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The modern theory of public debt or the new orthodoxy as Buchanan puts it, is an offshoot of the economics of depression or the Keynesian
economics. The economic anamoly created by the great depression of the 1930s, led to the development of the new theory of public debt. The modern theory states that a huge public debt is a national asset rather than a liability and continuous deficit spending is essential to the economic prosperity of the nation. A.H. Hansen, the exponent of modern fiscal theory, declares that
public debt is an essential means of increasing employment and has become an instrument of economic policy today.
The modern theory of public debt is concerned with macro-economic variables and not with individual utilities, economists treat the whole economy as one unit. They are mainly concerned with internal debt as they regard external debt as a definite burden since repayment of principal and interestto foreign countries are entailed, such repayment involves a transfer of real goods and services from the debtor to the creditor country in the payment of interest and principal amount. Until a few years ago, the modern version of public debt remained unchallenged.
The Keynesian economics has also discarded the notion of debt burden on basis of income creating potentialities. Debt creation brings into the
exchequer unutilised resources and the productive employment of these resources leads to an increase in the national income. Tax payments, necessary for servicing the debt are met out of the increased income and therefore it is not burden on the economy. Prof. J.M. Buchanan in his book Principles of Public Debt declared that the 'New Orthodoxy' has produced three main
propositions which are as follows :
1. The creation of public debt does not involve any transfer of the primary real burden to future generations.
2. The analogy between individual or private debt and public debt is fallacious in all essential respects.
3. There is a sharp and important distinction between an internal and an external public debt.
After Keynesian era there were some economists who also accepted the central idea of the new orthodox that the burden of public debt rests on the generation living at the time of debt creation. However, their emphasis was on the transfer of secondary burden to the individuals of the future generation. As D Mc. Wright stated, that "an internally held public debt imposes no economic
burden on society, is not entirely true. The burden has been enormously exaggerated but it would be foolish to deny that it does not exist.'' However,
they also suggested that proper methods of taxation can reduce this burden to some extent, but they never attacked their (New Orthodox's) central ideas.
Buchanan's Thesis : Revolt against the 'No Burden Hypothesis'
The dissent from the 'no burden' thesis has arisen with the publication of J.M. Buchanan's Principles of Public Debt in 1958. Professor Buchanan holds that the financing of a project by the government by means of borrowing does shift a burden
to the future generations. According to him the concept of burden should be interpreted in terms of the individual attitudes towards their economic well-being rather than in terms of changes in private sector outputs and real income because
of the inheritance by the later generations of a larger or smaller amount of capital instrument. Buchanan argues that during the period in which the project is financed and borrowing takes place, no burden of any kind is created : individuals who give loans to the government voluntarily exchange liquid funds for less liquid government bonds instead of using the funds of acquiring consumption or investment goods since this is done voluntarily by the individuals concerned, they do not feel themselves worse off. When, however, the bonds are repaid in the future, funds are
taken from the taxpayers to change bonds into cash of the bond holders; as a result, the taxpayers feel themselves to be worse off, but the bond holders are not better off since they have now merely changed bonds for cash. In other words, as
the bond holders are not worse off by changing cash into bonds so also they cannot be better off later by the changing of bonds into cash. But in the later periods the taxpayer's future generations are worse off-since tax is a compulsory payment. As
a result, the society as a whole becomes worse off during the future. It is in this sense that the burden is shifted to the future generations.
Bowen, Dawis, Kopf Thesis : Bowen, Dawis and Kopf (B.D.K.) consider a society with a changing composition over time and define in terms of the
life-time consumption of different generations of taxpayers. They demonstrated that even if a project is financed wholly by a reduction in consumption by generation I, a burden is nevertheless shifted to the future generations. Thus suppose, a country producing only timber, in year 1900, quantum of 100 tons of timber is consumed by the government for meeting, say, war needs and the "project" is "financed" wholly by a reduction of 100 tons of timber consumption
by generation I. Supposing that the life span of each generation is 44 years and assuming that the reduction in the consumption of timber made by each generation at the time of its appearance is met by a corresponding increase in its consumption before it passes away, the pattern of timber consumption by three generations will be as follows :
consumption of timber by generation I still the Consumption of every generation is deferred by 44 years : and this will continue until the debt floated by the government for consuming the timber initially is matched. The deferred consumption, according to BDK, is a burden even though the whole of the initial consumption of timber by the government is matched by a corresponding decrease in the private consumption.
