Module 3

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. In
this wider sense, the proceeds of such public borrowing constitute
public income.

However, since debt has to be repaid along with interest from whom it
is borrowed, it does not constitute income. Rather, it constitutes public
expenditure. 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.

What is true about public borrowing is that, like taxes, public borrowing
is not a compulsory source of public income. The word ‘compulsion’ is
not applied to public borrowing except in certain exceptional cases of
borrowing.

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 owed to the citizens and institutions are called internal debt and
sums owed to 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). Maturity period
of 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.

Below are 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 management

Sovereign or public debt management is the process of establishing and
executing a strategy for managing the government’s debt to raise the
required amount of funding.

It aims to achieve its risk and cost objectives and to meet any other
sovereign debt management goals the government may have set, such as
developing and maintaining an efficient market for government securities.

In 2015, the creation of a statutory body called Public Debt Management

Agency (PDMA) was envisaged in India.

 As the RBI set interest rates and conducted the purchase and
sale of government bonds, it raised issues of conflict of
interest.
 Till the time a PDMA comes into place, the government created
an interim arrangement that deals with the management of
public debt called the Public Debt Management Cell.

Public Debt Management Cell

Public Debt Management Cell is an interim arrangement before setting up
an independent and statutory debt management agency namely the
Public Debt Management Agency (PDMA).

PDMC has the following advisory functions to the Government:

  Plan borrowings of the Government, including market
borrowings, other domestic borrowings, SGBs
 Manage Central Government’s liabilities including NSSF, and
contingent liabilities.
 Monitor cash balances of the Government, improve cash
forecasting, and promote efficient cash management practices.
 Advise other Divisions in DEA on matters related to External
Debt involving external borrowings through MI, Bilateral
cooperation, and other possible sources, in terms of cost,
tenure, currency, hedging requirements, etc., and monitor
developments in foreign exchange markets.
 Foster a liquid and efficient market for Government securities
 Develop interfaces with various stakeholders/agencies in the
regulatory/financial architecture etc. to carry out assigned
functions efficiently.
 Advice on matters related to investment and capital market
operations.
 Undertake research work related to new product development,
market development, risk management, debt sustainability
assessment, other debt management functions, etc.
 Develop a database system for collecting and maintaining a
comprehensive database of Government of India liabilities on a
near real-time basis and shall be responsible for the publication
of relevant information.
 Carry out Preparatory work for independent PDMA.

Conclusion
An excessive level of public debt can result in higher interest rates, which
has a crowding effect on the amount of private investment in the
economy and the rate of economic expansion as a whole.

Although it temporarily boosts overall demand, if left unchecked it can

cause a country’s economy to experience spiraling losses.

Economic Effects of Public Debt

1. Effect on Consumption: Public debt has a contractionary effect on
the economy through reduced consumption expenditure. The purchasing
power of the customers is reduced due to their contribution towards
public debt, making them unable to buy goods and services in the same
quantity in which they used to purchase them earlier. It is on account of
this that governments all over the world resort to large-scale public
borrowings to reduce the impact of inflation. Foreign loans can have a
positive impact on domestic consumption. If foreign loans are used for
importing those goods and services that are needed by domestic
consumers, the result will be increased consumption expenditure and
reduced inflationary pressure in the economy.
2. Effect on Private Investment: Public debt leads to less availability
of funds for private investors for investment opportunities. Investible
funds are limited in the market. If the funds get blocked in public debts,
fewer funds will be available to the private sector. Public debt; therefore,
impinges directly on the availability of funds to the private sector.
3. Effect on Distribution: Public debts also affect distribution. If the
public loans are subscribed by rich people only and the amount so
realised is spent by the government on the economic welfare of poor
people or low-income groups, the benefit will be a narrowing down of the
inequalities and more equal distribution of income between people.
However, if the poorer classes have to bear the burden of public debt
along with interest payments, the tendency of public debt would increase
the inequalities of incomes.
4. Effect on Production: If the people buy government
bonds/securities by withdrawing money from their industrial concerns or
by selling debentures and shares of industrial concerns or financial
institutions and even commercial banks subscribe to government loans
out of funds meant for investment, then the investment is adversely
affected, leading to adverse effects on production. However, if the
government utilises this money in commercial public enterprises, the
total investments available for production may not be adversely affected.
5. Public Debts and Credit Control: Public debt also produces some
impact on the effectiveness of credit control measures by the Central
Bank. It is well known that the main contributors to public loans are the
commercial banks, which are required to invest a pre-determined
percentage of their investible funds in government loans in exchange for
bonds. These government bonds are highly liquid assets that are
converted into cash in no time.
6. Effects on Cost of Production: The cost of production of a product
depends upon the prices of raw materials and other factors used in
production. The state utilises the borrowed money in providing raw
materials to the producers at reasonable/concessional rates. The state
may also utilise borrowed money in promoting industrial research as well
as in providing subsidies to private enterprises.
7. Effects of Foreign Loans on Economy: External borrowing in the
economic development of under-developed and developing countries has
made possible the import of high-priority goods or capital goods or goods
to be used to create, build, and develop capacity for accelerating the
rate of growth of the economy.

