CHAPTER SIX: PUBLIC DEBT

6.1 Concept of Public Debt

• 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.

• It encompasses public debt owed by the federal government, the

state government, and even the municipal and local
governments.

• Public debt is a debt or loan taken by the govt. from its own
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people as well as from foreign countries or both.
• The government needs to borrow when current revenue falls
short of public expenditure.

• Since current public revenue is usually insufficient to meet the

current development expenditure of the modern government, the
government has no alternative except to borrow money.

• The instruments of public borrowings are in the form of various

types of government bonds and securities.

• Bond - certificate promising debt repayment: a certificate

issued by a government promising to pay back borrowed money
at a fixed rate of interest on a specified date 2
 6.2 Causes of Increase in PD
• To cover the budget deficits in the current account.

• War or war-preparedness, including nuclear programs.

• Natural Calamities:- So as to provide relief to the victims, PD

is increased.

• To undertake public welfare schemes.

• Urge for economic growth.

• Economic stability:- The government borrows to control

inflationary conditions.
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 6.3 Objectives/ Importance of PD
• Bridging the gap between revenue and expenditure through
temporary loans from National banks.

• To reduce depression in the economy and finance public works

programs.

• To curb inflation by withdrawing the purchasing power from

the public.

• Financing economic development especially in under-

developed countries.

• For the development of social welfare schemes like education,

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health, general insurance

 Cont’d
• Financing the public sector for expanding and strengthening
the public enterprises.

• A lot of money has to be spent by the government at the time of

wars, floods, epidemics, and famines.

6.4. Classification of public debt

• Internal and external debt
• Productive and unproductive debt
• Compulsory and voluntary debt
• Redeemable and irredeemable debt
• Funded and unfunded debt
• Short-Term, Medium-Term and Long-Term Debt 5
❖ Internal and external debt (Source)
o Internal debt: Public loans floated within the country are called
internal debt. When a state finds that it is impossible to obtain
further money by taxation, it resorts to borrowing from citizens
and financial institutions within the country.

o If the state is passing through a very critical period, it can

borrow all the money the nation saves. In that case, trade and
industry will suffer a lot because no money is left to finance
them. In the normal period, however, the state can borrow only
surplus funds which are left with the businessmen after meeting
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all the needs of the business.
 Cont’d
o External debt: is always in terms of foreign currency. The
government borrows from friendly foreign countries or
international financial institutions.

• When a state needs money, it tries to get as much loan as it can

from other states.

• The foreign governments do not advance loans without a limit.

• They intensively study the budgetary position of the borrowing

country, the tax-bearing capacity of the nation, the per-capita
income of the people, and the purpose for which the loan is
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desired.
 Cont’d
• If the position of the budget is sound and the taxable capacity of
the nation is high, then a foreign government may advance a
sizable loan to the borrowing country.

❖ Productive and unproductive debt (Purpose)

• Public debt may be productive or unproductive depending on the

use of public loans.

• Productive debts are those which are used for those projects
which yield income to the government. Thus, when the
government borrows for developmental expenditure, the debt is
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productive.
• When the government borrows for non-developmental purposes
such as war finance or wastefulness in public administration, the
debt becomes unproductive.
❖Compulsory and voluntary debt ( Nature)
• When the govt. borrows from the public by using forceful
methods, i.e., by virtue of its sovereign powers, we may call it
compulsory debt. 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
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voluntary debt.
❖ Redeemable and irredeemable debt (Maturity)

• Redeemable loans are those loans which the govt. promises to

pay off at some future date. Irredeemable debts are those which
are raised without any intention to repay the principal, though
the govt. continues to pay interest on such debts.
❖ Funded and unfunded debt (Period/Mode of repayment)
• Funded debt is a long-term debt, exceeding the duration of at
least a year. These are permanent debts in the sense that new
securities are issued every time the debt matures. A debt
fund is created in which some money is deposited every
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year so as to repay this type of debt.
• Thus, the permanent debt covers loans raised in the open market
by the sale of securities.

• Unfunded or floating debt is a relatively short-period debt,

meant to meet current needs. They are generally redeemable
within a year.

• The government does not create any separate funds to repay the
debt. Such a debt is repaid out of current receipts, by floating
additional bonds in the market.

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❖Short-term, Medium-term and Long-term loans
(Duration of the loan)
o Short-term debts: Short-term debts are those debts that mature
within a period of three to nine months.

o Medium-term debts: one to ten years

o Long-term debts: ten years or more

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 6.5 Effects of Public Debt

o Effects on Production

o Effects on Consumption

o Effects on Distribution

o Effects on the Level of Income and Employment

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❖ Effects on Production
• If public debts are raised to finance productive purposes,
overall production is positively affected. But if it is used for
wasteful or non-productive purposes, total production is
affected negatively.