Modigliani's Burden Thesis :
Prof. Modigliani's analysis of the burden of public debt is different from that of his predecessor. He is of the opinion that pubic debt is a burden on the future Generation because of the loss of partial capital formation and the consequent reduction of the potential future income. The community's income need not fall simply because of the fall in
the private capital formation. If government's capital formation increases through borrowing methods and the borrowed funds are utilised productively, the income of the nation is bound to rise. Therefore, the important problem is whether
the borrowed funds are employed productively and contribute to economic development. Modigliani himself accepts that through productive capital formation, the burden that falls on the future generation might be fully or partly off set.
Musgrave's Thesis of Inter-Generation Equity :
R.A. Musgrave explains the same problems that has been examined by 'BDK', but his assumption
regarding the reactions of the tax payers and the lenders are fundamentally different. Musgrave feels that the burden of debt financed expenditure shifts via reduction in private investment. He constructs a case in which, regardless of the reduction of generation I, loan finance, always divides the cost among generations whereas tax finance can never do so. In the sense, loan financing does shift (equitably) the burden to the generations to come. Musgrave is concerned with a long-lived government facility the cost of which is to be distributed equitably amongst those who make use of it.
Suppose that the project has a life of three periods and each generation has a life span of three periods. As period I opens, generation I already in its last period, is on the scene : as also Generation II, with one more period to go and generation III in its initial periods. In the second period, there exists
generation II in its last period as also generation III and IV. In the third period, there will be generation III, IV and V respectively in their third, second
and first periods. The problem is how to take from the generations in question their "due" shares of the cost of the project, namely, the following :
requires generation I to pay 1/9th of the cost in form of taxation and so on. As to financing the project in its year of construction, 6/9th must be covered by loan; but no part of the loan can be demanded from generation V, since it is already in its last period, and thus could never be repaid. Generation I is vanishing at the end of the first period so 6/9 is financed by loans from generations II and III, who are repaid before they vanish. Thus everybody gets his moneyback, except to the extent that he is required to pay tax, and tax is distributed over time in accordance with the degree of service use. From the above explanation it is clear that there had been taxation and the total cost of the period had been taken from them. GI, GII, GIII in Ist period, no cost would have been transferred to subsequent generations.
Domer assumed initially that the burden of the debt or the average tax rate covering interest charges to income, or the ratio of the debt to income multiplied by interest rate paid on bonds proceeding with simple mathematical relations, he arrived at the formula for debt as under :
Tax rate = L/n, i
where L = fraction of national income borrowed
i = interest paid on bonds and
n = relative annual rate of growth of income.
From the above analysis it is clear that the tax rate, given constant rate of interest, depends usually on the ratio of money income on the debt. From this analysis, it is very clear that for the first time, a systematic attempt has been made to link up the burden of a country's debt with growth of its national income.
Secondary Burden of Public Debt : New economists analysed the secondary burden of public debt in terms of the effects on incentive to save, work and invest on account of the tax friction caused by existence of a large public debt.
1. Pigou Effect or Wealth Effect : The existence of a large public debt implies large holding of wealth by people in the form of government securities.
Due to this, the incentive to save will be adversely affected, because already sufficient amount is held by them. However, it is difficult to measure that to what extent the incentive to save is affected by the existence of a large public
debt.
