Public Finance

TYBA ( SPECIAL PAPER – IV )

Unit no – 4
Public debt

DR. RAHUL MORE

Head, Department Of Economics
Abeda Inamdar Senior College, Pune.
 PUBLIC DEBT
MEANING :
Public debt refers to the loans raised by government from within or outside the country. Every govt.
has to borrow when its expenditure exceeds its revenue. The borrowing or taking loans by the government
is known as public debt.

 COMPARISON BETWEEN PUBLIC AND PRIVATE DEBT :

1. Compulsion : The government can compel the people or institution in a country to lend funds to it in
case of war, economic crises or any other emergencies but no private individuals can force or compel
another private individual to lend them money
2. Repudiation : Under abnormal conditions the govt. can refuse the payments of loan taken by it from
people but the private individuals cannot do so under any circumstances.
3. Time Period : The government can borrow from public for longer periods because it is a permanent
institution and people have faith in it. Private individual can barrow for short period of time due to
risks involved on the part of the lender.
4. Rate of Interest : Because of its high credit worthiness government can borrow at lower rate of
interest but it is not so in case of private borrower who has to pay a very high rate of interest because
risk is involved in it.
5. Sources : The government can take loan within the country and also from abroad but a private
borrower can borrow only from within the country.
6. Mode of Payment : The government repays its loan by taxiing the people but in case of private debt
the borrower has to repay loan out of his own saving.
7. Effect on the Economy: Public debt makes its effect on production distribution of income and wealth
in country but private loans make no such effects due to its micro nature.

 NEED FOR PUBLIC DEBT :

In recent times government have been barrowing huge sums both internally and externally for the
following reasons.
1. Deficit budget - The government may borrow to cover budgetary deficit on account of large
expenditure incurred on administration and for financing unforeseen events like floods famines
epidemics.
2. To finance war - Modern wars are very costly they cannot be financed unwarily through taxation
thus public debt becomes necessary.
3. Natural calamities - Natural calamities like earthquake, flood, famines etc. lead to increase in
government expenditures in order to provide relief to the victims. It necessitates huge public
borrowing by the government.
 4. Economic development - Public debt is considered a very important tool for the development of a
country. Both developed and developing countries borrow for economic development. Developing
countries do not have sufficient resources to finance their plan they therefore borrow not only from
within the country but also from foreign sources for the development of agriculture, industry, power,
transport communication etc. Developed countries also borrow to modernized their infrastructure
facilities like roads, railways power plant etc.
5. To finance Public enterprise - Every country whether a socialist economy or missed economy runs
certain public enterprises like railways, postage and telegrams, power work et. Which require large
funds The government can meet them only through public borrowing rather than by taxation.
6. To check economic stability - Government borrows to stabilize, to control inflationary conditions.
The govt. borrows to take away excess money supply from the public. Since public borrowing is
voluntary. This is a better method then raising taxes. Because loans from public do not increase the
cost of production. Public borrowing also helps to lift the economy from depression. During a
depression ideal funds lying with the bank govt. borrows in order to spend on public work
programmers.
7. To provide foreign exchange - In case of deficit in the balance of payment. Foreign exchange is
needed to correct it. In such a condition government borrow from foreign countries as well as from
international financial institution in the form of foreign exchange..
8. Soft Revenue option - With increase in public expenditure government needs a lot of fund. Taxation
is a source of income for the government but it cannot be increased at a very high rate to meet the
expenses because it pinches a lot to the people. Therefore many a limes government chooses soft
loan option of meeting its increasing expenditure by raising loans and thereby saving itself from
public opposition.

 CLASSIFICATION OF PUBLIC DEBT :

1. Internal & external debt :
2. Productive & unproductive debt :
a) Productive debt is defined as a loan, which is used for project which yields an income to the
government like railways, construction, irrigation, power etc.
b) Unproductive debt is defined as that loan which does not yield any income to the govt. like debt
for natural calamities and to finance war etc. this debt is also known as dead weight debt.
3. Redeemable & Irredeemable debt :
a) Redeemable debt refers to that loan which govt. promises to pay off at some future date. The
interest on this loan is paid by the government regularly half yearly or annually. When the debt
matures the govt. pays back the principal amount to the lender.
b) Irredeemable debt is that loan in which the principle amount is never returned by the government
although the interest is paid regularly for the period of its duration.
4. Short term and long term debt.:
 a) Short term debt is defined as that debt which may mature within a period of 3 to 4 months. This debt
is like treasury bills & advances from central bank. Interest on such loans is generally low.
b) Long term loans are repaid in a long period say roughly after 10 years or more. Usually such debt bears
a higher rate of interest.
5. Funded and Unfunded debt :
a) Funded debt is a long term debt whose payment is made at least after a year. In order to repay a
debt fund is created in which some money is deposited by the government and the debt is paid out
of this fund at the time of maturity.
b) Unfunded debt is for short period or less than a year. The govt. does not create any separate fund
to repay the debt. Treasury bills are unfunded debt.
6. Voluntary & Compulsory Debt :
a) Voluntary debt is defined as that debt which is paid without any legal enforcement in this the people
voluntarily or willingly subscribe to govt. loans. In fact ,all public loans are voluntary.
b) Compulsory debt are those debt which are forcibly taken by the government. Such loans are taken
only during wars and national emergencies.
7. Marketable and Non-Marketable debt :
a) Marketable debt is defined as one in which the securities are negotiated in open market. for example,
all types of securities sold in the secondary market
b) Non- Marketable debt are such loans where securities cannot be sold in the stock exchange market,
for example, PPF,PF,NSC etc.
8. Gross debt and Net debt :
a) Gross debt consists of the total amount of all the debt out standing at any time
b) Net debt is balance amount of gross debt after exclusion of sinking fund and other assets meant for
repayment of debt.

