Burden of Debt finance21st January 2021
It is said that an internal debt has no direct money burden since the interest payment on debt and the imposition of taxation to pay interest to the lenders is simply a transfer of purchasing power from one to another. This means that in case of internal debt, money is borrowed from individuals and institutions within the country.
Repayment (raised from taxation) constitutes just a transfer of resources from one group of persons to another. In other words, these are transfer payments and do not affect the total resources of the community Truly speaking, government collects money through taxation imposed on the richer people who are also the buyers of government bonds.
Burden of public debt is a misleading and highly confused concept. The 1930’s and 1940’s witnessed an array of debate over the issue of debt burden. The focus of debate was between those who feared that the creation of debt in course of deficit finance would burden the future and others who believed that such finance would not do so.
Later on, two extreme views emerged in this regard. The burden controversy attained its logical end in the pronouncement of A.C. Pigou, A.P. Lerner, Alwin. H. Hansen and Prof. P.E. Taylor.
In this context, Prof. Taylor point out that “the nature and severity of the burden have however frequently been improperly understood largely because of the temptation to think of public debt in terms of private debt and to apply identical standards to both”.
Moreover, while discussing the burden of public debt, we have to bear in mind not only the amount of debt but also the corresponding credit. As A.P. Lerner point out “the great misconception lies in looking at only one side of debt-credit relationship.
Every debt has a corresponding credit and this fact is frequently over looked when considering the burden of public debt. In this context, Taylor point out “the liability of the debtor to the creditor is matched by the asset value of the creditors claim.
This is a routine fact which is frequently over looked when considering the nature of debt”. The views of these economists remained unchanged for quite a long time. The Keynesian approach disagreed with the classical burden thesis.
Burden of External Debt:
During a given period, the direct money burden of external debt is the interest payment as well as the principal repayment (i.e., debt servicing) to external creditors. The direct real burden of such external borrowing is measured by the sacrifice of goods and services which these payments involve to the members of the debtor country.
There is also indirect money burden of external debt. Loan repayment by the debtor country implies more exports of goods and services to the creditor country. Thus, a debtor country experiences a fall in welfare of the community.
- Traditional Views on the Burden of Public Debt:
The traditional view is that public debt as in the case of private debt imposes a real burden on the community. The classical view maintains that if the government expenditure is financed through taxation the present generation bears the burden. But if government expenditure is financed through public borrowing, the present generation gets relieved from the cost and burden is shifted to the future generation.
The future generation suffers when present generation reduces its saving in-order to meet the debt finance and leave a smaller amount of capital resources for the future. This will reduce the productive capacity of the future generation and accordingly they will stand to lose.
In a sense, war finance through public debt has double effect. For example, in-order to contribute to war finance, the present generation has either to curtail its consumption or saving or both. If savings are reduced the future generation suffers on account of reduced inherited capital.
On the other-hand, if the present generation does not reduce its consumption, burden of public debt may pass on to the future generation. This view is held by David Hume, Adam Smith and David Ricardo.
According to the classists public debt necessitate a transfer of resources from the private sector to the government in the form of additional taxation. Secondly, the classist held the view that public debt is a more costly method of financing public expenditure than taxation.
This is so because interest payment is an additional cost burden in the case of public debt. Thirdly as stated earlier, public debt tends to transfer the burden of a particular outlay to the future generation.
Moreover, excess borrowing and mounting public debt of the government may undermine the very creditworthiness of the government. Hence the traditional economists strongly argued that public debt should be kept to the minimum and should be redeemed as early as possible.
- Modern Views:
Economists like J.M. Keynes, Harris, Buchanan, Musgrave, and Modigliani are the chief exponents of the modern version of debt burden. The modem theory of public debt is put as “the new orthodoxy” by Prof. Buchanan.
The worldwide depression of 1930’s and the emergence of Keynesian economics paved the way for the development of the new theory of public debt. The new theory is diametrically opposed to the classical concept of public debt. Modern theory firmly advocates that large volume of public debt is a national asset rather than a liability. This theory recognizes that persistent deficit spending is a tonic to the economic development of nations.
During periods of depression, the technique of deficit budget financed through borrowing can be fruitfully utilized to improve employment situation and generating effective demand and thereby raising the level of economic activity.
Under the shadow of Says Law, propagated the misconception that persistent technique of unbalancing the budget coupled with increasing proportion of public debt endangers the very economic stability of the nation.
However, the modern theories strongly believe that public expenditure is not at all wasteful. To them, public expenditure can be made productive and an important means to increase employment in the economy.
As a corollary to this concept, Prof. A.H. Hansen, the chief advocate of modern theory states that public debt is an essential means of increasing employment and it has become an instrument of modern economic policy of nations.
Prof. James Buchanan in his book “Public principles of public debt”, states that debt burden implies a compulsory sacrifice. He argued that the primary burden of the internally held public debt is always in the future.
Buchanan held the view that burden of debt should be considered in terms of reduction in personal satisfaction. When a public debt is floated, the lenders voluntarily purchase bonds. There is no loss of satisfaction in the process of exchanging more liquid money for less liquid bonds. Here people prefer government bonds as a good form of investment.
- Direct Money Burden:
Repayment of public debt involves payment of interest and the principle by the government. Hence the government will have to raise the necessary resources by way of taxation.
