Unit – IV
Public Debt
Meaning of 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.
However, since the debt has to be repaid along with interest from whom it is borrowed, it does not constitute income. Rather, it constitutes public expenditure. Public debt is incurred when the government floats loans and borrows either internally or externally from banks, individuals or countries or international loan-giving institutions.
What is true about public borrowing is that, like taxes, public borrowing is not a compulsory source of public income. The word ‘compulsion’ is not applied to public borrowing except in certain exceptional cases of borrowing.
Classification of Public Debt:
The structure of public debt is not uniform in any country on account of factors such as categories of markets in which loans are floated, the conditions for repayment, the rate of interest offered on bonds, purposes of borrowing, etc.
In view of these differences in criteria, public debt is classified into various categories:
i. Internal and external debt.
ii. Short term and long term loans.
iii. Funded and unfunded debt.
iv. Voluntary and compulsory loans.
v. Redeemable and irredeemable debt.
vi. Productive or reproductive and unproductive debt/deadweight debt.
ii. 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). The maturity period of the Treasury bill is usually 90 days.
The government borrows money for such a period from the central bank of the country to cover temporary deficits in the budget. Only for long term loans, the 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 unfounded because no separate fund is maintained by the government for 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, the 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, society will have to face the consequence of the 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 that 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., the income of the government will increase ultimately.
Productive loans thus add to the total productive capacity of the country.
In the words of Findlay Shirras: “Productive or reproductive loans which are fully covered by assets of equal or greater value, the source of the interest is the income from the ownership of these as railways and irrigation work.”
Public debt is unproductive when it is spent on purposes that 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.
Sometimes, the government may resort to an extreme step, such as repudiation of debt. This extreme step is, of course, a violation of the contract. The use of repudiation of debt by the government is economically unsound.
Here, instead of concentrating on the repudiation of debt, we discuss below other important methods for the retirement or redemption of public debt:
I Refunding:
Refunding of debt implies the 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 refund, 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 the postponement of the debt- repayment to save future debt.
II Conversions:
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 a 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 ag
IV. 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 a deficit budget. A surplus budget is usually not made.
V. 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.
VI. 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 a 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 the situation so demands.
Effects of Public Debt:
A peculiar profile of public borrowing is its voluntary nature, as contrasted to the compulsory features of taxation. When the government offers its securities to the public, persons are free to purchase them.
If they subscribe to government bonds, they suffer no net diminution in their wealth, as occurs when they pay taxes. In exchange for liquid cash, they receive bonds or other securities which bear interest and which will ultimately be paid off.
The government in turn receives money for meeting its expenditure but incurs a liability for the payment of interest and the repayment of principal in the future.
The economic effects of a government programme financed by borrowing are different from the effect of a similar programme financed by taxation. This is partly because the lending of money to the government is purely voluntary and partly because the making of such loans does not reduce the personal wealth of the lenders but merely changes its form.
A major consequence of these types of fund mobilization is that borrowing, on the whole, is likely to have a less contractionary effect upon aggregate demand, than raising an equivalent amount by way of taxation.
Hence a programme of expenditure financed by borrowing is likely to have a greater net expansionary effect upon the economy than a programme of the same magnitude financed by taxation.
1. Effect of Borrowing upon Consumption:
In the case of borrowing, curtailment of consumption spending is likely to be slight, except in wartime borrowing programmes in which substantial pressure is applied to individuals to reduce consumption and buy bonds.
Hence compared with taxation, public debt does not have any serious effect on the level of current consumption. In the case of individuals, their consumption pattern is set by their current income. Loans are advanced out of saving, whereas taxes are paid out of income.
Under certain conditions, there is a greater possibility of an increase in the spending on consumption, due to government borrowing. The bondholders regard their bonds as wealth and a source of income.
Moreover, by holding government bond, their liquidity position is not very much affected because bonds can be converted into cash at any time. Hence there will be a tendency to increase spending on consumption.
2. Effect of Borrowing on Saving and Investment:
The floating of public debt influences saving and investment through the interest rate mechanism. The floating of public debt will raise the rate of interest. Since savings interest elastic, the creation of public debt will raise savings.
Investment expenditure of the bondholders is influenced through the claimed effect on investment. That is through an increase or decrease in interest rate. When bonds are issued, the ratio of the money supply to debt supply will be reduced and as a result rate of interest will increase.
As a result, the effect of public debt will be, reduced investment expenditure. On the other hand when bonds are purchased by the government from the open market, or when government repay public debt, the ratio of the money supply to debt supply increases and the rate of interest declines.
This will lead to an increase in investment. The overall effect on the economy depends largely on the way in which the investment is made in the public sector, compared with what could have been achieved in the private sector.
The effect of public debt on investment also depends on the method of raising loans. Suppose if the government borrows from commercial banks and central bank of a country, it will increase the money supply or purchasing power and hence the funds available for investment will not be reduced.
However, if the government bonds are subscribed by the public and financial institutions, out of funds meant for investment, then automatically investment expenditure will be curtailed.
3. Effect of Borrowing on Production:
In general, government borrowing results in enhancing the productive capacity of the economy. If the borrowed money is used by the government to finance developmental projects, it will generate income and employment opportunities.
Such investments strengthen the capital base of the economy and help to increase the production of goods and services. Moreover, the government will be able to repay the debt and interest charges in future without much difficulty.
Whereas, if the public purchases government bonds, by selling their shares or debentures, invested in private industrial concerns, it will create an adverse effect on private investment.
However, when the borrowed money, as stated above is used for highly productive activities, overall production is not affected badly. Likewise, if the public subscribes to government bonds by withdrawing their bank deposits, it will adversely affect the lending capacity of commercial banks and thereby private investment activities.
However, if public debt is purchased by the individuals, utilizing their idle funds, it will not adversely affect private investment. Whereas borrowing resorted to meeting current expenditure or for financing a war, would result in the diversion of resources from productive activities to wasteful expenditure flows.
4. Effect of Public Debt on Distribution:
Borrowing leads to the transfer of resources from one section of the community to another section. If this transfer takes place from the rich to the poor, the inequality in the distribution of income and wealth would be reduced and as a result, the economic welfare of the community will be enhanced.
On the other hand, if the transfer of wealth takes place from the poor to the rich, the disparity in the income distribution will be aggravated.
Usually, government bonds are subscribed by the richer income group. Whereas, the burden of taxation imposed for financing debt service and repayment of public debt, falls on the poor section. Therefore generally public debt has a tendency to increase economic inequality.
Whereas suppose the public debt is mobilized through the small savings of lower-income group. Correspondingly debts are serviced and repaid through taxation imposed on the richer income group.
Then public debt will not result in increased income inequality. Hence, loan finance can be used as a means to redistribute income between different segments of the society.
5. Other Effects of Public Debt:
(a) Public debts in the form of government bonds are negotiable credit instruments. They are highly liquid form of assets. The investors can freely convert them into liquid cash at any time to meet their demand for money.