As credit becomes more widely available in India, concerns about falling

into a "debt trap" have gained momentum. The debt trap issue depicts
individuals who, despite the convenience of getting loans, struggle to
repay them, compromising their financial security. As a result, many find
themselves stuck in a loop where fulfilling basic needs becomes difficult.
This pattern highlights the necessity of responsible borrowing habits and
financial literacy measures in mitigating the adverse effects of excessive
borrowing on individuals.

What is a Debt Trap?

A debt trap means a situation that arises when borrowers are driven to
seek additional financing in order to repay previous ones, resulting in a
cycle of EMI trap. It happens when financial responsibilities exceed the
borrower's ability to repay debts, initiating a borrowing cycle.
In simple terms, individuals get trapped in a cycle where loan repayments
become unsustainable, forcing them to seek further borrowing to cover
previous debt. This retains the cycle and can lead to significant financial
problems. Without appropriate assistance or a planned repayment
plan, debt trap diplomacy can cause long-term financial instability and
severely affect debtors' financial well-being.

How Does a Debt Trap Work?

Knowing what is debt is just a first step. Understanding how it works is

more crucial as it will provide awareness to borrowers.
When you borrow a loan or credit, both the initial loan amount and the
interest rate affect the repayment structure. As you start repaying, each
instalment normally includes the principal amount and interest, according
to an amortisation schedule. However, failing to make payments might
lead to a debt trap. If the principal does not reduce and interest
continues to increase, repaying the debt becomes difficult. This never-
ending cycle of borrowing and paying back can lead to financial despair.
Ultimately, the inability to lower the principle while collecting interest
creates a situation in which escaping the EMI trap becomes increasingly
difficult.

What are the Indicators of Debt Trap?

Indicators of a debt trap encompass various factors:

 EMI-Salary Ratio: This ratio measures how much of an individual's

monthly income goes towards loan repayments. It acts as a
measure to determine if more loans may be accommodated without
affecting current financial obligations. By analysing this ratio,
individuals can learn about their ability to take on additional debt
while properly managing existing costs.
  Loan-Asset Ratio: The loan-to-asset ratio is a financial metric that
compares a person or entity's total loans or debt to the entire value
of their assets. A high loan-to-asset ratio shows that a considerable
part of assets are financed with debt, which may imply more
financial risk if the borrower struggles to meet their debt
commitments. In contrast, a lower proportion indicates less reliance
on debt funding, perhaps suggesting a healthier financial situation.

 Lack of Financial Knowledge: Insufficient understanding of

financial concepts and practices can lead individuals to make poor
borrowing decisions, increasing the likelihood of falling into a debt
trap due to mismanagement of finances and loans. Thus, it's
important to know the debt trap meaning to keep yourself aware.

Features & Benefits of Instalment Loans

Here are the several features & benefits of instalment loans:

 Structured Repayment: Instalment loans are repaid over a fixed

period through regular, predetermined instalments, making
budgeting and planning more manageable.

