Chapter 10: Public Finance

10.1 Definition of Public Finance

Public finance can be defined as the collection of revenue by the central government and local government and all the expenditure (spending) of revenue in the provision of public utilities. According to Findlay Shirras (year) public finance is the study of the principals underlying the spending and raising of fund by public authorities.

10.2 Principles and Components of Public Finance

Principles of Public Finance

The constitution of Kenya has identified the following principles shall guide all aspects of public finance in the Republic–

  • There shall be openness and accountability, including public participation in financial matters;
  • The public finance system shall promote an equitable society, and in particular—
  • The burden of taxation shall be shared fairly:
    • Revenue raised nationally shall be shared equitably among national and county governments; and
    • expenditure shall promote the equitable development of the country, including by making special provision for marginalised groups and areas;
  • The burdens and benefits of the use of resources and public borrowing shall be shared equitably between present and future generations;
  • Public money shall be used in a prudent and responsible way; and
  • Financial management shall be responsible, and fiscal reporting shall be clear.

Components of Public Finance

The components of public finance include:

  • Public income/revenue: This refers to government income collected from various sources. The main sources of public revenue include taxes, fees, fines and penalties, income from properties, interest from loans repayment, sale of real assets and royalties.
  • Public expenditure: This refers to spending by the government. Public expenditure covers the canons or the principals which govern it and its effects on production, employment, income distribution, stability and growth. It also includes reasons for increase in public expenditure and changes in the pattern.
  • Public debt: When public revenue falls short of public expenditure, the government borrows to meet the gap. This is the public debt. Therefore public debt includes reasons, methods and sources of public debts, its effects on production, consumption, income distribution and economy, the burden of public debt and methods of debt redemption.
  • Financial administration: The aim of financial administration is to control processes and operations of public revenue, public expenditure and public debt. The scope of financial administration includes the collection, custody and disbursement of public money, the coordination of expenditure according to a well-formulated plan, the management of public debt and the general control of the financial operations of the state. It also includes the preparation of the budget, its execution and auditing of the state.

Purpose of Public Finance

  • To ensure redistribution of wealth to all persons in the society i.e. both the rich and the poor are taxed and poor are given inform of housing, health care, education and other amenities
  • To control the consumption of harmful products. heavy taxes are levied on commodities e.g. alcoholic beverages and cigarettes
  • Provision of public goods and services. This include police protection, maintenance of law and order, public health care, disaster management and public infrastructure. This all is aided by public finance through the government.
  • It ensures collection of revenue where the government uses revenue to finance its activities
  • It also promotes equitable regional development. The government tries to attain balanced regional development throughout the country. This is done through equitable resources allocation achieved through public finance.
  • To promote government investment. The government invests in particular projects e.g. electric power generation and distribution, construction of infrastructure and establishing industries. Such investments help to spur economic activities leading to economic growth and development throughout the country.
  • Promoting economic stability. The government adopts suitable policies aiming at spurring economic activities
  • Can reduce inflation i.e. the government can impose high taxes to reduce the high money in the economy.

10.3 Sources of Government Revenue

There are two major sources of public debt:

  • Public revenue
  • Public debt (government borrowing)
  • Public Revenue:

This refers to the income that the government gets from its citizens. The government can raise its revenues through taxation or non-tax activities. This gives rise to tax revenue and non-tax revenue.

  • Tax Revenue

Taxation is considered the most important source of public revenue. A tax is a compulsory payment made to the government without any direct benefit to the individual or firm. Revenue raised through taxation is used for the benefit of everyone in the society. Taxes can be classified as either direct or indirect taxes. Examples of direct tax are income tax, corporation tax, capital gains tax, estate duty/inheritance tax. Examples of indirect tax are custom duties, exercise duties, sales tax and value added tax. In the year 2005/2006 88% of the government revenue was from taxes while only 12 % was from other sources. Income tax contributes the highest percent, followed by customs and excise, and then VAT.

  • Non Tax Revenues
    • Surpluses from public corporations: A public corporation is an organization in which the government has a stake in its ownership. Public corporation normally provides essential services at a fee to the members of the society, e.g. Kenya Pipeline Company, KBC, KB Standards, etc. When the revenue earned from the supply of these services is more than the expense incurred, the surplus is paid to the government.
    • Fines and penalties: The judicial system in the country is made of courts and tribunals which impose fines and penalties on individuals, firms and corporations that break the laws of the land. The money raised from the fines and penalties becomes public revenue.
    • Fees: The government renders some direct services to its citizens such as licensing of marriages, issuing birth certificates, permits, issuing and renewal of driving licenses. For such services a small fee is usually charged. Such fees are a source of public revenue.
    • Income from properties: The government owns many properties. These include homes for which rent is charged, land for which rates are charged and game parks where entry fees are charged. This also is a source of public revenue.
    • Interest earned from loan repayments: The government charges interest on loans borrowed by the public through its corporations e.g. Agricultural Finance Corporation, Kenya Industrial Estate (K.I.E) etc. This interest collected constitutes part of the public revenue.
    • Sale of real assets: The government may sell assets that belong to its parastatals and other state corporations as well as local authority assets. This may take the form of privatization of state corporations, sale of council assets and direct sale of government properties (e.g. vehicles, Grand Regency)
    • Royalties: These are payments to the government arising from the use of natural resources by companies and individuals e.g. in the use of mines and forests.
      • Dividends and profits earned from government direct investments
      • Escheats; if a person dies without a proper will and has no legal heirs, properties of such a person revert to state and may constitute part of public revenue
    • Public Debt: This source of government revenue will be covered a little later in the course.

10.4 Purpose of Taxation

  • Raising revenue which is used by government in providing goods and services
  • Discouraging consumption of certain products e.g. beer/cigarettes.
  • Discouraging importation of certain products e.g. sugar in order to protect local industries i.e. heavy taxes on imports. When export duties are lowered, export trade increases.
  • Reducing inequality in income distribution by taxing the rich and using finances realized to finance activities that benefit the poor
  • Controlling inflation/maintaining economic stability: during times of prosperity, the government may raise tax levels to control unplanned expenditure by people. Excessive expenditure may raise inflation in the society. During tough economic times, tax rates may be reduce making goods relatively cheaper and thus encouraging consumption in the economy.
  • Helps in location of businesses. High tax on businesses located in urban areas would make entrepreneurs locate their businesses in rural areas where tax is less. This assists in solving localisation and delocalisation.
  • Protection of local industries. Heavy taxation makes imported goods more expensive than local ones. Individuals therefore prefer relatively cheaper locally manufactured goods. Local industries therefore have already market for their goods and are able to compete favourably with foreign firms.
  • Helps in correction of balance of payments .high tax on imported products discourage importation, thereby increasing balance of payments.

Adam Smith was the first economist who laid down four important canons of taxation which are the efficiency principals/canons of taxation to which were added few more by subsequent economists. This are conditions/guidelines which a good tax system ought to fulfill.

