CHAPTER FOUR

PUBLIC DEBT

4.1. Introduction

Public debt is of recent growth and was unheard of prior to the 18th century. In modern times,
however, borrowing by the States has become a normal method of government finance along
with other sources such as taxes, fees, etc. The government may borrow from banks, business
houses, other organizations and individuals. Besides, it can borrow within the country or from
outside. The government loan is generally in the form of bonds (or treasury bills if the loan is
required for short periods) which are promises of the government to pay to the holders of these
bills the principal sum along with interest at the stated rate. Borrowing is resorted to in order to
provide funds for financing a current deficit.
Public debt is also sometimes referred to as government debt. It is a term for all of the money
owed at any given time by any branch of the government. i.e. federal government, the state
government, and even the municipal and local government.
Public debt is a debt or loan taken by the govt. from
 own people
 Foreign countries or both.
4.2. Objectives of Public Debt / Borrowing
1. Income and Revenue: The target of public debt normally is to cover the ditch that
developed in any year between proposed expenditure and expected revenue. Whenever
because of increased administrative expenditure or flood, feminine, earth quake and
communicable diseases like unexpected problem government's income becomes less
because they have to spend it to covers these problems then government cover it by
taking Indian and Foreign debts. This is the government; whose income is different from
all the taxes and revenue sources.
2. In Times of Depression: Depression is the condition when costs reduce, there is a lack
of courage in people for spending money on industries and in future there is no
possibility of getting gain. This condition can be removed when there is increase in the
demand of things and services and that is possible when in the country there is an
increase in the expenditure of public construction work or most important public use and
infra-structure services.

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 3. To Curb Inflation: Inflation is the name of that condition at the time of increased cost.
So, government by taking debt can take back a big quantity of work power from the
hands of people but modern economists believe that as comparison to government tax,
taxation is said to be more important will to remove inflation, because if the debated
government money is never used in productive use, it increase the responsibility for
government to give it back. But waste tax -income can easily to be debited in the
government fund so the pressure can be removed from Production in economy.
4. To Finance Development Plans: In undeveloped economy, there is always a lack. In
these countries, as the ability to pay the bill is less. So, government cannot take shelter on
heavy taxation. But to remove poverty from the country, this is also most needed and
important to do arrangements of development plans. In this condition, the only way is to
take public debt. So, the governments of undeveloped countries take debts from within
the country or from foreign governments or from people to do finance arrangements.
5. The Finance Public Enterprises: Government also takes debts for the arrangement of
finance for the commercial enterprises running by it.
6. Expansion of Education and Health Services: Government can also take debt for the
Construction and development of education and health services and other services like
this. That helps to increase normal social welfare but does not give any direct finance and
that is not productive from the angle of currency.
7. To Finance War: Government can take debt for the self-defense work. In the present
century of increased international pressure and atomic war, there is a need of money in
big amount to save the country from foreign attacks and for self-defense services and to
do the arrangement of modern decoration. But it is very difficult to collect the money for
modern wars only by taxation because it affects the production unfavorably. So, to cope
up with this type of situation government can take shelter from public debt from inside
and outside the country.
8. For the Establishment of Social Society: For the establishment of socialist society,
government is doing nationalism of industry and business in present time and running it
themselves, but to run modern industries, there is a need of big quantity of money
government can only fulfill this by taking debts.

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 9. To Cover the Expenditure on Administrative Work till Getting Income: The income
which government got from taxes that is available at the end of the year but expenditure
is from the starting of the year so at the beginning of the year government spends money
by taking debt and pays the debts when it got the income in the last of the year.
10. To Make the Public Verdict Favorable: When the citizens are not able to pay the tax
then the governments have to take debt. Sometimes even then the more capability of
public, the Government never increase taxes because the public verdict sticks to
favorable.
4.2. Classification of public debt
 Source of Borrowing
 Purpose of the loan
 According to nature
 Funded and unfunded debt
 Time Duration of loan
1. Source of Borrowing (internal debt and external debt).
There are two sources of public debt, internal and external. Internal debt refers to public loans
floated within the country, while external debt refers to the obligations of a country to foreign
governments, or foreign nationals or international institutions. Though external debt is becoming
very common these days, there has been general prejudice against foreign debt, based on
ignorance and faulty economics.
2. Purpose of the loan (Productive and unproductive debt)
Public debt is said to be productive if the investment yields an income which will not only meet
the yearly interest payments of the debt but also help repay the principal over the long run. All
public debt can be said to be productive in another sense too. The government may undertake
certain projects through loans which may not be productive in the sense given above but which
may be really useful to the community – for example, a railway line connecting a backward
region, an irrigation work to prevent famine conditions in an area, and so on. In this sense all
public debt is productive. But in many cases, public debt may be contracted during war-time to
finance war. Such debt is unproductive because it does not create an asset; it is a dead-weight
debt or a useless burden on the community.
3. According to nature: Compulsory and voluntary debt