 Flexibility: These loans come in various forms, such as Personal

Loans, Home Loans, and so on, catering to different borrowing
needs and allowing flexibility in terms of loan purpose and duration.

 Lower Interest Rates: Instalment loans often come with lower

interest rates than alternative forms of credit, making them more
cost-effective for borrowers over time.

 Credit Building: Timely repayment of instalment loans can

positively impact credit scores, demonstrating responsible financial
behaviour and potentially improving access to future credit at
favourable terms.

What are the Causes of Debt Trap?

Here are some of the primary reasons that create a debt trap:

 Unforeseen Emergencies: Unexpected circumstances, such as

medical emergencies or job loss, can cause financial difficulty,
forcing individuals to take on debt to fund vital needs.

 Overspending: Compulsive spending can burden your finances,

perhaps trapping you in debt. Impulsive purchases, particularly
 those accompanied by appealing EMI programs or discounts,
increase the risk of debt accumulation.

 Exhausting Credit Limit: Credit card debt increases the likelihood

of getting into a debt trap. The reason behind this is individuals are
easily drawn in by alluring offers and wind up stuck in a never-
ending cycle of payments.

Avoiding Falling into a Debt Trap

With good planning, falling into a debt trap can be avoided. Here are
some tips:

 Prioritise Debt Repayment: Pay off the high-interest obligations

first while making minimal payments on lower debts.

 Budgeting: Create a realistic budget describing your income and

spending to avoid overspending.

 Limit Credit Card Usage: Use credit cards carefully and pay off
the entire sum each month to avoid accumulating high-
interest debt trap diplomacy.

 Seek Financial Advice: Consult a financial advisor for guidance on

managing debt and improving financial health.

Get Out of Debt Easily with Debt Consolidation

Here’s the step-by-step process for getting out of debt easily with debt
consolidation:

 Assess Your Debt: Begin by creating a complete list of your debts,

including outstanding balances, interest rates, and minimum
monthly payments.

 Research Debt Consolidation Options: Explore various debt

consolidation methods such as Online Personal Loans, balance
transfer credit cards, or debt consolidation loans to determine which
option best suits your financial situation.

 Compare Interest Rates and Terms: Evaluate the interest rates,

payback terms, and costs associated with each debt consolidation
plan to determine the best terms for combining your debts.

 Apply for Debt Consolidation Loan: If opting for a debt

consolidation loan, apply for the loan amount that covers all your
 existing debts. Ensure you meet the eligibility criteria and provide
all necessary documentation for the application process.

 Use Consolidation Funds to Pay Off Debts: Once approved, use

the funds to pay off your existing debts in full. This simplifies your
debt repayment process by consolidating multiple debts into a
single monthly payment.

Conclusion
Now that you know about the debt trap in detail, apply the ways to get out
of the trap or avoid getting into one. One of the ways to avoid getting into
a debt trap is to calculate your EMIs using a Loan Calculator on the Kotak
Mahindra Bank website before applying and plan your repayment
accordingly.

Fiscal Federalism in India

Fiscal federalism in India represents the financial relations
between units of government in the Indian federal system. The
Constitution of India establishes a dual polity consisting of the
Union at the center and the states at the periphery, each
endowed with sovereign powers to be exercised in the field
assigned to them respectively by the Constitution. Read here to
learn more.

The Union government has been cutting back on financial

transfers to States ever since the commencement of
the Fourteenth Finance Commission award term (2015-16).

This is especially odd considering that the suggestion of the

Fourteenth Finance Commission, which is a clear 10 percentage
points higher than that of the Thirteenth Finance Commission,
was to transfer 42% of Union tax income to the States.
Except for the devolution to Jammu and Kashmir (J&K) and
Ladakh, which were reclassified as Union Territories, the Fifteenth
Finance Commission kept its 41% proposal. It should be 42% if
the contributions of J&K and Ladakh are taken into account. To
raise its discretionary spending, the Union administration boosted
overall revenue while simultaneously decreasing budgetary
transfers to the States.

Since the Union government’s discretionary spending is not going

via the state budgets, it may have varying effects on the various
states.