10.5 The Principles or Canons of Taxation

The canon of equality

The canon of equality, equity or justice is the most important canon of taxation. Smith explained it thus: “The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities, that is, in proportion to the revenue which the respectively enjoy under the protection of the State.” It means that every person should pay the tax according to his ability and not the same amount. It also means that everybody should not pay at the same rate. Rather, every taxpayer should pay the tax in proportion to his income. The rich should pay more and at a higher rate than the other person whose income is less. Thus this canon implies equality of sacrifice or ability to pay the tax in proportion to the income of the taxpayer.

The canon of certainty

According to smith, there should be certainty in taxation because uncertainty breeds corruption. By the canon of certainty he means that “the tax which each individual is bound to pay ought to be certain, and quantity to be paid ought all to be clear and plain to the contributor and to every other person.” Thus this canon requires that there should be no element of arbitrariness in a tax. It should be clear to every taxpayer as to what, when, and where the tax is to be paid. Nothing should be left to the direction of the income tax department. Certainly also means that the state should also be certain about the amount of tax revenue and the time when it is expected to flow in the exchequer.

The canon of convenience

This canon lays down that both the time and manner of payment should be convenient to the taxpayer. In the words of smith, “Every tax ought to be levied at the time or in the manner in which it is most likely to be convenient for the contributor to pay.” In India, the payment of land revenue is in keeping with this canon because it is to be paid after harvesting. Similarly, the payment of sales tax and excise duty by the consumer is also convenient because he pays these taxes when he buys commodities and at a time when he has the means to buy. The manner of payment is very convenient to him because these taxes are included in the prices of commodities.

The canon of economy

Every tax should satisfy the canon of economy in two ways. First, it should be economical for the state to collect it. If the cost of collection in the form of salaries of tax officials is more than what the tax brings as revenue, such a tax is uneconomical, and hence it should not be levied. Second, it should be economical to the taxpayer. It means that he should have sufficient money left with him after paying the tax. A very heavy tax on incomes will discourage saving and investment, and thus adversely affect the productive capacity of the community. Smith states this canon in these words: “Every tax ought to be so contrived as both to take out and to keep out of the pockets of the people as little as possible, over and above what it brings into the public treasury of the state.”

The canon of productivity

According to this canon, a tax should be productive in the sense that it should bring large revenue which should be adequate for the government. But it does not mean that in its efforts to raise more revenue, the government should tax the people heavily. Such an effort would adversely affect the productive capacity of the economy. Further, this canon implies that one tax which brings large revenue is better than a number of taxes which bring small revenue. Many taxes may not be productive. They may also be uneconomical

The canon of elasticity

This canon is closely related to that of productivity. The canon of elasticity requires that the government should be able to raise the rates of axes when it is in need of more revenue. In other words, taxes should be elastic. The best example is excise duties. They can be levied on any number of commodities and their rates can be increased every year in order to raise more revenue. But care has to be taken that the rates of excise duties should not be so raised that they may encourage inflationary pressures in the economy.

The canon of flexibility

Flexibility in taxation is different from elasticity. Flexibility means that there should be no rigidity in taxation. The tax system can be changed to meet the revenue requirements of the state. On the other hand, elasticity in taxation means that the revenues can be increased under the prevailing tax system. But there cannot be any elasticity in taxation without flexibility because some change is required in the rates and structure of taxes if the state wants to increase revenue.

The canon of simplicity

The tax system should be simple, plain and intelligible to the common taxpayer. The tax system should not be complicated. It should be simple to understand as to how it is to be calculated and how much is it to be paid. The form/forms to be filled up for calculation and payment of a tax should be simple and intelligible to the taxpayer. This canon is essential in order to avoid ambiguity, corruption and oppression on the part of the tax department.

The canon of diversity

There should be diversity or variety in taxation. A single or a few taxes would neither meet the revenue requirements of the state nor satisfy the canon of equity. There should, therefore, be a variety of taxes so that all citizens should contribute towards the state revenues according to their ability to pay. There should be a variety of direct and indirect taxes. But a large multiplicity of taxes will be difficult to administer and hence uneconomical.

The canon of expediency

This implies that possibility of imposing tax should be taken into account from different angles i.e. reaction upon tax payers should also be taken into one should do what is convenient rather than what is morally right.

The Canon of Coordination

In democratic countries taxes are imposed by state, central state and local government and it is therefore desirable that there must be desirable coordination between different taxes imposed by different taxing is very much needed considering the interest of tax payer and government especially in democratic countries.

Characteristics/Essentials of a Good Tax System

  • Maximum social benefit thus reducing inequalities.
  • Just distribution of tax burden.
    • Universal application of taxes i.e. each person should pay tax according to his ability to pay and individuals possessing same ability should contribute same amount by way of taxes.
  • Revenues should increase with increase in national income.
  • Tax should be balanced.
  • Tax structure should facilitate use of fiscal policy.

Impact and Incidence of Tax

The person on whom tax is initially imposed may either bear the whole of it or pass part or the whole of it to someone else. The burden on the initial person is known as the impact of tax. The final resting place of tax burden is known as the incidence of tax.

10.6 Classification/Types of Taxes

Classification According to Impact of Tax

  • Direct tax
  • Indirect tax

Direct Tax

Direct taxes occur when impact and incidence of tax are on the same person. It is not possible for such an individual to shift any part of tax to anybody else. The examples include: personal income tax (PAYE), death duty, profits and property of individual, corporation tax, stamp duty (tax paid in areas e.g. conveyancing of land or securities transfer from one person to another), wealth tax which is levied on personal wealth that goes beyond a certain limit i.e. on land, houses, accumulated profits, savings and all realizable assets, motor vehicle licence fees, fuel levies paid by motorists companies capital transfer tax and capital gains tax.

Merits of Direct Taxes

  • Economical in collection
  • Enhances equality and fairness because payment is based on size of citizen’s income.
  • Tax revenue is certain as the government can compile income categories as well as contributors in each category from annual returns made by tax contributors. The tax payer also knows how much to pay.
  • The society is conscious(civic conscious) as the tax payer feels the pinch of paying tax and is therefore keen in examining expenditure ensuring the government uses correctly what it collects.
  • There are no leakages as the taxes are mostly paid directly to tax authorities and not collected by middlemen.
  • Elasticity is enabled as they can be expanded to cover as many areas as desirable. In periods of decreased economic stability, tax rates are reduced to ensure people have money to spend.
  • Does not affect price of goods and services as this tax is not inflationary as it only affects consumers’ disposable incomes and not the price of goods and services.
  • Brings redistribution of wealth and this is mainly seen in progressive tax system where wealthier members are taxed more than poorer. The finances obtained from wealthier members are used to finance services that benefit poor members of community.
  • Usually simple to understand by both the contributor and collector.
  • Desirable as it only affects people who fall within the jurisdiction of income tax and corporation tax.
  • Flexible as this tax is elastic i.e. can be raised or reduced according to needs of the society.