Moreover, as far as financial institutions are concerned, it adds to the liquidity position of these institutions, because of its transparency inconvertibility.
(b) During times of inflation, when the government borrows from the people, the purchasing power in the hands of the public will be reduced. As a result, inflationary pressure in the economy will be reduced.
On the contrary, during the depression, when the borrowed funds are utilized for development projects, it will generate additional purchasing power, employment and income. Hence, during depression, public debt can be utilized as an effective instrument to curb deflationary fluctuations in economic activity.
Hence, in modern times, public debt is used as an important instrument to bring about economic stability in the economy. In fact, one of the major objectives of government borrowing today is to strengthen the economy by freeing it from the evils of depressions and also to build up the economy and stable economic growth. Owing to this reason, rapid increase in public debt need not be viewed with concern.
The burden of Public Debt:
The burden of public debt is a misleading and highly confusing concept. The 1930s and 1940s witnessed an array of debate over the issue of debt burden. The focus of the 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 points 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 the debit-credit relationship.
Every debit has a corresponding credit and this fact is frequently overlooked when considering the burden of public debt. In this context, Taylor points 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 overlooked 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.
The Keynesian approach strongly advocates that public borrowing for the purpose of generating effective demand will not generate any burden. It will help to activate idle savings in the private sector and generate income and employment. However, with the publication of James Buchana’s “Public Principles of Public Debt” in 1958, the debt burden controversy got again activated and fueled.
1. 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 the burden is shifted to the future generation.
The future generation suffers when the present generation reduces its savings 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 a 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, the 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 necessitates 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.
2. Modern Views:
Economists like J.M. Keynes, Harris, Buchanan, Musgrave, and Modigliani are the chief exponents of the modern version of debt burden. The modern theory of public debt is put as “the new orthodoxy” by Prof. Buchanan.
The worldwide depression of the 1930s 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 a 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 the employment situation and generate effective demand and thereby raising the level of economic activity.
Under the shadow of Say's Law, propagated the misconception that the persistent technique of unbalancing the budget coupled with an increasing proportion of public debt endangers the very economic stability of the nation.
However, 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 the 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 the burden of debt should be considered in terms of a reduction in personal satisfaction. When 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.
Buchanan argues that when government debt is serviced there is a burden in the form of a claim on the taxpayer’s income. That is when the debt is repaid; the future generation has to pay tax. This will reduce either their consumption or saving.
This will lead to reduced satisfaction. Hence, the primary burden is shifted to the future generation. This view of Prof. James Buchanan was widely supported by a number of economists. The conclusions emerging from the forgone analysis can be summarized as follows. The existence of the large debt is neither a blessing nor an evil. It produces both favourable and adverse effect on the economy.
Public debt should be treated as an important instrument of fiscal policy. Both these conflicting views on the burden of public debt can be easily shown to be misleading. Hence it would be convenient and useful to adopt Dalton’s distinction between direct and indirect burden of public debt and between money burden and the real burden of public debt, to analyse the overall burden of public debt.
3. 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 principal components. In the case of 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 monetary 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.
4. Direct Real Burden:
The 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 the public debt will help to reduce the inequalities of income in the community. In such circumstances there is no direct burden; instead, there is a direct real benefit to the community.
5. 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 and 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.
6. 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 (bondholders) 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 productive activity, the profit generated from it can be used to pay off the debt, whereas 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 pay 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 the 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 may be 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.
7. Burden of External Debt:
In several aspects, external debts differ from internal debt. Still, in the case of the burden of debt, both share some similar characteristics. For the payment of the internal and external debt, the 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 a greater burden than internal debt. In the case of internal debt, there is no resource transfer to outside the country. The repayment of principal and interest charges doesn’t lead to the transfer of resources from one 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 a foreign nation.
By way of interest charges and repayment of principal, 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.
Public Debt Management:
Public debt management is the process of establishing and executing a strategy for managing the government’s debt in order to raise the required amount of funding at the lowest possible cost over the medium to long term, consistent with a prudent degree of risk. It should also meet any other public debt management goals the government may have set, such as developing and maintaining an efficient market for government securities.
In a broader macroeconomic context for public policy, governments should seek to ensure that both the level and rate of growth in their public debt are on a sustainable path and that the debt can be serviced under a wide range of circumstances, including economic and financial market stress while meeting cost and risk objectives. While the responsibility for compliance with debt ceilings and for conducting debt sustainability analysis lies with the fiscal authorities, public debt managers should share fiscal and monetary policy authorities’ concerns that public sector indebtedness remains on a sustainable path. Debt managers should ensure that the fiscal authorities are aware of the impact of the government’s financing requirements and debt levels on borrowing costs. Examples of indicators that address the issue of debt sustainability include the public sector debt service ratio, and ratios of public debt to GDP, exports, and tax revenue. Such indicators should be evaluated considering a wide range of scenarios.
Every government faces policy choices concerning debt management objectives, in particular its preferred risk tolerance, the parts of the government balance sheet that debt managers should be responsible for, the management of contingent liabilities, and the establishment of sound governance for public debt management. On many of these issues, there is increasing convergence on what is considered prudent public debt management practices that can also reduce vulnerability to contagion and financial shocks. These include recognition of the benefits of clear objectives for debt management; weighing risks against cost considerations; the separation of debt and monetary management objectives and accountabilities (where appropriate, combined with consultation and information sharing between the debt manager and the central bank); the need to carefully manage refinancing and market risks and the interest costs of debt burdens; and the necessity of developing a sound institutional structure and policies for reducing operational risk, including clear delegation of responsibilities and associated accountabilities among government agencies involved in debt management.
Poorly structured debt portfolios, in terms of maturity, currency, or interest rate composition and large contingent liabilities, have been important factors in inducing or propagating economic crises in many countries throughout history.1 For example, irrespective of the exchange rate regime, or whether domestic or foreign currency debt is involved, crises have often arisen because of an excessive focus by governments on possible cost savings associated with short-term or floating rate debt. The issuance of large volumes of such debt instruments has left government budgets seriously exposed to changing growth and financial market conditions, including changes in the country’s creditworthiness, when this debt has to be refinanced. Excessive reliance on foreign currency debt poses particular risks as it can lead to exchange rate and/or monetary pressures if investors become reluctant to refinance the government’s debt. By reducing the risk that the government’s own debt portfolio will become a source of instability for the private sector, prudent government debt management, along with sound policies for managing contingent liabilities, can make countries less susceptible to contagion and financial risk. Further, a debt portfolio that is robust to shocks places the government in a better position to effectively manage financial crises.
Sound risk management practices are essential given that a government’s debt portfolio is usually the largest financial portfolio in the country and can contain complex and risky financial structures, which have the potential to generate substantial risk to the government’s balance sheet and overall financial stability. Sound risk management by the public sector is also essential for risk management by the private sector. Sound debt structures help governments reduce their exposure to interest rate, currency, refinancing, and other risks. Many governments seek to support these structures by establishing targets and ranges for key risk indicators or, where feasible, target portfolios related to the desired currency composition, duration, and maturity structure of the debt to guide borrowing activities and other debit transactions. When made public, such targets help to increase the predictability and transparency of debt management operations, and in turn reduce uncertainty for investors.
