Dr. S. Thirumal, M.Com., M.Phil., MBA., PGDCA., Ph.

D,

Assistant Professor

School of Excellence in Law

The Tamil Nadu Dr. Ambedkar Law University

Chennai – 600 113

E-mail: drthirumal20@gmail.com

UNIT - 3

PUBLIC EXPENDITURE AND PUBLIC DEBTS

PUBLIC EXPENDITURE

Public expenditure is spending made by the government of a country on collective needs

and wants, such as pension, provisions, security, infrastructure, etc. A public expenditure review
(PER) analyses the quantity and quality of public spending over time against policy goals and
performance indicators. They may cover all government expenditure or focus on one or more
priority sectors, such as health, education or water and sanitation. PERs can be used to inform
strategic planning and budget preparation and to identify ways in which to improve the efficiency
and effectiveness of government resources.

Public expenditure is expenditure incurred by the government (Example. Central

Government, State Governments, Lower Level Governments i.e. District Office, Gram Panchayat,
etc.). Such expenditures are made for social welfare of people and to run the government
administration. The importance attached to public expenditure has varied between different
schools of thought.

World-wide, there has been a continuous increase in public expenditure. The range of
activities performed by the governments span areas like national defence, police and internal
security, development of education and health sectors, policies to remove poverty, etc.

FACTORS OF INFLUENCE IN PUBLIC EXPENDITURE

a. Growth of Population:

A large and growing population is one of the main reasons behind growing public
expenditure. A country with large population will have to create more schools, hospitals, transport
facilities, roads and other amenities to meet the needs of its large population as compared to
countries with smaller population. In order to control the population growth, the government
intervenes with policies on family planning creating necessary infrastructure to administer such
policies.

b. Growth of Democracy:

The structure of the democratic form of the government is such that it will require more
public expenditure. It requires regular and continuous maintenance of the political institutions. For
instance, periodic conduct of elections would be required at all levels of the government. Countries
with a democratic form of government will always therefore have a higher level of public
expenditure. Additionally, to increase their chances of re-election local politicians will be more
responsive to demands of the people in their jurisdiction. This requires the setting up of large scale
‘public goods’ in all jurisdictions which require funds on regular basis for their maintenance
(called non-plan or revenue expenditure). Therefore, the political and governing structure of
country always serves as a significant factor behind a large scale public expenditure.

c. Welfare State:

Various positive effects of public expenditure on increasing production and employment,

reducing income inequality, etc. were ignored. In successive decades, the understanding of the
term ‘modern state’ evolved over time. This changed the concept of ‘police state’ to ‘welfare state’
under which large emphasis is placed on the welfare related measures required to uplift the social
welfare of the marginalised sections of people. For instance, creation of employment opportunities,
social security measures, creation of welfare related infrastructure, etc. would all require greater
role by the government. The ‘theory of public expenditure’ has therefore recognised distortions
created by ‘market mechanism’ in ensuring full employment of job seeking population. Due to
these factors and increased sensitisation for the welfare of people, the extent of public expenditure
incurred has increased enormously over the years.

d. Defence Expenditure:

In modern society, every country wants to protect its borders. The possibility of wars
require the nations to equip themselves with arms. This process, in turn, requires large scale public
expenditure to equip their defence sector.

e. Expansion of Public Sector and Administrative Set up:

Creation of large scale administrative set up requires large scale public expenditure. This
is more likely for countries with large geographic area with decentralised government systems
(e.g. Canada, Australia, India). This entails expenditure on large scale police and public services
machinery in every nook and corner of the country to maintain internal security, public
administration, public sector enterprises, etc.
 f. Poverty Alleviation Programmes:

Countries which have chronic poverty have to incur large scale expenditure in the form of
poverty alleviation programmes. This is especially so for countries like India (and other developing
countries) which rely heavily on public programmes to improve the well-being of their poorest so
as to bring them up to join and benefit from the mainstream development process of the country.

g. Urbanisation:

Countries with a larger, and especially growing, urban population also require growing
public expenditure to expand their urban amenities (such as establishment of better quality schools,
drainage system, hospitals, drinking water facilities, better law and order condition in the society,
etc.).

h. Income Re-distribution:

Policies targeted for income re-distribution collect taxes from richer states and spend them
in poorer states leading to transfer of funds. For instance, government collects taxes from richer
areas with proceeds from certain taxes earmarked to be spent for the development of poorer
regions. This is needed because such regions cannot raise enough funds from their own jurisdiction
due to lower level of development. The extent of public expenditure is therefore large in such a
federal set up.