2. Kaldor Effect : The existence of a large public debt also has adverse consequence on incentive to work, invest and accumulate. However, in practice, it is difficult to establish how far this has affected the incentive to work, invest and accumulation. However, there are some economists who are of the opinion that there
are several advantages and disadvantages of the offset of the existence of a large public debt. A.H. Hanson thinks that a large public debt provides a
certain amount of security in times of depression. It acts as a built-in-stabilizer and that is kind of National Insurance. A.P. Lerner also tried to show that without the creation of debt, usually public
expenditure is impossible and that only alternative to debt is depression or widespread poverty. He also emphasized that even in the absence of a large public debt, tax friction may take place for other reasons. Less public debt means more private debt, the servicing of which will have the same inflationary effect and to meet this inflationary threat, an increase in the tax on income and wealth becomes inevitable. Some timesthis tax rate may be much greater than what would be required to service the public debt. The only way to prevent these evils, he says, is to maintain a state of depression in which people are too poor to accumulate wealth. Further he is of the opinion that when unemployment is fought by deficit spending and as such the amount of public
debt increases, the so-called burden of the debt should be weighed against the burden of unemployment which would be there if deficit spending programme had not been undertaken. And if this is done, the burden of the debt may appear to be much smaller and even nil or negative.
Does Borrowing Shift Burden of Government Activities to Future Generations
A long debated question which has given rise to a great deal of controversy in recent years is whether the system of financing a project by means of public debt shifts the burden to the future generations. One traditional argument is
this : If taxes are used to finance a project, persons pay for the project now; if funds are raised by borrowing the present generation escapes the cost and the burden is shifted to the future generation which pays the interest and the
principal. Hence the public debt shifts the burden to the future generation. The 'No Burden Thesis' is once again established. Lerner in an observation also warns that it is not quite right to say that public debt does not matter at all. R.N. Bhargava also emphasized this 'No burden analysis' in the context of internal debt. If posterity inherits the burden of paying interest and principal of the debt, it also inherits a corresponding and equivalent right to receive this interest and principal.
Thus its liability to pay is matched by an equivalent right to receive that payment and in the case of external debt, the posterity will have to use a part of its current resources for servicing the debt, that is, a part of total output of goods and services
produced within the country will have to be used for servicing the external debt.
However, these depend upon the purposes for which the debt is incurred. If the debt was obtained for development purposes the posterity benefits from this expenditure. In the absence of foreign loans, this expenditure would not have been incurred and national income and output would have been adversely affected. If foreign loans were incurred to fight against war then the lack of foreign loans might have meant defeat
and slavery. Thus posterity would benefit from the independence of the country that it inherits. Similarly, if foreign loans were incurred for the useful consumption purpose, there would be improved health and efficiency of the people and against the burden of servicing foreign debt we have to balance the advantage posterity inherits from a more efficient and healthy working 'force'.
Principles of Debt Management
Debt Management means the formulation and implementation of a debt policy regarding the forms of public debt to be issued, terms on which new bonds are to be sold, the pattern of maturities of the debt, ownership pattern of debt and methods of redemption of public debt. Hence the management of public debt is concerned with the decision regarding floatation, refunding and
retirement of debt as to gain the greatest economic advantages or to create the least economic disadvantages. The objectives of debt management are to manage public debt in a way that meets the governments gross funding needs
at the lowest possible long-term cost, with due regard to the underlying risks. Debt management is guided by the following principles :
(i) Management must be capable of generating the necessary funds from the lending market without undue coercion and that at the lowest feasible interest cost. This principle suggests that debt should be managed in such a manner that necessary funds are available from the lending market. Besides, it is also needed that these funds are procured at the minimum interest cost.
(ii) Public debt should be managed in such a way that the needs of the investors are satisfied. An efficient debt management policy not only keeps the interest rates on government bonds low but should also devise the pattern of interest rates on government obligations which conform to the preference pattern of the investors.
(iii) Refunding and flotation of debt should be managed in such a way that the economic stability is not disturbed.
(iv) Public debt policy must be co-ordinated with fiscal and monetary policy.
(v) Public debt policy should maintain a suitable structure of maturity.
(vi) There are two important issues relating to management of foreign debt. These are (a) the extent of government regulation of foreign debt and (b) the appropriate composition of debt.
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