611: Public Finance and

Taxation

Dr. Mohammed Jamal Uddin FCMA

Topic-5: Fiscal Policy and Stabilization

MBA, Evening,
Fall 2021
 Contents

 Principles of stabilization policy:

 Multiplier models,
 Stabilization in the open economy,
 Inflation and rational expectations,
 Economics of public debt:
 Definition,
 Public debt and economic growth,
 Public debt and inflation,
 Burden of public debt,
 Fiscal policy of Bangladesh
 Principles of stabilization policy

Introduction

 Budget policy plays its role in economic stabilization. Budget

operations affect the level of aggregate demand, and
changes in the level of aggregate demand affect the level of
employment and of prices.
 Like it or not, the budget thus has important repercussions
on the macro behavior of the economy and, in tum,
becomes an important tool by which to affect that behavior.
 Moreover, budget policy affects the division of total output
between consumption and capital formation and thereby
the rate of economic growth.
Multiplier models with Investment Fixed
Income Determination without Budget
Multiplier models with Investment Fixed
Income Determination without Budget
Multiplier models with Investment Fixed
Income Determination with Budget
Multiplier models with Investment Fixed
Income Determination with Budget
 Multiplier models with Investment Fixed
Income Determination with Budget

Allowing for Lump-Sum Taxes

Role of Transfers
Multiplier models with Investment Fixed
Income Determination with Budget
 Multiplier models with Investment Fixed
Income Determination with Budget

System with Income Tax

Multiplier models with Investment Fixed
Income Determination with Budget
 Stabilization in the open economy

 So far we discussed various aspects of stabilization policy

and the relation between fiscal and monetary approaches as
seen in the context of a closed economy.
 But in fact most economies are intimately linked to the rest
of the world, through both product and capital flows.
 This linkage has important implications for the conduct of
stabilization policy, which must now be considered.
 Fixed Exchange Rates Under a system of fixed exchange
rates, expansionary measures, by raising income, lead to
increased imports.
 Flexible Exchange Rates In a world of fixed exchange rates,
expansionary policy thus results in rising imports and a
deficit in the balance of payments.
 Inflation and rational expectations

 So far we have assumed that the price level remains constant, so

that the impact of budgetary policy upon the level of aggregate
demand was reflected in a corresponding change in output and
employment.
 But such may not be the case. An increase in aggregate
expenditures may come to be reflected in rising prices rather than
in rising output.
 As the economy moves from a position of substantial
unemployment and underutilization of capacity to one of ''full
employment,'' a further increase in the level of expenditures
tends to be reflected more largely in rising prices, especially if the
increase in demand is so rapid as to outrun the economy's ability
to expand output.
 Stabilization policy must then seek to pursue a careful path so as
to avoid inflation while overcoming unemployment.
Public Debt
 Public Debt

Introduction
Normally, a modern-day government has a large variety of debt
obligations. And the term 'public debt’ may be defined to cover
some or all of them as per data availability and purpose in
hand. Thus, at one extreme, it may include all financial
liabilities of the government (including its currency obligations),
while at the other extreme, it may be confined to only a
selected few items. An unambiguous decision is also needed
regarding the coverage of inter-governmental financial
obligations and borrowings of authorities from the central bank
of the country.
At this juncture, it would be helpful to have a brief idea of the
type of obligations which the government of a country usually
incurs.
 Public Debt

Introduction
Firstly, there is the currency itself. Generally, however, the
government creates only a part of the currency; the rest is
created by the central bank of the country. Therefore, the
entire currency circulating in the market may be included in
public debt only if the central bank is classified as a wing of the
government. In any case, currency obligations normally remain
dormant or inactive and the government is not required to pay
(redeem) them at the most a part of these obligations may be
replaced by others.
 Public Debt …

Introduction…
Secondly, another set of obligations of the government
constitutes its short-term debt. These obligations are
normally of a maturity of less than one year at the time of
issue and consist of components like the treasury bills.
Thirdly, some obligations do not have any pre-determined
maturity. They are known as floating debt. Examples of this
category include provident funds, small savings, reserve
funds and deposits, and so on. In India, the Government of
India also issues certain special securities to meet its
obligations towards international institutions like the
International Bank for Reconstruction and Development and
the International Monetary Fund. These special securities
may be called special floating debt.
 Public Debt …
Introduction…
Fourth category of government obligations consists of the permanent
(also known as dated or funded) debt. Such loans have a maturity of
more than one year at the time of issue. In practice, their maturity is
usually between three and thirty years. Some of them may even be
non-terminable (or perpetuities) so that the government is obliged to
pay only the interest on such debt without ever repaying the
principle amount.
Fifthly, obligations owed to foreign governments, institutions, firms
and individuals are called external loans. More precisely, they are
‘loans raised from outside the country'. They may have a wide range
of maturities and be subject to their own specific terms and
conditions.
The foregoing description shows the possibility of defining public
debt with alternative coverage in conformity with the purpose in
hand and data availability, etc.
 Public Debt And Private Debt