CLASSIFICATION OF PUBLIC EXPENDITURE

Different economists have classified Public Expenditure into different forms. Prof. Adam
Smith has classified public expenditure on the basis of functions performed by the government.
They are defence expenditure, commercial expenditure and development expenditure. Prof. Dalton
classified public expenditure into grants and purchase price. When the government transfers its
resource without any quid pro quo, it is grant. Expenditure incurred to provide services is grant.

a. Revenue expenditure:
This means expenditure on civil administration, defence and welfare schemes, etc.
 b. Capital expenditure:
This is incurred once and all. It is non-recurring expenditure. Expenditure on multipurpose
projects, big factories like steel and cement, money spent on machinery, building and land are
all capital expenditure.
c. Development expenditure:
This is made on irrigational development, industrial development, education and health etc.
d. Non-development expenditure:
This is the money spent on civil administration, police force, defence forces, judiciary, etc.

CANONS OF PUBLIC EXPENDITURES

The principles of public expenditure are certain guidelines for the public authorities in
spending government money. They are also known as canons of expenditure. These canons are:

a. Principle of Maximum Social Advantage

The objective behind this principle is that public money should be spent for general cause
and must promote social welfare. It should not be spent for the benefit of a particular group of
society. Public expenditure should result in increased production, elimination of inequality and
promotion of welfare of all. It should secure internal peace and also protection from external
aggression.

b. Canon of Economy

The authorities are expected to follow utmost economy in its expenditure. Public money
should not be misused and not result in any wastage. Whenever money is raised by taxation,
public expenditure in return should bring maximum benefit. It should not produce unfavorable
effect on production. Canon of economy does not mean niggardliness or miserliness. It simply
means the prevention of extravagance and waste of all kinds.

c. Canon of Sanction

Without the sanction of the public authority, no money should be spent. At the same time, the
amount of money must be spent for the purpose for which it was sanctioned.
This will ensure that:

▪ waste and extravagance are avoided,

▪ there is proper audit done compulsorily,
▪ there is control and legislative supervision over public expenditure,
▪ It is seen whether the expenditure has fulfilled the objective.
In the absence of proper sanction, there may be misuse and misappropriation of public funds. The
Public Accounts Committee established by every legislature sees that these objectives are
achieved.

d. Canon of Neutrality

This principle talks about the equilibrium in public expenditure. This means public expenditure
must keep an equilibrium level which is favorable to the entire parts of the economy. It should not
badly affect the economy such as production, distribution, exchange tec. In fact, canon of neutrality
is emphasis on the sustainability of an economy.

e. Canon of Elasticity

This implies that there should be scope for varying the expenditure according to need or
circumstances. There should not be any rigidity in public expenditure.

f. Canon of Certainty

Canon of certainty refers that, there should be a surety in public expenditure. Because, there
are so many groups in the economy, whose are interested to know about public expenditure. Surety
in public expenditure denotes the government support. This is very essential for the creation of
inspiration among producers, consumers and other economic agents.

g. Canon of production and Distribution

This principle of public expenditure refers to the public expenditure must ensure maximum
productivity. This will help the country to achieve growth and development. Along with that, the
public expenditure aims at the sustainability. Similarly on the side of distribution, public
expenditure must be based on the principle of equality. It should help the country to eliminate
inequality in gender, community, classes etc.

h. Canon of Surplus

To greater extent, the government expenditure should lead to increased production,

employment and income. The expenditure should be within the revenue of the State. Deficit is
permitted only for a short duration. In times of crisis, government is allowed to have deficit budget.
The deficit must be made good after the normalcy returns.

Finally, public expenditure should promote economic growth, stability and social justice.
Public expenditure should be directed to achieve economic and social objectives of the country.

EFFECTS OF PUBLIC EXPENDITURE

Public expenditure is beneficial since it influences the economy in many directions. The
effects of public expenditure are always beneficial. It increases the capacity of the people to
produce output efficiently. It influences the production not only directly but also indirectly. It
increases the community’s productive power. It promotes social and economic equality and
finally increases income, employment and welfare.

a. Effects on production

Expenditure on defence becomes productive and it becomes a protective expenditure.

