Chapter:4

Public finance

Meaning
Public finance is a study of income and expenditure or receipt and payment of government.
It deals the income raised through revenue and expenditure spend on the activities of the
community and the terms ‘finance’ is money resource i.e. coins. But public is collected name
for individual within an administrative territory and finance.
On the other hand, it refers to income and expenditure. Thus public finance in this manner
can be said the science of the income and expenditure of the government.

Definition
According to prof. Dalton “public finance is one of those subjects that lie on the border lie
between economics and politics. It is concerned with income and expenditure of public
authorities and with the mutual adjustment of one another. The principal of public finance are
the general principles, which may be laid down with regard to these matters.
According to Adam Smith “public finance is an investigation into the nature and principles of
the state revenue and expenditure”

Public finance v/s private finance

What is Public finance?
Public finance is a study of the income and expenditure activities of the government.

“public finance is the branch of economics that studies the revenue and expenditure of the
government. And the change of one or the other to achieve desirable effects and avoid
undesirable ones.”  The goal of public finance is to benefit the public. Government has many
resources to gain income. Public finance has three main functions.

 The effective use of available resources.

 Income distribution among citizens.
 The economy’s stability.
There are five main components of public finance. – tax collection, expenditure, budget, the
national debt. Government has many resources to get revenue. Collecting tax is the main
resource of the government. The government spends that money on projects. Those projects
are beneficial to the general public. Such as building roads, providing electricity, water, etc.
 Government usually makes a budget for the expenditures of projects. When expenditure is
more than income then budget is deficit budget. To increase the collection of taxes, the
government borrows money. Which increases the national debt. Governments usually prefer
deficit budgets. Because it helps in economic growth, causes positive inflation. The
development of entire nations depends on the effective management of public finance. Public
finance plays an important role in reducing economic inequalities.

What is private finance?

The study of private finance includes the income and expenditure of a person or company.
The goal of private finance is to make a profit and fulfill private desires. In private finance,
individuals or a company have fewer resources to earn an income. Individuals or companies
prefer surplus budgets to make a profit.

There are two types of private finance –Personal finance and business finance. Personal
finance is only limited to an individual or household level. It includes investment, banking,
saving, loans, tax management, and retirement planning.  Individuals make short-term
investments where they can earn quickly. They always consider their income before making
investments. Business finance means the management of the financial activities of a
company. In this, we study how to get capital and use it for the growth of the company. Well,
management of finance can help increase the capital of a company.

Difference between public finance and private finance

Basis Public finance Private finance

Public Finance is a  study of Private finance is the study of the

Definition government revenue and revenue and expenditure of
expenditure activities. individuals and private entities.

The objective of private finance

The objective of public finance
Objective
is to benefit the public. is to make a profit.

The government chose a deficit Private individuals prefer surplus

Budget
budget. budgets…

Government make a transaction private individuals make

for business transactions for
Motive of Expenditure
public benefit. profit.

Financial transaction government make its In private finance, an individual

 can keep their transaction
budget proposals and allocation
secret.
of resources to the public.

 
 

Government has full control over Private individuals have control

Currency ownership
the currency. over the currency.

The government invests in Private investors put their money

Long term consideration projects that are beneficial for where the returns are quick and
the public. immediate.

The government first decides the

amount of  A private individual considers
Determination of expenditure. expenditure and then finds income first and then decides
resources of income. how much to spend.

The government have more

resources to make money such as
printing
currency, passing laws to Individuals have fewer resources
Resources
increase its income to make income.

etc.

Private individuals cannot use

Government can use coercive force to get income.
Coercive methods methods to get income such as
taxes.  

Components of public finance

1. Public revenue
2. Public expenditure
3. Public dept
4. Financial administration
5. Economic stabilization
Public revenue :
' Public revenue ' ( or Government revenue ) is concerned with the Income of the Government
through various sources . The Government collects / earns money through various forms of
tax and non tax revenue , and use this money to meet its administrative and other
expenditures .
It is the money received by a government from taxes and non - tax sources to enable it to
undertake government expenditures .
The income of the government through all the sources is called public income or public
revenue .

Public expenditure :
Public expenditure is spending made by the government of a country on collective needs and
wants , such as pension , provisions , security , infrastructure , etc.
Expenses incurred by the public authorities - central , state and local self - governments - are
called public expenditure . Such expenditures are made for the maintenance of the
governments as well as for the benefit of the society as whole .