Government borrowings have some similarities with private ones. Like a private
borrower, the government may also borrow either for consumption or for investment
purposes. Most of its debt obligations are also interest bearing. But the dissimilarities
between the two are more fundamental.
(i) A private economic unit cannot borrow internally, that is to say, it cannot borrow from
itself. However, the government usually borrows internally, that is, from its own subjects
and from within the country.
(ii) While a private economic unit can repay the debt either out of its earnings or out of
its accumulated assets or by fresh borrowings (thus substituting one debt for the other),
such need not be the case with the government. The government is the creator of
currency and can pay its debt straight-away by creating more of it. The fact that it usually
does not do so only reflects its concern for the welfare and stability of the economy and
not the lack of its power to do so. However, external debt can be discharged in this
manner only if it is repayable in local currency. Creation of domestic currency cannot be
the means of repaying it if the foreign debt is repayable in foreign currency or gold. In
that case, foreign currency will have to be procured through export earnings or through
some other means, failing which gold will have to be paid out.
 Public Debt And Private Debt

(iii) Public borrowings have a profound effect on various parameters of the

economy-distribution, capital accumulation, economic growth, income and
employment stability, and so on. This way, public debt is both a source of
problems and a tool of economic management in the hands of the authorities.
(iv) A government can raise non-terminable loans (these loans have no maturity
date). This is because the government is supposed to have a perpetual life and
top-rate creditworthiness. In contrast, a private borrower is not endowed with
these powers.
(v) If need be, a government may even forcibly borrow from within the country;
or it may lay down laws under which the savers are ‘compelled' or 'induced' to
invest in government loans. In India, for various reasons, these tactics were
extensively used by the government. It is only in recent years that market forces
are being allowed a freer play.
 Why Public Debt?
A government may resort to borrowing because of some fiscal compulsions, in pursuance of a
deliberate policy or for meeting an emergent need.
1. A government, like any other economic unit, collects revenue and spends it. And it is also a fact
that its revenue and expenditure flows may not match each other during any given time period
There are bound to be intervals when its revenue receipts exceed its expenditure and vice versa. Of
course, unless the government adopts a policy of spending too much or too little compared with its
receipts, it will try to equate the two. In other words, the deficits and surpluses will tend to
counterbalance each other so that over a longer time interval there will be a tendency for the
budget to ‘balance’
2. There may be a sudden spurt in government expenditure. There may be wars, or natural
calamities in which case the government would be forced to incur much larger expenditure and may
run into a debt.
3. Modern governments subscribe to the view that the public budget should be a surplus, deficit or
balanced one as the need be. This approach is sometimes referred to as that of functional finance-in
which the government is ready to have repeated surplus or deficit budgets for achieving a variety of
objectives including those of economic growth and stabilization. In contrast the traditional
philosophy was based upon the following reasons.
Firstly, the historical experience of the governments raising loans had not been a happy one. Public
loans had been frequently raised by rulers for financing useless and expensive wars, conspicuous
consumption, and other form of wasteful expenditure. To thinkers of those days, therefore, the
practice of raising public loans and having deficit budgets symbolized an irrational government
behaviour which should be avoided.
 Why Public Debt?

Secondly, the belief in laissez-faire philosophy also dictated that the authorities
should avoid undue interference in the working of the market. Raising loans and
spending them militated against this thinking.
Thirdly, Government loans were considered akin to private loans. It was
believed that like private loans, public loans should also be retired as soon as
possible. But we know that public loans need not be repaid at all. Maturing
loans may be replaced by new ones by either conversions or through cash
subscriptions. Also some loans may be perpetuities.
4. These days it is widely believed that the government of an underdeveloped
country should play an active role in the development of the economy. In this
view, budgetary policy is an important and effective tool in accelerating the
process of capital accumulation and economic growth. This may be done
through borrowing and investing those funds in developmental projects. Loans
may even be earmarked for certain project.
In this context, care should be taken to note that when a government adopts a
deficit budget, it need not necessarily add to its debt from open market. This is
because the government may finance its budgetary deficit by one or more of
the following means.
 Why Public Debt?

(a) It may run down its cash reserves.