Fiscal federalism in India

Fiscal federalism in India is designed to ensure the division of
fiscal responsibilities and revenue sources between the central
and state governments, enabling both to perform their functions
effectively.

This framework encompasses mechanisms for revenue collection,

allocation, and expenditure responsibilities, aiming to achieve
economic efficiency, equity, and macroeconomic stability.

 Division of Powers and Responsibilities: The

Constitution divides the legislative, administrative, and
fiscal powers between the Centre and the States. List I
(Union List), List II (State List), and List III (Concurrent
List) in the Seventh Schedule of the Indian Constitution
delineate these divisions.
 Revenue Sources: Taxes are divided between the
central and state governments. While the Centre has
the authority to levy taxes such as income tax (except
on agricultural income), customs duties, and central
excise (outside GST), states have the power to collect
taxes on sales (within GST), state excise on liquor,
stamps on property transactions, and agricultural
income.
 Goods and Services Tax (GST): Introduced in July
2017, GST represents a significant step towards a
unified national market, eliminating a cascading tax
system and integrating state economies. GST is
administered through the GST Council, where both the
 Centre and the States have representation, showcasing
cooperative federalism.
 Financial Distribution Mechanisms: The Constitution
provides for the distribution of financial resources
between the Centre and states through mechanisms like
the Finance Commission, which makes
recommendations on the distribution of the union taxes
to the states, principles governing grants-in-aid to
states, and measures needed to augment the
Consolidated Fund of a State to supplement the
resources of the Panchayats and Municipalities.
 Planning and Development: Though the Planning
Commission has been replaced by the NITI Aayog, the
latter plays a crucial role in fostering cooperative
federalism through a bottom-up approach to planning
and development, focusing on the involvement of States
in the economic policy-making process.
 Borrowings: Both the Centre and the States can
borrow within the limits set by the Fiscal Responsibility
and Budget Management (FRBM) Act, aimed at
maintaining fiscal discipline. The Centre can make loans
to the States or give guarantees on their behalf, with
conditions for borrowing being laid down by the Centre.
 Grants and Loans: The Central Government provides
grants and loans to States for various purposes,
including disaster relief, and development projects, and
to compensate for a reduction in revenue due to policy
implementations like GST.

Centralization of Fiscal federalism

The Finance Commissions recommend a state portion of the
Union government’s net tax revenue.

 The tax money to be allocated to Union territories,

collection expenses, cess, and surcharges are all
included in the difference between the gross and net tax
revenue.
 The proportion of gross tax income was only 35% in
2015-16 and 30% in 2023-24, even though the
Fourteenth and Fifteenth Finance Commissions
proposed that the States receive 42% and 41%,
respectively, of the net tax revenue (Budget Estimate).
  The States’ portion of Union tax revenue climbed from
₹5.1 lakh crore to ₹10.2 lakh crore over these two
years, even though the Union government’s gross tax
collection increased from ₹14.6 lakh crore in 2015-16 to
₹33.6 lakh crore in 2023-24.
 The rants-in-aid to States declined in absolute amount
from Rs 1.95 lakh crore in 2015-16 to Rs 1.65 lakh crore
in 2023-24.

Cess and surcharge

 The fact that the net tax income is calculated after

subtracting the money collected under the cess and
surcharge, the revenue collected from the Union
Territories, and the expense of tax administration is one
of the reasons why the States’ share of gross revenue
decreased during this time.

Direct financial transfers

There are two more avenues by which the Union government can
directly transfer funds to the States: Central Sector Schemes (CS)
and Centrally Sponsored Schemes (CSS).

 Through CSS, wherein the Union government provides

half the money and the States are responsible for the
remaining portion, the government affects the priorities
of the States.
 Put another way, it suggests the plans, and the States
carry them out while contributing financial resources.
 The allocation for CSS grew via 59 CSS from Rs 2.04
lakh crore to Rs 4.76 lakh crore between 2015-16 and
2023-24.
 One significant feature of CSS shared schemes is the
availability of matching grants to States able to provide
matching funds from their state budgets. Regarding
interstate equality in public budgets, this has two
distinct impacts.

