Public Finance Revision E-notes


Public finance deals with the finances of public bodies – national, State or Local for the performance of their functions. The performance of these functions leads to expenditure. The expenditure is incurred from funds raised through taxes, fees, sale of goods and services and. loans. The different sources constitute the revenue of the public authorities. Public finance studies the manner in which revenue is raised; the expenditure is incurred upon different items etc. Thus, public finance deals with the income and expenditure of public authorities and principles, problems and policies relating to these matters. We can analyse some important definitions of public finance given by some leading authorities in public finance

Public Finance is the fiscal science, its policies are fiscal policies, and its problems are fiscal problems. PE. Taylor (The Economics of public finance)


Provision of public goods: -For providing public goods like roads, military services and street lights etc. public finance is needed. Business firms will have no incentive to produce such goods, as they get no payment from private individuals.

Public finance helps governments to redistribute income. To reduce the In equality in the economy, the governments can impose taxes on the richer people and provide goods and services for the needy ones.

Public Finance

The acceptance of the principle of welfare state, the role of public finance has been increasing. Modern governments are no more police states as the classical economists viewed.

Public finance provides many a programme for moderating the incomes of the rich and the poor. Such programmes include social security, welfare and other social programmes.


The indivisible goods, whose benefits cannot be priced, and therefore, to which the Principle of exclusion does not apply are called public goods. The use of such goods by one individual does not reduce their availability to other individuals. For example, the national defence.

Characteristics of Public goods
Non-rival in consumption: – One person’s consumption does not diminish the amount available to others. Once produced, public goods are available to all in equal amount. Marginal cost of providing the public goods to additional consumers is zero.
Non-excludable:- Once a public good is produced, the suppliers cannot easily deny it to those who fail to pay. That is, those who cannot (or do not agree to) pay its market price are not debarred or excluded from its use.

3) Free-rider problem: – People can enjoy the benefits of public goods whether pay for them or not, they are usually unwilling to pay for public goods. This act is the so-called free-rider problem.

Private goods refer to all those goods and services consumed by private individuals to satisfy their wants. For example, food, clothing, car etc.

Characteristics of Private goods

Excludable: – The suppliers of private goods can very well exclude those who are unwilling to pay.
Rivalry in consumption: – One person’s consumption reduces the amount available to others. That is, the amount consumed by one person is unavailable for others to consume.
Revealed Preference: – The consumers reveal their preferences through effective demand and market price. These revealed preferences are the signals for the producers to produce the goods the individuals want.

THE PRINCIPLE OF MAXIMUM SOCIAL ADVANTAGE One of the important principles of public finance is the so – called Principle of Maximum Social Advantage explained by Professor Hugh Dalton. Just like an individual seeks to maximize his satisfaction or welfare by the use of his resources, the state ought to maximize social advantage or benefit from the resources at its command.

The principles of maximum social advantage are applied to determine whether the tax or the expenditure has proved to be of the optimum benefit. Hence, the principle is called the principle of public finance. According to Dalton, “This (Principle) lies at the very root of public finance”

He again says “The best system of public finance is that which secures the maximum social advantage from the operations which it conducts.” It may be also called the principle of maximum social benefit. A.C. Pigou has called it the principle of maximum aggregate welfare.

Public expenditure creates utility for those people on whom the amount is spent. When the volume of expenditure is small with a slighter increase in it, the additional utility is very high. As the total public expenditure goes on increasing in course of time, the law of diminishing marginal utility operates. People derive less of satisfaction from additional unit of public expenditure as the government spends more and more. That is, after a stage, every increase in public expenditure creates less and less benefit for the people. Taxation, on the other hand, imposes burden on the people. So, when the volume of taxation becomes high, every further increase in taxation increases the burden of it more and

more. People under go greater scarifies for every additional unit of taxation. The best policy of the government is to balance both sides of fiscal operations by comparing “the burden of tax” and “the benefits of public expenditure”. The State should balance the social burden of taxation and social benefits of Public expenditure in order to have maximum social advantage.

Attainment of maximum social advantage requires that;

Both public expenditure and taxation should be carried out up to certain limits and no more.

Public expenditure should be utilized among the various uses in an optimum manner, and

The different sources of taxation should be so tapped that the aggregate scarifies entailed is the minimum.