(b) It may sell some of its assets like properties and investments, etc.
(c). It may create additional currency and use it.
(d) It may borrow from the central bank and spend.
It is seen that the second method of meeting the deficit does not increase the
indebtedness of the government, though a government seldom adopts this
approach. The first and third methods increase the supply of currency of the
government in the market, Whether or not public debt increases in the
accounting sense, depends upon whether currency obligations of the
government are included or not in the definition of public debt. As regards the
fourth method, the government may borrow from the market proper or it may
borrow from the central bank. In the former case, there is obviously an increase
in outstanding public debt. Borrowing from the central bank increases the
government's indebtedness only if the former is not classified as an integral
wing of the government.
 Prominent Kinds Of Debt

Before we take up various theoretical and policy issues connected with the
public debt of a country, it might be useful to get familiar with some of the
important terms usually used in relation to public debt.
Public debt may be internal or external. When it is owned or held by the
subjects of the indebted government, it is an internally held debt. In this case,
the community owes this debt to some of its own members. The debt will be
external if the creditors are foreigners and there is a draining of national
resources in favour of foreign countries when the debt is serviced. It is clear
that if loan obligations are allowed to change hands, internal debt may get
converted into foreign debt and vice versa. Similarly, loans are called
marketable if existing holders can sell them to others. Non-marketable loans,
on the other hand are those which have been issued in favour of specified
debt holders only and cannot be sold to others.
 Prominent Kinds Of Debt

Government loans may be interest-bearing or non-interest-bearing (that is interest-free).

An interest-bearing loan may carry a fixed coupon, i.e., a fixed periodic interest
entitlement, or the coupon may be a variable one. Alternatively, a loan may be issued at a
discount through bids. Such loans are termed zero-coupon bonds. A time-tested historical
example of such loans is that of treasury bills.
The coupon or discount at which the government is able to issue the loan depends upon
the circumstances in the market—the general level of interest rates, whether the market is
having a lean or a busy season, the general conditions regarding the availability of
investible funds, and so on. In general, however, the government is able to borrow at rates
much lower than the ones prevailing in the market because of its high credit standing and
liquidity and marketability of its loans. Of course, the return on government loans can vary
from time to time and generally shorter maturity loans carry a lower rate than longer
maturity ones. Moreover, effective rates of yield on government loans keep fluctuating in
response to shifts in market interest rates. Thus with an increase in the level of interest
rates in the market, prices of government securities tend to fall with a corresponding
increase in their rates of yield to maturity. Just the opposite is expected to happen when
market interest rate declines. This phenomenon of interdependence between interest
rates, coupon rates, and maturity composition of securities can be used by the
government, if it so desires, to influence the market behaviour.
 Prominent Kinds Of Debt

Public loans are also classified into productive and unproductive ones. But
this classification cannot give us a clear-cut categorization. Essentially, a
loan is termed productive if it is used for acquiring income-earning assets
or project(s) for the government or on those heads which add to the
productive capacity of the economy as a whole, like education and health
services etc. But in reality, even fighting a war may not always be an
unproductive act because defense of the country is a prerequisite for all
productive activities. Moreover, loans are seldom earmarked for specific
investments or projects. Therefore, instead of labeling government loans
as productive and unproductive, a more useful exercise is to examine the
expenditure policy of the government in detail and assess the desirability
or otherwise of each item of expenditure and the amount going into it.
 Limits Of Raising Public Debt

We find that in most countries public debt has registered a continuous upward trend
during the last few decades. As seen above, some inherent forces contribute to this
trend. But still a question arises as to whether there are any definite limits beyond
which a government cannot raise loans and add to its outstanding debt obligations. To
answer this question, we shall distinguish between the will and capacity of the
government to raise loans both in the short-run and long-run.
1. It must be noted at the outset that a modern government is not expected to borrow
for the sake of it. It is not expected to borrow suit the personal whims of individuals
running the government. It would borrow for reasons of either economic compulsions
or for furthering social and economic goals of the society. On these criteria, it may
borrow even for consumption purposes such as for defense, for education for indulging
in 'wasteful expenditure of any kind or to and health, for meeting natural calamities
and for other welfare objectives. Similarly, it may borrow so as to assist the economy in
its growth activities via capital accumulation, and anti-cyclical measures. In other
words, it is expected that the government would abide by a self-imposed limitation
that all borrowings must be for ‘public purposes'.
 Limits Of Raising Public Debt
2. In some cases, there may also be specific legal restrictions on public
borrowings.
3. Given total loanable funds, government borrowings add to their demand and
cause an upward pressure on interest rates. Thus higher interest cost can act as
a deterrent against the borrowing programmes of the authorities. If compelled
to borrow on a large scale, such as during a war, then it may try to keep the
interest cost low by concentrating on short maturity loans.
4. In the long run, however, total volume of public debt can increase gradually
and in line with the growth in national income and credit structure. Therefore,
no definite limit may be stated to exist for the volume of public debt in the long-
run (unless the law sets such a limit). The authorities need not reduce the
outstanding debt—it can just be renewed by borrowing afresh. In the process,
even total outstanding debt may be allowed to increase. The philosophy that
the government should be guided by over-all requirements of the economy
without worrying about the actual budgetary surpluses or deficits has also freed
the government from its inhibitions about the absolute size of the public debt.
 Limits Of Raising Public Debt