Demerits of Direct Taxes

  • Possible tax evasion by either falsifying information or just ignoring payments
  • Unpopular with citizens as the burden of tax is borne by tax payer directly.
  • No consultations are made of tax payers
  • In most developing countries most people have low incomes and the government of these countries rely on direct taxes as the main source of revenue
  • It is not imposed on all citizens i.e. low income earners outside tax brackets are exempted and this makes them not contribute anything to state and they are therefore not interested in scrutinizing government expenditure to ensure proper use of resources.
  • It is a deterrent to saving as high taxation on peoples income would reduce their ability to save as it leaves them with less disposable income.
  • Encourages capital flight because direct taxes like corporation taxes encourage capital flight from the country. This is because the high taxes in country force foreign investors to withdraw their investments and transfer them to countries with lower taxes.
  • Inconvenience as the tax payer has to submit statement of his total income along with the sources of income from which it is derived which is generally subject to complications.
  • Possibility of injustice as it is difficult to access income of all classes accurately. Hence, it may not fall with equal weight on all classes. Moreover direct taxes are arbitrary fixed by the government and they may not be dealt on basis of ability to pay.

Indirect Tax/Commodity Tax

This is a type of tax whereby the person on whom it is initially imposed may not shoulder the whole tax burden but may shift either the whole or part of it to someone is usually based on consumption of goods and services. Examples include: VAT, import duty, export duty (discourages exports) etc.

Merits of Indirect Tax

  • Coverage: the government raises high amounts because taxes are levied on a wide range of essential commodities and every member of community will be taxed.
  • Convenient because it is not paid in lump sum but in small bits as one buys the commodity and the pinch is not experienced and tax is hidden in price of commodity and therefore the payer may not be aware of it.
  • Difficult to evade because all those who buy the taxed commodity have to pay the tax.
  • Ease of collection: indirect taxes are collected by manufacturers and sellers of goods and services and then remitted in lumpsum payment to tax authorities.
  • Promotes social welfare e.g. harmful products like cigarettes and alcoholic drinks may be taxed heavily to discourage their consumption.
  • Can be used selectively to achieve a given objective like price i.e. high tax is likely to increase product price.
  • Promotes equality as this tax is charged at fixed rates to all the people in the society.
  • It is flexible/elastic as it enables the government to either raise or reduce tax rate to suit the prevailing economic situation in the country. Any slight increase in tax rate greatly increases the revenue.
  • Tax payment is voluntary e.g. if one doesn’t want to pay tax, he/she would only need to avoid the taxed commodity i.e. those who do not take beer don’t pay tax on it.
  • Stimulates effort as increase in this tax is likely to stimulate effort as people struggle to maintain their current standards of living.

Demerits of Indirect Tax

  • Uncertainty in revenue yield as one may not predict the amount of revenue as it is not easy to forecast sales.
  • Expensive to administer as the state has to employ many tax inspectors who ensure that the correct amount of taxes are being collected and remitted to tax authorities.
  • Regressive/less equitable as the burden falls more heavily on consumers with low incomes compared to high income earners
  • May fuel inflation/increase price of commodities
  • Encourages falsification of records as revenues depends on the sales recorded by traders so as to pay less.
  • Lacks contributors’ awareness, thus tax payers do not take an active interest in government spending.
  • Leads to low savings due to increasing tax and the extra income consumers could have saved and invested decreases as consumers pay more for goods and services.
  • Impartial/can be avoided as it usually targets few sets of goods e.g. cigarettes, alcoholic beverages and motor vehicles and consumers of these goods are heavily penalized.
  • Absence of civic consciousness.

Classification based on rates of tax or tax structure

Taxes are classified according to the relationship between amount paid as tax and income of the tax payer.

  • Regressive tax: takes a higher proportion of low income earners as compared to high income earners
  • Proportional tax: tax payers pay a fixed percentage of their income as tax.
  • Digressive tax: combines progressive and proportional tax systems. The tax rate keeps rising up to a maximum limit.
  • Progressive tax: amount paid increases proportionally

Merits of Progressive Tax

  • Helps in reduction of income inequalities. The higher income earners pay relatively more tax.
  • Reduced collection of tax as the revenue yielded is high but collection cost remains the same.
  • Motivation to work if rates are high as consumers will work harder to maintain their living standards.
  • Enhances distribution of resources as the rich are taxed more which reduces the gap between the rich and poor. The revenue raised from high income earners is used to improve welfare of poor.
  • Economical because the administrative tax do not rise with increase in tax rates.
  • Easily elastic can be helpful in curbing inflation.

Demerits of Progressive Tax

  • Discourages savings as those who work hard and earn more income are taxed heavily. Their savings are also taxed at increasing rates.
  • Encourages tax evasion as high incomes attracts high taxes. People will try to conceal some of their incomes.
  • Oppressive as the tax impair savings and thus hurt the levels of investment
  • Makes some assumption i.e. progressive taxes assumes that persons earning the same income derive the same benefits from that income and this is not always true.
  • Deterrent to work as high tax rate may deter people from working harder e.g. a progressive tax on personal income would make an individual to opt for leisure instead of working overtime to get extra income.
  • Inconvenient because taxation inconveniences tax-payer who has to comply with complicated formalities relating to sources of income as well as expenses incurred while generating it.
  • Deterrent to investment as heavy taxation deter entrepreneurs from investing in highly risky but profitable areas

10.7 Meaning of Fiscal Policy

Fiscal policy is the management of public finance by the government so as to influence the economy in the desired direction. It is the conduct by the government of its financial operations in the pursuit of economic stabilization. The government must frame its taxation, expenditure and public debt policy so as to secure economic stability with growth.

Comparison between Fiscal Policy and Monetary Policy

Both aim at regulating the level of aggregate demand for domestic goods and services or the output of the economy.

Fiscal policy is formulated and enforced by the government directly. While monetary policy is formulated and enforced by the Central Bank. However, there is nowhere in the world where the Central Bank is thoroughly independent of the government. It functions under the governor, in Kenya under the Ministry of Finance.

Fiscal policy is government revenue, expenditure and debt management with a view to have a direct impact on the economy i.e. so as to manage the allocation of resources and the flow of funds in order to affect the level of income, prices, employment and output. Monetary policy on the other hand is government policy in relation to money supply to achieve the same policies as those of taxation.

Origin of Fiscal Policy

Until the great depression of 1930, monetary policy had been the main instrument of economic stabilization. The great depression saw the failure of free enterprise economy. During this period, under monetary policy economies failed completely. The prices went down men and machines were thrown out of work. Demand contracted and workers had no purchasing power to buy goods and services. Investment failed to peak up even a 1% rate of interest failed to attract the demand for investment. Capital and the capitalist system collapsed suggesting monetary policy could no longer click. It was against this background of universal despair that Keynes in his general theory (1936) gave an insight into the determinants of national income and the role of government in making capitalist economies to work.