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When the govt. borrows from public by using forceful method,. For example, the loans raised
during an emergency e.g. war. When the govt. borrows money from the public, individuals and
institutions by issuing securities like bonds etc., it is called voluntary debt.
4. Funded debt and unfunded or floating debt.
Broadly speaking, funded debt is a long-term debt, undertaken for creating a permanent asset and
the government normally makes arrangements about the mode and the time of repayment.
Unfunded and floating debt is a relatively short-period debt meant to meet current needs. The
government undertakes to pay off the unfunded debt in a very short period, say, within six
months. Treasury bills are examples of unfunded debt. The rate of interest on unfunded debt is
lower.
5. Time Duration of loan (short, medium, and long term loan).
According to time duration of the loan, public debt can be classified into short term, medium
term, and long term loans. Short term loan is usually incurred for a period varying from three
months to one year. Usually government gets such loans from the central (national) banks by
using treasury bills. These loans are also called ‘ways and means advances’. Such loans are
obtained to overcome temporary deficits in payment to be made by the government in the course
of one year to pay salaries etc. Medium term loans are those which are obtained for more than
one year but less than ten years. Usually the governments borrow only long term loans for more
than ten years. The maturity period is long so that the rate of interest tends to be higher on the
long term loan than short term loan. Long term loans are incurred to finance development
schemes.
4.3 . Burden of Public Debt
Public borrowings are to be paid along with interests. Govt. imposes new taxes upon the people
to repay the loans and meet the annual interests on such loans. The sacrifice of the people in the
form of tax payment is the burden of public debt.
If the debt is taken for productive purposes, for e.g., for irrigation, transportation, roads,
information technology, human skill development, etc., it will not mean any burden. But if the
debt is unproductive it will impose both money burden and real burden on the economy.
The burden of public debt into:
 Burden of internal debt
 Burden of external debt

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 i) Burden of internal debt
Internal debt involves a series of transfers of wealth within the country, i.e., from lender to
government and then later on at the time of redemption from government to lender. Money is
thus transferred from one section of the community to other sections. In this case the money
burden on the economy is zero. But there may be real burden on the community. In order to
repay the interest and the principal amount of the debt, the government has to levy taxes. What
the taxpayers pay the lenders receive. The lenders are generally rich people and tax burden is fall
on poor especially in the case of indirect taxes. The net result may be that the wealth is
transferred from poor to rich. This is the loss of economic welfare.
ii) Burden of external debt
External debt also involves a series of transfer of wealth from the foreign lender to the borrowing
country, and when it is repaid the transfer is in the opposite direction. As the borrowing country
paid interest to the foreign lenders, a direct money burden is fall on the whole community. This
burden depends on the rate of interest. If the rate of interest is high, the money burden, is also
high and vice-versa. The community is also suffered from real burden of external debts. The real
burden of the external debts depends on the nature and use of these debts. If it is used for
productive purpose, the real burden of these debts will be less. If external debts to be used for
non-productive purposes, much real burden will have to be borne in order to repay such a debt.
As a result the production, consumption and distribution of income is badly affected. Moreover,
the foreign lender has direct involvement in the economic activities of the country.
4.5. REDEMPTION OF PUBLIC DEBT
Redemption is a way of escape from the burden of a public debt. Redemption means
repayment of loans. The various methods available to the government to pay off its debt are:
A. Repudiation of Debt. Repudiation of debt means simply that the government refuses to
pay the interest as well as the principal. Repudiation is not paying off a loan but
destroying it. Normally, a government does not repudiate its debt, for this will shake the
confidence of the general public in the government. However, in extreme circumstances,
a government may be forced to repudiate its internal or external debt obligations. For
instance, internally the country may be facing financial ruin and bankruptcy and
externally, it may be faced with shortage of foreign exchange. Generally, a government
may not repudiate its internal debt lest it should lead to internal rebellion: those who have

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 lent to the government would obviously rise against the government. However, the
temptation of a government to repudiate its external debt obligation may be strong at
certain times. Of all the methods of redeeming debt, repudiation is the most extreme.
B. Conversion of Loans:- Another method of redemption of public debt is known as
conversion of loans, that is, an old loan is converted in to a new loan (in a broad way,
conversion is the same as refunding debt; i.e., repayment of a debt through a new loan).
Conversion may be resorted to:
(i) When at the time of redemption of a loan, the government has not the necessary funds, and/or
(ii) When the current rate of interest is lower than the rate which the government is paying for
its existing debt, so that the government can reduce its interest obligations. Conversion of a loan
is, always done through the floating of a new loan. Hence, the volume of public debt is not
reduced. Really speaking, therefore, conversion of debt is not redemption of debt.
C. Serial Bond Redemption The government may decide to repay every year a certain
portion of the bonds issued previously. Therefore, a provision may be made so that a
certain portion of public debt may mature every year and decision may also be made in
the beginning about the serial number of bonds which are to mature each year. This
system enables a portion of the debt being paid off every year. A variant of this type of
bond redemption is to determine the serial number of bonds to mature every year through
lottery. While under-the first variant, the bond-holders know when the different sets of
bonds would mature and could take up the bonds according to their convenience, under
the second variant, the bond-holders are uncertain about the time of repayment and they
may get back their money at the most inconvenient time.
D. Sinking Fund. Sinking fund is probably the most systematic and, therefore, the best
method of redeeming public debt. It refers to the creation and the gradual accumulation
of a fund which will be sufficient to pay off public debt. Suppose the government floats a
loan of Birr10 billions, redeemable in say, 10 years, for the purpose of road construction.
At the time the government is floating the loan, it may levy a tax on petrol, the proceeds
of which would be credited to a fund known as the sinking fund. Year after year, the tax
proceeds as well as interest on investments will make the fund grow till after 10 years it
becomes equivalent to the original amount borrowed; at that time, that debt will be paid
off. One danger of the sinking fund methods is that a government, in need of money, may

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 not have the patience to wait till the end of the period of maturity but may utilize the fund
for purposes other than the one for which originally the sinking fund was instituted.