5. A line of thinking propounded by Gurley and Shaw and the Radcliffe Committee
emphasizes the important role of public debt in the economy of a country. Gurley and
Shaw claim that the physical growth of an economy cannot be sustained without a
healthy and strong financial sector. And this in turn necessitates the growth of public
debt since the latter provides a basis for the superstructure of credit in the economy.
Similarly, the Radcliffe Committee emphasized the role of public debt as a powerful tool
in the credit and monetary regulation of the economy. This line of reasoning has been
subsequently advocated, elaborated and emphasized by many writers.
6. A fear is expressed that unless checked by some means, a government may resort to
excessive borrowing and get into a 'debt trap'—that is, a situation in which it has to
borrow afresh to service its existing debt. This state of affairs may eventually raise
interest cost to unmanageable proportions of its revenue receipts and expenditure. In
the case of a foreign debt, the country's resources also get drained. And in any case, the
government loses much of its budgetary maneuverability on account of the committed
debt servicing obligations, Such a situation also leads to many other ill-effects like those
on investment, economic stability and balance of payments.
 Public Debt And Economic Growth

A. ROLE IN THE FINANCIAL SYSTEM

Economic growth is accompanied with increasing monetization of economic
activities, that is, economic activities generate corresponding financial
transactions. Consequently, financial needs of the economy increase both in
absolute terms and in relation to national income. Financial assets may be
divided into two parts, viz., 'inside money' and 'outside moneyʻ. The former refers
to financial claims against the private sector of the economy while outside money
refers to financial claims against the government sector. Simultaneously,
government obligations act as an acceptable and sound base for the private
financial assets, that is, financial claims upon the private sector have the highest
acceptability when they are payable in ‘legal tender' (or official money). Credit
being ultimately an expression of confidence, its best base can only be the
government obligations. There is no risk of default in their case and they have a
ready marketability. And these qualities are not found in as much measure in
private debt obligations. Therefore, existence of government debt becomes a
precondition for the existence of a developed financial system of the economy.
 Public Debt And Economic Growth…

B. FACILITATING SAVING AND INVESTMENT

Modern economies are characterized by 'roundabout processes of
production, that is, their production processes comprise several stages
before products reach final consumers. Roundabout production adds to the
overall productive capacity of the economy; and, in general, more the
stages, greater is this addition. Thus, growth-oriented investment involves
long gestation periods and future planning which, in turn are facilitated by
a developed, diversified and sensitive financial system. It is noteworthy that
the need for growth-oriented investment is more intense in the case of a
less developed country, particularly in the area of infrastructure. However,
a less developed country suffers from a weak financial system and
insufficient savings. Accordingly, the government has to help the economy
by raising public borrowings and investing the same in growth-oriented
projects. However, the net effect of public borrowings also depends upon
the sources from which they come.
 Public Debt And Economic Growth…
B. FACILITATING SAVING AND INVESTMENT…
1. In the case of borrowings from the market, if the public reduces its own
consumption and lends its savings to the government, the result will be a net
increase in the rate of savings. This may happen if people voluntarily save more
under the temptation of an interest income. However, if loans to government
are given by diverting the savings from private investment, then there would be
no net increase in saving and investment activity. But public loans can still help
economic growth through reallocation of resources. Public investment is more
likely to be in the capital goods sector while private investment tends to
concentrate in consumption goods sector because of its greater profitability.
2. When the authorities borrow from the central bank of the country, there is an
addition to aggregate money supply in the country. This causes an addition to
demand flows and an upward pressure on prices. A part of the supplies is
purchased away by the authorities by spending the newly created money and
the market is left with smaller supplies. In that sense, this process of forced
savings and capital accumulation is not always a desirable one on account of its
harmful inflationary effects.
 Public Debt And Inflation

It is claimed that most public borrowings from the market only divert
funds into the hands of the government. As a result, there is no net
addition in aggregate demand and hence no increased pressures on prices.
This reasoning is quite misleading because it tries to hide some basic facts.
Firstly, even if public debt does not add to aggregate demand, it is bound
to be inflationary because the economy's productive resources get
diverted from the production of consumption goods into that of capital
goods. By their very nature, investment goods industries have longer
gestation periods and therefore during the intervening period, the demand
for consumption goods tends to exceed their supply.
Secondly, borrowings used for war activities, for meeting natural calamities
and for other relief measures are most likely to be inflationary in their
impact because they are basically consumption oriented.
 Public Debt And Inflation…

Thirdly, when a government borrows from the central bank, there is an

addition in money supply which in turn adds to demand and pushes up
prices.
Fourthly, holding of public debt by commercial banks can also leads to an
addition in demand and inflationary pressures. Banks rate government
securities as highly liquid which can be encashed at any time with
minimum risk of capital loss. This assured liquidity position, therefore,
tempts them to increase their loans and advances and thus add to the
inflationary pressures in the market.
However, if public debt is used to bring about an increase in productivity of
the economy leading to an increased supply of the demanded goods,
inflationary forces would be checked to that extent. In addition, the
authorities may resort to price controls, rationing and other measures to
keep prices under control.
 Public Debt And Economic Regulation

