreign loans.

Developing countries raise loans from the government of other countries and from international financial institutions like IMF, IBRD.

They get external loans for short term for meeting balance of payment difficulties and for long term for development projects.

5. To Check Recession:

The government of developed countries have been borrowing to control recession and to prevent the possibility of occurrence of depression.

Recession arises because of a fall in private consumption and investment expenditures.

To overcome this situation, the government can raise loans so as to increase aggregate demand and would save the economy from the evils of depression.

6. Meeting Unforeseen Expenses:

Some times, the country has to face some unforeseen emergencies such as flood, famine, tsunami, epidemic etc.

The government is required to undertake huge expenditure to cope up with this situation.

To meet this large expenditure, the government has to raise loans.

7. To Finance Public Enterprises :

In developing countries like India the government has to promote economic development by establishing public enterprises.

The government has to incur a large expenditure on development activities of public sector like expansion of basic and heavy industries, creation of economic and social infrastructure etc.

The government can not provide such huge funds out of taxation alone.

Therefore the government raises loans to meet these financial requirements of public sector.

8. Soft Revenue Option:

Since the public expenditure is increased in large scale All over the world, and it is not possible to finance it through taxes alone.

Taxable capacity of people is very low in underdeveloped countries and increase in taxes is resented by the people everywhere.

So the government chooses the soft option of raising loans to meet its mounting expenditure and saves itself from public opposition.

Methods of Debt Redemption:

Redemption means repayment of a loan and public debt redemption is repayment of public debt.

If the government fails to repay debt, its credibility will be lost and it may not be in a position to raise loans in future.

Various methods are used by the government to redeem its debt. Some of which are as follows :

1. Repudiation of Debt

2. Refunding

3. Debt Conversion

4. Budgetary Surplus

5. Terminal Annuities

6. Sinking Fund

7. Statutory Reduction in the Rate of Interest

8. Capital Levy

9. Export Surplus

1. Repudiation of Debt :

Repudiation means refusal to pay a debt by the government.

When the government repudiates public debt, (t does not recognise its obligation to pay the loans. It refuses to pay the interest as well as the principal amount of debt because of financial constraints. This is called repudiation of public debt.

Normally the government does not like to repudiate its debt because:

It shakes the confidence of people in the government.
It is considered immoral and dishonest as well
It leads to political repercussions in case of repudiation of external debt.
The government may face the difficulty in raising new loans in future.

So the government does not want to repudiate.

Example, the policy of repudiation was followed by Soviet Russia in 1917.

2. Refunding:

Refunding is the process by which the government raises new bonds to pay off the maturing bonds. Thus the government takes a fresh loan to repay an old loan.

In such case, the money burden of the debt is not liquidated and the debt continues to accumulated but is postponed to some future date.

Usually, this method is adopted when the government is not in a position to repay its outstanding loans for the time being.

3. Debt Conversion:

Conversion of public debt means exchange of new debt for the old debt.

In this method, the loan is actually not repaid but the form of debt is changed.

The process of conversion the loan consist of converting a high interest debt into a low interest debt.

The government might have borrowed when the rate of interest was high, but if the market rate of interest falls, it may convert old high interest loan into a new low interest loan.

This way the government is able to reduce the burden of debt.

This method of redemption is possible only when the government enjoys good credit worthiness.

4. Budgetary Surplus:

Sometimes, the government is able to generate a surplus in its budget. It can use this budget surplus to pay off its debt to the people.

A policy of surplus budget may be followed annually for paying off public debt gradually.

The government may use this surplus to purchase back its own bonds and securities from the market.

As a result, there is automatic liquidation of the debt liability of the government.

This surplus budget method of debt redemption is rare phenomenon these days.

5. Terminal Annuities :

In this method the government pays its debt in equal annual instalments, which include interest as well as the principal amount of debt. The annual payments are called annuities.

The government is not required to repay the entire debt at a time, but the burden of debt is reduced every year.

The burden of debt goes on diminishing annually and by the time of its maturity it is already fully paid off.

6. Sinking Fund:

Sometimes, the government establishes a separate fund for the repayment of its debt. This fund is known as ‘sinking fund’.

The government credits (deposits) certain amount of its revenue every year for the repayment of outstanding debt.

This sinking fund is used for the payment of outstanding debt, payment of interest and ultimate repayment of loans as they fall due.

7. Statutory Reduction in the Rate of interest:

Sometimes, the government takes a statutory decision to reduce the rate of interest payable on its public debt.

The creditors are forced to accept the reduced rate of interest because of statutory power of the government.

Normally the government does not follow this policy of reducing the rate of interest. But it may adopt this policy during the period of financial crisis.

8. Capital Levy:

Capital levy refers to a very heavy tax on property and wealth. It is a once for all tax imposed on capital assets of a certain value. It is just like wealth tax.

This tax is imposed on rich and propertied individuals on a progressive scale.

This system is suggested to pay off the war time debts by taxing rich section of community.

It is a quick and equitable method of debt redemption during emergencies but it is not practical method during normal time.

9. Export Surplus:

This method is used to pay external debts.

External debt needs to be repaid normally in foreign exchange. It can be done by creating an export surplus.

If foreign loans are invested in those industries which produce exportable goods, the loans may easily be repaid.

If the loans are utilised for unproductive purposes, export surplus can be generated by reducing the availability of goods for domestic consumption.

In this case, the burden of debt may be very much felt by the people.

Public Debt : Types, and Methods of Debt Redemption -Fiscal Policy Class 12 Economics

Public Debt:

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