Assumptions of the Principle

The public revenue consists of only taxes (and not of gifts, loans, fees etc.) and the state has no surplus or deficit budgets. 2)
3) Public expenditure is subject to diminishing marginal social benefits and the taxes are subject to increasing marginal cost or disutility.

According to Dalton, maximum social advantage is at a point where the Marginal Social Sacrifice (MSS) of taxation and Marginal Social Benefit (MSB) are equal. The point of equality between MSS and MSB is referred to as the point of maximum social advantage or least aggregate social sacrifice.

Musgrave calls Dalton’s principle as “Maximum Welfare Principle of Budget Determination.” He puts that the optimum size of the budget is determined at point where Net Social Benefit (NSB) of fiscal operations to the society becomes zero. The NSB is the difference between MSB and MSS. (NSB=MSB-MSS). Musgrave presented Dalton’s principle of MSA with some slight differences.

Diagrammatic Representation

The curves MSS and MSB show the marginal social scarifies of taxation and marginal social benefit of public expenditure respectively. MSS curve slopes up words since taxation increases marginal social sacrifices. MSB curves slopes down wards showing that public benefit goes on declining with every increase in public expenditure. The ideal point of financial operations is where the governments collect OM taxation from the society and uses it for public expenditure. At this point, MSS is exactly equal to MSB (Point E) at OM 1 , MSS is M1 F1 which is less than MSB (M1 E1) thus depicting a loss of welfare to the society (E1 F1). Similarly, the government is collecting OM2 taxation to finance larger public expenditure; The MSS is higher than MSB by E2 F2. So the ideal level of taxation and expenditure is at OM.

According to Dalton “Public expenditure in every direction, should be carried just so far that the advantage to the community of a further small increase in any direction is just counter balanced by the disadvantage of a corresponding increase in taxation or in receipts from any other source of public income. This gives the ideal public expenditure and income”.

Public Expenditure: Meaning and Importance
The expenses incurred by the governments for its own maintenance, preservation and welfare of the economy as a whole is referred to as public expenditure. In other words, it refers to the expenses of public authorities-central, state and local governments in a federation-for the satisfaction of collective needs of the citizens or for promotion of economic and social welfare. The development functions include education, public health, social security, irrigation, canal, drainage, roads, buildings, etc. The major cause of increase in the public expenditure is nothing but, these developmental functions. Hence, the study of public expenditure has become very significant in the study of public finance. The two major reasons for the same are: a) the economic activities of the state has increased manifold and b) nature and volume of public expenditure have greatly affected the economic life of the country in a different manner. i.e., it has affected production and distribution and general level of economic activities. In the laissez-faire era the state was assigned a very limited role to play. The functions assigned to the state where based on the principle of least interference or ‘that government is the best which spends the least.’ According to the classical school led by Adam Smith restricted the functions of the state to ‘Justice, Police and Arms.’ They considered government expenditure wasteful and that money could be used much well by private persons than by the government. Adam Smith in his magnum opus ‘The Wealth of Nations’ published in 1776 observed that the sovereign has three main duties to perform as a) to protect the society from violence and invasion of other independent societies b) to protect against injustice and c) erecting and maintaining certain public works.

According to David Ricardo, ‘If you want a peaceful government you must reduce the budget’. JB Say opined that ‘the very system of all plans of finance is to spend little and the best of all taxes is that which is least in amount’.

Professor RA Musgrave, the twentieth century economist, advocated public expenditure since a government is forced to do many activities such as 1) activities to secure a reallocation of resources 2) redistribution activities, 3) stabilizing activities and 4) commercial activities.

Causes for the Increase in Public Expenditure:

One of the most important features of the present century is the phenomenal growth of public expenditure. Some of the important reasons for the growth of public expenditure are the following.

Welfare state: Modern states are no more police states. They have to look in to the welfare of the masses for which the state has to perform a number of functions. They have to create and undertake employment opportunities, social security measures and other welfare activities. All these require enormous expenditure.

Defence expenditure: Modern warfare is very expensive. Wars and possibilities of wars have forced the nation to be always equipped with arms. This causes great amount of public expenditure.

Growth of democracy: The form of democratic government is highly expensive. The conduct of elections, maintenance of democratic institutions like legislatures etc. cause great expenditure.