It is possible to regulate the economy's financial system through variations in

the volume, composition and yield rates of public debt. A lengthening of the
maturity composition of public debt is expected to reduce its over-all
liquidity, while its shortening is expected to have the opposite effect. The
authorities therefore can swap longer maturities with the shorter ones and
vice versa as a matter of policy. Since every financial liability is ultimately
payable in official currency and since public debt usually forms a significant
portion of the total supply of credit in the country, liquidity variations in it
become an important policy tool in the hands of the authorities. In the
process, they also affect the yield structure of the entire spectrum of
financial assets. There are of course differences of opinion as to the exact
margins by which variations in public debt affect the yield structure on public
debt and the yield structure in the economy but the fact of its existence
cannot be denied.
 Public Debt And Economic Regulation…

Ownership of government securities enables its holder to quickly and easily

convert it into spendable purchasing power. Therefore, public debt policy
may aim at directly influencing the sum total of purchasing power or
‘liquidity of the public debt. However, public debt is an imperfect substitute
of official currency so that one rupee of public debt can do the job of less
than a rupee of cash. Further, shorter-maturity debt is a closer substitute for
cash than the longer maturity one because it carries a smaller capital risk.
Since public debt forms a base for the private credit structure of the
economy, therefore, it can also be used quite effectively for its restructuring.
For example, through open market operations and, therefore, by changing
the volume of outstanding debt in the market, the banking credit can be
influenced. Similarly, by exerting a downward or an upward pressure upon
the yield structure of the government securities, the authorities can hope to
influence the market values of various financial and real assets. Changing
values of these assets are bound to affect volume and patterns of the
demand and consumption in the economy.
 Public Debt And Economic Regulation…

There is no doubt that the manner and extent of changes in the interest rate
structure and the volume and composition of public debt affect the volume
and composition of the demand flows, investment and other decisions in the
economy. But these effects are a matter of empirical investigation and
cannot be generalized. However, it is possible to state some general
tendencies. For example, it is very likely that an increased supply of liquid
purchasing power will push up demand and (if the supply does not rise fast
enough) prices also. A fall in the supply of liquidity should similarly
discourage demand aid prices. In the same way, when interest rates go up,
investment activity will be checked unless counteracted by heightened
inflationary expectations. Higher interest rates, moreover, tend to push down
the values of the assets (both real and nominal) and this has a dampening
effect on both consumption and investment. Lower interest rates, on the
other hand, induce extra expenditure in the economy including investment.
 Public Debt And Economic Regulation…
These tendencies can be used as inputs for an anti-cyclical debt policy.
During the boom period, for example, aggregate availability of liquidity
should be reduced. This may be done by reducing the availability of
aggregate liquidity in the market while taking care that this is not
counteracted by an increase in money supply with the public. This is sought
to be achieved through sales of securities in the open market operations.
However, a more effective approach is that of reducing the supply of debt
without a corresponding increase in the supply of money. Similarly, within
the given volume of public debt, the maturity composition could be
lengthened, and particular interest rates (or yields) could be raised. While
combating a depression, similarly, the modus operandi can be to increase
the total supply of liquidity. This may be done by simply adding to the
money supply, or adding to the public debt, replacing public debt with
money supply (through open market operations) and reducing the general
level of interest rates.
 Public Debt And Economic Regulation…

It would be noticed that an anti-cyclical debt policy must work in harmony

with the monetary policy of the country. For example, for regulating overall
availability of credit in the economy, open market operations are mostly
conducted by sale and purchase of public debt. However, anti-cyclical policy
comes in conflict with that of reducing the interest cost of public debt. This
implies that during the depression when interest rates are low, the
authorities should (i) add to their debt obligations, and (ii) convert the
existing short-term loans into longer-term ones, at the same or lower
interest rates. However, these steps would also result in reduced aggregate
flow of money and credit (and thus liquidity) in the market A shift towards
longer maturities in the public debt will have the same effect. In contrast,
tenets of monetary policy dictate that during depression, authorities should
aim at increasing aggregate liquidity in the market. Similarly, there can be
other areas of conflict between monetary and debt policies.
 Public Debt Vs. Taxation
The choice between debt and tax financing is a subject of an ongoing debate. It is noteworthy that none of the
two methods has a universal edge over the other. The choice depends upon the attendant situation and the
over-all long-term implications for the economy. It is obvious that a part (and a major part for that) of
government expenditure ought to be financed through tax revenue. The real issue therefore is to decide how
to choose between tax and debt finance for the remaining expenditure.
According to Gurley and Shaw, mounting volume of public debt is a pre-requisite of a strong and healthy
financial structure of an economy. That being so, some secular increase in public debt should be planned by
every government of a market-oriented modern economy. However, it appears that hardly any government
plans a long-term increase in debt with that end in view. Factually speaking, the volume of public debt has
tended to increase in response to compulsions of the moment. Its benefits through contribution to the
financial structure of the economy are only incidental.
Under some circumstances debt financing becomes either unavoidable or preferable. Thus during war and
other emergencies when suddenly large funds are needed and additional tax revenue cannot be raised, debt
financing has to be resorted to. Till mid twentieth century, wars were the foremost cause of mounting public
debt in most countries. Developmental and regulatory factors gained prominence only later.
For some projects, debt financing meets the test of cost-benefit analysis. Such projects are estimated to benefit
specific areas or sections of the people who can be expected to bear the cost of the project out of the benefits
they would receive. For example, the cost of an irrigation dam may be first met through public borrowing, and
then recovered from the beneficiaries through a levy or some other means. Similarly, there can be some
commercial projects which add to the productivity of the economy and which can be expected to be self-
financing. Their investment funds can be raised through market borrowings and the debt can be retired
through the profits of these undertakings. Examples are of electricity generating projects, transport
undertakings, and so on.
 Public Debt Vs. Taxation