Challenges
  Vertical Imbalance: The division of fiscal powers often
leads to a mismatch between the revenue-generating
capacities of the states and their expenditure
responsibilities, leading to vertical imbalances that
require intergovernmental transfers to correct.
 Horizontal Imbalance: Differences in fiscal capacities
and needs among states necessitate mechanisms for
redistributing resources to ensure equity and balanced
development across regions.
 GST Implementation Issues: While GST has
streamlined tax administration and broadened the tax
base, it has also faced challenges related to revenue
allocation, compliance, and technological glitches.
 Fiscal Autonomy vs. Central Oversight: Balancing
fiscal autonomy for states with the need for central
oversight to maintain macroeconomic stability remains
a delicate task.

Conclusion
Fiscal federalism in India is a dynamic and evolving system,
reflecting the country’s socio-economic diversity and political
complexities. While it has facilitated economic unity and
contributed to the nation’s development, ongoing reforms, and
adjustments are necessary to address emerging challenges,
promote state equity, and ensure efficient and effective
governance at all levels.

What is the Finance Commission of India?

The Finance Commission is a constitutional body for the purpose of
allocation of certain revenue resources between the Union and the State
Governments. It was established under Article 280 of the Indian
Constitution by the Indian President. It was created to define the financial
relations between the Centre and the states. It was formed in 1951.

Article 280 of the Indian Constitution

 President after two years of the commencement of the Indian Constitution

and thereafter every 5 years, has to constitute a Finance Commission of India.
Note: The President can also constitute the Finance Commission before
the expiry of five years if he considers it necessary.

Article 281 of the Indian Constitution

 It is related to the recommendations of the Finance Commission:

 The President has to lay the recommendation made by the Finance

Commission and its explanatory memorandum before each House of
Parliament

Who Constitutes Finance Commission of India?

The President of India constitutes the Finance Commission every five
years or on time considered necessary by him.

What is the composition of Finance Commission of

India?
Finance Commission Chairman and Members

 Chairman: Heads the Commission and presides over the activities. He should
have had public affairs experience.
 Four Members.
 The Parliament determines legally the qualifications of the members of the
Commission and their selection methods.

Qualifications of Finance Commission Chairman and

Members
 The 4 members should be or have been qualified as High Court judges, or be
knowledgeable in finance or experienced in financial matters and are in
administration, or possess knowledge in economics.
 All the appointments are made by the President of the country.
 Grounds of disqualification of members:
 found to be of unsound mind, involved in a vile act, if there is a conflict of
interest
 The tenure of the office of the Member of the Finance Commission is specified
by the President of India and in some cases, the members are also re-
appointed.
 The members shall give part-time or service to the Commission as scheduled
by the President.
 The salary of the members is as per the provisions laid down by the
Constitution.

Finance Commission of India Functions

The Finance Commission makes recommendations to the president of
India on the following issues:

 The net tax proceeds distribution to be divided between the Centre and the
states, and the allocation of the same between states.
 The principles governing the grants-in-aid to the states by the Centre out of
the consolidated fund of India.
 The steps required to extend the consolidated fund of a state to boost the
resources of the panchayats and the municipalities of the state on the basis of
the recommendations made by the state Finance Commission.
 Any matter in the interest of sound finance may be referred to the
Commission by the President.
 The Commission’s recommendations along with an explanatory memorandum
with regard to the actions done by the government on them are laid before
the Houses of Parliament.
 The FC has sufficient powers to exercise its functions within its activity
domain.
 As per the Code of Civil Procedure 1908, the FC has all the powers of a Civil
Court. It can call witnesses, ask for the production of a public document or
record from any office or court.

Advisory Role of Finance Commission

The recommendations made by the Finance Commission are of an
advisory nature only and therefore, not binding upon the government. It is
up to the Government to implement its recommendations on granting
money to the states. To put it in other words, ‘It is nowhere laid down in
the Constitution that the recommendations of the commission shall be
binding upon the Government of India or that it would amount to a legal
right favouring the recipient states to receive the money recommended to
be provided to them by the Commission.