Objectives of Fiscal Policy

The objectives of fiscal policy are the same as monetary policy objectives these are:

  • Stabilization of the economy
  • Price stability
  • Economic growth
  • Full employment
  • Redistribution of income and wealth
  • Equilibrium in balance of payments

Fiscal Policy Instruments

The fundamental objects of the fiscal policy are to find revenue for the government to finance its growing expenditure. Fiscal policy seeks to achieve its objectives through 3 major ways.

  • Taxation
  • Public expenditure
  • Public debt management

Since we have already discussed taxation, we will now talk about government expenditure and public debt as methods of implementing fiscal policy. However, we will first address the topic of public budget. It is an important one at this level.

10.8 National Budget

National budget is a statement of estimates /proposals of the way the government plans to raise finances and how such finances are to be spent in a given financial year.

Types of Budgets

There are three major types of budgets

  • Deficit: budgeted revenue is less than budgeted expenditure.
  • Balanced: budgeted expenditure equals the budgeted revenue.
  • Surplus: budgeted revenue is more than the budgeted expenditure.

The raising of government revenue and expenditure of the revenue so raised in order to achieve the desired objectives is known as the fiscal policy. Budgetary policies enable the government to realize its budget objectives and the ultimate goal is to ensure economic stability prevails in the country.

The Budget as a Tool for Planning

  • Outlines all the government expenditure.
  • Outlines government revenue.
  • Enables government planning of programmes that lead to economic growth and development in a country.
  • Introducing changes in taxation. All changes are contained in annual budget.
  • Regulating money supply. Here, monetary policy instruments are used.
  • Assists in stimulating economic activity. When the level of economic activity is low, budget can be used to increase government expenditure in the economy.

Factors Determining Taxable Capacity

The taxable capacity of a country depends on the following factors:

Size of national income: Taxable capacity depends on the size of national income or wealth or natural resources of a country and the extent to which they are developed. The higher the national income, the higher the taxable capacity of a country, and vice versa.

Distribution of national income: In a country where there is inequality of income, taxable capacity is high because the few rich can be taxed heavily. On the other hand, if there is equality of income, the taxable capacity is relatively low because the government expenditure to uplift the poor will be less.

Stability of income: In developed countries, the incomes of individuals are stable, the taxable capacity is high. But where incomes are subject to fluctuations and are unstable, as in underdeveloped countries, the taxable capacity is low.

Size and growth of population: If the size and growth rate of population are high, the per capita income will be low. So the taxable capacity will also be low, and vice versa.

Standard of living: If the standard of living of the people is high, it means that people are spending more on comforts and luxuries. So their capacity to pay taxes is also high, and vice versa.

Tax system: The type of tax system affects the taxable capacity. A progressive tax system has a higher taxable capacity because it falls on higher income groups, as in the case of direct taxes on incomes. On the other hand, regressive indirect taxes which fall heavily on low income groups have low taxable capacity.

Sources of Revenue: Taxable capacity depends on the number of sources of revenue available to the government. The greater the number of revenue sources that are productive, the higher the taxable capacity, and vice versa.

Public expenditure: If public expenditure is meant to increase the welfare of the people, people do not mind paying taxes. If the government spends money on unnecessary and unproductive projects, people will not be willing to pay taxes. Thus taxable capacity is high for productive public expenditure which increases national income, and vice versa.

Taxing and spending income. Taxable capacity depends on the manner and timing of both taxing and spending income by the government. This involves compensatory spending and compensatory taxation. Compensatory spending compensates for the fall in private investment and increases output, employment and income. Compensatory taxation compensates for the fall in private expenditure, compensates for the fall in private expenditure, saving or investment by taxing the people. Both tend to increase economic activity and national income thereby raising the taxable capacity.

Price situation: Taxable capacity is determined by the price situation in the country. If prices are rising, the real income of the people falls and their taxable capacity declines. The converse is the case when prices are falling.

Organization of the economy: If the economy s primarily agricultural, the taxable capacity will be low because the income from agricultural operations is uncertain. On the other hand, an industrial economy has high taxable capacity because the industrial sector generates larger income than the agricultural sector.

Psychology of the people: Taxable capacity also depends upon the psychology of the people. People are prepared to more pay taxes honestly and willingly during a war and natural calamities like floods, earthquakes, etc. As pointed out by Findlay Shirras, “the psychology of the people has much to do with the extent of taxable capacity. People are often willing to bear heavier taxation on patriotic or sentimental grounds. On the other hand, adverse psychology of the people has much to do with the extent of taxable capacity. People are often willing to bear heavier taxation patriotic or sentimental grounds. On the other hand, adverse psychology of the people towards the payment of the taxes lowers down the taxable capacity.

Political conditions: What should be the level of taxation is a political factor these days. A country with has political stability, its taxable capacity will be high if there is political instability or the government is unsympathetic and repressive, the taxable capacity will be low.

10.9 Public/Government Expenditure

Government expenditure, also known as public expenditure, refers to spending by government of finances it has raised.

Categories of Public/Government Expenditure

Capital/development expenditure: This refers to government spending on projects aimed at facilitating economic development in a country e.g. road construction, water provision, electrification of rural areas etc.

Recurrent/consumption expenditure: Refers to government spending that takes place on a regular basis. Every financial year the government has to allocate funds to meet such expenditure e.g. payment of salaries to civil servants, provision of drugs in public hospitals and fuelling government vehicles and protecting the country from external invasion.

Transfer payments: The government makes transfer payments to recipients who do not directly contribute to a country national income. This transfer payments include amount spent by the government on disaster management e.g. famine relief, grants to educational institutions and pension to retirees.

Principles of Public/Government Expenditure

The principles of government expenditure are considerations to be taken into account before the government incurs any expenditure and they are also known as canons of government expenditure.

  • Maximum social benefit: any public expenditure must be incurred in such a way that majority of people are able to reap maximum benefit out of it.
  • Economy: public expenditure must be incurred in the most economical way by avoiding any possible waste or not spend more than what has been raised.
  • Sanctions: before public expenditure is incurred, it must be sanctioned/approved by relevant authority e.g. parliament in Kenya. This ensures that public authorities do not abuse their powers and spend public funds.
  • Elasticity/flexibility: expenditure policies should be able to change. This is so as to meet the prevailing economic situations e.g. war times; during drought, public expenditure should be incurred to avert hunger disaster. When drought is not there, expenditure should be incurred on development projects.
  • Equity/equitable distribution: public expenditure should be carried out with the aim of reducing income and wealth inequalities in the society. Expenditure should be distributed favourably to all sectors in the economy.
  • Proper financial management: public funds should be well managed. This should be facilitated by maintenance of proper accounting records which should be audited as required
  • Productivity: this ensures production is increased and efficiency enhanced i.e. a small proportion should be spent on non-development projects and a major proportion spent on development projects.
  • Surplus: the principle requires that government incurs current expenses based on its current revenue projections.
  • Canon of benefit: expenditure to provide maximum benefit to the society as a whole.