Public debt :
Public debt is the total amount , including total liabilities , borrowed by the government to
meet its development budget .
Government borrow money from the public when it's expenditure exceeds it's revenue .
Public debt in simple words loan raised by a government within the country and outside the
country .

Public administration :
Financial administration is that part of government organisation which deals with the
collection , preservation and distribution of public funds , with the coordination of public
revenue and expenditure with the management of credit operations on behalf of the state and
with the general control .
Financial Administration includes all the activities which generate , regulates , and distribute
monetary resources needed for the sustenance and growth of the members of a political
community .

Economic stabilization :
Economic stabilization policies are macroeconomic policies implemented by governments
and central banks in an attempt to keep economic growth stable and less volatile .
Policymakers carefully monitor the business cycle , and make adjustments to fiscal and
monetary policy in an attempt to create stable and sustainable growth and reduce the damage
caused by downturns .
 Economic stabilisation is one of the main remedies to effectively control or eliminate the
periodic trade cycles which plague capitalist economy

Maximum social advantage

Principles of maximum social advantage
Introduction
The principle of Maximum social advantage is the ‘Principle of Public Finance’.
It is the fundamental principle which should determine fiscal operations of the government.
This principle is formulated and popularized by Dr. Dalton and Prof. Pigou.
Dr. Dalton calls it as the principle of maximum social advantage and Prof. Pigou describe as
principle of Maximum Aggregate Welfare.
The principle provides guidance to the Govt. regarding public revenue and public expenditure
or public finance operations so as to maximize social advantage or welfare
Taxation by itself is a loss of utility to the people,
while public expenditure by itself is a gain of utility to the community.
The principle of maximum social advantage implies that public expenditure is subject to
diminishing marginal social benefits and taxes are subject to increasing marginal social costs.
Assumptions
1. All taxes result in sacrifice and all public expenditures lead to benefits.
2. Public revenue consists of only taxes and no other sources of income to the
government.
3. The government has no surplus or deficit budget but only balanced budget.
4. Public expenditure is subject to diminishing marginal social benefit and taxes are
subject to increasing marginal social sacrifice.
Explanation
The Principle of Maximum Social Advantage states that public finance leads to economic
welfare when public expenditure & taxation are carried out up to that point where the benefits
derived from the MU (Marginal Utility) of expenditure is equal to the Marginal Disutility or
the sacrifice imposed by taxation.
Hugh Dalton explains the principle of maximum social advantage with reference to
1.Marginal Social Sacrifice
2. Marginal Social Benefits
Marginal social sacrifice
Marginal social sacrifice (MSS): Amount of social sacrifice undergone by the public due to
the imposition of an additional unit of tax.
Dalton says that the additional burden (marginal sacrifice) resulting from additional units of
taxation goes on increasing i.e. the total social sacrifice increases at an increasing rate.
This is because, when taxes are imposed, the stock of money with the community diminishes.
As a result of diminishing stock of money, the marginal utility of money goes on increasing.

 This diagram indicates that the Marginal Social Sacrifice (MSS) curve rises upwards
from left to right.
 This indicates that with each additional unit of taxation, the level of sacrifice also
increases.
 When the unit of taxation was OM1, the marginal social sacrifice was OS1, and with
the increase in taxation at OM2, the marginal social sacrifice rises to OS2 and so on.
Marginal social benefits
Marginal social benefit (MSB): benefit conferred on the society by an additional unit of
public expenditure.
Just as the marginal utility from a commodity to a consumer declines as more and more units
of the commodity are made available to him, the social benefit from each additional unit of
public expenditure declines as more and more units of public expenditure are spent.
In the beginning, the units of public expenditure are spent on the most essential social
activities. Subsequent doses of public expenditure are spent on less and less important social
activities.
  In the above diagram, the marginal social benefit (MSB) curve slopes downward from
left to right.
 This indicates that the social benefit derived out of public expenditure is reducing at a
diminishing rate.
 When the public expenditure was OM1, the marginal social benefit was OB1, and
when the public expenditure is OM2, the marginal social benefit is reduced at
OB2and so on
The point of maximum social advantage
Social advantage is maximized at the point where marginal social sacrifice cuts the marginal
social benefits curve.