Debt financing, however, as compared with tax financing, has its own limitations
which can sometimes outweigh its advantages. Public debt, by definition, has to be
serviced. Interest has to be paid on it, and the principle is also to be repaid. This
means that those who contribute to the financing of the expenditure in the first
instance really do not lose. In the case of taxation, the taxpayers straight away
lose some resources in favour of the government without any claim to their
recovery. Debt financing, therefore, adds to the future budgetary commitments of
the authorities. A part of the future revenue has to go into servicing of the debt.
Ordinarily, therefore, the authorities may be expected to favour tax financing,
unless the other attending considerations are more weighty. Moreover, since it is
the richer sections only which can subscribe to the public debt, debt servicing
becomes a medium for redistributing national income in favour of the rich unless
counter-balanced by other policy measures. It is also a possibility that the projects
chosen for debt financing are really not run efficiently enough and do not generate
surpluses to pay off their cost. But this, we must remember, is a question of wrong
calculations at the planning stage and mismanagement of the projects which
should be avoided. A major drawback of debt financing of a war is that effective
supplies in the market are reduced without a corresponding reduction in the
purchasing power. This does not happen with taxation. Therefore, the problem of
keeping inflation under check is more troublesome under debt financing than under
tax financing of war.
 BURDEN OF DEBT
This dimension of public debt has attracted a lot of attention in economic literature. The classical philosophy
of laissez-faire assumed that the State was external to the “real economy which comprised only the private
sector. Accordingly, resources transferred to the State were ‘lost' to 'the economy'. In line with this reasoning,
laissez-faire philosophy was against deficit public budgets, except under dire necessities. In addition, any
deficit was to be wiped out as soon as possible. "The national debt used to he regarded as an aftermath of
war. an incubus to be swept away as quickly as the taxpayer would allow; and the management of the debt
used to consist of a search for the cheapest way of dealing with a nuisance.”“ Furthermore, public debt was
often divided into productive and dead-weight categories. The general idea was that the government should
not raise loans for consumption activities; at the most it may do so for the investment activities only. Public
debt should not become a drain upon its budget. Debts raised during a war etc. were, therefore, very
obnoxious according to this approach.
Assuming that the State was not an integral part of the “economy’, E. D. Domar7 claimed that interest
payment on public debt should be taken to represent a 'burden of debt'. He related the interest payments to
the level of national income and thus pointed out that as interest on debt as a proportion of national income
rises, a larger portion of national income will have to be taxed to pay thaj interest. We must, however,
remember that the tax revenue collected for interest payment, is being disbursed to the debt holders. The
burden that arises from a large public debt and a large tax collection for interest payment, therefore, really
depends upon three things.
• Resource cost of tax collections and interest payments.
• Loss of manoeuvrability in the public budget and related constraints.
• Distributive effects of activities and decisions associated with existence, operations and management of
public debt: For example, an increase in inequalities is taken to add to the burden of public debt.
Opponents of public debt claim that it is burdensome on the basis of some other criteria as well. Those who
make the mistake of equating national economy with the private sector only, also tend to ignore the fact that
resources are also transferred from the government to the private sector. Factually speaking, transfers between
the government and the private sector are transfers within the economy and, therefore, by themselves, are
neither burdensome nor beneficial. Burden of public debt takes the form of its spill-over effects. It may
become even 'unsustainable' and the government may fall into a debt trap', that is, a situation in which it has to
borrow afresh to service its existing debt.
While internal debt does not cause a direct variation in aggregate resource availability for the country,
external debt does. At the time of contracting external loans, the debtor country acquires some real
resources and loses them when that debt is serviced. Ordinarily, an external debt raised for meeting
consumption needs does not add to the productive capacity of the borrowing country and results in a net
drainage of resources at the time of its repayment-more so if the loans are interest bearing. However, the
net outflow will also depend upon the terms of trade. If the terms of trade have moved in favour of the
debtor country, then to that extent the burden of the debt is reduced. The debtor country may even gain in
the net.
Judiciously used for investment purposes, foreign loans are expected to add to the productive capacity of
the borrowing country. In that case, they need not inflict any net burden on the borrowing country. This is,
however, subject to the condition that the borrowing country is able to have an export surplus for servicing
the external debt.
DEBT BURDEN AND FUTURE GENERATIONS
It is sometimes claimed that debt financing of current expenditure leads to a burden upon future
generations of the society. Two interrelated questions are involved here.
• Does public debt necessarily imposes a burden or a sacrifice upon the future generations?
• Is it possible to inake the future generations contribute to the present utilization of resources through
debt financing?
As explained below, the classical position is that in debt financing, the current generation can use only those
resources which are available to it. It cannot draw resources from the future. Future generations suffer only
if the current generation reduces its saving and capital formation, thereby retarding the growth of future
productive capacity of the economy. In other words, consumption of currently available resources, however,
may have the spill-over effect of reducing availability of capital resources for the future generations.
It is claimed that debt financing is more burdensome for future generations than tax financing for the
following reasons as well. Debt financing leaves in the hands of the debt owners bonds and securities which
they consider as part of their wealth. While in the case of taxation, they believe themselves to be poorer, in
the case of debt financing, they are not likely to do so. Accordingly, under debt financing, consumption is
not likely to fall. By implication, debt financing can impose a burden upon future generations, but it is not a
result that must necessarily follows.
 DEBT BURDEN AND FUTURE GENERATIONS