Effects of Public Expenditure

Effects of Public Expenditure on Production

According to Dalton, production and employment in a country depend on three factors:

  • Ability of the people to work, save, and invest;
  • Willingness to work, save and invest’
  • Diversion of economic resources as between different uses and localities.

Public expenditure influences these factors in a number of ways and thus helps in increasing production and employment within the country. The ability and Willingness to work, save and invest depend on the nature of expenditure. The former increase with the increase in the efficiency of workers which, in turn, raises production and employment.

On Social Insurance. Public expenditure on social insurance benefits such as unemployment, sickness, maternity, old age pensions, etc. tends to increase the purchasing power of workers indirectly. When these facilities are provided by the state to the workers indirectly. When these facilities are provided by the state, the workers are not required to spend on them, thereby increase their real purchasing power. The money so saved is spent by them on other articles. It means an increase in their standard of living which raises their efficiency and production. If, on the other hand, the workers spend the money so saved on gambling, drinking, etc. their ability and willingness to save fall which adversely affect their ability and willingness to save fall which adversely affect their ability to work, thereby reducing production.

On Basic Facilities. Public expenditure on basic facilities also tends to raise efficiency and ability to work. When the state provides such basic facilities as cheap ration, low-rent houses, mid-day meals to children, cheap milk, etc. the ability to save increases. This, in turn, tends to raise their ability to work, thereby increasing production.

On Education and Public Health. Public expenditure on education and public health has direct welfare effects on society. Expenditure on education is regarded as investment in human capital because it helps in skill formation and thus raises the ability to work and produce core. Similarly, public health is also another form of investment in human capital. Healthy workers, who are free from diseases, work more and raise production.

On Economic Overheads, Basic Industries, etc. Public expenditure on economic overheads, basic industries, etc. also helps in increasing the productive capacity of the economy. Public expenditure on power, transport, communications, irrigation, soil erosion. Land reclamation, etc. tends to increase the supply of resources for production over a long period. Moreover, expenditure on roads, railways, and other means of transport also affects the mobility of men and materials, which, in turn help in increasing the productive capacity. Further, the development of basic industries like iron and steel, engineering, heavy chemicals, fertilizers, etc. is very helpful in the development of other industries. Again, public expenditure on river valley projects helps in providing larger employment opportunities. It provides protection against floods and drought, thereby avoiding loss of resources.

On Credit and Banking Facilities. Public expenditure in providing credit and baking facilities also helps in increasing the productive capacity of the economy. It is through bank nationalization and/or through state and cooperative banks and opening of a network of branches throughout the country that the state can provide cheap and better credit and banking facilities to agriculture, industry and trade, and thus help in increasing their productivity.

On Backward Regions and Areas. Public expenditure on the development of backward regions and depressed areas helps in providing employment through basic facilities. The private enterprise is shy to invest in these areas. It is only the state which by providing all types of basic facilities like roads, railways, power, industries, etc. develops such areas whereby the people get jobs and the production power of the area increases.

In the Form of Grants and Subsidies. Public expenditure in the form of grants and subsidies to farmers, firms and industries is highly productive. When there is a bumper crop, the prices of farm products fall considerably. The state can save them from disaster through price support. It can purchase their surplus stocks at fixed minimum prices. In order to encourage higher production, the state can provide such inputs as fertilizers, seeds, pump sets, etc. at subsidized prices. Similarly, the state can help develop industries by providing them subsidies. Some of the industries have high costs in the initial stage of production. As a result. The prices of their products are high and they are not in a position to compete in the market, and thus they meet an early death. To save such industries, public expenditure in the form of subsidies may enable them to develop without charging high process from its customers.

On Information. Public expenditure on providing information in the form of such publicity media as TV, commercial broadcast, etc. helps private and public enterprises in getting their products publicized. As a result, their sales and production increase. Similarly, public expenditure on employment news, bureaux and exchanges helps in placing the right man at the right job and in this way provides larger employment opportunities and tends to increase productivity.

Effects of Public Expenditure on Diversion of Resources

Public expenditure affects the pattern of production through the diversion of resources from existing uses to more productive uses. In fact, government expenditure in itself is a diversion of resources from private to public uses. Public expenditure induces people to divert their resources to more productive uses in the following ways:

  • On Infrastructure. Public expenditure on the development of roads and railways helps in diverting resources to more productive uses when the market for products becomes large. Again, public expenditure on generation of power supply and irrigation facilities helps in the diversion of resources to large industries and agriculture. Further, public expenditure on providing research technical education, etc. tends to divert economic resources in order to create conditions of economic stability. Further, when public expenditure is made on such long-run infrastructural facilities as roads, railways, power, irrigation, etc it is trying to divert resources from their present to future uses which are more productive.
  • On Backward Areas. Public expenditure on the development of backward regions or areas brings diversion of resources from more developed to less developed areas. Such diversion takes place when the government incurs more expenditure in the form of transport, power, and on the establishment of public enterprises in a backward region. Grants made by the government for the development of such areas helps in diverting natural and human resources from the developed to backward areas.
  • To private enterprise. Public expenditure in the form of loans and subsidies to private enterprise helps in the diversion of resources into productive channels. Sometimes loans and subsidies are made conditional. They are dependent on the quality of the product. In such cases, diversion of resources leads to the production of better quality product. In such cases, diversion of resources leads to the production of better quality products as against inferior goods
  • On defence. Public expenditure on defence or war leads to the greatest diversion of resource. Such expenditure diverts resources from peaceful uses to war uses. It is normally regarded as the wastage of human and material resources which can otherwise be used for social benefits. But to defend a country s the foremost duty of government. It provides security to life and property and saves the nation from foreign domination. All expenditure on defence is not wasteful rather it is productive indirectly. Defence expenditure on the construction of roads, bridges, aerodromes, shipyards, and on other means of transport and communications help in building infrastructure in the country which are ultimately used by the civilian population. It also provides employment to people engaged in their construction. Moreover, public expenditure incurred in maintaining the armed forces in the form of supplies of food, clothing and other materials increases their demand and production and helps in increasing employment opportunities manifold. No doubt, when resources are diverted from their private uses to war, their supplies to the masses are reduced which adversely affect their standard of living. But this is only a temporary phase so long as the war continues.

Effects of public expenditure on income distribution.

Public expenditure by increasing social welfare helps in reducing inequalities of income and wealth. According to Dalton, it is only progressive expenditure that tends to reduce inequalities. A progressive expenditure is one when a person with lower income receives larger benefits as compared to a person with higher income.

Public expenditure for purposes of income distribution is of two types: transfer expenditure and exhaustive expenditure. In the case of transfer expenditure, low income groups are given cash benefits in the form of unemployment, sickness, disablement, dependents, and maternity benefits, and old age pensions. All such expenditures by the state help the poor and middle income groups in raising their incomes indirectly. Exhaustive public expenditure also tends to reduce income in equalities and it is in the form of free and cheap services of commodities, such as free education, free medical facilities, free milk or meals to school children, free transport for school children and for workers subsidized rations, subsidized lunch to workers, rent – free quarters, etc.