• In the diagram, the marginal disutility or social sacrifice is equal to the marginal
utility or social benefit at the point P. Beyond this point, the marginal disutility or
social sacrifice will be higher, and the marginal utility or social benefit will be lower.
• At point P social advantage is maximum. If we consider Point P1, at this point
marginal social benefit is P1Q1. This is greater than marginal social sacrifice S1Q1.
Since the marginal social sacrifice is lower than the marginal social benefit, it makes
more sense to increase the level of taxation and public expenditure.
• This is due to the reason that additional unit of revenue raised and spent by the
government leads to increase in the net social advantage. This situation of increasing
taxation and public expenditure continues, as long as the levels of taxation and
expenditure are towards the left of the point P.
 • At point P, the units of taxation and public expenditure moves up to OQ, the marginal
utility or social benefit becomes equal to marginal disutility or social sacrifice at this
point.
• Therefore at this point, the maximum social advantage is achieved. If we moved
forward to OQ levels of units, the marginal social sacrifice S2Q2 is greater than
marginal social benefit P2Q2.
• Therefore, beyond the point P, any further increase in the level of taxation and public
expenditure may bring down the social advantage. This is because; each subsequent
unit of additional taxation will increase the marginal disutility or social sacrifice,
which will be more than marginal utility or social benefit.
• This shows that maximum social advantage is attained only at point P & this is the
point where marginal social benefit of public expenditure is equal to the marginal
social sacrifice of taxation.
Criticism
( i) Difficulties in Measuring Social Benefits:
The principle of maximum social advantage is theoretically explained with the help of the
marginal utility analysis. The Marginal benefits of public expenditure and the marginal
disutility on sacrifice of public revenue are concepts, the objective measurement of which is
extremely difficult.
(ii) Unrealistic Assumptions:
It is unrealistic to assume that government expenditure is always beneficial and that every tax
is a burden to society. For example, taxes on cigarettes or alcohol can provide benefit to
society; expenditure on social overheads like health care will give rise to social benefit
whereas unnecessary increase in expenditure on defense may divert resource from productive
activities causing loss of welfare to society.
(iii) Neglect of Non – Tax Revenue:
The principle says that the entire public expenditure is financed by taxation. But, in practice,
a significant portion of public expenditure is also financed by other sources like public
borrowing, profits from public sector enterprises, imposition of fees, penalties etc. Dalton
fails to take into account all such other sources.
(iv) Lack of divisibility:
The marginal benefit from public expenditure and marginal sacrifice from taxation can be
equated only when public expenditure and taxation are divided into smaller units. But it is not
possible practically.
(v) Large Budget Size:
The financial operations of the government involve collection of large sums of money from
taxation and other sources and the disbursement of large amounts by way of public
expenditure. The effects of small additional amounts of these on the community are difficult
to measure. Therefore, in practice, the public authorities are not in a position to estimates the
marginal benefits and the marginal sacrifice.
 Public revenue
Meaning of public revenue
The income of the government through all its sources is called public income or public
revenue. It includes income from taxes, prices of goods and services supplied by the public
enterprises, revenue from the administrative activities, such as fees, fines etc., and gifta and
grants.
SOURCES OR PUBLIC REVENUE
1 Tax revenue
a. Direct tax
b. Indirect tax
2 Non tax revenue
a. Grants and Gifts.
b. Fees.
c. Licence Fees.
d. Special Assessment.
e. Fines.
f. Forfeitures.
g. Escheat.

