Accounting For Assest | Course Paper

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LECTURE EIGHT

ALTERNATIVES TO TAXATIONS

8.1 INTRODUCTION

8.2 LECTURE OBJECTIVE

PUBLIC DEBT

The government of a country gets its income from two sources:

i). Public Revenue and

ii). Public Borrowing or Public Debt.

Public revenue consists of money that the state is under no obligation to return to the very

individuals from whom it has obtained. Public debt, on the contrary, carries with it the

obligation on the part of the state to pay the money back to the persons from whom it has

been received.

8.3 THEORY OF PUBLIC DEBT

Public debt is of recent growth and was not heard of prior to the 18th century. The classical

economists were generally against the public debt. They assumed that individual consumer

and business firms make use of the resources more efficiently. Thus, under a fully employed

economy, the state can acquire resources by public debt only at the cost of private sector

where they are more efficiently used.

The next chapter introduces you to the other sources of government finances. Apart from

taxation which constitutes over 90 % of government funds there are other sources which need

to be explained.

At the end of the lecture you should be able to:

a) Explain the various sources of public debts

b) Discuss the ways that can be adopted to redeem public debts

c) Discuss the effects of public debt in an economy

d) Compute the public sector borrowing requirement

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It was Keynes who effected a truly significant revision in the theory of public debt. He

rejected the classical view of a free enterprise economy which is self-equilibrating at full

employment level. He developed and advanced the concept of under-employment

equilibrium. Resources in the private hands may remain unemployed for relatively long

periods if corrective or compensating action is not taken by the government.

During World War II and in the post-war years, the size of public debt increased enormously.

In modern times borrowing by the state has become a normal method of government finance

along with other sources such as taxes, fees, etc. The government may borrow from banks,

business-houses, other organizations and individuals. Besides, it can borrow within the

country or from outside. The government loan is generally in the form of bonds (or treasury

bills if the loan is required for short periods) which are promises of the government to pay to

the holders of these promises the principal sum along with interest at the agreed rate.

8.4 CLASSIFICATION OF PUBLIC DEBT

Public debt has been classified in many ways, though all the classifications are not equally

useful.

i). Internal and External Debt. Internal debt refers to the public loans floated within the

country, while external debt refers to the obligations of a country to foreign

governments, foreign nationals or international institutions. Internally the government

borrows from private individuals, institutions, commercial banks etc. External loans

may help the government in difficult times, when internal resources are not sufficient to

meet the financial requirements.

ii). Productive and Unproductive Debt. Public debt is said to be productive if the

investment yields an income which will not only meet the yearly interest payments of

the debt but also help repay the principal over the long run. They help in the creation of

remunerative capital assets that yield revenue to the government. For example, loans

raised for the development of railways, irrigation projects e.t.c. are productive loans. On

the other hand, public debt incurred to cover budgetary deficits on revenue account is

classified as unproductive debt. It is also called dead-weight debt. They have no

existing assets. They do not create assets nor any income to the government. The

government may undertake certain projects through loans which may not be productive

in the sense given above but which may be really useful to the community, as for

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example, a railway line connecting a backward region, an irrigation work to prevent

famine conditions in an area and so on. In this sense, most public debt is productive.

But public debt may be contracted to finance a war. Such debt is unproductive because

it does not create an asset, it is a dead weight debt or a useless burden on the community

iii). Redeemable and Irredeemable Debt. The redeemable debts are those which the

government promises to pay off in future at a specified date: they are terminable loans.

Irredeemable debt refers to a debt which may not be redeemed at all but on which the

government promises to pay the interest regularly. These loans may be known as

perpetual debt. The redeemable loans may be further classified into short period and

long period loans depending upon the period of redemption.

iv). Funded and Unfunded Debt. Public debt is also classified into funded and unfunded or

floating debt. Broadly speaking, funded debt is a long-term debt, undertaken for

creating a permanent asset and the government normally makes arrangements about the

mode and time of repayment. Unfunded or floating debt is a relatively short period debt,

meant to meet current need. The government undertakes to pay off the unfunded debt in

a very short period, say within six months.

v). Compulsory and Voluntary Debt. Generally, government debt is of a voluntary type,

that is individuals and institutions are invited to take up government bonds freely. On

the other hand, a compulsory loan implying force is not common in modern times.

However, pressure may be applied by the government at certain times in selling its

bonds.

vi). Marketed and non marketed debt. A marketed debt is one in which the debt

instruments are negotiable. That is it can be freely bought and sold in the market. Non-

marketable debts are those debts such as savings bonds which cannot be bought and

sold in stock-exchange markets.

vii). Callable and non callable. Callable debts are those debts which the government can

repay even before the period of maturity, whenever it is found convenient for the

government to do so. The government can pay back these types of debts, whenever it

enjoys surplus funds, or when the prevailing interest rates are low. Non- callable debts

cannot be repaid in this manner. It can be repaid only at the time of maturity.

viii). Short term, medium term and long term debt. Short term debts are those debts which

mature within a period of three to six months. These loans are drawn from the central

bank by using the credit instrument of treasury bills. Medium term loans are those loans

which mature within a period of one to ten years. Long-term loans mature for over ten

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years. They are usually raised for financing development projects and carry a high rate

of interest.

ix). Gross debt and net debt. Gross debt refers to the total debt obligation of a government

outstanding at a particular time, whereas net debt is gross debt minus sinking fund or

other assets crated for the repayment of loans.