This stand has been challenged by several writers like Buchanan, Bowen, Davis, Kopf, Musgrave, Modigliani and
others. James Buchanan, in his book Public Principles of Public Debt takes the position that a burden implies an
involuntary sacrifice.' Holders of public debt, however, voluntarily opt for it. However, Buchanan is making the
mistake of taking an individualistic view-point where, for an individual, a tax entails a loss of resources while a
debt does not. But the economy as a whole suffers a loss of resources in both debt financing and tax financing
We have noted above that that if the present generation provides the resources for debt financing by cutting its
consumption, then savings and capital formation would not be adversely affected and the future generation would
not be burdened on account of reduced capital stock. Bowen, Davis and Kopf take the extreme position where the
present generation chooses not to reduce its consumption at all, but finance entire debt through reduced savings.
Modigliani tries to show that debt financing by the government necessarily leads to a reduction in capital stock
inherited by the future generations." To elaborate, if the economy is already at full employment and the
government adds to its own expenditure, then there is bound to be a fall in either private consumption or
investment or both. And the outcome is the same (though a milder one) even when the economy is working at a
level below full employment.
 DEBT BURDEN AND FUTURE GENERATIONS

The foregoing arguments and analysis ignore, expenditure side of government activities; or alternatively, it is
being assumed that the government expenditure is necessarily of the consumption type, such as, in the case
of a war. This is mostly an erroneous assumption. In an underdeveloped country, especially, public debt is
very likely to be raised with the specific intention of increasing investment and capital stock. And to a smaller
extent, this holds even for developed countries. It is for this neglect of the expenditure side of the
government's budget that Mishan calls all those who support the theory of shift of burden to future
generations, the burden mongers'.12 The net effect of any debt operation, therefore, need not be
burdensome for the future generations at all.
There is, however, one clear-cut case where the burden of the debt can be passed on to the future
generations. It is when the debts are raised externally. The current generation receives the resources
(whether for consumption, or investment, or for destruction in a war) and the future generations pay back
the debt. The future generations may not feel the burden on account of increased productivity etc., but the
burden of repayment certainly lies on them.
In conclusion, therefore, we may say that public debt (for that matter, even taxation) will put a burden on
future generations if two conditions are satisfied:
(i) the present generation does not reduce its savings, and
(i) the government does not add to the capital stock and productive capacity of the country.
While arguing this problem, different authors have made alternative assumptions regarding the response
pattern of the private sector and the expenditure policy of the government and have thus reached non-
identical conclusions. The thinking on the possibility of shifting debt burden to the future generations ignores
the economic implications and ill effects of the debt trap in which the government may find itself. This is a
manifestation of a real burdent which is worth avoiding.
 DEBT REDEMPTION