Finance Commissions mainly focuses on the financial

relations between the State government and the
Central government. These recommendations
progressively increase share of the state governments in
the proceeds of the income tax. They also increased
gradually the amount of grants-in-aids to be given to the
states. As a result the states now enjoy considerable
degree of financial autonomy so necessary for the proper
functioning of the federation.

It can be said that the Finance Commission as an

autonomous body has served a wonderful purpose. In, as
complex a society as India is, it acted as an agency to bring
about coordination and cooperation for smooth working of
a federal system.

Burden of Public Debt and Its Measurement!

Burden of Internal Debt:

It is said that an internal debt has no direct money burden since the
interest payment on debt and the imposition of taxation to pay interest
to the lenders is simply a transfer of purchasing power from one to
another. This means that in case of internal debt, money is borrowed
from individuals and institutions within the country.

Repayment (raised from taxation) constitutes just a transfer of

resources from one group of persons to another. In other words, these
are transfer payments and do not affect the total resources of the
community Truly speaking, government collects money through
taxation imposed on the richer people who are also the buyers of
government bonds.

That is to say, government collects money from the left pocket and
pays it back to the right pocket. Thus, under internal debt, since all
payments cancel out each other in the community as a whole, there is
no direct money burden.

Above all, money collected from internal source of borrowing is usually

spent for various developmental activities. Such expenditure results in
transfer of resources in the community and, as a result, aggregate
resources of the country increase. Thus, there can be no direct money
burden of internal debt.

But there is no denying the fact that internal debt involves direct real
burden to the community according to the nature of the series of
transfer of incomes from taxpayers to the creditors. If we assume that
the taxpayers and bondholders are the same persons then there can be
no direct real burden of debt. But we know that the taxpayers and the
bondholders belong to different income groups in the community.

Usually, the bondholders are richer people compared to the taxpayers.

Certainly, it is necessary to raise taxation to pay interest on the debt

and, the greater the debt, greater the amount of taxation required to
provide the interest on it. Ordinarily, taxpayers are poor people. When
the government pays interest with principal to the bondholders, it
results in the transfer of purchasing power from the poor people to the
richer people.

Thus, the payment of internal debt involves redistribution of aggregate

income. This results in inequalities in the distribution of income and
wealth. This is the direct real burden of debt on the community.

Again, it is argued that taxpayers are generally active people while

bondholders are idle, old and inactive ones who live on accumulated
wealth. In case of repayment of internal debt, wealth thus gets
transferred from the active persons, i.e., taxpayers, to the inactive
persons, i.e., bondholders. This certainly adds to the real burden of
debt.

Some economists argue that public debt is invariably a burden on the

future generation.

They argue that when the government borrows, the present generation
escapes the burden. After the loan is repaid at a later date with
interest, the future generation has to suffer by being forced to pay
additional taxes. In other words, the future generation will suffer when
the present generation reduces its savings as disposable income
declines following a rise in taxation.

However, there are some people who do not agree with this view. They
argue that there is no shifting of the basic burden to the future.
According to modern economists, the real burden of governmental
activities must be borne during the period in which expenditures are
made, since, during this period, only resources are diverted from
private to public sector use.

Borrowing method affects the future generations in two ways only. To

the extent to which public debt reduces capital formation, the stock of
capital goods and the potential level of national income in future
generations will be less.

Further, the borrowing methods create some problems for the future
generations in the form of adverse effects on the economy from the
taxes necessary to pay interest and principal, inflationary or
deflationary effects of the existence of the debt, etc. Thus, there is no
shifting of the basic burden to the future.

According to J. M. Buchanan, during the period in which the

governmental activities and borrowing take place, no burden is
created, because burden, by nature, implies a compulsory sacrifice.
Individuals in most cases voluntarily exchange their liquid funds for
government bonds. Thus, the present generation does not feel any
burden on them. However, it is a burden on the future generations who
pay taxes (compulsorily) for the retirement of public debt.

So, we can conclude that the question of shifting the burden of public
debt to the posterity or future generation is still an unresolved
phenomenon.