Development of infrastructures facilitates production and thereby helps to increase national
income and in turn per capita income. Expenditures on social services like free education, health
and medical aid, which increase the capacity of the people to work and save and productive power.

b. Effects on distribution
Public expenditure is an ideal medium to remove economic inequalities in society. The
government should tax more the rich. The amount so collected should be spent on free education,
medical aid, cheap food, subsidized houses, old age pension, etc. This process of public
expenditure will bring about redistribution of national income in favour of the poor.

c. Effects on income and employment

Public expenditure affects the level of income and employment in the country by removing the
widespread unemployment. Investing more on public works like roads, hydro-electric generating
works, etc. will create a multiplier effect on the economy and thereby increases the income and
employment. This results in increased consumption and in turn develops the consumption goods
industries and capital goods industries.

Thus, public expenditure plays a vital role in the economic development of a country. It also
creates necessary environment for the expansion of private enterprise and initiative.

OBJECTIVES OF PUBLIC EXPENDITURE

a) Administration of Law & Order

b) Industrial Development
c) Creation of Social Goods
d) Servicing of Public Debt
e) Transport & Communication Development
f) Maintenance of defense goods
g) Maintenance of diplomats in foreign countries
h) Maintenance of police force
i) Provision for public health
j) Public Administration

PUBLIC DEBT

Public debt meaning: In the Indian context, public debt includes the total liabilities of the
Union government that have to be paid from the Consolidated Fund of India.

According to the IMF (International Monetary Fund), India's debt-to-GDP ratio for 2020
was 89.60% as against 74.08% in 2019 and was projected to rise to a record of 90.6% in FY22.
How does high debt affect the economy? Increasing public debt results in a rise in interest
payments burden. (14-Feb-2022)

CLASSIFICATIONS OF PUBLIC DEBTS

a. 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.

b. Short term and Long Term Loans:

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

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

c. Funded and Unfunded or Floating Debt:

Funded debt is the loan repayable after a long period of time, usually more than a year. Thus,
funded debt is long term debt. Further, since for the repayment of such debt government maintains
a separate fund, the debt is called funded debt. Floating or unfunded loans are those which are
repayable within a short period, usually less than a year.

It is unfunded because no separate fund is maintained by the government for the debt
repayment. Since repayment of unfunded debt is made out of public revenue, it is referred to as a
floating debt. Thus, unfunded debt is a short term debt.
 d. 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.

e. Redeemable and Irredeemable Debt:

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

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

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

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

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

IMPORTANCE OF PUBLIC DEBT IN INDIA

a. Covering the gap between expenditure & Tax Revenue

If the Government’s revenue from taxes falls short of expenditure, public borrowings
becomes a necessity. The excess of Government expenditure over its revenue creates a deficit in
the Government Budget. The growing deficit in the Government budget has been the principal
reason for public borrowings in India.

b. Controlling Inflation

At times of inflation, the Government tries to reduce the purchasing power of consumers,
so that the pressure of excess demand may be reduced. Like taxes, public debt also takes money
away from people’s hand. Hence, public debt is used, side by side with taxes, as an instrument of
inflation control.

c. Controlling recessions

During recessions, people do not want to invest their money. As a result, the levels of
output and employment are stagnant. The Government may borrow money from the public and
invest the money in various projects.

d. Development financing

In a less developed economy like India, the Government often has to play a leading role in
economic development. For raising the necessary funds, the Government takes recourse to
borrowing from public. In India, public debt has been the major source of financing the
development plans.

e. Social development

Financing is needed not only for economic but also for social development projects like
education, health care etc. For this purpose also, the Government borrows from the public.

BURDEN OF PUBLIC DEBT

g. Public debt constitutes the financial obligation or liabilities of the government

h. Debt burden is measured as ratio of outstanding debt to GNP
i. Debt= Outstanding Debt/ GNP
j. Burden of Public Debt consist of the sacrifice that tax payer have to make for financial
repayment of principle and interest.
k. Increases inequality: Purchasing power transfers from poor to rich.
 l. Adversely affects the ability and desire to work, save and invest
m. Transfer purchasing power from young to older generation.
n. Reduces private investment.

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.

The Reserve Bank of India (RBI) is responsible for managing India's public debt, especially
debt denominated in the domestic currency. The management of the central government's debt is
conducted by RBI under statutory provisions that oblige the central government to delegate its
debt management to the RBI.

GOALS / OBJECTIVES OF GOVERNMENT DEBT MANAGEMENT

i. Meet the borrowing requirements of the government;

ii. Borrow at the lowest possible cost over the medium to long run;
iii. Keep a prudent degree of risk in the debt portfolio; and
iv. Meet any other goals the government may have set, such as developing and maintaining an
efficient market for government debt securities.

