Public Debt and Budget

Among the non-tax sources, the major source of revenue of the government is public debt.
That is, borrowing. It may either be internal or external debts. When the government raises
revenue by borrowing from within the country, it is called internal debt. Similarly, if the
government is borrowing from the rest of the world, it is a case of external debt. According to
Philip E. Taylor, “The debt is the form of promises by the treasury to pay to the holders
of these promises a principal sum and in most instances interest on the principal.
Borrowing is resorted to provide funds for financing a current deficit.”

Causes for Public Debt

Till the beginning of the 20th century, state performed only very limited functions
maintenance of law and order, protection of the country from external attack etc. Therefore,
the state had to collect only small revenue and little debt. Recently, in almost all countries of
the world there has been a great increase in the magnitude and variety of governmental
activities. The acceptance of the principle of the welfare state increases the role of state
participation in economic activity. This has necessitated the need to find out additional
sources of finance. Hence, modern governments have come to rely on public borrowings.

Objectives of public debt: The objectives of public debt are the following.

1)To bridge the budget deficit (Deficit Financing)

2) To fight against depression.

3) To check inflation.

4) To finance economic development.

5) To meet unforeseen contingencies.

6) An alternate source of income when taxable capacity is reached.

7) To finance wars.

8) To finance public enterprises.

9) To carry out welfare programmes.

10) To create infrastructure.

11) For creation of productive assets.

12) For creation of essential non-income yielding assets (provision of public goods) etc.

Important Sources of Public Debt

Every government has two major sources of borrowing—internal and external. Internally the
government can borrow from individuals, financial institutions, commercial banks and from
the central bank. Externally, the governments borrow from individuals and banks,
international institutions like IMF, IBRD, ADB etc. and from foreign governments. They can
be briefly summarized as follows.

1) Borrowing from individuals.

2) Borrowing from Non-Banking Financial Institutions (Insurance companies, investment

trusts, mutual funds etc.)

3) Borrowing from commercial banks.

4) Borrowing from central banks.

5) Borrowing from External sources (IMF, IBRD, ADB, Foreign Governments or countries)

Classification of Public Debt

1) Voluntary and compulsory (On the basis of legal enhancement): Voluntary debt is the
debt which is paid any legal enforcement. Whereas compulsory debt is legally forced in
nature. Here people have no option but repay the debt.

2) Funded and unfunded debt (Provision for repayment): Funded debt is long term or
‘definite period’ debt. A proper agreement and terms and conditions of repayment with the
percentage of interest payable are declared. They are used for creation of permanent assets.
Unfunded debt is for a short term and for indefinite period. It is paid through the income
received from other sources. These are used for meeting current needs.

3) Internal and external debt: When the government raises revenue by borrowing from
within the country, it is call internal debt. Whereas if the government is borrowing from the
rest of the world, it is case of external debt.

4) Productive and Unproductive(Purpose of loans): Loans on Projects yielding income

(Construction of plants, railways, power schemes etc.) are called productive debt. Loans on
loan non income yielding projects are called unproductive loans (war, famine relief etc.)

5) Redeemable and Irredeemable loans (Promise to repay): Redeemable debts refers to the
loan which the government promises to pay off at some future date. (principal plus interest)
Irredeemable debts are those, principal amount of which are never returned by the
government but pays interest regularly.

6) Short / Medium/ Long term loans (Time duration): Short term loans are usually incurred
for a period varying from three months to one year. Usually governments get such loans from
the central bank by using treasury bills. These loans are calls ‘ways and means advances.’

Medium Term loans are those which are obtain for more than one year but less than ten years.

Long term loans are those which are obtain for more than ten years. These are used to finance
developmental activities.

Redemption of Public Debt

Redemption of public debt means repayment of a loan and it is an important responsibility of

the government. All government loans should be repaid promptly. It is, therefore, necessary
that the provision of repayment should be inherent in the scheme itself.

Advantages of debt redemption

1) It saves the government from going into bankruptcy.

2) It checks extravagance on the part of the governments.

3) It preserves the confidence of the lenders.

4) It makes easy for the government to float future loans.

5) It reduces the cost of management of public debt.

6) It saves the future generations from the pressure of public debt.

7) The resources obtained after redemption of the debt would be diverted towards private
investments and therefore a favourable climate for investment could be created.

8) Redemption of debt may act as a useful tool to curb deflation.

METHODS OF REPAYMENT OF DEBT

1) Repudiation: It means refusal to pay a debt by governments. This method was followed
by the USA after the civil war and by the USSR after the 1917 Revolution. This method is
undesirable and has not been used recently anywhere in the world. Repudiation shakes the
confidence of the people in public debt and many provoke retaliation from creditor countries.

2) Refunding: Refunding is the process of replacing maturing securities with new securities.
In some cases the bonds may be redeemed before the maturing date when the government
intends to rearrange the maturity of outstanding debts or when current rate of interest is low.
Generally, short-term borrowings are made in anticipation of tax collections for meeting
current expenditure. However, excessive burden of new expenditure does not permit the
retirement of the debt by means of revenue newly raised or by means of long term borrowing.