Debt crises have highlighted the importance of sound debt management practices and the need for an efficient and liquid domestic capital market. Although government debt management policies may not have been the sole or even the main cause of such crises, the maturity structure, and interest rate and currency composition of the government’s debt portfolio, together with substantial obligations in respect of explicit and implicit contingent liabilities—not least in relation to the financial sector—have contributed to the severity of the crises. Even in situations where there are sound macroeconomic policy settings, risky debt management practices increase the vulnerability of the economy to economic and financial shocks. Sometimes these risks can be readily addressed by relatively straightforward measures, such as by lengthening the maturities of borrowings and paying any associated debt servicing costs, or by adjusting the amount, maturity, and composition of foreign exchange reserves. It is also important for governments to review criteria and governance arrangements in respect of contingent liabilities to ensure that these are consistent with transparent and sound fiscal and budget management principles.
Key Takeaways:
Fiscal policy has a number of objectives depending upon the circumstances in a country.
Important objectives of fiscal policy are:
1. Optimum allocation of economic resources. The aim is that fiscal policy should be so framed as to increase the efficiency of productive resources. To ensure this, the government should spend on those public works which give the maximum employment.
2. Fiscal policy should aim at equitable distribution of wealth and income. It means that fiscal policy should be so designed as to bring about reasonable equality of incomes among different groups by transferring wealth from the rich to the poor.
3. Another objective of fiscal policy is to maintain price stability. Deflation leads to a sharp decline in business activity. On the other extreme, inflation may hit the fixed income classes hard while benefiting speculators and traders. Fiscal policy has to be such as will maintain a reasonably stable price level thereby benefiting all sections of society.
4. The most important objective of fiscal policy is the achievement and maintenance of full employment because through it most other objectives are automatically achieved. Fiscal policy aimed at full employment envisages the direction of tax structure, not with a view to raising revenue but with a view to noticing the effects with specific kinds of taxes have on consumption, saving and investment.
The problem is determination of the volume and direction of government spending not only to provide certain services but also to fit public expenditure into the general pattern of total spending currently taking place in the economy.
These objectives are not always compatible, particularly those of price stability and full employment. The objective of equitable distribution of income might come in conflict with the objectives of economic efficiency and economic growth. Fiscal policy can be geared to transfer wealth from the rich to the poor through taxation with a view to bringing about a redistribution of income. But the transfer of income from the rich to the poor will adversely affect savings and capital formation. Thus, equity and growth objectives conflict.
Instruments of Fiscal Policy:
The tools of fiscal policy are taxes, expenditure, public debt and a nation’s budget. They consist of changes in government revenues or rates of the tax structure so as to encourage or restrict private expenditures on consumption and investment.
Public expenditures include normal government expenditures, capital expenditures on public works, relief expenditures, subsidies of various types, transfer payments and social security benefits.
Government expenditures are income-creating while taxes are primarily income-reducing. Management of public debt in most countries has also become an important tool of fiscal policy. It aims at influencing aggregate spending through changes in the holding of liquid assets.
During inflation, fiscal policy aims at controlling excessive aggregate spending, while during depression it aims at making up the deficiency in effective demand for raising the economy from the depths of depression. The following considerations may be noted in the adoption of proper policy instruments.
A Contra cyclical Budgetary Policy:
The policy of managed budgets implies changing expenditures with constant tax rates or changing tax rates with constant expenditures or a combination of the two. Budget management may be used to tackle depression and inflationary situations. Deliberate attempts are made under this policy to adjust revenues, expenditures and public debt to eliminate unemployment during depression and to achieve price stability in inflation.
Contra cyclical policy implies unbalanced budgets. An unbalanced budget during depression implies deficit spending. To make it more effective, the government may finance its deficits by borrowing from the banks. During periods of inflation, the policy is to have a budget surplus by curtailing government outlays.
The government may partly utilize the budget surplus to retire the outstanding government debt. The belief is that a surplus budget has deflationary effect on national income while a deficit budget tends to be expansionary. During depression when we need an increase in the flow of income, deficit budgets are desired. Conversely, in inflation when we need to check the overflow of income, surplus budgets are favoured.
However, following a contra cyclical budgetary policy is not an easy task. Predicting a recession or an inflationary boom is a difficult job. Adjusting the budget to the fast changing economic conditions is still more difficult especially when budget is a political decision to be taken after a good deal of delay and discussion. Therefore, emphasis has also to be laid on adjustment of individual items of the budget in order to make it more effective as a contra cyclical fiscal policy weapon.
Taxation Policy:
The structure of tax rates has to be varied in the context of conditions prevailing in an economy. Taxes determine the size of disposable income in the hands of the general public and therefore, the quantum of inflationary and deflationary gaps. During depression tax policy has to be such as to encourage private consumption and investment; while during inflation, tax policy must curtail consumption and investment.
During depression, a general reduction in corporate and income taxation has been favoured by economists like Prof. A H. Hansen, M. Kalecki, and R.A. Musgrave on the ground that this leaves higher disposable incomes with people inducing higher consumption while low corporate taxation encourages ‘venture capital’, thereby promoting more investment.
But there are others who express grave doubts about the supposed stimulating effect of taxation reliefs on investment. It has been argued that even a heavy reduction in taxes does not alter an entrepreneur’s decisions.
Mr. Kalecki expressed the view that the policy of reducing taxes for increasing consumption and stimulating private investment is not a practical solution of the unemployment problem because income-tax cannot be changed so often. The government will have to evolve a long-term fiscal policy.
During inflation, new taxes can be levied to wipe off the surplus purchasing power. Caution, however, should be taken not to raise the taxes so high as to stifle new investment and generate a business recession. Expenditure tax and excise duties are anti-inflationary in character. During inflation fiscal authority should aim at levying such taxes as reduce current excessive demand for specific commodities rather than aggregate demand.
Redistributive taxation is probably the best measure for raising and stabilising the consumption function. Redistributive taxation implies a progressive tax structure. This implies taxing the high-income groups at higher rates, and the middle and low-income groups at lower rates with a view to raising consumer spending.
Public Debt:
A sound programme of public borrowing and debt repayment is a potent weapon to fight inflation and deflation. Government borrowing can be in the form of borrowing from non-bank financial intermediaries, borrowing from the commercial banking system, drawings from the central bank or printing of new money.
Borrowing from the public through the sale of bonds and securities which curtails consumption and private investment is anti-inflationary in effect. Borrowing from the banking system is effective during depression if banks have got excess cash reserves.
Thus, if unused cash lying with banks can be lent to the government, it will cause a net addition to the national income stream. Withdrawals of balances from treasury are inflationary in nature but these balances are likely to be so small as to be of little importance in the economic system. However, the printing of new money is highly inflationary.