8.5 WHY IS PUBLIC DEBT INCURRED?

Public loans in modern times are necessary to meet important situations. They can be

explained as below:

i). To meet budget deficits. Modern governments do not have large accumulated balances

or treasure to meet any budget deficit. Normally, the annual expenditure of the

government should be and is met by annual income. But because of many

circumstances the yield from taxation and other sources may not be equal to the actual

expenditure. Similarly, there may be unplanned and unexpected emergency situations

like major fires, floods and famines. Short-term borrowing is ordinarily used to meet

these emergencies.

ii). To meet war expenditure. Modern warfare is so costly that the normal income through

taxation falls short of the actual war expenditure. Besides, taxation beyond certain

limits has disastrous consequences for production, and thus interferes with the most

important objective during a war, viz., the winning of the war. Moreover, a public loan

is better and easier method of collecting revenue than taxation. Governments, therefore,

have to borrow extensively from individuals and institutions towards war financing. In

fact, the enormous increase in public debt in most countries is due mainly to the First

and Second World Wars.

iii). To remedy a depression. Public borrowing is considered very useful to remedy a

depression; in fact, the strongest case for public borrowing is as a remedy for

depression. During a period of depression, the level of economic activity is low,

resulting in low production and unemployment. The depression and unemployment are

generally due to deficiency of demand for goods and services. Many economists like

Keynes have advocated increased public expenditure financed through borrowing and

not through taxation, for while taxation will reduce incomes and demand still further,

borrowing will have no such effect. Besides, loans enable the government to make use

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of idle and unutilized funds of the public. Thus, there is a strong justification in favour

of public borrowing to cure unemployment.

iv). To develop the economy. Public loans are resorted to for development purposes. Even

advanced countries have to undertake the construction of public works like roads,

railways, irrigation works, powerhouses, etc., for accelerating their economic progress.

Underdeveloped countries interested in the development of their natural resources to the

optimum level find public borrowing a very useful device to finance the various

development projects.

v). To finance social overheads. Public debt is used to finance the creation and

development of social overheads capital like education and health care facilities. These

basic facilities require huge investments, which cannot be met by ordinary source like

taxation. Hence modern governments utilize borrowed money to finance these projects.

The first factor, mentioned above, is only to meet temporary difficulties and is soon repaid

out of tax receipts in the subsequent period. The second cause of public borrowing—the

prosecution of a war—has been probably the most important factor for increasing public debt

in all major countries in recent years. But this and the first factor are of an unplanned type.

But the third and fourth cases may be called planned borrowings, for the Government

deliberately plans to use the proceeds of public debt to finance certain specific projects. In

this case, the Government may borrow resources and would otherwise have been used by the

private sector and also resources that may remain unemployed.

8.6 SOURCES OF PUBLIC BORROWING

Every government has two major sources of borrowing – internal and external. Internally, the

government can borrow from individuals, financial institutions, commercial banks and the

central bank. Externally, the government borrows from individuals and banks, international

institutions and foreign governments.

Borrowing from Individuals

When individuals purchase government bonds, they are diverting funds from private use to

government use. Individuals may be able to subscribe to government bonds either through

curtailment of current consumption needs (this may be very rare) or through diversion of

funds from their own business or diverting funds into government bonds from corporate

securities. Normally, the sale of government bonds to individuals should not curtail either

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consumption or business expansion. To a large measure, the bonds will be absorbed out of

funds that would have been lying idle or would have been used to buy other securities.

Borrowing from Non-banking Financial Institutions

More important than individual subscribers to government bonds are the financial institutions

such as insurance companies, trusts, mutual savings banks, etc. These non-banking financial

institutions prefer government bonds because of the security provided by the latter and also

due to their high negotiability and liquidity. The rate of interest is low and hence in many

cases financial institutions may prefer high-risk (i.e. high-return securities) particularly

equities. When non-banking financial institutions fake up government bonds, they do so to

reduce their cash holdings.

Borrowing from Commercial Banks

While individuals and non-banking financial institutions take up government bonds out of

their own funds, commercial banks can do so by creating additional purchasing power known

as credit creation. The banking system as a whole can make additional loans up to an amount

several times as great as the excess cash reserves. This is possible because the loans the

bankers make are typically book entries in the names of borrowers who pay in the form of

cheques to others who have also bank accounts. The result is that so long as cash is not

withdrawn from the banks, it serves as the basis for the expansion of loans.

Commercial banks can subscribe to government loans through creation of credit. They need

not contract their other loans and advances. Whenever the banking system has excess cash

reserves, it can absorb an amount of government bonds considerably greater than the excess

cash reserves. It is important to note that the power to buy bonds is essentially created rather

than merely transferred. So if commercial banks create additional purchasing power and

place it at the disposal of the government to finance the latter’s expenditures, inflationary

pressures will be generated (if previously, the economy has been working at full

employment).

Borrowing from the Central Bank

The central Bank of the country also subscribes to government loans. The action is exactly

similar to the system of creation of additional purchasing power by the commercial banking

system. By purchasing government bonds, the central bank credits the account of the govern-

ment. The latter pays to its creditors out of its account with the central Bank. Those who have

received cheques from the government on the central bank deposit the amount with their

banks. These banks find themselves with large cash reserves which become the basis for

additional loans and advances. It will be seen that borrowing from the central bank is the

most expansionary of all the sources for not only the government secures funds for its

expenditure but the commercial banking system gets additional cash which can be used as the

basis for further credit expansion.

While the borrowings from individuals and financial institutions are simply transfer of funds

from private to government use and, therefore, will not be expansionary in their effect on the

economy (unless the funds were previously lying idle and are being activised through

government borrowing), borrowing from the commercial banking system and the central

bank will have expansionary effect.

Borrowing from External Sources

Government may borrow from other countries too. These borrowings can be used to finance

war expenditure, or to produce defence equipment, or to pay for development projects, or to