Tax revenue
Taxes are the first and foremost sources of public revenue. Taxes are compulsory payments
to government without expecting direct benefit or return by the tax-payer. Taxes collected by
Government are used to provide common benefits to all. Taxes do not guarantee any direct
benefit for person who pays the tax. It is not based on “quid pro quo principle.” The Tax has
been divided into two types such as Direct Taxes and Indirect Taxes
(A) Direct Taxes:
Direct taxes are those taxes which are paid by the same person on whom it has been
imposed. The impact and incidence of tax fall on the same person, because the tax burden
cannot be shifted to others. Direct taxes include the following taxes.
i) Personal Income tax is a tax imposed on the excess income earned by an
individual over and above the limit decided by the finance ministry form time to
time. It is progressive in nature.
ii) Corporate Tax is a tax levied on the profits earned by registered companies.
iii) Capital Gains Tax is a tax imposed on the net profits earned through capital
investment in stock market ,Rreal estate, Gold and Jewelry etc.
iv) Wealth Tax (or) Property Tax is a tax levied upon the property owned by
individuals. The property includes Land, Building, shares, Bonds, Fixed Deposits,
Gold and Jewelry etc.
v) Other taxes :These taxes include taxes like Gift tax and Estate duty.
 (B) Indirect Taxes:
Indirect taxes are those taxes which are imposed on one group of people, but the ultimate
burden will fall on another group of people. The impact of tax and incidence of tax are on
different people. In case of Indirect taxes tax burden can be shifted. There are middlemen
between the Government and the tax payer.
The important Indirect Taxes are as follows:
i) Excise Duty is a tax imposed on the manufacturers as per the value of goods
produced but the ultimate burden will fall on the final consumers.
ii) Customs Duty is a tax imposed on import and export of Goods. Customs duty may
be specific or advalorem. Advalorem duty is a tax imposed on the basis the value
of goods imported while specific duty is imposed as per the number of units
imported.
iii) Value Added Tax (VAT) is a part of a sales tax imposed by the state government.
iv) Sales Taxrevenue goes to the state government when sale or purchase takes place
within the state. Sales tax revenue on interstate transactions goes to the central
government.
v) Service Tax is tax imposed on services provided. The impact is on the service
provider and the incidence of tax false on the customers. Service tax is the fastest
growing tax in India.
vi) Octroiis a tax levied on transfer of goods from one state to another or from one
region to another.

Non-Tax Revenue:
These sources of revenue are classified as administrative revenues, commercial revenues
and grants and gifts.
1) Grants:
Grants are made by a higher public authority to a lower one, for example, from the
Central to the State government or from the State to the local government. Grants are
given so that a public authority is able to perform certain activities at the local level.
There is no repayment obligation in case of grants.
2) Gifts:
Gifts and donations are voluntarily made by individuals, organizations, foreign
governments to the funds of the government, e.g. Prime Minister’s Relief Fund. Such
gifts are usually made at the time of crisis like war or floods. Gifts cannot be considered
a regular source of revenue.
3) Fees:
Fees are an important source of administrative non-tax revenue to the government.The
government provides certain services and charges, certain fees for them. For example,
fees are charged for issuing of passports, granting licenses to telecom companies,
driving licenses etc.
4) Fines and Penalties:
Another source of administrative non-tax revenue includes fines and penalties. They are
imposed as a form of punishment for breaking law or non-fulfillment of certain
 conditions or for failure to observe some regulations. They are not expected to be a
major source of revenue to the government.
5) Special Assessment: It is a kind of special charge levied on certain members of the
community who are beneficiaries of certain government activities or public projects. For
example, due to public park in a locality or due to the construction of a road, people in the
locality may experience an appreciation in the value of their property or land.
6) Surpluses of Public Enterprises: Most countries have government departments and
public sector enterprises involved in commercial activities. The surpluses of these
departments and enterprises are an important source of non-tax revenue. These revenues
are in the form of profits and interests and are termed as commercial revenues.
7) Borrowings: When government revenue is not sufficient to meet the public
expenditure government borrows either from internal or external sources. Borrowing is
income of the government which creates liability because the government has to repay the
borrowings with interest.

Meaning of Public expenditure

Expenses incurred by the public authorities—central, state and local self- governments—are
called public expenditure. Such expenditures are made for the maintenance of the
governments as well as for the benefit of the society as whole.
Public expenditure can be defined as, "The expenditure incurred by public authorities like
central, state and local governments to satisfy the collective social wants of the people is
known as public expenditure."

Classifications of public expenditure

1. Revenue expenditure and Capital Expenditure
Revenue expenditure are current or consumption expenditures incurred on civil
administration, defence forces, public health and education, maintenance of government
machinery. This type of expenditure is of recurring type which is incurred year after year.
On the other hand, capital expenditures are incurred on building durable assets, like
highways, multipurpose dams, irrigation projects, buying machinery and equipment. They are
non recurring type of expenditures in the form of capital investments. Such expenditures are
expected to improve the productive capacity of the economy.

2.Developmental expenditure and Non-Development

Expenditure:
If any particular expenditure by the Government promotes development. All those
expenditures of Government which promote economic growth are called developmental
expenditure.Expenditure on irrigation projects, flood control measures, transport and
communication, capital formation in agricultural and industrial sectors are described as
developmental.
On the other hand, expenditure on defence, civil administration (i.e., police, jails and
judiciary), interest on public debt etc., are put into the category of non-development
expenditure.