During war, borrowing becomes necessary when inflationary pressures become strong. In a period of inflation, therefore, public debt has to be managed in such a way as reduces the money supply in the economy and curtails credit. The government will do well to retire debt through a budget surplus.
During depression, on the opposite, taxes are reduced and public expenditures are increased. Deficits are financed by borrowings from the public, commercial banks or the central bank of the country. The public borrowing of otherwise idle funds will have no adverse effect on consumption or on investment. When budgets are deficit, it is very difficult to retire debts.
Actually, it pays to accumulate debt during depression and redeem it during a period of expansion. Along with this, the monetary authority (the central bank) must aim at a low bank rate to keep the burden of debt low. Thus, ‘public debt becomes an important tool of anti-cyclical policy.
Public Expenditure:
Public expenditure can be used to stimulate production, income and employment. Government expenditure forms a highly significant part of the total expenditure in the economy. A reduction or expansion in it causes significant variations in the total income. It can be instrumental in adjusting consumption and investment to achieve full employment.
During inflation, the best policy is to reduce government expenditure in order to control inflation by giving up such schemes as are justified only during deflation. While expenditures are reduced, attempts are made to increase public revenues to generate a budget surplus.
Though it is true that there is a limit beyond which it may not be possible to reduce government spending (say on account of political, and military considerations), yet the government can vary its expenditure to some extent to reduce inflationary pressures.
It is during depression that public spending assumes greater importance. A distinction is made between the concepts of public spending during depression, that is, the concepts of pump priming and the ‘compensatory spending’. Pump priming means that a certain volume of public spending will help to revive the economy which will gradually reach satisfactory levels of employment and output. What this volume of spending may be is not specific. The idea is that, when private spending becomes deficient, then a small dose of public spending may prove to be a good starter.
Compensatory spending, on the other hand, means that public spending is undertaken with the clear view to compensating for the decline in private investment. The idea is that when private investment declines, public expenditure should expand and as long as private investment is below normal, public compensatory spending should go on. These expenditures will have multiplier effects of raising the level of income, output and employment.
The compensatory public expenditure may take the forms of relief expenditure, subsidies, social insurance payments, public works etc.
Essential requisites of compensatory public spending are:
(1) It must have the maximum possible leverage effects;
(2) It must not be mutually offsetting;
(3) It must create economically and socially desirable assets. But pump priming expenditures are of limited relevance in advanced economies where the deficiency of investment is not merely cyclical but also secular.
Public Works:
Public expenditures meant for stabilisation are classified into two types:
(i) Expenditures on public works such as roads, schools, parks, buildings, airports, post-offices, hospitals, canals and other projects.
(ii) Transfer payments, such as interest on public debt, pensions, subsidies, relief payment, unemployment insurance, social security benefits etc.
The expenditure on building up of capital assets is called capital expenditure and transfer payments are called current expenditure. It has been recommended that governments should keep ready with them a list of public works which may be taken up when the economy shows signs of recession.
Such a programme of public investment will tone up the general morale of businessmen for investing. The primary employment in public works programmes will induce secondary and tertiary employment. As soon as the economy is put on the expansion track, such programmes may be slackened and may be given up completely so that at any time public investment does not compete with private investment.
Public works programmes suffer from a few limitations and practical difficulties. It is unrealistic to expect that public works will fill all the investment gaps of the private sector of the economy. To be genuinely effective in promoting investment during depression, public works require proper timing, proper financing and general approval of business and investing opportunities.
Public works programmes cannot be varied easily along with the trade cycle because many projects like river dams take a long time for completion and many others like schools and hospitals cannot be postponed, for if these are needed, these have to be built anyway.
Again, certain heavy projects requiring a long time for completion and started during the depression cannot be given up without serious loss of goodwill to the government. Then, there are problems of forecasting, of being able to know when a period of inflation or deflation may set in and of determining quickly the exact nature of programmes to be undertaken. Besides, there are delays in getting them started. Again, they impose a heavy debt burden and sometimes cause misallocation of resources, for projects may be located in one region while the unemployed resources are located in another region.
It is because of these limitations of public works that some economists favour a comprehensive programme of social security measures like pensions, subsidies, unemployment, insurance etc. These will not only raise consumption during depression but also stabilise it in the long-run. If such a programme of social security is financed through progressive taxation, the purpose would be better served. The wise course would be to coordinate the programmes of social security measures and public works.
Built-in-Flexibility:
One practical difficulty of public finance is of making the fiscal tools flexible enough for prompt and effective use. For example, the tempo of business activity may change suddenly manifesting itself in booms and slumps but fiscal tools cannot be geared all at once to meet such situations. To overcome such practical difficulties, built-in-flexibility has to be ensured in the fiscal tools.
A fiscal system has built-in-flexibility if a change in employment in the economy brings about a marked compensating change in the government’s revenues and expenditures. Unemployment insurance schemes have built-in-flexibility on both the spending and taxing sides.
As employment increases, the money spent on dolls is automatically reduced. Price support programmes, some kinds of excise duties, especially those levied on luxuries, also have built-in-flexibility to some extent.
However, built-in-flexibility may prove inadequate to cope with strong deflationary and inflationary pressures. Therefore, formula flexibility (or flexibility by way of executive discretion) is required.
A system of formula flexibility provides for specific changes in the tax structure and the volume of government spending as necessitated by certain clearly-recognised problems in business activity. It requires decision making on the part of the administration about the necessary changes which must be given effect to without delay.
Executive discretion implies the delegation to the chief executive the authority to order whatever changes he thinks fit in government spending and tax structure. These measures are required to supplement the built-in-flexibility of some schemes.
Built-in-Stabilizers:
The fact that both taxes and transfer payments automatically vary with changes in income level is the basis of the belief in built-in-stabilizers. The term ‘stabilizers’ is used because they operate in a manner as counteracts fluctuations in economic activity. They are called ‘built-in’, because these come into play automatically as the income-level changes.
Taxes may act as a stabilizing influence upon the economic system if the tax structure is such that the amount of taxes collected by the government rises automatically with increases in national income, for in this case the effect will be to reduce the expansion of disposable income. From the stabilizing point of view, it means a slower rise in induced consumptions.
If the tax system is such that only the absolute amount of tax revenue but also the percentage of income paid in taxes increases with an increase in income, its stabilizing impact will be greater. That will happen if the rate structure of the tax system is progressive, that is, the effective rates rise as the level of income increases.
Similarly, the various forms of transfer payments also operate in a countercyclical fashion. Only such transfer payments have a stabilising effect as decrease in amount when income increases and increase when income declines.
For example, when employment is falling, payments to the unemployed automatically increase, thereby increasing the disposable income and vice-versa. It would be too much to presume that these stabilizers by themselves can smoothen fluctuations in income but most would agree that these are effective complements to discretionary actions aimed at stabilising the economy.