Growth of population: tremendous growth of population necessitates enormous spending on the part of the modern governments. For meeting the needs of the growing population more educational institutions, food materials, hospitals, roads and other amenities of life are to be provided.

Rise in price level: Rises in prices have considerably enhanced public expenditure in recent years. Higher prices mean higher spending on the part of the govt. on items like payment of salaries, purchase of goods and services and so on.

Expansion public sector: Counties aiming at socialistic pattern of society have to give more importance to public sector. Consequent development of public sector enhances public expenditure.

Development expenditure: for implementing developmental programs like Five Year Plans, Modern governments are incurring huge expenditure.

Public debt: Along with debt rises the problem like payment of interest and repayment of the principal amount. This results in an increase in public expenditure
Grants and loans to state governments and UTs: It is an important feature of public expenditure of the central government of India. The government provides assistance in the forms of grants-in-aid and loans to the states and to the UTs.

Poverty alleviation programs: As poverty ratio is high, huge amount of expenditure is required for implementing alleviation programmes.

Classification of public expenditure:
Public expenditure has been classified in to a) Revenue expenditure and b) Capital expenditure. Revenue expenditure is current expenditure. For example, it includes administrative expenditure and maintenance expenditure. This expenditure is of a recurring type. Capital expenditure is of capital nature and is incurred once for all. It is non-recurring expenditure. For example, expenditure in building, multipurpose projects or on setting up big factories like steel plants, money spent on land, machinery and equipment. Revenue Budget or Revenue Account is related to current financial transactions of the government which are of recurring in nature. Revenue Budget consists of the revenue receipts of the government and the expenditure is met from this revenues. Revenue Account deals with Taxes, duties, fees, fines and penalties, revenue from Government estates, receipts from Government commercial concerns and other miscellaneous items, and the expenditure therefrom. Revenue Receipts include receipts from taxation, profits of enterprise, other non-tax receipts like administrative revenue (fees, fines, special assessment etc.), gifts grants etc. Revenue expenditure includes interest-payments, defence expenditure major subsidies, pensions etc.

The Capital Account is related to the acquisition and disposal of capital assets. Capital budget is a statement of estimated capital receipts and payments of the government over fiscal year. It consists of capital receipts and capital expenditure. The capital account deals with expenditure usually met from borrowed funds with the object of increasing concrete assets of a material character or of reducing recurring liabilities such as construction of buildings, irrigation projects etc. Capital Receipts include a) Borrowings b) Recovery of loans and advances c) Disinvestments and d) Small savings. Capital Expenditure includes
Developmental Outlay b) Non-developmental outlay c) Loans and advances and d) Discharge of debts.

This can be explained as follows:

This is one of the branches of public finance. It deals with the various sources from which the state might derive its income. These sources include incomes from taxes, commercial revenues in the form of prices of goods and services supplied by public enterprises, administrative revenues in the form of fees, fines etc. and gifts and grants.

The income of government through all sources is known as public revenue or public income. Professor Dalton defined public revenue in two senses – Narrow sense and broader sense.

a) Narrow sense: In the narrow sense, it includes income from taxes, prices of goods and services supplied by public sector under takings, revenue from administrative activities, such as fees, finest. b) Wider sense: It includes all the incomes of the governments during a given period of time, including public borrowing from individuals and banks and income from public enterprise it is known as public receipts.
Difference between Public revenue and Public receipts
Public revenue includes that income which is not subject to repayment by the government. Public receipts include all the income of the government including public borrowing and issue of new currency. In this way public revenue is a part of public receipts.
a) Public Receipts = Public revenue + Public borrowing + issue of new currency

The sources of public revenue can be broadly classified in to two – Tax –source and non- tax source.
Taxes: Taxes are imposed by the government on the people and it is compulsory on the part of the citizens to pay taxes, without expecting a return.
The revenue from taxes came from three main sources. a) Taxes on income b) Taxes on wealth and property and c) Taxes on commodities. Characteristics of a Tax

  1. It is compulsory payments to the government from the citizen. Each individual irrespective of caste, colour or creed, of age or sex has to pay it. Refusal to pay it or delay in payment brings punishment.