❖ Effects on Consumption

• The effect of public debt on consumption depends upon how it is

financed by individuals. If they lend to the government out of
their idle savings, consumption is not affected. But if they lend
by cutting present savings, it may make them feel less secure and
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so they may reduce their consumption.
❖ Effects on Distribution
• Public loans transfer money from the rich to the government.

• The fiscal operations of the government are to benefit the poor

primarily. The income of the poor increases directly through
increased employment or it benefits them directly through the
enlargement of social services.
❖ Effects on the Level of Income and Employment
• In modern times, public borrowing is resorted to in order to raise
funds for financing agriculture, industry, mining, transportation,
communication, etc. It increases employment opportunities, the
level of income, and the standard of living. 15
 6.6 Measurement of the burden of public debt

o The burden of public debt can be measured by any of the

following methods.

• Income-Debt Ratio

• Debt Service Ratio

• Interest- Revenue Ratio

• Interest- Public Expenditure Ratio

• Interest- Export Earning Ratio

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❖Income-Debt Ratio
➢ The burden of the public debt can be measured as a ratio
of the size of the public debt and national income at
current prices.
PD
➢ i.e., PDB =
Y

If ΔPD > ΔY → Real burden Increases

If ΔPD < ΔY → Real burden Decreases

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❖ Debt Service Ratio
• The burden of the public debt can also be
measured as a ratio of annual interest
payment on public debt and the national
income.
• It is known as the Debt service ratio

i.e., PDB =
i
Y

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 Cont’d
• It indicates that a developed economy with a
high rate of growth of national income can
afford a large amount of public debt.
• An underdeveloped country, with a low rate of
growth of national income cannot afford a large
amount of public debt.
• In an underdeveloped country, most of the
government’s annual revenue will have to be
paid as interest on public debt and less amount
will be available for welfare and developmental
purposes. 19
❖ Interest Revenue Ratio
➢The burden of public debt can also be
measured as the ratio of annual interest
payment and aggregate tax revenue.

➢ i.e., PDB = i
R
➢The interest revenue ratio indicates the fiscal
burden of the public debt.
➢If this ratio is higher, it will mean fewer resources
will be available for developmental purposes and
thus the burden will be high. 20
❖ Interest- Public Expenditure Ratio
➢ The burden of the public debt can also be
measured by the ratio of annual interest
payment on public debt and total revenue
expenditure.
➢ i.e., PDB = i
E

➢This method measures the proportion of public

expenditure required to meet the annual rate
of interest.

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❖ Interest - Export Earning Ratio
➢ This method is used to measure the burden of
external debt.
➢ It calculates the ratio of interest payments
and export earnings.

i.e., PDEB = i
Ex

➢This ratio shows the proportion of export

earnings required to pay annual interest on
external debts. 22
 6.7 Redemption of Public Debt
➢ Redemption means repayment of loans.

❖Methods of debt redemption:

• Repudiation of Debt

• Conversion of Loans

• Serial Bond Redemption

• Buying up Loans

• Sinking Fund

• Capital Levy 23
 Cont’d
1. Repudiation of Debt

• This means simply that the government refuses to pay the

interest as well as the principal. In extreme circumstances, a
government may be forced to repudiate its debt obligations. Of
all the methods of redeeming debt, repudiation is the most
extreme.

2. Conversion of Loans

• Conversion of high-interest-rated loans to low-interest-rated

loans. A government may have borrowed when the rate of
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interest was high.
 Cont’d
• Now, if the rate of interest falls, it can convert a high-rated loan
into a low-rated one. It means repayment of a debt through a
new loan

3. Serial Bond Redemption

• The government may decide to repay every year a certain

portion of the bonds issued previously.

4. Buying up Loans

• The government may redeem its debt by buying up loans from

the market.
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 Cont’d
• Whenever the government has surplus income, it may spend the
amount to pay off government loan bonds from the market
where they are bought and sold.

• It refers to the purchase of government bonds

▪ The government may buy its stocks in the market, thus wiping
off its obligation to that extent.

▪ This may be done by the application of surplus revenues or by

borrowing at low rates if the conditions are favourable.

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 5. Sinking fund

▪ This is the most important method. A fund is created for the

repayment of every loan by setting aside a certain amount every
year out of the current revenue.

▪ The sum to be set aside is so calculated that over a certain period,

the total sum accumulated, together with the interest thereon, is
enough to pay off the loan.

6. Capital Levy

▪ Public debt may be redeemed through a capital levy

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 Questions For Discussion
[Link] public debt.
[Link] public dept?
[Link] are the objectives of public debt?
4. Explain the various classifications of public debt.
[Link] the effects of public debt on the economy of a country.
[Link] the methods of estimating debt burden.
[Link] the different methods of redemption of public debt.
[Link] is the difference between taxation and public borrowing?
9. Explain the differences between public debt and private debt.

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