Redemption of public debt

 Introduction

Most of the economists believe that debt redemption that is the repaymentof pubic debt is desirable for the government.The need to repay public debt exercises a sort of check on the recklessnessof the government. A weak government may borrow large amounts to finance its expenditure because public debt does not impose a burden on the subscriber to increase his income. However, the government will have to tax the people to pay interest on the debt even if it postpones repayment of the principal. A government that continuously borrows to finance its expenditure will be faced with a rising interest bill, it will not be able to postpone imposing the burden of taxation indefinitely. The need for debt redemption exercises beneficiary effect on the fiscal policy of the government, as it is then forced to increasea taxation to finance its regular current expenditure. 

Meaning and Need for Debt Redemption

Debt redemption implies repayment of public debt which the government borrows to finance its expenditure. Debt redemption is advantageous because it cancels outstanding claims against the government and places it in a stronger position to secure new loans at moderate rates of interest. The repayment of debt reduces the tax burden by eliminating debt charges and keeps the treasury in a strong position, provided that the redemption of debt is conducted in a manner that will not excessively burden the economy. If the governments knowin advance they must redeem their debts according to the terms of their loan contracts, imprudent spending is less likely to occur and public financing can be kept under more rational control.

Debt redemption enhances the credit worthiness of the government. When the government borrows, it promises to repay the loan at a stated time in the future. It has to redeem the debt to honour its pledged word. Debt redemption also produces a salutary effect on the people who think that, if the government is borrowing, it is simultaneously making efforts to repay the loans.

An advantage of debt repayment is that the problem of debt management becomes less difficult to handle as the amount of debt decreases. Government may also have more freedom of choice as to interest rates and can give more weight to consideration of monetary policy. As the banks find it less necessary to furnish credit to governments, they should be able to give more thought to the credit needs of private borrowers and to serve them more effectively.

Debt redemption saves the cost of debt administration and cost of collecting taxes to service the debt. This is desirable when there is full employment in the economy and the resources needed in debt administration and tax collection can be diverted to produce useful commodities and services that will increase the welfare of the people.

Must see public-debt-its-classifications-and-classical views

Methods of Redemption of Public Debt

The government can adopt several methods to redeem its debt.

1. Conversion or Refunding/Fresh Borrowing : 

The government may redeem its public debt by converting it into a new debt or it may issue conversion loan to the holders of existing debt. Alternatively, it may borrow in the open market and use the funds to repay the old debt. Generally, the government adopts this method when at the retirement of the debt the government has not the capacity to repay or when the current interest rate is lower than the rate which the government is paying for the existing debt and in this way government may reduce its interest expenditure. Strictly speaking, this is actually no retirement because the government incurs fresh obligations to repay old ones and there is thus no decrease in the total amount of public debt. Sometimes a distinction is made between refunding and conversion of debt, though some times both of them are used to mean the same thing. 

In the strict sense, refunding refers to the repayment of debt through fresh loans i.e., the method of paying off an old loan carrying a higher interest rate through a new loan carrying a lower interest rate whereas conversion involves a change in the rate of interest or other details of the lenders the government may pass an ordinance to reduce the rate of interest payable on its debt.

2) Additional Taxation : 

The government imposes new taxes to get revenue to repay the principal and interest of the loan. This is the simplest method of debt redemption.

3. Sinking Fund Method : 

The most commonly used device for the actual retirement of a debt is that of the sinking fund. The government sets aside a small amount every year from the revenue budget and this accumulates at compound interest so that it may equal the amount of the public debt by the time of its maturity. Thus, the burden of taxing the people to repay the debt is spread out evenly over the period of the accumulation of the fund. The government has, therefore, not to impose a concentrated burden, if it were to repay the debt by raising funds through taxation in one year only.