Key Takeaways:
1) Optimum allocation of economic resources. The aim is that fiscal policy should be so framed as to increase the efficiency of productive resources. To ensure this, the government should spend on those public works which give the maximum employment.
2) The tools of fiscal policy are taxes, expenditure, public debt and a nation’s budget. They consist of changes in government revenues or rates of the tax structure so as to encourage or restrict private expenditures on consumption and investment.
3) The policy of managed budgets implies changing expenditures with constant tax rates or changing tax rates with constant expenditures or a combination of the two.
4) The structure of tax rates has to be varied in the context of conditions prevailing in an economy. Taxes determine the size of disposable income in the hands of the general public and therefore, the quantum of inflationary and deflationary gaps.
5) A sound programme of public borrowing and debt repayment is a potent weapon to fight inflation and deflation.
6) Public expenditure can be used to stimulate production, income and employment. Government expenditure forms a highly significant part of the total expenditure in the economy.
7) Expenditures on public works such as roads, schools, parks, buildings, airports, post-offices, hospitals, canals and other projects.
8) One practical difficulty of public finance is making the fiscal tools flexible enough for prompt and effective use. For example, the tempo of business activity may change suddenly manifesting itself in booms and slumps but fiscal tools cannot be geared all at once to meet such situations. To overcome such practical difficulties, built-in-flexibility has to be ensured in the fiscal tools.
9) The fact that both taxes and transfer payments automatically vary with changes in income level is the basis of the belief in built-in-stabilizers.
The financial field to the centre is more powerful than the states. In fact, for their development plans the states are purely dependent on the centre. No state can afford to work without active financial assistance of the central government. Undoubtedly in all federations, the units are financially not self-sufficient, but in India economic dependence of the states on the centre is rather too much.
Division of subjects, as provided in the constitution is of such a nature that the states have many more sources of expenditure than those of income.
Of course, there are taxes which are levied and collected either exclusively by the states or centre, but there are also taxes which are collected by the states on behalf of the centre, white some of the taxes are collected by the union government and handed over to the states. On the whole, however, the states are to depend on the grant-in-aid to be given by the central government to the states.
In India system of taxation is very much based on the Act of 1935, with the provision that after every five years President shall appoint a Finance Commission to find out the ways and methods of properly distributing sources of income. The states are empowered to collect taxes, such as stamp duties, excise duties, etc., but are not required to deposit the amount so realised with the Union Government.
The taxes on such items as succession to property, terminal taxes on goods carried by railways, air force or navy, tax on railway fares and freights, tax on transactions in stock exchanges, etc., are to be collected by the Union Government but to be appropriated to the state governments.
It is also provided that the taxes on such items as income other than agricultural income, duties on excise, etc., will be levied and collected by the Union Government and shared between the Union and the States. Since the states have comparatively less sources of income, the central government provides grant-in-aid to them to run their administrative and development expenses.
The states receive grant-in-aid for the development of scheduled castes and scheduled tribes. Similarly the State of Assam receives special grant-in-aid for the administration of tribal areas.
There is no denial that the states are financially dependent on the centre for their financial allocations, but the system of appointing Finance Commissions has brought much flexibility in it.
In the words of Pylee, “No other federal constitution makes such elaborate provision as the Constitution of India, with respect to the relationship between the Union and the States in the financial field. In fact, by providing for the establishment of the Finance Commission for the purpose of allocating and adjusting the receipts from certain sources, the Constitution has made an original contribution in this extremely complicated aspect of federal relationship.”
The states are financially dependent on the Centre.
The distribution of financial resources between the Centre and the States is as under:
1. Taxes Exclusively Assigned to the Union:
(i) Customs and export duties.
(ii) Income tax.
(iii) Income from railways and postal departments.
(iv) Excise duty on tobacco, Jute cotton.
(v) Estate duty and succession duty in respect of property other than agricultural land.
(vi) Corporation tax.
(vii) Taxes on Capital values of both individual and companies assets.
2. Taxes Exclusively Assigned to the States:
a) Succession and estate duty in respect of agricultural land.
b) Taxes on Vehicles used on roads, animals, boats.
c) Income from land revenue and Stamp duty except on documents included in the Union List.
d) Taxes on consumption or sale of electricity.
e) Taxes on goods and passengers carried by road or inland water.
f) Toll tax.
g) Taxes on lands and buildings. Taxes on Professions and traders.
h) Duties on alcoholic liquors for human consumption. Taxes on opium and narcotic drugs.
i) Taxes on entry of goods into local areas.
j) Entertainment and amusement tax.
k) Taxes on gambling.
3. Taxes Leviable by the Union but to be Collected and Appropriated by the States:
a) Taxes on luxuries and betting.
b) Taxes on bill of lading, letters of credit.
c) Stamp duties on bills of exchange, cheques and promissory notes.
d) Excise duty on medicinal toilet preparations.
4. Taxes Levied and Collected by the Union but Assigned to the States:
a) Duty in respect of succession to property other than agricultural land.
b) Taxes on railway freights and fares.
c) Taxes on transactions in stock exchanges.
d) Terminal taxes on goods and passengers carried by railway, sea or air.
e) Taxes on sale and purchase of newspapers and on advertisements published there in.
5. Taxes levied and collected by the Union but shared with the States.
The basis of distribution in this case is decided by the Parliament by law. The taxes include tax on-
a) Income other than agricultural income.
b) Excise duties other than that leviable on medicinal and toilet preparations.
In the financial field a mention may also be made to the office of the Comptroller and Auditor General of India, who is appointed by the President of India. He can direct the state governments to keep their accounts in a particular manner and these are duty bound to obey his instructions. While doing so he need not consult any state government.
Financial Emergency:
But in times of financial emergencies control of the union government over the states is immense. As soon as a financial emergency is declared the Union government becomes so powerful as to direct the state governments to observe certain norms of financial propriety and other necessary safeguards.
It can also direct the state governments to reduce salaries and allowances of its employees and even those of the judges of the High Courts. All money bills passed by the legislature, then are to be reserved for the consideration of the President.
Finance Commission:
In the Centre state financial relations Finance Commission plays an important role. According to the Constitution the President is empowered to set up a Finance Commission after every five years to make recommendations to him about the distribution of net proceeds of taxes to be divided between the centre and the states.
The Commission is also required to suggest the principles on which grant-in-aid of the revenues should be given to the state governments out of Consolidated Fund of India.
It is also required to give its view on any matter which may be referred to it by the President in the interest of sound finances. So far President of India has been regularly setting up such a commission after every five years and each time its terms of reference has been made wider and wider.
By and large, the Union Government has also been accepting its recommendations and as such it has adopted liberal attitude about the recommendations of the Commission.
The Commission has touched even such subjects as debt burdens of the states, returns of public sector undertakings, etc. But even then there is demand by some states that distribution of resources should be such that these favour relatively poor states.