Thus, there is necessity of refunding the loans by old lenders and renewing the loans at lower
rate of interest for future period. The drawback of this method is that government is tempted
to postpone its obligation of debt redemption. This leads to a continuous increase in the
burden of public debt in future.

3) Conversion of Loans: It is a special type of refunding. Conversion of existing securities

into new securities before maturity. It is generally resorted to reduce the burden of debt by
converting high interest loans into low interest loans. According to Professor Dalton, the
conversion does not reduce the burden of public debt on the state; because a reduction in
interest rates reduces the ability of the creditors to pay taxes which may mean a loss of
income to the governments there by reducing its capacity to repay loans.
 4) Sinking Fund: Sinking fund is a special fund created for the repayment of public debt.
There is a theoretical justification for creating this fund because it imposes a requirement on
the government to pay the old debts regularly. According to this method, the government sets
aside a certain amount out of the budget every year for this fund. The balances in the funds
are also invested and the interest accruing on them is also credited in the fund.

Sinking fund is of two types: (i) certain sinking fund—here, the governments credit a fixed
sum of money annually. (ii)Uncertain sinking fund— the amount is credited when
government secures a surplus in the budget. The one danger of this method is that the
government may not wait till the end of the period of maturity and utilize the fund for some
other purpose than the one for which the fund was created originally. The practice of sinking
fund inspires confidence among the lenders and the enhancement of the creditworthiness of
governments.

5) Capital levy: Capital levy is a special type of “once for all” tax on capital imposed to
repay war debts. All capital goods are taxed above a minimum level of assets possessed by
residents of the country. Simply, capital levy refers to a very heavy tax on property and
wealth. This tax was levied immediately after the First World War. This method has been
advocated by economists like David Ricardo, Pigou and [Link] Dalton has
suggested that capital levy as a method of debt redemption with least real burden on the
society. It is useful on account of its deflationary character.

6) Surplus budget: Quite often, surplus budget may be used to clear public debt. But in
recent times due to the ever-increasing public expenditure, surplus budget is a rare
phenomenon.

7) Buying up of Loans: Governments redeems debt through buying up loans from the
market.

Objectives of Public Debt/Borrowing

▪ Income and Revenue: The target of public debt normally is to cover the gap that developed
due to mismatch between proposed expenditure and expected revenue.
o Whenever because of increased administrative expenditure or flood, feminine, earthquake
and communicable diseases like unexpected problems, the government's income becomes
less because they have to spend it to cover these problems.

▪ In Times of Depression: Depression is the condition when costs reduce, there is a lack of
courage in people spending money on industries and in future there is no possibility of
getting gain.

▪ To Curb Inflation: Inflation is the name of that condition at the time of increased cost. So,
the government by taking debt can take back a big quantity of work power from the hands of
people.

▪ To Finance Development Plans: In a developing economy, there is always a lack. The

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.

o In this condition, the only way is to take public debt. So, the government takes debts from
within the country or from foreign governments or from people to do finance arrangements.

▪ Expansion of Education and Health Services: Government also takes debt for the
construction and development of education and health services and other services like this.

▪ To Make the Public Verdict Favourable: When the citizens are not able to pay the tax then
the government has to take debt. Sometimes even then the more capability of the public, the
government never increases taxes because the public verdict sticks to favourable(populist
measures).

Burgeoning public debt

▪ India’s public debt (combined liabilities of the Central and State governments) to gross
domestic product (GDP), at constant prices, increased to a record high of 100.86 per cent in
2020 as against 76.86 per cent in 2014, as per the data from the Reserve Bank of India.

▪ Now, India has become the most indebted nation after Brazil and Argentina among the
emerging market economies. In South Asia too, India is the most indebted after Bhutan and
Sri Lanka. Interestingly, Brunei, United Arab Emirates, and Russia have low debt-to-GDP
ratios with 2.46 per cent, 19.35 per cent, and 19.48 per cent respectively.
 Reasons of Higher Public Debt

▪ Bank Recapitalisation: Infusing capital in state-run banks using recapitalization bonds in

2017-18 increased the total central government debt in both absolute terms and as a
percentage of GDP that fiscal.

o In 2017-18, Rs 80,000 crore of recapitalization bonds were used to fund state-run banks.

▪ UDAY bonds: The liabilities of states have increased during 2015-16 and 2016-17,
following the issuance of Ujwal Discom Assurance Yojna (UDAY) bonds.

▪ Small Share of Taxes in National Income: After India got independence, there is an
increase in national income four times more.

o Gross tax-to-GDP in India is around 10.2% in 2021.

o And the most part of the tax income is from indirect taxes.

▪ Imperfect Tax System: The Indian tax system has many loopholes. In India, there is very
high tax evasion because our tax system is full of errors.

▪ Misuse of Public Income: There is a big quantity spent on government departments where
there is corruption, bribe, and red tapism available and work is completed with very
difficulty. For this reason, there is a reduction in production.

Impact of Burgeoning Public Debt

▪ It is well-recognised that excessive public debt leads to higher risk premium in interest rates,
which results in reduction of private investment (crowding out effect) as well as contraction
of GDP in the long run.

▪ Though an increase in public debt will stimulate aggregate demand and output in the short-
run, the economic growth will turn negative in the long run if the debt-GDP ratio exceeds
90%.