Methods of Redemption of Public Debt

What is Redemption of Public Debt?

Redemption of Public Debt is defined as a process of repayment of public debt. The government needs to redeem its debts regularly to increase the confidence of lenders and save the government from bankruptcy. Many times government needs to take extreme steps that can violate the contracts, such as repudiation of debts.

What is Public Debt?

Public debt is defined as an amount consisting of liabilities that are borrowed by the government from the public for various development-related schemes for the public. The public debt is being borrowed by the government from various sources such as banks, financial institutions, or foreign countries. This borrowed public debt can be long-term, short term or medium-term debt.

Methods of Redemption of Public Debt

Below are the methods of redemption of public debt.

1. Conversion of Public Debt:

Conversion is defined as the process of converting existing debt into a new debt. This method reduces the interest burden by converting old loans that bear high interest into new loans that bear low interest. The method of conversion is implemented generally when the rate of interest in the market goes down. The lenders of money are given the instructions to take back their money in the form of cash or the form of new bonds. This method helps taxpayers by reducing their burden of interest. The conversion results in less unequal distribution of income because of the assumption that the taxpayers are mostly poor people whereas the lenders are the rich people.

2. Refunding:

Refunding of debt is defined as a process where governments issue new securities and bonds for repayment of old loans(matured loans). In the process of refunding, the short-term securities are replaced by long-term securities. When the refunding method is adopted by the government there is no burden of public debts.

3. Creation of Sinking Fund:

The creation of a sinking fund is defined as a process where the funds are created by the government and are accumulated each year by keeping them separately so that they are sufficient for paying off debts during the maturity period. Every year a specific amount of money is transferred to this fund so that it will be enough to redeem public debt. The creation of a sinking fund is considered the best and most systematic method of redemption of public debt. While using this method the overall burden of repaying the debts is felt less as it is evenly distributed throughout the year.

4. Capital Levy:

Capital Levy is considered the most controversial method of redemption of public debt. Capital levy is defined as a method where governments impose a levy on the assets of the rich people or sections of the society. During war or emergencies, governments usually raise money by imposing a special tax on the capital to redeem public debts. Quick repayment of loans is possible with capital levy. However, using this method has various disadvantages such as it hampers capital formation, employment and production are also adversely affected, etc. This method is mostly not adopted by the governments.

Arguments in Support of Capital Levy

i. Equal Distribution of Burden: During war-like crises, the people from the poor section of the country suffer more as they put their lives at risk by joining the defense force of the country. Whereas the people from the rich section of the country remain unaffected by such situations. Therefore war gives a substantial appreciation for the value of property and capital of rich communities. Therefore, enforcing the method of capital levy distributes the overall burden caused by war among rich and poor communities in the country. Hence, it is advocated that a capital levy on property and asset owners is a just method of distributing the burden caused by war.

ii. Timely Redemption of Debt: Using the method of capital levy for the redemption of public debt helps to from the war debt in a single time and within less time. The debt during the war is often unproductive and therefore it is a dead weight on the community. Adopting this method of capital levy helps to clear the long-term burden of public debt in one single stretch.

iii. Additional Tax Burden: If the debts caused by war are not repaid immediately, the common people will suffer from the additional tax burden for a much longer period which will be in terms of years. This would adversely affect the ability and incentives for working. In such scenarios using the method of capital levy will be considered as the best method.

iv. Managing the Inflationary situation: The situations that occur after the war are like inflationary situations, economic crises, etc. During inflation, the sacrifices by the taxpayers are low. Hence if the method of capital levy is imposed immediately would control the overall situation.

Arguments Against Capital Levy

i. Discouragement of savings of people: Capital levy is imposed may discourage the savings of people. This, in turn, will effect the industries unfavourably.

ii. Lowering the people’s confidence: The imposition of capital levy can hinder the people’s confidence in the government. The domestic people will start transferring their funds to the foreign countries, leaving domestic economy with lack of funds.

iii. Discouragement of Inflow: A capital levy might discourage the inflow of foreign capital into the country, thereby reducing the economic progress of the country.

5. Terminal Annuity:

Terminal Annuity is defined as a method where the government pays off its public debt through equal annual installments that consist of principal and interest. The terminal annuity method is similar to the method of sinking funds. Therefore, many times governments decide to end or terminate the public debt using the terminal annuity method. The amount of the terminal annuity is decided based on the annuity table. Through this method, the burden of public debt is reduced every year and paid fully until the maturity period.

6. Additional Taxation:

Additional taxation is defined as a type of method where the government imposes new taxes on people to get the required revenue for repayment of the public debt. This revenue is used to repay the principal amount as well as the interest amount. To pay the old debt the government levies both taxes such as direct and indirect. This method of additional taxation causes income redistribution as the resources are transferred from taxpayers to the bondholders. Using this method of additional taxation has a distortionary effect on the taxes.

7. Budget Surplus:

Budget Surplus is a condition where government incomes are more than government expenses. In case of a budget surplus, the excess earnings can be utilised by the government to pay back the principal amount borrowed under public debt. The government generally uses the budget surplus to buy its bonds and securities from the market.

8. Balance of Payments Surplus:

Public debts can be redeemed using the surplus balance of payments. For this, the country must increase its exports and/or decrease its imports. This will lead to the accumulation of foreign reserves within the country, which the respective country can use to pay off its public debts.

9. Compulsory Reduction in the Rate of Interests:

The government may pass the notice to decrease the interest rates payable on public debts. This generally happens in case of a government budget deficit or any other financial difficulties. In such a situation, the creditors have no other option except to reduce the interest rates.

10. Repudiation:

It is a term used when the government refuses to pay back off its public debts. A government can repudiate its international loans. However, the repudiation done by the governments affects their credit score in the money market and makes it difficult to access loans in the future.