It is imposes a personal obligation. It means that it is duty of tax payer to pay it and he should in no case think to evade it.
Absence of direct benefit or quid pro quo between the State and people. The tax payer do get many advantages from the public authorities but no tax payer can claim direct benefit as a matter of right on the ground that he is paying a tax.

It is payments for meeting the expenses in the common interest of all citizens.
The governments have to provide public utility goods. For this the governments have to incur huge amounts of expenditure. Therefore, taxes are imposed on all citizens so that all may share a common burden.
Certain taxes are imposed on specific objectives for example, tax on petrol to reduce consumption and tax on luxuries so as to divert resources for the production of essential commodities.
There is no tax without representation. This means that proposals regarding taxes are to be sanctioned in respective assembly of elected representatives.

Non – Tax Revenue
Commercial Revenue. (Income from public property and enterprises)

Administrative Revenue (Fee, Fine, Special assessment)
Gifts and grants and
Commercial Revenue: – Income earned by public enterprises by selling their goods and services. For example, Payments for postage, tolls, interest on borrowed funds etc.
They are also known as prices because they come in the form of prices and goods and services provided by government.
Administrative Revenue
The receipts of incomes accrued on account of performing administrative functions by the government are called administrative revenue. The important items of administrative revenue are listed below.
Fees: “Fee is a payment to defray the cost of each recurring service under taken by the government in the public interest” – Prof
Seligman. Fees are payments imposed by the government. For Example, Court Fee, License Fee, Passport, Fee etc.
Fines and Penalties – Fines penalties are imposed on persons as a punishment for infringement of laws. They are imposed to prevent crime. Fines and penalties are arbitrarily determined.

Special assessments: -According to Prof Seligman “A special assessment is a compulsory contribution levied in proportion to the special benefit derived to defray the cost of specific improvement to property under taken in the public interest”. For example, when the government constructs a highway, the prices of plots on either side of it will naturally go up. There for, the land owners may be required to bear a part of expenses incurred by the government. Such charges are called as special assessments. Gifts and grants: – In general gifts and grants are the payments made by one government to another for some specific functions for example, central grant to state government. Gifts are voluntary contribution made by the people to the government for some special purposes.
Other sources of Revenue:-Other sources of revenue are Forfeitures, Escheat, Issuing of currency and Borrowings
Forfeitures:-It is penalty imposed by the court for failure of individual to appear in the court to complete certain contract as stipulated.
Escheat: – Properties having no legal heirs or without will, that go to government are called Escheats.
Issue of Currency: – The printing of paper money yields income to the government. It is mean to create extra resources by the printing of paper money. It is normally avoided because if once this method of financing is started it becomes difficult to stop it. This further leads to inflation.
Borrowings: – This is another source of public revenue. That is through borrowings from the public in the shape of deposits bonds etc. It also includes external borrowings.

Objectives of Taxes Raising Revenue
Regulation of Consumption and Production
Encouraging Domestic Industries
Stimulating Investment Reducing Income Inequalities Promoting Economic Growth
Development of Backward Regions Ensuring Price Stability

Direct Taxes and Indirect Taxes
According to Dalton ‘A direct Tax is really paid by a person on whom it is legally
Imposed, while an indirect tax is imposed on one person, but paid partially or wholly by another, owing to consequential change in the terms of some contract or bargaining between them.’
According to J S Mill, ‘A direct tax is one, demanded from the very person who is intended or desired should pay it. Indirect taxes are those which are demanded from the one person in the expectation and intention that we shall identify him at the expenses of another’.