The traditional thinking on this problem has already been noted. It prescribed a policy of paying off the
public debt as soon as possible (though in practice some governments defaulted in debt repayment and
even repudiated it). Current thinking, however, places debt retirement in the context of over-all debt and
fiscal policies of the government and favours repayment of the debt under normal conditions.
One simple way of ending the debt obligations is to repudiate the debt. But it is unethical on the part of
the government to do so. Such an action erodes credit standing of the government and creates
difficulties for its future borrowing programmes. It is also disastrous for the financial system as a whole
and more so for those individual creditors who had invested their life-long savings in government debt or
who were relying upon the interest payments as a regular source of income.
There are two systematic approaches for retiring public debt. The first is to create a sinking fund in which
the government regularly puts aside some money and uses the accumulated fund for periodic and partial
retirement of the debt. The second approach is that of regularly retiring a small portion of the debt every
year. It is obvious that for either method of debt retirement, the government budget must have an over-
all surplus. Alternatively, the government may resort to printing of additional currency.
Sinking fund approach is followed in several countries. But this method can succeed in retiring the debt
only if the government has a substantial budgetary saving every year, uses the saved amount for this
purpose and does not resort to additional borrowings. Interest earned on the balances should also be
credited to the sinking fund. In olden days, public debt was usually raised during wars and other
emergencies and could not be paid off quickly. Therefore, sinking fund technique was considered a sound
and practical one. However, of late, this practice has degenerated into only a semblance of it. Compared to
the total outstanding debt the amounts credited to the fund are paltry. Sometimes, even authorized
amounts are not credited to the fund or they are even diverted to other uses.
 DEBT REDEMPTION

The method of paying off a portion of the debt every year may be effected in two ways. Firstly, the loans
outstanding may have staggered maturity dates. The public debt in this case can be in the form of serial bonds.
The advantage of this method is that the repayment obligations are well-spread over time and do not
concentrate the burden in a single year. It may not, however, be always possible to serialize the existing bonds
without unduly disturbing the government bonds market. Accordingly, the second method adopted is that of
earmarking a portion of the budget for debt retirement, purchasing the bonds in the market and canceling
them. The danger with this method is that it is of a voluntary character. Under short-term pressures, a
government may not adhere to the practice resulting in 'gap’ years.
When the government does not want to reduce its outstanding debt obligations, it may "fund the maturing
loans. This means that the existing debt is converted into a new one of longer maturity. The holders of
maturing debt are given an option to subscribe to the new debt by surrendering the older one. In addition,
fresh cash subscriptions may also be accepted. Funding is considered quite a legitimate alternative to retiring
the debt when the government is not in a position to do so or does not want to do so for policy reasons. In
India, it is a normal practice to borrow in excess of maturing loans resulting in a continuous addition to our
public debt.
It is noteworthy that these days, a reduction in outstanding debt liabilities of a modern government has
become a rare phenomenon. This is because of several reasons including the following.
• Indispensable role of public debt in being a foundation of the modem financial system.
• Potential of using public debt for regulating the financial system.
• Potential of using public debt for accelerating economic growth, and achieving various socio economic goals
like stabilization.
 SOME ISSUES IN DEBT MANAGEMENT
The term debt management refers to the formulation and implementation of a debt policy designed to
achieve certain objectives. According to the traditional philosophy, debt management consisted of
minimizing its interest cost and paying it off as early as possible. However, a modern welfare state uses
debt management as a policy tool for achieving various socio-economic objectives. Of course, every
government is still interested in keeping the interest cost to the minimum possible but if this objective is in
conflict with other objectives, it is sacrificed. Other important objectives before authorities include
economic stabilization, growth, employment and overall soundness of the financial system as a whole.
Debt management policy has to run in harmony with the monetary management of the country. They both
influence stabilization and economic growth. Open market operations are usually conducted by
sale/purchase of government securities. Through general and selective credit controls, monetary policy
tries to influence the volume and flows of funds and thereby the working of the entire economy. The way
in which debt management can also contribute to this policy objective has been discussed above. It has
also been seen how the objective of reducing interest cost on debt can come into conflict with the anti-
cyclical monetary policy of the country.
It should be noted that the aggregate volume of outstanding debt reflects a cumulative effect of budgetary
policy of the government. The volume of debt increases or decreases in line with deficit or surplus
budgeting. But monetary policy can aim to alter the volume and composition of money and credit without
any such constraint. In the case of public debt, the management part would mainly comprise changing its
maturity composition so as to affect its yield structure and liquidity content. But it must be reiterated that
monetary policy and public debt are closely linked.
In a big country with a multi-layer government, effort must be made to ensure of inter-government
coordination. Care has also to be taken to ensure that their borrowing programmes and terms and
conditions of loans to be raised do not come in conflict with each other. Normally, the national government
is able to borrow at lower rates than a sub-national government. Therefore, the rates of interest offered on
central and state governments loans should vary to accommodate this fact. Again - different governments
should avoid entering the market at the same time or in quick succession, particularly if the availability of
funds in the market is limited compared with combined requirements of the governments. In India, the
task of coordination in all these aspects is entrusted to the Reserve Bank of India. It advises them regarding
the timings, terms, and the amounts of loans that can be raised in the market without undue difficulty.