Burden of External Debt:

During a given period, the direct money burden of external debt is the
interest payment as well as the principal repayment (i.e., debt
servicing) to external creditors. The direct real burden of such external
borrowing is measured by the sacrifice of goods and services which
these payments involve to the members of the debtor country.

There is also indirect money burden of external debt. Loan repayment

by the debtor country implies more exports of goods and services to
the creditor country. Thus a debtor country experiences a fall in
welfare of the community.

Indirect real burden of external borrowing is crucial. Usually,

government imposes taxes to finance external debt. But taxes have
disincentive effects. It discourages work- effort and saving. Lower the
saving, lower is the capital formation. Thus, external borrowing eats
away economic growth since growth largely depends on capital
formation. This indirect real burden of external debt is quite similar to
internal debt.

Knowing fully well the dangers of borrowing, governments of LDCs are

compelled to public borrowing—both from internal and external
sources.

Measurement of the Burden of Debt:

Usually, burden of debt refers to financial burden of the government.

But as it does not indicate true burden, we consider following

ratios to estimate the burden of debt:

i. Income-Debt Ratio:

It is estimated as:

size of public debt/national income = D/Y

If Y remains at a very high level, the burden of debt, D, will be
insignificant. However, if the ratio becomes high, debt then poses a
great burden.

ii. Debt-Service Ratio:

This ratio is measured as:

Annual interest payments of borrowing/National income = i/Y

Increase in Y means lower debt-service ratio. However, taxes are

collected for the repayment of public debt. Thus, this ratio indicates
the necessity of imposing higher taxes.

iii. Debt Service-Tax Revenue Ratio:

It is worked out as:

Annual interest payments/Aggregate tax revenue = i/T

An increase of this ratio indicates the financial weaknesses of the

government.

Public debt refers to the total borrowings of a government

to finance its expenditures. It can be classified into two
main categories: internal debt and external debt, based
on the source of borrowing. Here's an overview of these
sources:

1. Internal Debt

Internal debt is raised within the country and owed to

domestic lenders. Its sources include:
a. Borrowings from the Public

 Government Bonds and Securities: Issued to

individuals, institutions, and companies within the
country.
 Treasury Bills: Short-term debt instruments sold to
domestic investors.

b. Borrowings from Financial Institutions

 Commercial Banks: Loans or investments in

government securities by domestic banks.
 Non-Banking Financial Institutions: Insurance
companies and pension funds investing in government
debt.

c. Borrowings from the Central Bank

 Monetization of Debt: The central bank buys

government securities or directly lends to the
government.

d. National Savings Schemes

 Fixed deposits, certificates, and savings bonds aimed

at mobilizing funds from citizens.

e. Other Domestic Sources

 State or local government borrowings within the

country.
 Loans or advances from domestic development
finance institutions.

2. External Debt

External debt is raised from foreign lenders and owed to

international creditors. Its sources include:

a. Multilateral Organizations
  World Bank: Loans for development projects.
 International Monetary Fund (IMF): Loans for
balance of payments support or economic
stabilization.
 Regional Development Banks: Such as the Asian
Development Bank (ADB) or African Development
Bank (AfDB).

b. Bilateral Loans

 Borrowings from foreign governments under economic

or development agreements.

c. Commercial Borrowings

 Foreign Banks: Loans or credit lines.

 International Capital Markets: Issuance of
Eurobonds or other international bonds.

d. Export Credit Agencies

 Loans or credit guarantees provided by agencies in

foreign countries to promote exports.

e. Foreign Direct Investment (FDI) and Portfolio

Investment

 Though not classified as traditional "debt," some

international investments may carry obligations
similar to debt.

f. Sovereign Wealth Funds and Foreign Entities

 Loans or investments made by foreign institutions or

sovereign wealth funds.

Comparison of Internal and External Debt

  Currency Risk: External debt may expose the
country to currency exchange risks, unlike internal
debt.
 Interest Rate Impact: Internal debt can affect
domestic interest rates, while external debt impacts
foreign reserves.
 Repayment Terms: External debt often includes
stricter repayment terms and conditionalities.

Balancing internal and external debt is essential to

maintain financial stability and manage repayment
obligations effectively.