Following are the main merits of direct taxes.
Equity: direct taxes such as income taxes, taxes on property, capital gain taxes etc. are progressive in their nature. That is, higher incomes are taxed heavily and lower incomes are taxed lightly. Hence, direct taxes are based on ability to pay of the tax payer and they ensure the canon of equity.
Economy: The administrative cost of collecting the direct taxes is low. The tax payers directly pay the tax to the state. So there is not much waste of resources and time. That is, direct taxes satisfy the canon of economy.
Certainty: Another merit of direct tax is that it is certain. The tax payers know how much tax is to be paid, on what basis tax is paid to the government etc. Thus, the tax payer is able to make adequate provision the payment of tax in advance. The government can also plan development activities since they can estimate the amount of revenue they receives in the form of taxes.
Elasticity and revenue generation: the yield from direct taxes increases as the country economically advances. The government gets more revenue through direct taxes automatically at higher rates.
Distributive justice: Since direct taxes are progressive in rates, tax rate increases as the income of individuals rises. The tax burden will heavily be on the richer sections of the society. The increased revenue through taxes is allocated for providing subsidized food, clothing and housing to the poor and needy people. This will bring about distributive justice in the country.
Civic consciousness: Direct taxes create civic consciousness among the tax payers. The tax payers will be vigilant in the utilization of the tax revenue and will see whether the resources are efficiently used and wastage is avoided.
Absence of leakages: since there is direct payment of taxes by tax payers to the government, there is no room for any wastage. The whole amount of direct taxes such as income taxes, property taxes, and taxes on capital gains etc., reaches the treasury without any middlemen.
It cannot bring adequate revenue to meet the needs of the modern governments.
Single tax system violates the principle of ability to pay.
The burden of taxation is not equally distributed.
The tax system is not effective during the period of emergency or crisis.
Tax evasion is much possible.
It lacks elasticity.


VAT is a multi-point tax levied at each stage of value addition chain with a provision to allow input tax credit on tax paid at an earlier stage. It is a general consumption tax assessed on the value added to goods. In the case of sales tax, there are problems of double taxation of commodities and multiplicity of taxes, resulting in cascading of tax burden. This results in double taxation with cascading effects. Under
VAT set off is given for input tax as well as tax paid on previous purchases. Multiplicity of taxes with overlapping nature like the turn over taxes, Octroy, the CST and surcharges is another feature of the present indirect tax regime. VAT is unanimously acknowledged to be a major reform in the indirect taxation system.
VAT was first proposed by Germany but first implemented by France in 1954. The European Economic Community introduced VAT in 1967. In India ‘The Indirect Taxation Enquiry Committee’ (L.K.Jha Committee), 1976 suggested to adopt VAT applied to the manufacturing stage
combined with a reformed system of sales taxation. In pursuance of the proposal made in the Long Term Fiscal Policy, the government introduced a modified system of value added or MODVAT in the budget for 1986-87. It came in to force with effect from March 1, 1986. The government has introduced the new Central Value Added Tax (CENVAT) scheme by replacing the MODVAT scheme, with effect from April 1, 2000.
Following the June 18, 2004 decision of the Empowered Committee (convenor: Asim Das Gupta) of state finance ministers to implement State- level VAT from April 1,2005, all 28 states and Union Territories had introduced VAT. The first state to introduce VAT was Haryana in 2003 and the last state was Utter Pradesh in 2008.

It eliminates the cascading effects of taxes. It promotes competitiveness of exports.
This is tax one pays when they buy goods or services.
The shopkeeper or service provider adds it to the cost of the goods or services. This is a known as a consumer tax in some countries.
In some countries, goods are priced in the shop minus this type of tax, but when the customer comes to the checkout they will be asked for the cost price plus the consumer tax.
The shop collects this tax on behalf of the government.
The difference between the amount of VAT the producer, wholesaler or retailer charged the shopkeeper and the amount the shopkeeper charged the customer must be paid to the government.
If the amount of VAT paid by the business exceeds the VAT charged by business, the government will repay the excess. This ensures that VAT is paid by the ultimate customer, not by the business.
A value-added tax is an indirect national tax levied on the value added in production of a good or service.
In many European and Latin American countries the VAT has become a major source of taxation on private citizens.