The role of the Finance Commission has considerably eclipsed the increasing role of the Planning Commission through which more funds are transferred to the states than through the Finance Commission. Not only this but it is the Planning Commission which regulates discretionary grants and not the Finance Commission.
Planning Commission:
In centre-state relations a very significant role is being played by the Planning Commission. It has even reduced the importance of the Finance Commission. It is an extra constitutional body. It has more resources to disburse than the Finance Commission.
It decides the plan outlay of each state on which depend all developmental activities of the states. Since its meetings are to be presided over by the Prime Minister, therefore, it is virtually dominated by the central government, through which funds flow to the state government.
Grand-in-Aid to the States:
According to the Constitution states are to receive grant-in-aid from the Centre out of Central revenue. It is to be given with the approval of the parliament to a deserving state out of Consolidated Fund of India. The amount in each case is to be decided by the Parliament.
The Central Government also gives grants both capital and recurring to the states for implementation of certain schemes like uplift of scheduled castes and scheduled tribes. Special Grant-in-aid is also given by the Central Government to the state governments of Assam, Bihar, Orissa and West Bengal out of Consolidated Fund of India. The amount to be paid in each case is to be decided by the President of India.
Weak Position of the States:
In administrative, legislative and financial matters, as compared with the centre, the position of the states is very weak. The states are always to look forward to the centre and such a situation continues no matter whether same political party is in power both at the centre and the states, or there are different political parties in position and authority at these two levels of Indian federation.
In the financial field, the states are to depend on the central government even for their development. The Planning Commission, which finally decides about plan projects plays a big role in the development of the states, though it is the creation of and is controlled by the central government.
Then another reason of state’s dependence on the central government is that all foreign assistance which flows into India and is quite massive, is channelised through the central government. Once the extent of foreign aid is decided and made available to India, it becomes the responsibility of the Central Government to decide in which state and to which extent the money should be poured in.
Under the Constitution, no state on its own can sign any agreement with any international agency or organisation. The State government now, however, is inviting foreign investments in certain priority areas and signing agreements with foreign governments.
Not only this, but the Central Government can bring any subject from the state to the concurrent list thereby depriving the former of many of its financial resources. Even in the distribution of financial resources, the central government can patronise the states which have political parties of their choice in power and thus use economic power for strengthening its political authority and position.
That is the reason that usually those Chief Ministers who do not belong to the political party in power at the centre, complain that they are being given step-motherly treatment. Though in matters of financial allocation states may be consulted, but in actual practice final decision in this regard finally rests with the centre.
Since there are always financial limitations, therefore, the states which are deliberately made to starve of the finances, can hardly initiate or execute plans of far-reaching magnitude to satisfy the electorates, who had returned them to power on certain promises.
In the words of Misra, “As a consequence of the above, the role of the federal government in controlling in and coordinating the finances of the states is much more important in India than it is in other leading federations.” Dr. K.V.R. Rao once said, “I know no federation where its constituent units are so heavily dependent on the federal government as they are in so-called Indian federation.”
Key Takeaways-
1) The financial field to the centre is more powerful than the states. In fact, for their development plans the states are purely dependent on the centre.
2) Of course, there are taxes which are levied and collected either exclusively by the states or centre, but there are also taxes which are collected by the states on behalf of the centre, white some of the taxes are collected by the union government and handed over to the states.
3) In the financial field a mention may also be made to the office of the Comptroller and Auditor General of India, who is appointed by the President of India. He can direct the state governments to keep their accounts in a particular manner and these are duty bound to obey his instructions. While doing so he need not consult any state government.
4) But in times of financial emergencies control of the union government over the states is immense.
5) The Commission is also required to suggest the principles on which grant-in-aid of the revenues should be given to the state governments out of Consolidated Fund of India
6) The role of the Finance Commission has considerably eclipsed the increasing role of the Planning Commission through which more funds are transferred to the states than through the Finance Commission
7) In centre-state relations a very significant role is being played by the Planning Commission. It has even reduced the importance of the Finance Commission. It is an extra constitutional body. It has more resources to disburse than the Finance Commission.
8) According to the Constitution states are to receive grant-in-aid from the Centre out of Central revenue. It is to be given with the approval of the parliament to a deserving state out of Consolidated Fund of India. The amount in each case is to be decided by the Parliament.
Matter of the Financial Relations between Centre and State:
In financial field too the centre is more powerful than the states. In fact, for their development plans the states are purely dependent on the centre. No state can afford to work without active financial assistance of the central government. Undoubtedly in all federations, the units are financially not self-sufficient, but in India economic dependence of the states on the centre is rather too much.
Division of subjects, as provided in the constitution is of such a nature that the states have many more sources of expenditure than those of income.
Of course, there are taxes which are levied and collected either exclusively by the states or centre, but there are also taxes which are collected by the states on behalf of the centre, white some of the taxes are collected by the union government and handed over to the states. On the whole, however, the states are to depend on the grant-in-aid to be given by the central government to the states.
In India the system of taxation is very much based on the Act of 1935, with the provision that after every five years the President shall appoint a Finance Commission to find out the ways and methods of properly distributing sources of income. The states are empowered to collect taxes, such as stamp duties, excise duties, etc., but are not required to deposit the amount so realised with the Union Government.
The taxes on such items as succession to property, terminal taxes on goods carried by railways, air force or navy, tax on railway fares and freights, tax on transactions in stock exchanges, etc., are to be collected by the Union Government but to be appropriated to the state governments.
It is also provided that the taxes on such items as income other than agricultural income, duties on excise, etc., will be levied and collected by the Union Government and shared between the Union and the States. Since the states have comparatively less sources of income, the central government provides grant-in-aid to them to ran their administrative and development expenses.
The states receive grant-in-aid for the development of scheduled castes and scheduled tribes. Similarly the State of Assam receives special grant-in-aid for the administration of tribal areas.
There is no denial that the states are financially dependent on the centre for their financial allocations, out the system of appointing Finance Commissions has brought much flexibility in it.
In the words of Pylee, “No other federal constitution makes such elaborate provision as the Constitution of India, with respect to the relationship between the Union and the States in the financial field. In fact, by providing for the establishment of Finance Commission for the purpose of allocating and adjusting the receipts from certain sources, the Constitution has made an original contribution in this extremely complicated aspect of federal relationship.”
The states are financially dependent on the Centre.
The distribution of financial resources between the Centre and the States is as under:
1. Taxes Exclusively Assigned to the Union:
(i) Customs and export duties
(ii) Income tax
(iii) Income from railways and postal departments.
(iv) Excise duty on tobacco, Jute cotton.
(v) Estate duty and succession duty in respect of property other than agricultural land.
(vi) Corporation tax
(vii) Taxes on Capital values of both individual and companies assets.