There are also intangible benefits such as providing rent and recreation centres, public parks reading rooms and libraries etc. Which tend to raise the efficiency of workers indirectly. Such nonmonetary benefits increase the real income and standard of living of the workers and masses. Public expenditure of both transfer and exhaustive types helps in the redistribution of income. On the other hand, if such benefits reduce the desire to work and save, they will tend to reduce the incomes of the beneficiaries. Consequently, the inequalities are not reduced. To conclude with Dalton, “that system of public expenditure is best which has the strongest tendency to reduce the inequalities of incomes.

Effects of public expenditure on economic stability

Increase in public expenditure tends to raise national income, employment output, and prices. An increase in public expenditure during deflation increases the aggregate demand for goods and services and leads to a large increase in income via the multiplier process. It has the effect of raising disposable income thereby increasing consumption and investment expenditure of the people. The public expenditure includes expenditure on such public works as roads, canals, dams, parks, schools, hospitals and other buildings, etc. And on such relief measures as unemployment insurance, pensions, etc. Expenditure on public works creates demand for the products of private construction industries and helps in reviving them, while expenditure on relief measures stimulates the demand for consumer goods industries. But the effectiveness of public expenditure primarily depends upon the public work programme, its importance in the economic system, the volume and nature of public works and their planning and timing.

Effects of public expenditure on economic development

The effects of public expenditure on economic development lie in increasing the growth rate of the economy. But investment in the capital goods sector may increase production in the long run. Therefore, public expenditure should also be directed towards meeting the immediate needs of the economy, so as to raise agricultural and industrial production, and to increase the production of essential consumer goods.

Rise in growth rate of the economy: Public expenditure on the establishment of heavy and basic goods industries in the initial periods increases the growth rate of the economy. But investment in the capital goods sector may increase production in the long run. Therefore, public expenditure should also be directed towards meeting the immediate needs of the economy, so as to raise agricultural and industrial production, and to increase the production of essential consumer goods.

Increase in employment, income and production: Public expenditure on economic and social overheads provides larger employment opportunities, raises incomes and, above all, the productive capacity of the economy.

Increase in revenue and profit. To increase the production of certain essentials commodities, to end private monopoly in various spheres, and to control the “commanding heights” of the economy, the state starts public enterprises. These bring revenue to the government and profits.

Reduction in inequalities. Public expenditure tends to lessen inequalities of income and wealth by raising the earning capacity of the people. This is done by providing educational facilities and through skill formation

Help to private enterprise. Public expenditure helps in encouraging private enterprise by establishing state-owned financial and banking institutions to provide cheap credit.

Regional balance. Public expenditure helps in bringing about regional balance in the economy by diversifying industries in backward and less developed areas of the country. Thus, public expenditure is one of the important instruments for economic development.

Growth of Public Expenditure

There has been a phenomenal increase in public (centres, state and civic bodies) expenditure over the years. The following reasons are given for this.

Expansion of state activities. Adolph Wagner, a German economist, writing in 1883 propounded the law of Ever-increasing state activity. According to Wagner, public expenditure increases in response to the law of increasing expansion of public activities. He maintained that there is a persistent tendency both toward an intensive and expensive increase of state functions and activities. New duties are being continuously undertaken and old ones are being performed on a large scale. As a result, public expenditure is increasing steadily

Internal security. Wagner also referred to the maintenance of internal security as an important factor for the increase in government expenditure. Enforcement of law and order for maintaining peace and security has led to the expansion of legal and administrative systems and police force. These have led to the increase in public expenditure.

Defence. Every country pays greater attention to its defence preparedness against foreign attacks. As a result, public expenditure on equipping its armed forces with the latest armaments has increased. As Adam Smith said long ago, Defence is better than opulence.” So public expenditure on defence is essential.

Welfare activities. Wagner wrote about the increase is public expenditure due to the expansion of cultural and welfare activities of the state. Modern states are welfare sates which provide free education, medical facilities, and social security measures, maintain historical monuments, museums and public libraries, and encourage cultural, sports and health programmes.Consequently, public expenditure has tended to increase.

Population increase. The increase in population on account of better health and medical facilities leading to reduction in death rates has resulted in increasing public expenditure on the people. The state has to spend more on roads, railways, schools, colleges, houses, etc.

Urbanization. With the growth of population, there is migration of population form rural to urban areas in search of employment. Existing cities expand and new cities come up. These require huge public expenditure in schools, parks, zoos, houses, etc. Simultaneously, the expenditure on civic administration also increases.

Price Rise. In modern times, prices have a tendency to rise continuously with the increase in the growth rate of the economy. As a result, the government expenditure on goods and services increase. The rise in the cost of living further increases government expenditure by way of higher salaries and enhanced D.A. to its employees in various civil and military departments.

Economic Development. Modern governments are engaged in the development of their economies. They spend large sums on infrastructural facilities, on research and development in various fields, on the development agriculture and industry, on the development of public sector, etc. This has led to the increase in public expenditure.

Public Debt. The state borrows both internally and externally to meet its eve increasing public expenditure. This further raises public expenditure in the form of repayment of loans and interest charges.

Burden of democracy. Modern governments are democratic in nature. Countries are run on a multi-party system with elections after four or five years. Often governments fail due to lack of majority in the parliament. This necessitates frequent elections. This tends to increase public expenditure. Further, there are “pressure groups’” and “interest groups” within the parliament which want allocation of government funds for providing public services in their constituencies. Moreover, according to the World Bank, wide spread corruption in democratic countries has increased public expenditure manifold.

Development Expenditure of Developing Economies

Development expenditure refers to public (government) expenditure of developing the economy. The development expenditure of modern developing economies consists of expenditure on:

Social services like education, health, social security and others;

Economic services like agriculture, industries, minerals fuel and power, transport and communication and others

Community services such as roads and bridges, sanitation and others.

On the other hand, the non-development expenditure of modern developing economies includes.

Expenditure on general services such as defence, justice, police and general administration;

Expenditure on unallocable and other purposes such as interest on public debt.

But in these countries, these two types of expenditure cannot be placed in water-tight compartments. This is because without expenditure on defence, police etc., it is not possible to keep up the pace of development if there is aggression from outside an unrest from within the country. Unless there is peace on the boarders and protection of life and property within the country, economic development is not possible. Similarly, interest on public debt may also be regarded as development expenditure. This is because governments of developing counties borrow both internally and externally mainly for development purpose.

Role of Development Expenditure in a Developing Economy

The role of development expenditure in a country lies in increasing the growth rate of the economy, providing more employment opportunities, raising incomes and standard of living, reducing inequalities of income and wealth, encouraging private initiative and enterprise, and bringing about regional balance in the economy.