Many economists prefer a VAT to an income tax because the incentive effects of the two taxes differ sharply.
The Goods and Services Tax (GST) is an indirect tax reform measure. It is a tax on goods and services, which is liveable at each point of sale or provision of service, in which at the time of sale of goods or providing the services the seller or service provider can claim the input credit of tax which he has already paid while purchasing the goods or procuring the service. GST is similar to VAT; the only difference is that it takes into account services also. GST is a broad based and a single comprehensive tax levied on goods and services consumed in an economy.
The Finance Minister P. Chidambaram in his Budget speech in 2006 had said: “It is my sense that there is a large consensus that the country should move towards a National Level Goods and Service Tax (GST) that should be shared between the Centre and the states. I propose that we set April 1, 2010 as the date of introducing GST. World over, Goods and Services attract the same rate of Tax. This is the foundation of GST. People must get used to the idea of a GST. We must converge progressively the service tax rate and CENVAT rate. I propose to take one step this year and increase the service tax rate from10 per cent to 12 per cent. Let me hasten to add that since service tax paid can be credited against service tax payable or excise duty payable, then impact will be very small.”
The GST can be divided into following sections to understand it better:
Charging Tax: The dealers registered under GST (Manufacturers, Wholesalers and Retailers and Service Providers) are required to charge GST at the specified rate of tax on goods and services that they supply to customers. The GST payable is Included in the price paid by the recipient of the goods and services. The supplier must deposit this amount of GST with the Government.
Getting Credit of GST: If the recipient of goods or services is a registered
Dealer (Manufacturers, Wholesalers and Retailers and Service Providers), he will normally be able to claim a credit for the amount of GST he has paid, provided he holds a proper tax invoice. This “input tax credit” is set off against any GST (Out Put), which the dealer charges on goods and services, which he supplies, to his customers.
Ultimate Burden of Tax on Last Customer:
The net effect is that dealers charge GST but do not keep it, and pay GST but get a credit for it. This means that they act essentially as collecting agents for the Government. The ultimate burden of the tax falls on the last and final consumer of the goods and services, as this person gets no credit for the GST paid by him to his sellers or service providers.
Registration: Dealers will have to register for GST. These dealers will include the suppliers, manufacturers, service providers wholesalers and retailers. If a dealer is not registered, he normally cannot charge GST and cannot claim credit for the GST he pays and further cannot issue a tax invoice.
Tax Period: The tax period will have to be decided by the respective law and normally it is monthly and/or quarterly. On a particular tax period, which is applicable to the dealer concerned, the dealer has to deposit the tax if his output credit is more than the input credit after considering the opening balance, if any, of the input credit.

Refunds: If for a tax period the input credit of a dealer is more than the output credit then he is eligible for refund subject to the provisions of law applicable in this respect. The excess may be carried forward to next period or may be refunded immediately depending upon the provision of law.
Exempted Goods and Services: Certain goods and services may be declared as exempted goods and services and in that case the input credit cannot be claimed on the GST paid for purchasing the raw material in this respect or GST paid on services used for providing such goods and services.
Zero Rated Goods and Services: Generally, export of goods and services are zero-rated and in that case the GST paid by the exporters of these goods and services is refunded. This is the basic difference between Zero rated goods and services and exempted goods and services.
Tax Invoice: Tax invoice is the basic and important document in the GST and a dealer registered under GST can issue a tax invoice and on the basis of this invoice the credit (Input) can be claimed. Normally a tax invoice must bear the name of supplying dealer, his tax identification nos., address and tax invoice nos. coupled with the name and address of the purchasing dealer, his tax identification nos., address and description of goods sold or service provided.

Objectives of GST
To lower tax rates due to broadening of the tax base and minimizing exemptions & exclusions.
Creation of a common market across the country.
Redistribution of the burden of taxation equitably between manufacturing and services.
Reduction in transaction and compliance costs.
Facilitation of business decisions on purely economic considerations.
Enhanced efficiencies & productivity through the supply chain.
Recommendations of Thirteenth Finance Commission on GST
Single 12% rate on all goods and services. (5% for Central GST and 7% for State GST).
All indirect taxes and cess to be subsumed in GST.
Railways fares and freight, electricity to attract GST.
Only possible services by governments, service transactions between employer and employee and health and education should be exempted from GST.
Petrol, diesel, alcohol, and tobacco may be changed to GST with additional levies by centre and states.
Exports to be zero rated.

Among the non-tax sources, the major source of revenue of the government is public debt. That is, borrowing. It may either be internal or external debts. When the government raises revenue by borrowing from within the country, it is called internal debt. Similarly, if the government

is borrowing from the rest of the world, it is a case of external debt. According to Philip E. Taylor, “The debt is the form of promises by the treasury to pay to the holders of these promises a principal sum and in most instances interest on the principal. Borrowing is resorted to provide funds for financing a current deficit.”

Causes for Public Debt

Till the beginning of the 20th century, state performed only very limited functions maintenance of law and order, protection of the country from external attack etc. Therefore, the state had to collect only small revenue and little debt. Recently, in almost all countries of the world there has been a great increase in the magnitude and variety of governmental activities. The acceptance of the principle of the welfare state increases the role of state participation in economic activity. This has necessitated the need to find out additional sources of finance. Hence, modern governments have come to rely on public borrowings.

