Methods for redemption of public debt

Methods that are adopted for redemption of public debt are: 1. Refunding 2. Conversion 3.
Surplus budgets 4. Sinking fund 5. Terminable annuities 6. Additional Taxation 7. Capital
Levy 8. Surplus Balance of Payments.

Redemption is a way of escape from the burden of public debt. Redemption means
repayment of a loan.

1. Refunding:
Refunding of debt implies the issue of new bonds and securities by the government in order
to repay the matured loans.
In the refunding process, usually short-term securities are replaced by issuing long-term
securities. Under this method the money burden of public debt is not relinquished but it is
accumulated owing to the postponement of debt redemption.

2. Conversion:
Conversion of public debt implies changing the existing loans, before maturity, into new
loans at an advantage in servicing charges. In fact, the process of conversion consists
generally, in converting or altering a public debt from a higher to a lower rate of interest.

A government might have borrowed at a time when the rate of interest was high. Now, when
the rate of interest falls, it may convert the old loans into new ones at a lower rate, in order to
minimise the burden. Thus, the obvious advantage of such conversion is that it reduces the
burden of interest on the tax​payers. Furthermore, lower interest rates on public loans would
mean a less unequal distribution of income
The success of conversion, however, depends upon:
(a) The creditworthiness of the government,
(b) The maintenance of adequate stock of securities,
(c) The efficiency in managing the public debt.
Furthermore, for a successful conversion, the government will have to offer new low-interest
bearing bonds at a discount rate and which will have to be redeemed at full value, causing
thereby a capital appreciation (which may be even free of income-tax).
Ultimately, thus, the conversion does not benefit the treasury as the price of the bonds will
have to be paid at a higher rate (i.e., at par, at the time of redemption) than its selling price,
which in turn increases the liability of the government in future, for a capital sum greater than
that borrowed will have to be repaid. Hence, conversion is no substitute for repayment, when
a substantial reduction of burden of public debt is desired.
Dalton, as such, opines that debt conversion does not really relax the debt burden. Because,
a reduction in interest rate reduces the ability of bond-holders to pay taxes which may cause
a reduction in public revenue, thereby reducing the government’s capacity to redeem loans.
3. Surplus budgets:
Quite often, surplus budgets (i.e., by spending less than the public revenue obtained) may
be utilised for clearing off public debts. But in recent years due to ever-increasing public
expenditures, surplus budget is a rare phenomenon.
Moreover, heavy taxes have to be imposed for realising a surplus budget, which may have
dire consequences. Or, when public expenditure is reduced for creating a surplus budget, a
deflationary bias may develop in the economy.
4. Sinking fund:
A sinking fund is a fund created by the government and gradually accumulated every year by
setting aside a part of current public revenue in such a way that it would be sufficient to pay
off the funded debt at the time of maturity. Perhaps, this is the most systematic and best
method of redemption.
Sinking fund is in essence, like a depreciation fund prudentially created. Under this method,
the aggregate burden of public debt is least felt, as the burden of taxing the people to repay
the debt is spread evenly over the period of the accumulation of the fund. The practice of a
sinking fund inspires confidence among the lenders and the government’s creditworthiness
increases thereby.
5. Terminable annuities:
This method of debt redemption is similar to that of the sinking fund. Under this method, the
fiscal authorities clear off a part of the public debt every year by issuing terminable annuities
to the bond-holders which mature annually. Thus, it is the method of redeeming debts in
installments. By this method, the burden of debt goes on diminishing annually and by the
time of maturity it is fully paid off.
6. Additional Taxation:
The simplest measure of debt redemption is to impose new taxes and get the required
revenue to repay the loan principal as well as the interest.
This method causes redistribution of income by transferring the resources from tax-payers to
the hands of bond-holders. It may also impose a burden on the future generation if new
taxes are levied to repay the long-term debts.
7. Capital Levy:
Capital levy is strongly recommended by Dalton as a method of debt redemption with the
least real burden on the society. Capital levy refers to a very heavy tax on property and
wealth. It is once- for-all tax on the capital assets and estates.
8. Surplus Balance of Payments:
The redemption of external debt, however, is possible only through an accumulation of
foreign exchange reserves. This necessitates creation of a favourable balance of payments
by the debtor country by augmenting its exports and curbing its imports, thereby improving
the position of its trade balance.
Thus, the debtor country has to concentrate on the expansion of its export sector industries.
Further, loans raised must be productively utilised, so that they may become self-liquidating,
posing no real burden on the economy.
In underdeveloped countries like India, where external debt has increased tremendously, it is
necessary that its burden is reduced by changing the terms of repayment or by rescheduling
the debts.
In fact, the best redemption policy is a that part of the public debt, internal as well as external
is redeemed every year so that there is no mounting of a total real burden of debt upon the
present generation or on posterity.