2. Taxes Exclusively Assigned to the States:
a) Succession and estate duty in respect of agricultural land.
b) Taxes on Vehicles used on roads, animals, boats. Income from land revenue and Stamp duty except on documents included in the Union List.
c) Taxes on consumption or sale of electricity.
d) Taxes on goods and passengers carried by road or inland water.
e) Toll tax.
f) Taxes on lands and buildings. Taxes on Professions and traders.
g) Duties on alcoholic liquors for human consumption. Taxes on opium and narcotic drugs.
h) Taxes on entry of goods into local areas.
i) Entertainment and amusement tax.
j) Taxes on gambling.
3. Taxes Leviable by the Union but to be Collected and Appropriated by the States:
a) Taxes on luxuries and bettings.
b) Taxes on bill of landing, letters of credit.
c) Stamp duties on bills of exchange, cheques and promissory notes.
d) Excise duty on medicinal toilet preparations.
4. Taxes Levied and Collected by the Union but Assigned to the States:
a) Duty in respect of succession to property other than agricultural land.
b) Taxes on railway freights and fares.
c) Taxes on transactions in stock exchanges.
d) Terminal taxes on goods and passengers carried by railway, sea or air.
e) Taxes on sale and purchase of news papers and on advertisements published there in,
5. Taxes levied and collected by the Union but shared with the States.
The basis of distribution in this case is decided by the Parliament by law. The taxes include tax on.
a) Income other than agricultural income.
b) Excise duties other than that leviable on medicinal and toilet preparations.
In the financial field a mention may also be made to the office of the Comptroller and Auditor General of India, who is appointed by the President of India. He can direct the state governments to keep their accounts in a particular manner and these are duty bound to obey his instructions. While doing so he need not consult any state government.
Financial Emergency:
But in times of financial emergencies control of the union government over the states is immense. As soon as financial emergency is declared the Union government becomes so powerful as to direct the state governments to observe certain norms of financial propriety and other necessary safeguards.
It can also direct the state governments to reduce salaries and allowances of its employees and even those of the judges of the High Courts. All money bills passed by the legislature, then are to be reserved for the consideration of the President.
Finance Commission:
In Centre state financial relations Finance Commission plays an important role. According to the Constitution the President is empowered to set up a Finance Commission after every five years to make recommendations to him about the distribution of net proceeds of taxes to be divided between the centre and the states.
The Commission is also required to suggest the principles on which grant-in-aid of the revenues should to be given to the state governments out of Consolidated Fund of India.
It is also required to give its view on any matter which may be referred to it by the President in the interest of sound finances. So far President of India has been regularly setting up such a commission after every five years and each time its terms of reference has been made wider and wider.
By and large, Union Government has also been accepting its recommendations and as such it has adopted liberal attitude about the recommendations of the Commission.
The Commission has touched even such subjects as debt burdens of the states, returns of public sector undertakings, etc. But even then there is demand by some states that distribution of resources should be such that these favour relatively poor states.
The role of Finance Commission has considerably eclipsed because increasing role of Planning Commission through which more funds are transferred to the states than through the Finance Commission. Not only this but it is the Planning Commission which regulates discretionary grants and not the Finance Commission.
Planning Commission:
In centre-state relations a very significant role is being played by the Planning Commission. It has even reduced the importance of the Finance Commission. It is an extra constitutional body. It has more resources to disburse than the Finance Commission.
It decides the plan outlay of each state on which depend all developmental activities of the states. Since its meetings are to be presided over by the Prime Minister, therefore, it is virtually dominated by the central government, through which funds flow to the state government.
Grand-in-Aid to the States:
According to the Constitution states are to receive grant-in-aid from the Centre out of Central revenue. It is to be given with the approval of the parliament to a deserving state out of Consolidated Fund of India. The amount in each case is to be decided by the Parliament.
The Central Government also gives grants both capital and recurring to the states for implementation of certain schemes like uplift of scheduled castes and scheduled tribes. Special Grant-in-aid is also given by the Central Government to the state governments of Assam, Bihar, Orissa and West Bengal out of Consolidated Fund of India. The amount to be paid in each case is to be decided by the President of India.
Weak Position of the States:
In administrative, legislative and financial matters, as compared with the centre, the position of the states is very weak. The states are always to look forward to the centre and such a situation continues no matter whether same political party is in power both at the centre and the states, or there are different political parties in position and authority at these two levels of Indian federation.
In financial field, the states are to depend on the central government even for their development. Planning Commission, which finally decides about plan projects plays a big role in the development of the states, though it is the creation of and is controlled by the central government.
Then another reason of state’s dependence on the central government is that all foreign assistance which flows into India and is quite massive, is channelised through the central government. Once the extent of foreign aid is decided and made available to India, it becomes the responsibility of the Central Government to decide in which state and to which extent the money should be poured in.
Under the Constitution, no state on its own can sign any agreement with any international agency or organisation. The State government now, however, are inviting foreign investments in certain priority areas and signing agreements with foreign governments.
Not only this, but the Central Government can bring any subject from the state to the concurrent list thereby depriving the former of many of its financial resources. Even in the distribution of financial resources, the central government can patronise the states which have political parties of their choice in power and thus use economic power for strengthening its political authority and position.
That is the reason that usually those Chief Ministers who do not belong to the political party in power at the centre, complain that they are being given step-motherly treatment. Though in matters of financial allocation states may be consulted, but in actual practice final decision in this regard finally rests with the centre.
Since there are always financial limitations, therefore, the states which are deliberately made to starve of the finances, can hardly initiate or execute plans of far-reaching magnitude to satisfy the electorates, who had returned them to power on certain promises.
In the words of Misra, “As a consequence of the above, the role of the federal government in controlling in and coordinating the finances of the states is much more important in India than it is in other leading federations.” Dr. K.V.R. Rao once said, “I know no federation where its constituent units are so heavily dependent on the federal government as they are in so-called Indian federation.”
Key Takeaways-
1) The financial field to the centre is more powerful than the states. In fact, for their development plans the states are purely dependent on the centre.
2) Of course, there are taxes which are levied and collected either exclusively by the states or centre, but there are also taxes which are collected by the states on behalf of the centre, white some of the taxes are collected by the union government and handed over to the states.
3) In the financial field a mention may also be made to the office of the Comptroller and Auditor General of India, who is appointed by the President of India. He can direct the state governments to keep their accounts in a particular manner and these are duty bound to obey his instructions. While doing so he need not consult any state government.
4) But in times of financial emergencies control of the union government over the states is immense.
5) The Commission is also required to suggest the principles on which grant-in-aid of the revenues should be given to the state governments out of Consolidated Fund of India
6) The role of the Finance Commission has considerably eclipsed the increasing role of the Planning Commission through which more funds are transferred to the states than through the Finance Commission
7) In centre-state relations a very significant role is being played by the Planning Commission. It has even reduced the importance of the Finance Commission. It is an extra constitutional body. It has more resources to disburse than the Finance Commission.
8) According to the Constitution states are to receive grant-in-aid from the Centre out of Central revenue. It is to be given with the approval of the parliament to a deserving state out of Consolidated Fund of India. The amount in each case is to be decided by the Parliament.