3.Productive Expenditure and Unproductive Expenditure :

Expenditure on infrastructure development, public enterprises or development of agriculture
increase productive capacity in the economy and bring income to the government. Thus they
are classified as productive expenditure.
Expenditures in the nature of consumption such as defence, interest payments, expenditure on
law and order, public administration, do not create any productive asset which can bring
income or returns to the government. Such expenses are classified as unproductive
expenditures.

4.Transfer Expenditure and Non-transfer expenditure

Transfer expenditure :
Transfer expenditure relates to the expenditure against which there is no corresponding
return.Such expenditure includes public expenditure on National Old Age Pension Schemes,
Interest payments, Subsidies, Unemployment allowances, Welfare benefits to weaker
sections, etc.
By incurring such expenditure, the government does not get anything in return, but it adds to
the welfare of the people, especially belong to the weaker sections of the society. Such
expenditure basically results in redistribution of money incomes within the society.
Non-Transfer Expenditure:
The non-transfer expenditure relates to expenditure which results in creation of income or
output.
The non-transfer expenditure includes development as well as non-development expenditure
that results in creation of output directly or indirectly.
Economic infrastructure such as power, transport, irrigation, etc.
Social infrastructure such as education, health and family welfare. Internal law and order and
defence. Public administration, etc.
By incurring such expenditure, the government creates a healthy conditions or environment
for economic activities. Due to economic growth, the government may be able to generate
income in form of duties and taxes.
Meaning of Canons of Taxation:
By canons of taxation we simply mean the characteristics or qualities which a good tax
system should possess. In fact, canons of taxation are related to the administrative part of a
tax. Adam Smith first devised the principles or canons of taxation in 1776.

Even in the 21st century, Smithian canons of taxation are applied by the modern
governments while imposing and collecting taxes.

Types of Canons of Taxation:

In this sense, his canons of taxation are, indeed, ‘classic’. His four canons of taxation
are:

(i) Canon of equality or equity

(ii) Canon of certainty

(iii) Canon of economy

(iv) Canon of convenience.

Modern economists have added more in the list of canons of taxation.

These are:

(v) Canon of productivity

(vi) Canon of elasticity

(vii) Canon of simplicity

(viii) Canon of diversity.

Classical canons of taxation:

i. Canon of Equality:

Canon of equality states that the burden of taxation must be distributed equally or equitably
among the taxpayers. However, this sort of equality robs of justice because not all taxpayers
have the same ability to pay taxes. Rich people are capable of paying more taxes than poor
people. Thus, justice demands that a person having greater ability to pay must pay large
taxes.
If everyone is asked to pay taxes according to his ability, then sacrifices of all taxpayers
become equal. This is the essence of canon of equality (of sacrifice). To establish equality in
sacrifice, taxes are to be imposed in accordance with the principle of ability to pay. In view
of this, canon of equality and canon of ability are the two sides of the same coin.

ii. Canon of Certainty:

The tax which an individual has to pay should be certain and not arbitrary. According to A.
Smith, the time of payment, the manner of payment, the quantity to be paid, i.e., tax liability,
ought all to be clear and plain to the contributor and to everyone. Thus, canon of certainty
embraces a lot of things. It must be certain to the taxpayer as well as to the tax-levying
authority.

Not only taxpayers should know when, where and how much taxes are to be paid. In other
words, the certainty of liability must be known beforehand. Similarly, there must also be
certainty of revenue that the government intends to collect over the given time period. Any
amount of uncertainty in these respects may invite a lot of trouble.

iii. Canon of Economy:

This canon implies that the cost of collecting a tax should be as minimum as possible. Any
tax that involves high administrative cost and unusual delay in assessment and high
collection of taxes should be avoided altogether.

According to A. Smith: “Every tax ought to be 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.”

iv. Canon of Convenience:

Taxes should be levied and collected in such a manner that it provides the greatest
convenience not only to the taxpayer but also to the government.

Thus, it should be painless and trouble-free as far as practicable. “Every tax”, stresses A.

Smith: “ought to be levied at time or the manner in which it is most likely to be
convenient for the contributor to pay it.” That is why, after the harvest, agricultural
income tax is collected. Salaried people are taxed at source at the time of receiving salaries.
Modern cannon of taxation
i. Canon of Productivity:

According to a well-known classical economist in the field of public finance, Charles F.