  • Heavy and basic goods industries. Development expenditure on the establishment of heavy and basic goods industries in the initial period increases the growth rate of the economy. But investment in the capital goods sector increases production in the long run.
  • Consumer goods and raw materials. To meet the immediate needs of the economy, development expenditure should be directed towards increasing agricultural productivity to meet the growing demand for goods and raw materials, and increasing the supply of consumer goods by encouraging establishment and expansion of the small industries sector which may also provide sufficient employment opportunities. The growth rate of the economy can be increased only when public expenditure fulfills the short-term and long-term objectives of the development plan. Moreover, to prevent inflationary tendencies within the economy, the public expenditure should secure a balance between demand and supply of goods.
  • Economic overheads. Economic overheads are such public works as roads, railways, canals, power project, etc. When the government spends on such project, it provides employment to millions of an employment people in underdeveloped countries. The provision for such services helps to increase production, trade an commerce. As a results, employment and incomes increase.
  • Social overheads. Development expenditure on social overheads like education, public health, cheap housing, etc. makes the people healthier and efficient. It is the state which can create the “critical skills” needed for rapid development by investing in human capital.
  • Allocation of resources. Development expenditure helps in improving the allocation of resources towards desired channels. In order to remove scarcities of food product, the state opens fair price shops and may even subsidise food for the working classes to maintain their health and efficiency. It may fix minimum prices for food grins, and through state trading and creation of buffer stocks encourage farmers to produce more.
  • Public enterprises. To increase the production of certain essential commodities to and private monopoly in various spheres of production, and to supplement private enterprise, the state may start public enterprises. The services, to developed and conserve natural resources, to establish basic and key industries like heavy electrical, chemicals, fertilizers, machine tools, defence production, etc. to undertake state trading, etc.
  • To stimulate private enterprise. Development expenditure helps in stimulating private enterprise through the establishment of state-owned financial and banking institutions to provide chap credit of farmers, small and large industries, traders, etc. Development expenditure also encourages the agricultural and industrial sectors of the economy by means of grants, subsidies, tax   exemptions, etc. Moreover, when the state spends on the creation of economic and social overheads like power, transport, education, etc., they pave the way for the establishment and expansion of the private sector. The creation of the infrastructure leads to external economies that are reaped by the private sector.
  • To remove inequalities. Developing counties are characterized by extreme inequalities of income and wealth. Development expenditure tends to lessen them. Expenditure on education, public health and medical facilities helps n human capital formation. As a result, the earning power of the working population is enhanced. As economic development proceeds rapidly through rising public expenditure, the barriers to upward mobility are removed. Occupations expand and spread, providing more jobs to the people. With acquisition of skills, the level of wages tends to rise within the economy. Moreover, industrialization increases the share of wages and decreases the share of profits in national income in the long run, and the gap between higher and lower incomes is narrowed.
  • To remove regional imbalance. Development expenditure helps to remove regional imbalance in the economy. if things were left to market forces, commerce, banking, industries and almost all the main activities would be localized in a few selected regions, and the rest of the economy may be in a state of perpetual backwardness, as was the case developed areas and backward regions can be developed by staring a certain projects like building a dam, digging a canal, starting new industries, etc. Such project will not only promote but also secure larger employment opportunities, thereby increasing per capita output and income of such areas in developing countries.

10.10 Public Debt

National debts are debts which a state owes to its own subjects or to the nationals of other countries. Public debt is a source of government revenue. In the case of public debt the government has to pay interests and repay the principal to the public.

NB: Nothing is required to be paid by the government in respect to all other sources of revenue.

Sources of Public Debt

There are two major sources of public borrowings namely internal and external

  • Internal sources: Internally the government borrows from individuals, corporations, nonbanking financial institutions, commercial banks or from the central bank. These institutions lend to the government through buying of treasury bills or government bonds. The treasury bills and bonds sold by the government are relatively safe.
  • External sources: Externally, the government borrows in the form of foreign capital which can enter a country as private capital and/or public capital. Private foreign capital may take the form of direct or indirect investments in the borrowing country. Public foreign capital may consist of bilateral hard loans e.g. giving of loans by the British government in Sterling Pounds to Kenyan government, bilateral soft loans and multilateral loans (e.g. loans from IMF, World Bank, UNDP) and Intergovernmental grants.

Internal debt + external debt = national debt.

Classification/Types of public debt

Public debts are of various kinds and include:

  • Voluntary debt and compulsory debt: Voluntary Debt is that debt which is taken by the government without any force or coercion. People lend it to the government voluntarily. Actually all public debts are voluntarily. However, sometimes the government compels the people to buy governments bonds, e.g. in case of a war or a national emergency. These are the compulsory debts.
  • Funded debts and unfunded debts: Funded debt is a long term debt for a definite period. The interest rate to be paid, with terms and conditions of repayment are clearly stated in the debt instrument (certificate). In order to repay the debt, a debt fund is created in which some money is deposited every year by the government. The debt is repaid out of this fund on maturity. Unfunded debt is for a short period of less than a year. The government does not create any separate fund to repay the debt. Such a debt is repaid out of its current receipts often by floating additional bonds in the market. Thus it is also called a floating debt.
  • Productive debt and unproductive debt.
    • Productive/ reproductive loans are debts which are fully covered by assets of equal or greater value and the source of the interest is the income from the ownership of these, such as railways, oil pipeline etc. Thus a debt is productive when its amount is spent to finance a project which in long run brings revenue to the government, out of which interest is paid on the debt.
    • Unproductive debt does not increase the productive capacity of the economy because it is not backed by any existing assets e.g. loans taken by the government for covering the budget deficit or to help during war, famine, earthquake and flood victims etc. These do not bring any revenue to the government and are therefore called dead weight debts
  • Redeemable debt and irredeemable debt
    • Redeemable debt is that which is repayable by the government after a fixed period of time. The interest on this loan is paid by the government regularly, half yearly or annually. When the debt matures, the government pays back the principal amount to the lenders. For the repayment of the principal either the government creates a fund in which a fixed amount is deposited every year or it raises the amount through taxation
    • Irredeemable debt is that whose principal amount is not refunded by the government. However, interest is paid regularly on such a debt for the period of its duration. Debt incurred during a war may be nonredeemable by the government.
  • Internal debt and external debt
    • Internal debt is that debt which is raised by the government from individuals, institutions etc. within the country while external debt is a debt that is raised by the government from person or institution outside the country such as IMF, World Bank etc.

Need For Public Debt

Deficit budget: The government borrows when it has a deficit budget. The deficit budget can be met by raising the tax rates or levying new taxes. However tax collection takes a long time. By giving a particular date for the subscription of a loan, the government can meet its requirements immediately. That is why government prefers debt to other sources of revenue.

War: The government borrows from the public when it is involved in a war. During a war, the government’s expenditure increases many times on armaments and forces. This can be met by raising public loans on a large scale rather than through taxation.