Meaning of Deficit Financing:
Deficit financing in advanced countries is used to mean an excess of expenditure over revenue—the gap being covered by borrowing from the public by the sale of bonds and by creating new money. In India, and in other developing countries, the term deficit financing is interpreted in a restricted sense.
The National Planning Commission of India has defined deficit financing in the following way. The term ‘deficit financing’ is used to denote the direct addition to gross national expenditure through budget deficits, whether the deficits are on revenue or on capital account. The essence of such policy lies in government spending in excess of the revenue it receives. The government may cover this deficit either by running down its accumulated balances or by borrowing from the banking system (mainly from the central bank of the country).
The Government of India has announced a mammoth spending plan on Monday during the Union Budget 2021-22 to revive the pandemic-affected economy despite the crunch of money. The gap between the spending plan and available money will mostly be financed by small savings and market borrowings.
The economy has floundered, and the statistics ministry forecast that the economic growth rate is set to see the biggest contraction since 1952. Finance Minister Nirmala Sitharaman came out with ambitious spending plans of the Rs 35 trillion for the year starting April 1.
The Finance Ministry has revised the fiscal deficit target of 9.5 per cent of gross domestic product (GDP) for the financial year 2021 against the earlier estimate of 3.5 per cent. The government has fixed the target to spend Rs 11.7 trillion in only three months in the current financial year, which ends on March 31. In the next financial year, net market borrowing would be Rs 9.17 lakh crore to meet the fiscal deficit of 6.5 per cent of GDP.
“We plan to continue on our path of fiscal consolidation and intend to reach a fiscal deficit level below 4.5% of GDP by 2025-2026 with a fairly steady decline over the period,” Sitharaman said in her budget speech.
Unlike the current financial year, most of the fiscal deficit will be financed through domestic sources in the financial year 2022. In FY22, the government has estimated to finance only Rs 1,514 crore from external debt; 99.9 per cent of fiscal deficit will be financed from domestic sources against Rs 54,522 crore (97.1 per cent) financed from domestic sources in FY2021.
The gap between resource and spending (fiscal deficit) for this year is reported to be more than Rs 18 lakh crore or 9.5 per cent of the country's GDP in FY2021. Government has doubled the net market borrowing amount in a revised estimate of the financial year 2021 from Rs 5.10 lakh crore to Rs 10.48 lakh crore. It is almost 69 per cent net of fiscal deficit.
The heavy borrowing will cost nearly 6.92 lakh crore and 8.09 lakh crore in the next two years; however, subsidies will reduce to Rs 3.7 lakh crore from Rs 6.5 lakh crore.
The government continues to rely on small savings to finance its fiscal deficit. It revised the portion used for deficit financing of small savings from Rs 2.40 lakh crore to Rs 4.80 lakh crore (2.5 per cent of the country's GDP) for the current financial year. An almost similar portion of small savings will also be used for FY22 which is pegged at Rs 3.9 lakh crore or 26 per cent of the fiscal deficit (Rs 15.6 lakh crore) for the financial year 2022.
Experts say the government will not be going for a rate cut in the small saving scheme now. “This, in turn, underlines the importance of small savings collections for the government and bond market. For comparison, aggregate bank deposits have risen by Rs 2.52 lakh crore in the last 12 months. This indicates that it will be difficult for the government to cut small savings rates so as to continue attracting inflows, and that would continue to impair monetary transmission,” SBI said in its research.
The Centre and States' net borrowings are budgeted at Rs 18.1 lakh crores, which is marginally higher than Rs 17.8 lakh crores in the FY21 budget. “We must understand that out of an estimated 9.5 per cent of fiscal deficit for FY 21, 1.6 per cent of GDP is only because of the jump in the food subsidy bill, which underlines the humanitarian aspect of India's pandemic response,” the bank further said.
DISINVESTMENT STRATEGY
FM Sitharaman has announced a target of Rs 1.75 lakh crore of disinvestment for the next financial year, starting from April 1. Along with LIC'S IPO (Initial Public Offer), the government has a plan to sell Air India, BPCL, Shipping Corporation of India, Container Corporation of India, IDBI Bank, BEML, Pawan Hans and Neelanchal Ispat Nigam limited, in the financial year 2022.
The heavy investment in infrastructure with low revenue receipts will add to the debt burden in this financial year. The government estimates that such investment will boost the GDP growth, and debt ratio will come down by 45.5 per cent in FY-23. However, this year's budget documents have not provided the exact outstanding debt figures and only said that "Central government Debt to GDP ratio is estimated to be 3.1 per cent due to higher borrowings''.
According to the SBI calculation, the central government debt to GDP ratio is 3.1 per cent higher than the 47.7 per cent figure for FY20. “More clarity is needed as a 50.1 per cent Debt to GDP ratio will translate to only Rs 97 lakh crore for FY21 and the quarterly report on public debt management states that by end Sep '20 Total Debt/ Liabilities were already at Rs 107 lakh crore,” the bank said.
Key Takeaways
1) Deficit financing in advanced countries is used to mean an excess of expenditure over revenue—the gap being covered by borrowing from the public by the sale of bonds and by creating new money. In India, and in other developing countries, the term deficit financing is interpreted in a restricted sense.
2) The economy has floundered, and the statistics ministry forecast that the economic growth rate is set to see the biggest contraction since 1952. Finance Minister Nirmala Sitharaman came out with ambitious spending plans of the Rs 35 trillion for the year starting April 1.
3) The Finance Ministry has revised the fiscal deficit target of 9.5 per cent of gross domestic product (GDP) for the financial year 2021 against the earlier estimate of 3.5 per cent. The government has fixed the target to spend Rs 11.7 trillion in only three months in the current financial year, which ends on March 31. In the next financial year, net market borrowing would be Rs 9.17 lakh crore to meet the fiscal deficit of 6.5 per cent of GDP.
4) The heavy borrowing will cost nearly 6.92 lakh crore and 8.09 lakh crore in the next two years; however, subsidies will reduce to Rs 3.7 lakh crore from Rs 6.5 lakh crore.
5) The government continues to rely on small savings to finance its fiscal deficit. It revised the portion used for deficit financing of small savings from Rs 2.40 lakh crore to Rs 4.80 lakh crore (2.5 per cent of the country's GDP) for the current financial year.
6) The Centre and States' net borrowings are budgeted at Rs 18.1 lakh crores, which is marginally higher than Rs 17.8 lakh crores in the FY21 budget. “We must understand that out of an estimated 9.5 per cent of fiscal deficit for FY 21, 1.6 per cent of GDP is only because of the jump in the food subsidy bill, which underlines the humanitarian aspect of India's pandemic response,” the bank further said.
Reference:
1. Indian Economy (B.Com. - III) Paperback – 1 January 2014
by T R Jain (Author), Mukesh Trehan (Author), Ranju Trehan (Author).
2. Indian Economy Key Concepts (English, Paperback, Karuppiah Sankarganesh).