Bastable, taxes must be productive or cost-effective. This implies that the revenue yield
from any tax must be a sizable one. Further, this canon states that only those taxes should be
imposed that do not hamper productive effort of the community. A tax is said to be a
productive one only when it acts as an incentive to production.

ii. Canon of Elasticity:

Modern economists attach great importance to the canon of elasticity. This canon implies
that a tax should be flexible or elastic in yield.

It should be levied in such a way that the rate of taxes can be changed according to
exigencies of the situation. Whenever the government needs money, it must be able to
extract as much income as possible without generating any harmful consequences through
raising tax rates. Income tax satisfies this canon.

iii. Canon of Simplicity:

Every tax must be simple and intelligible to the people so that the taxpayer is able to
calculate it without taking the help of tax consultants. A complex as well as a complicated
tax is bound to yield undesirable side-effects. It may encourage taxpayers to evade taxes if
the tax system is found to be complicated.

A complicated tax system is expensive in the sense that even the most honest educated
taxpayers will have to seek advice of the tax consultants. Ultimately, such a tax system has
the potentiality of breeding corruption in the society.

iv. Canon of Diversity:

Taxation must be dynamic. This means that a country’s tax structure ought to be dynamic or
diverse in nature rather than having a single or two taxes. Diversification in a tax structure
will demand involvement of the majority of the sectors of the population.

If a single tax system is introduced, only a particular sector will be asked to pay to the
national exchequer leaving a large number of population untouched. Obviously, incidence of
such a tax system will be greatest on certain taxpayers. A dynamic or a diversified tax
structure will result in the allocation of burden of taxes among the vast population resulting
in a low degree of incidence of a tax in the aggregate.

PUBLIC DEBT
Modern governments need to borrow from different sources when current revenue falls short
of public expenditures. Thus, public debt refers to loans incurred by the government to
finance its activities when other sources of public income fail to meet the requirements. In
this wider sense, the proceeds of such public borrowing constitute public income.

Classification of Public Debt:

i. Internal and External Debt:

Sums owed to the citizens and institutions are called internal debt and sums owed to
foreigners comprise the external debt. Internal debt refers to the government loans floated in
the capital markets within the country. Such debt is subscribed by individuals and institutions
of the country.

On the other hand, if a public loan is floated in the foreign capital markets, i.e., outside the
country, by the government from foreign nationals, foreign governments, international
financial institutions, it is called external debt.

ii. Short term and Long Term Loans:

Loans are classified according to the duration of loans taken. Most government debt is held in
short term interest-bearing securities, such as Treasury Bills or Ways and Means Advances
(WMA). Maturity period of Treasury bill is usually 90 days.

Government borrows money for such period from the central bank of the country to cover
temporary deficits in the budget. Only for long term loans, government comes to the public.
For development purposes, long period loans are raised by the government usually for a
period exceeding five years or more.

iii. Funded and Unfunded or Floating Debt:

Funded debt is the loan repayable after a long period of time, usually more than a year. Thus,
funded debt is long term debt. Further, since for the repayment of such debt government
maintains a separate fund, the debt is called funded debt. Floating or unfunded loans are those
which are repayable within a short period, usually less than a year.
It is unfunded because no separate fund is maintained by the government for the debt
repayment. Since repayment of unfunded debt is made out of public revenue, it is referred to
as a floating debt. Thus, unfunded debt is a short term debt.

iv. Voluntary and Compulsory Loans:

A democratic government raises loans for the nationals on a voluntary basis. Thus, loans
given to the government by the people on their own will and ability are called voluntary
loans. Normally, public debt, by nature, is voluntary. But during emergencies (e.g., war,
natural calamities, etc.,) government may force the nationals to lend it. Such loans are called
forced or compulsory loans.

v. Redeemable and Irredeemable Debt:

Redeemable public debt refers to that debt which the government promises to pay off at some
future date. After the maturity period, the government pays the amount to the lenders. Thus,
redeemable loans are called terminable loans.

In the case of irredeemable debt, government does not make any promise about the payment
of the principal amount, although interest is paid regularly to the lenders. For the most
obvious reasons, redeemable public debt is preferred. If irredeemable loans are taken by the
government, the society will have to face the consequence of burden of perpetual debt.

vi. Productive (or Reproductive) and Unproductive (or Deadweight) Debt:

On the criteria of purposes of loans, public debt may be classified as productive or
reproductive and unproductive or deadweight debt. Public debt is productive when it is used
in income-earning enterprises. Or productive debt refers to that loan which is raised by the
government for increasing the productive power of the economy.