 SOURCES OF PUBLIC DEBT :

There are 2 main sources.
(1)Internal (2) external
(1) Sources of Internal Debt : It refers to govt. loans floated in capital markets within the political
boundaries of the country . the main sources of internal borrowing are :
i) Individuals.
ii) Banking & non-banking institutions.
iii) Central Bank.
Sources of External Debts :
It refers to govt. loans floated in foreign capital market. The main sources are.
i) Foreign governments.
ii) International Monetary agency like World Bank IMF, International Finance Corporation,
International Development Association.
 EFFECTS OF PUBLIC DEBT :

 POSITIVE EFECTS :
1. Mobilization of resources : Public borrowing is very helpful in implementing 5 year plans and
various other projects. With the help of borrowing govt. can easily make various types of plans to
mobilize the resources efficiently.
2. Increase in the productive capacity : With increase in barrowing productive capacity of a country
can easily be increased. Borrowing is very much helpful in using capital intensive techniques to
increase the productive capacity of a country.
3. To promote Investments : Public borrowing helps in promoting investments, borrower fund can be
utilized for strengthening infrastructure and promoting economic development of country.
4. Developmental expenditure : Barrowing can be used to meet the developmental expenditure like
roads, communication system, railways telecom, finance etc.
5. Obtaining foreign exchange : Borrowing in the form of foreign exchange can be used to meet
developmental activities. For development purpose govt. tries to acquire money capital, raw material
from foreign countries. It can then only be possible if we have good stock of foreign exchanges with
us.

 ADVERSE AFFECTS :
1. Inflationary impact :- With increase in the public borrowing money supply in the market also
increases which increases the prices of the commodity.
2. Additional tax burden :- To repay the old loans. Government has to impose new taxes on people
which will be extra tax burden on the people and it pinches a lot.
3. Adverse effect on saving and investment :- for the repayment of loan when govt. imposes new
taxes on the people there will be adverse effect on saving and investment b/c more saving & more
investment means more tax.
4. Effects on distribution of income :- Public debt may sometime effect distribution of income among
people. Govt. raises loans from higher income group people and the return of it is also given to them
only. Thus rich becomes richer and poor becomes poorer.
5. Unproductive debt:- a part of the loan taken by the govt. is used to meet the non-developmental
expenditure which never helps in increasing the production in the country. Thus it is called dead
weight debt which is very difficult to repay.
6. Debt servicing burden :- The annual interest paid by the govt. in lieu of debt increase is known as
debt servicing burden. There is very large increase in debt servicing burden in every country in
modern times which has very dangerous consequences.
 METHODS OF REPAYMENT OF PUBLIC DEBT :
1. Repudiation of debt : It means refusal to pay a debt all together. The government refuses to pay the
interest as well as the principle amount. This method of debt redemption is not practical because the
government reputation may be at stake the consequences of this method may be dangerous. Debt
repudiation is not popular in modern times. Russia did so in 1971.
2. Debt conversion : In this method the debt with high interest rate is converted into new debt when
the market rate of interest falls. The government borrows at low rate of interest and repays the past
debt even before it matures. The lender is free to take his money back or get his loan converted into
a fresh loan. However conversion can be successfully carried out ,if the credit of the govt.is good.
3. Budgetary surplus : A policy of surplus budget may be followed annually for clearing of public
debt gradually instead of creating a fund for its repayment on maturity. But in recent years due to
rapidly increasing public expenditure ,surplus budget is a rare phenomenon
4. Terminal Annuities : Under this method the physical authorities clear off. Part of public debt on
the basis of terminal annuities into equal annual installments including interest along with the
principle amount. This is the easiest method similar to sinking fund. According to this method ,the
burden of debt goes on diminishing and by the time of maturity ,it is already fully paid off.
5. Refunding : There is issue of new bonds and securities by the government in order to repay the
matured loans. Refunding is the process by which the maturing bonds are replaced by new bonds .A
major drawback of this method is that the govt. would be tempted to postpone its obligations of debt
redemption and the total burden of debt would continue to increase in future.
6. Sinking fund : In this system the government establishes a separate fund known as sinking fund. A
fixed amount of money is credited by the government to this fund every year. By the time one debt
matures. There is enough amount in fund to pay off loans along with the rate of interest. In practice
sinking funds are not accumulated, Government do not create such fund if even if they create they
utilize it for the other purposes whenever they are in need of funds.
7. Capital levy : It refers to a very heavy tax on property and wealth. It is a once for all taxes imposed
on the capital assets above the certain value. in fact capital levy is advocated immediately after the
war to repay the unproductive war debts.
8. Reduction of rate of interest : sometimes the govt. takes statuary decision to reduce the rate of
interest. Payable on its public debt. The creditors are forced to accept the reduced rate of interest.
This method is normally used by the govt. during financial crisis.
9. Additional provision of taxation : In this method new taxes are imposed to collect revenue. It is a
method of redistribution of income by transferring it from the tax payer into the hands of bonds
holders.
10. Debt Trap : It refers to a phenomenon where the government of a country has to raise fresh loan
just in order to pay the interest charged on the earlier loan borrowed by govt. and it is very difficult
to repay the amount. The govt. is trapped in vicious circle of borrowing.