The direct money burden of public debt consists of the tax burden imposed on the public and it is equal to the sum of money payments for interest and the principle components. In the case of an internal debt, there will be no direct money burden because all the money payments and receipts cancel out.
In this context, Dalton observes “thus all transactions connected with an internal debt resolve themselves into a series of transfers of wealth within the community. It follows that there can never be any direct money burden or direct money benefit of an internal debt”. However, in the case of external debt money payments by the debtor nations to the creditor constitute a clear direct money burden.
- Direct Real Burden:
Real burden of public debt refers to the distribution of tax burden and public securities among the people. In a sense, it is the hardship sacrifice and loss of economic welfare shouldered by the taxpayers on account of increased taxation imposed for repayment of public debt.
It is a fact that people hold public debt and they also pay taxes towards the cost of debt service. If the proportion of taxation paid by the rich towards the cost of debt, service is smaller than the proportion of public securities held by them, whereas, if the proportion of taxation paid by the poor and middle-income group towards the cost of debt service is larger than the proportion of public securities held by them, there is a direct real burden from public debt.
Whereas suppose government bonds and securities are held by the working classes, while the taxation towards the cost of debt service is paid by the rich only, then public debt will help to reduce the inequalities of income in the community. In such a circumstances there is no direct burden; instead there is a direct real benefit to the community.
- Indirect Money Burden and Real Burden:
It is argued that heavy taxation to meet debt service charges may reduce taxpayers ability and willingness to work an save. In turn this will check production. Moreover, heavy debt charges may also force the government to curtail and economies some desirable social expenditure, which may promote economic development.
However, if it is possible to neutralize the adverse effect of taxation resulting from the problem of debt service by some favourable effect of public expenditure, the indirect burden of public debt can be cancelled out. Dalton observes that practically this is not possible. In the case of external debt, indirect money and real burden arise from its bad effect on production because of additional taxation to pay for debt charges.
Burden of Internal Debt:
Internal debt involves no significant burden on the community as a whole. The payment of interest and increased taxation to meet the servicing and principle component of debt involves a transfer of purchasing power from one section of the community to another.
In the case of internal debt, the people owe themselves the debt and the question of the burden need not be treated as raising any major issue. Money does not flow out of the domestic market.
However, if the creditors (bond holders) and the taxpayers belong to different income strata’s, there may occur a change in the distribution of income among different sections of the community. But Dalton observes that while estimating the burden of public debt, we should consider the purpose for which the loan is raised.
Suppose if the public debt is floated specifically for raising investment funds for a productive activity, the profit generated from it can be used to pay off the debt, where as a debt raised for financing a war may be a dead weight and it will have to be paid out of increased taxation.
So in the first case there is no burden as such. In the second case also it is argued that the burden imposed by taxation upon the taxpayers will be offset by the benefit which the taxpayers receive in the form of interest on public debt.
However, if the rich pays taxes less than proportionately, to the proportion of public securities held by them, then there will be a direct real burden. The reason is that usually public securities are held mainly by the wealthier class.
Progressive taxation doesn’t tend to be sharply progressive to counterbalance the gain obtained by wealthier class from the possession of public debt. In usual practice, the debt servicing burden will fall upon the poor section in the form of heavy taxation on commodities.
As a result there is a net increase in the burden on the community. Sometimes this may adversely affect the power and willingness to work and save and even the productive capacity of the economy.
Hence, the repayment process of public debt should be managed in such a way that, it may not exert any adverse effect on production and distribution. So it maybe concluded that if not planned and utilized scientifically, internal debt can practically impose a burden on the community, even though theoretically it is not correct.
On several aspects external debts differ from internal debt. Still in the case of burden of debt, both share some similar characteristics. For the payment of internal and external debt, imposition of additional taxation is imperative.
In the words of Prof. Dalton “as a general rule, an internal debt is likely to involve an additional and indirect burden on a community, an external debt does the same”.
But in another sense, external debt involves greater burden than internal debt. In the case of internal debt there is no resource transfer to outside the country. The repayment of principle and interest charges doesn’t lead to the transfer of resources from the country to another country.
It merely results in the transfer of income from one section of the community to another section. Moreover, the taxpayers and receivers of interest constitute the same class of people. Whereas external debt specifically involves resource transfer to foreign nation.
By way of interest charges and repayment of principle, resources are transferred to the creditors abroad. Therefore, payment of interest on foreign debt reduces the net income of the debtor country. Internal debt carries with it no such evil effect. Hence, we can safely say that external debt involves a greater burden than internal debt.
Measurement of the Burden of Debt:
Usually, burden of debt refers to financial burden of the government.
But as it does not indicate true burden, we consider following ratios to estimate the burden of debt:
- Income-Debt Ratio:
It is estimated as:
size of public debt/national income = D/Y
If Y remains at a very high level, the burden of debt, D, will be insignificant. However, if the ratio becomes high, debt then poses a great burden.
- Debt-Service Ratio:
This ratio is measured as:
Annual interest payments of borrowing/National income = i/Y
Increase in Y means lower debt-service ratio. However, taxes are collected for the repayment of public debt. Thus, this ratio indicates the necessity of imposing higher taxes.
- Debt Service-Tax Revenue Ratio:
It is worked out as:
Annual interest payments/Aggregate tax revenue = i/T
An increase of this ratio indicates the financial weaknesses of the government.