A productive debt creates sufficient assets by which it is eventually repaid. If loans taken by
the government are spent on the building of railways, development of mines and industries,
irrigation works, education, etc., income of the government will increase ultimately.

Public debt is unproductive when it is spent on purposes which do not yield any income to
the government, e.g., refugee rehabilitation or famine relief work. Loans for financing war
may be regarded as unproductive loans. Instead of creating any productive assets in the
economy, unproductive loans do not add to the productive capacity of the economy. That is
why unproductive debts are called deadweight debts.
Methods of Redemption of Public Debt:
Redemption of debt refers to the repayment of a public loan. Although public debt should be
paid, debt redemption is desirable too. In order to save the government from bankruptcy and
to raise the confidence of lenders, the government has to redeem its debts from time to time.

i. Refunding:
Refunding of debt implies issue of new bonds and securities for raising new loans in order to
pay off the matured loans (i.e., old debts).

When the government uses this method of refunding, there is no liquidation of the money
burden of public debt. Instead, the debt servicing (i.e., repayment of the interest along with
the principal) burden gets accumulated on account of postponement of the debt- repayment to
save future debt.

ii. Conversion:
By debt conversion we mean reduction of interest burden by converting old but high interest-
bearing loans into new but low interest-bearing loans. This method tends to reduce the burden
of interest on the taxpayers. As the government is enabled to reduce the burden of debt which
falls, it is not required to raise huge revenue through taxes to service the debt.

Instead, the government can cut down the tax liability and provide relief to the taxpayers in
the event of a reduction in the rate of interest payable on public debt. It is assumed that since
most taxpayers are poor people while lenders are rich people, such conversion of public debt
results in a less unequal distribution of income.

iii. Sinking Fund:

One of the best methods of redemption of public debt is sinking fund. It is the fund into
which certain portion of revenue is put every year in such a way that it would be sufficient to
pay off the debt from the fund at the time of maturity. In general, there are, in fact, two ways
of crediting a portion of revenue to this fund.

The usual procedure is to deposit a certain (fixed) percentage of its annual income to the
fund. Another procedure is to raise a new loan and credit the proceeds to the sinking fund.
However, there are some reservations against the second method.

Dalton has opined that it is in the Tightness of things to accumulate sinking fund out of the
current revenue of the government, not out of new loans. Although convenient, it is one of
the slowest methods of redemption of debt. That is why capital levy as a form of debt
repudiation is often recommended by economists.
iv. Capital Levy:
In times of war or emergencies, most governments follow the practice of raising money
necessary for the redemption of the public debt by imposing a special tax on capital.

A capital levy is just like a wealth tax in as much as it is imposed on capital assets. This
method has certain decisive advantages. Firstly, it enables a government to repay its
(emergency) debt by collecting additional tax revenues from the rich people (i.e., people who
have huge properties).

This then reduces consumption spending of these people and the severity of inflation is
weakened. Secondly, progressive levy on capital helps to reduce inequalities in income and
wealth. But it has certain clear-cut disadvantages too. Firstly, it hampers capital formation.
Secondly, during normal time this method is not suggested.

v. Terminal Annuity:
It is something similar to sinking fund. Under this method, the government pays off its debt
on the basis of terminal annuity. By using this method, the government pays off the debt in
equal annual instalments.

This method enables government to reduce the burden of debt annually and at the time of
maturity it is fully paid off. It is the method of redeeming debts in instalments since the
government is not required to make one huge lump sum payment.

vi. Budget Surplus:

By making a surplus budget, the government can pay off its debt to the people. As a general
rule, the government makes use of the budgetary surplus to buy back from the market its own
bonds and securities. This method is of little use since modern governments resort to deficit
budget. A surplus budget is usually not made.

vii. Additional Taxation:

Sometimes, the government imposes additional taxes on people to pay interest on public debt.
By levying new taxes—both direct and indirect— the government can collect the necessary
revenue so as to be able to pay off its old debt. Although an easier means of repudiation, this
method has certain advantages since taxes have large distortionary effects.

viii. Compulsory Reduction in the Rate of Interest:

The government may pass an ordinance to reduce the rate of interest payable on its debt. This
happens when the government suffers from financial crisis and when there is a huge deficit in
its budget.
There are so many instances of such statutory reductions in the rate of interest. However,
such practice is not followed under normal situations. Instead, the government is forced to
adopt this method of debt repayment when situation so demands.