Objectives of public debt: The objectives of public debt are the following.
To bridge the budget deficit (Deficit Financing)
To fight against depression.
To check inflation.
To finance economic development.
To meet unforeseen contingencies.
An alternate source of income when taxable capacity is reached.
To finance wars.
To finance public enterprises.
To carry out welfare programmes.
To create infrastructure.
For creation of productive assets.
For creation of essential non-income yielding assets (provision of public goods) etc.

Important Sources of Public Debt
Borrowing from individuals.
Borrowing from Non-Banking Financial Institutions (Insurance companies, investment trusts, mutual funds etc.)
Borrowing from commercial banks.
Borrowing from central banks.

Borrowing from External sources (IMF, IBRD, ADB, Foreign Governments or countries).

Redemption of Public Debt
Redemption of public debt means repayment of a loan and it is an important responsibility of the government. All government loans should be repaid promptly. It is, therefore, necessary that the provision of repayment should be inherent in the scheme itself.

Advantages of debt redemption
It saves the government from going into bankruptcy.
It checks extravagance on the part of the governments.
It preserves the confidence of the lenders.
It makes easy for the government to float future loans.
It reduces the cost of management of public debt.
It saves the future generations from the pressure of public debt.
The resources obtained after redemption of the debt would be diverted towards private investments and therefore a favourable climate for investment could be created.
Redemption of debt may act as a useful tool to curb deflation.


Repudiation: It means refusal to pay a debt by governments. This method was followed by the USA after the civil war and by the USSR after the 1917 Revolution. This method is undesirable and has not been used recently anywhere in the world. Repudiation shakes the confidence of the people in public debt and many provoke retaliation from creditor countries.
Refunding: Refunding is the process of replacing maturing securities with new securities. In some cases the bonds may be redeemed before the maturing date when the government intends to rearrange the maturity of outstanding debts or when current rate of interest is low. Generally,
short-term borrowings are made in anticipation of tax collections for meeting current expenditure. However, excessive burden of new expenditure does not permit the retirement of the debt by means of revenue newly raised or by means of long term borrowing. Thus, there is necessity of refunding the loans by old lenders and renewing the loans at lower rate of interest for future period. The drawback of this method is that government is tempted to postpone its obligation of debt redemption. This leads to a continuous increase in the burden of public debt in future.

Conversion of Loans: It is a special type of refunding. Conversion of existing securities into new securities before maturity. It is generally resorted to reduce the burden of debt by converting high interest loans into low interest loans. According to Professor Dalton, the conversion does not reduce the burden of public debt on the state; because a reduction in interest rates reduces the ability of the creditors to pay taxes which may mean a loss of income to the governments there by reducing its capacity to repay loans.
Sinking Fund: Sinking fund is a special fund created for the repayment of public debt. There is a theoretical justification for creating this fund because it imposes a requirement on the government to pay the old debts regularly. According to this method, the government sets aside a certain amount out of the budget every year for this fund. The balances in the funds are also invested and the interest accruing on them is also credited in the fund. Sinking fund is of two types: (i) certain sinking fund—here, the governments credit a fixed sum of money annually.
(ii)Uncertain sinking fund— the amount is credited when government secures a surplus in the budget .The one danger of this method is that the government may not wait till the end of the period of maturity and utilize the fund for some other purpose than the one for which the fund was created originally.
The practice of sinking fund inspires confidence among the lenders and the enhancement of the creditworthiness of governments.
Capital levy: Capital levy is a special type of “once for all” tax on capital imposed to repay war debts. All capital goods are taxed above a minimum level of assets possessed by residents of the country. Simply, capital levy refers to a very heavy tax on property and wealth. This tax was levied immediately after the First World War. This method has been advocated by economists like David Ricardo, Pigou and Dalton.Professor Dalton has suggested that capital levy as a method of debt redemption with least real burden on the society. It is useful on account of its deflationary character.
Surplus budget: Quite often, surplus budget may be used to clear public debt.
But in recent times due to the ever increasing public expenditure, surplus budget is a rare phenomenon.
Buying up of Loans: Governments redeems debt through buying up loans from the market.

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