4)Inflation or Currency Expansion : 

This method amounts to confiscation. It implies a fall in the value of the monetary standard due to currency expansion or inflation in the economy. Therefore, the real value of public debt depreciates. If there is hyper-inflation in the economy then the value of the country's currency and also its public debt will become almost negligible. Under this method the debt holders are taxed in proportion to the debt held by them in order to repay the debt. This is very tax for the tax- payers but is related to the extent of their debt holding. Those who supported the government in the past by lending their savings are penalised, whereas those who chose other forms of investment escape the burden of taxationnecessary to redeem public debt. Accordingly, this method is exceedingly inequitable and for that reason, undesirable from the fiscal view point. When the government resorts to this method of liquidating its public debt, it loses confidence of the public and it may be difficult for the government to borrow funds again.

5. Repudiation : 

The most extreme solution to the problem of government debt is repudiation. In this case the government refuses to repay the public debt and in this way liability for public debt is extinguished. In the federal system the states being sovereign so far as debt is concerned, can repudiate their debts if they wish. The bond holders will be having no redress. This is actually no retirement but confiscation of the bond holders to the extent of their holding. A particular group of wealth owner is penalised. Other groups even benefit through reduction in taxation, as thereafter the government will not have to pay interest on the public debt. This procedure is exceedingly inequitable as those who supported the government by investing their savings in public debt suffer irrespective of their ability as compared with the owners of other forms of wealth. When the government repudiates its public debt, it loses the confidence of the public and it will find it extremely difficult to raise further loans in future. 

6. Serial Bonds :

The serial bonds are financial bonds that mature in installments over a period of times. It provides for establishing a scheme for annually retiring a state amount of the issues. The annual payments are usually uniform as they facilitate budgetary provision. The serial bond has become a popular method of retiring local government debt. Many states actually require its use by their local sub divisions.The disadvantage with the method is that it does not permit government to cease retirement of debt during periods of depression. The payments need not be made when the national income falls below a given level.

7.Capital Levy : 

This is a direct tax upon the capital rather than income of the tax payers.The government may retire its public debt by levying a heavy additional tax only once, or at the most twice. This special heavy tax to repay public debt is generally called a capital levy as it is assessed on the value of capital held by the rich people. Sometimes, when the heavy tax is levied on an index of ability other than capital, it is also known as special levy. It is also a capital levy over the sinking fund method it is that in the case of the latter method the government has to impose the burden of taxation to repay public debt over a period of years, whereas in the former case the burden of taxation is imposed once for all and, therefore gives some psychological relief to people that there will be no more taxation for the purpose of repaying debt. In times of war or emergencies, the money necessary for the redemption of the public debt is raised by imposing a special tax on capital.

A Disadvantages of Capital Levy :

A capital levy, according to its advocates, would have several advantages.It would raise a large sum by a special property tax that might be assessed only once, although the tax might be paid in convenient instalments. A capital levy would fall heavily on the wealthy classes who generally have most of the resources to pay taxes. These classes usually buy large amount of government loans and a tax on their capital would compel them to bear the burden of the levy. A capital levy imposed in lieu of borrowing would tend to reduce debt and keep the budget in better balance. This tax should also, if collected at steeply progressive rates from property owners, tend to reduce inequalities in the distribution of wealth.

A capital levy could be employed to equalise the distribution of wealth on ethical grounds as weapon of economic warfare to combat over-saving and under-consumption, thus striking at what are popularly regarded as causes of economic instability. The proposal raises the issues of the capital levy primarily as a regulatory measure and of the validity of theory of business cycles that would call for its application.

Disadvantages of Capital Levy :

However, as H.M. Groves mentioned, like the excess profit and the income tax the capital levy is weaker on its administrative side. Although the tax might be equitable, it is very difficult to apply. Probably, the most difficult part of a tax on capital is that of finding a fair value of property involved.There are certain disadvantages of a capital levy or special levy which may produce extremely adverse effects on the economy. They force a relatively small section of the population to meet an expenditure that is theoretically undertaken for the general welfare. A general capital levy might also be so heavy as to exert a deadening effect upon initiative and enterprise and seriously penalize saving.

Another important disadvantage of capital levy is that it produces a concentrated burden on the community whereas in the sinking fund method the burden is spread over number of years. Thus, the capital levy is discriminatory because it imposes burden on those who own capital on that particular date and relieves those who are likely to acquire or build up capital in the future.