Natural calamities: Natural calamities like earthquakes, floods, famine etc. tend to increase government expenditure in order to provide relief to the victims. This necessitates large public borrowing by the government.

Economic development: Both developed and developing countries borrow for their economic development. Developing countries do not have sufficient resources to finance their development plans because they are poor. Developing countries borrow for the development of agriculture, industry, power, transport, communication etc. Developed countries also borrow to modernize their infrastructure like roads, railways, powers, etc.

Public enterprise and utilities: Every country whether a socialist, capitalist or mixed economy runs certain public enterprises and utilities such as railways, power works, postal services etc.. which requires large funds. The government can meet them through public borrowing rather than taxation.

Economic stability: The government also borrows to stabilize the economy. To control inflationary conditions, the government borrows to take away excess money supply from the public. Since public borrowing is voluntarily, this is a better method than raising taxes because loans from the public do not increase the costs of production. Public borrowing also helps to lift the economy from a depression. During a depression, idle funds are lying with the banks which the government borrows in order to spend on public work programmes.

Burden of Public Debt

Public debt is required to be paid back along with interest from whom the government borrows. This is done by levying taxes on people. This involves hardship on tax payers which is the burden of the public debt. The debt may be internal or external

The burden of debt may be:

  • Direct money burden
  • Indirect money burden
  • Direct real burden
  • Indirect real burden

The burden of public debt can be examined from the point of view of internal debt or external debt.

External debt imposes burdens on society in the following ways:

  • Direct money burden: The direct money burden of an external debt is the amount which a debtor country pays to the foreign creditor country in the form of interest and principal. The repayment of loan and payment of the interest to the foreign country is made in foreign currency. This imposes a direct money burden to the borrower country.
  • Direct real burden: This is the loss of economic welfare of the people of the debtor country when they make payments to foreign creditor. In order to pay the interest and the loan, the debtor Country exports more to earn foreign exchange or pays the debt to the external creditor in the form of exports of goods and services. This is the real burden of external debt.
  • Indirect money burden: If the external burden is utilized for productive purpose such as building roads, channels, power projects etc. and establishing industries, this will increase employment, income and production. Its monetary burden will not be heavy because the payment of the principal and interest will be more than compensated by the benefits flowing from productive projects.
  • Indirect real burden: The imposition of more direct taxes on commodities in order to pay interest and principal on external loans puts heavy burden on the people. This is because their capacity to work and save declines. This leads to a fall in production. If interest on external debt consumes a large part of national income, the government is forced to reduce social and development expenditure. The burden of debt will be more. The indirect real burden is also very heavy if the external loans are used in unproductive channel like a war since it will be a dead weight debt on the people.

Management of Public Debt

Debt management refers to all actions of the government, including both the treasury and the central bank which affect the composition and retirement of the debt held by the public.

Objectives of Debt Management

The main objectives of public debt management are:

  • To minimize the interest cost of servicing the debt to the tax payer.
  • To employ it contra cyclically as stabilization weapon to supplement monetary and fiscal policy.

Techniques/Methods of Debt Management

The techniques of public debt management include:

  • Lowering the interest cost.
  • Changing the maturity structure.
  • Advance refunding.
  • Co-ordination with monetary and fiscal policies.

Redemption of Public Debt

This means the payment of interest and repayment of principal by the government. The methods of debt redemption includes:

  • Out of revenues – generally, the government pays the debts out of its revenue though a surplus budget. It makes a provision in the budget as the amount to be paid during the year.
  • Sinking fund – under this method, the government creates a fund for the repayment of the debts known as sinking fund and deposits a fixed sum of money out of its revenue each year for the period of the loan.
  • Serial bond redemption – according to this method, whenever debt is floated, the, date of maturity of certain bonds is fixed beforehand on the basis of their serial numbers. When the time for maturity comes, bonds bearing the serial numbers are paid back
  • Lottery method – according to this method, bonds which are to mature in a particular period time are drawn on the basis of the lottery system. Only the bond holders whose bond numbers have come out are paid back while the payments of others are deferred to the other lottery dates. Such a method creates uncertainty among the bond holders.
  • Debt conversion – in this method, the debt with the highest interest rate is converted into a 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 one.
  • Capital Levy – this is a once for all tax to redeem a public debt. It is levied on capital assets on a progressive scale just after a war or an emergency when the burden of the debt is very heavy.
  • Date repudiation – this means canceling of all debt all together. The government refuses to repay the debt. This method of debt redemption is not practicable because the government’s reputation may be at stake. Its very existence may be endangered. However, Russia did it in 1917

Effects of Public Debt on Economic Development

When government borrows, it transfers money from one type of people to another. Money flows from the people to the government and further to those on whom government spends the borrowed money. This leads to expenditure effects of public debt. When the government pays the interest and repays the loan, money is again transferred from those who are taxed (by the government in order to pay the interest and principal), to those who hold government’s bonds. This leads to revenue effects of public debt. These transfers of money from one set of people to another through public debt affects consumption, production, distribution and the business activity in general. Therefore public debt has the following effects:

  • Effects of public debts on consumption
  • Effects of public debt on production
  • Effects of public debt on distribution
  • Effects of public debts on prices or economic activity
  • Effects of public debt on private sector

Economic development may be defined as the increase in the standards of living of a nation’s population with sustained growth from a simple low income economy to a modern high income economy. Its scope includes the process and policies by which a nation improves the economic, social well-being of its people. Public debt plays an important role in economic development of a country in the following ways:

  • Capital formation
  • Anti-inflationary measure
  • Compulsory savings

Capital formation: Borrowing from the public can be another source of capital formation in undeveloped countries. This device is better that taxation. Taxation means forced saving, borrowing in voluntarily. The tax payer is never happy in paying tax for he doesn’t expect to get his money back. A lender, on the other hand, gives his money on loan of his own accord to receive it back along with interest after a stipulated period. Unlike taxation, borrowing does not adversely affect incentives to save and invest. The lure of interest is always there to increase the incentives instead.

Anti- inflationary. Public borrowing acts as an anti-inflationary measure by mobilizing surplus money in the hands of the people in a developing country. A successful public borrowing programme can be a useful tool of economic development by diverting resources from unproductive channels. Public borrowing is resorted to for specific development projects like power generation, irrigation works, road, railway, etc. Thus it is a useful way of financing development projects.

Compulsory savings: If sufficient funds are not forthcoming in the form of voluntary loans, the government may have to resort to compulsory borrowing for the mobilization of resources for capital formation. Compulsory public borrowing is therefore justified in those undeveloped countries where taxation and voluntary borrowing fail to bring adequate funds for development to the exchequer. Certain sectors of the society who waste a large portion of their income in unproductive channels or derive special benefits from particular development projects may be forced to subscribe to government bond. However, it is not advisable for any underdeveloped country to rely on this method of forced savings except for specific development projects and for a short period. Ultimately, governments will have to depend on voluntary borrowings.