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.
It owes its all to others. When a country borrows money from others 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,

(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 outcome — 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