IMPORTANTANCE OF DEBT MANAGEMENT

Public debt is an important measure of bridging the financing gaps of the government.
Prudent utilization of public debt leads to higher economic growth and adds to capacity to
service and repay external and domestic debt. It also helps the government to accomplish its
social and developmental goals.
a. Ensuring that the level and rate of growth of public debt is sustainable in a wide range
of circumstances.
 b. Lowering public borrowing costs over the long term, thus reducing the impact of deficit
financing and contributing to debt and fiscal sustainability.
c. Avoiding economic crisis because of poorly structured debt.

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, violation of the contract. Use of repudiation of debt by the government
is economically unsound.

CAUSES FOR THE INCREASE IN PUBLIC DEBT

a. War and Preparation of war

Waging war has become one of the important causes for incurring debts by the
governments. In modern times, the preparation for war and nuclear defence programmes take away
the major share of the government’s revenue and so it incurs debt.

b. Social obligations

Modern states are considered to be ‘Welfare States’ and they have to undertake many social
obligations like public health, sanitation, education, insurance, transport and communications, etc.,
besides providing the minimum necessaries of life to the citizens of the country. To finance these,
the State has to incur a heavy public debt.

c. Economic Development and Deficit

The government has to undertake many projects for economic development of the country.
Construction of railways, power projects, irrigation projects, heavy industries, etc., could be
thought of only by means of mobilising resources in the form of public debt. Due to heavy public
expenditure, the governments always face deficit budget. Such deficits have to be financed only
through borrowings.
 d. Employment

Most of the governments of modern days face the problem of unemployment and it has
become the duty to solve this by making huge public expenditure. To solve the unemployment
problem, and to fight recession, the government has to make huge expenditures. For this the States
have to resort to public debt.

e. Controlling inflation

The Government can withdraw excess money from circulation, by raising public debt and
thus prevent prices from rising.

f. Fighting depression

During the depression phase, private investment is lacking. The Government applies
compensatory public spending by borrowing from internal and external sources.

METHODS OF REDEMPTION / REPAYMENT OF PUBLIC DEBT

a. Refunding

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

b. Conversion

Conversion of loans is another method of redemption of public debt. It means that an old
loan is converted into a new loan. Under this system a high interest public debt is converted into a
low interest public debt. Dalton felt that debt conversion actually relaxes the debt burden. When
the rate of interest falls, it may convert the old loans into new ones at a lower rate, in order to
minimize the burden.

c. Surplus budgets
 When the Government presents surplus budget, it can be utilized for repaying the debt.
Surplus occurs when public revenue exceeds the public expenditure. But in recent years due to
ever-increasing public expenditures, surplus budget is a rare phenomenon. Moreover, heavy taxes
have to be imposed for realising a surplus budget, which may have dire consequences.

d. Statutory Reduction in the Rate of Interest

Sometimes, the government passes ordinances to reduce the rate of interest payable on its
debt. This happens when the government suffers from financial crisis and when there is a huge
deficit in its budget. There are so many instances of such compulsory reduction in the rate of
interest. However, this practice is not followed under normal circumstances. Instead, the
government is forced to adopt this method of debt management (repayment) only when the
situation so demands.

e. Sinking fund

Sometimes, this government of a country establishes a separate fund known as the ‘Sinking
Fund’ for the purpose of repaying its debt. Under this system, the government goes on crediting a
fixed amount of money to this fund every year. By the time the debt matures, the fund accumulates
enough amount to pay off the principal along with interest. This method was first introduced in
England by Walpol.

f. Terminable annuities

Government pays off the public debt on the basis of terminal annuity in equal annual
instalments. This is the easiest way of paying off the public debt. Under this method, the fiscal
authorities clear off a part of the public debt every year by issuing terminable annuities to the bond-
holders which mature annually. Thus, it is the method of redeeming debts in installments. By this
method, the burden of debt goes on diminishing annually and by the time of maturity it is fully
paid off.
 g. Additional Taxation

The simplest measure of debt redemption is to impose new taxes and get the required
revenue to repay the loan principal as well as the interest. This method causes redistribution of
income by transferring the resources from tax-payers to the hands of bond-holders. It may also
impose a burden on the future generation if new taxes are levied to repay the long-term debts.

h. Using Trade Surplus

The redemption of external debt, however, is possible only through an accumulation of

foreign exchange reserves. When the government borrows from other countries, it has to service
the debt in foreign exchange. The burden of country’s external debt is measured by its debt-service
ratio, which is a country’s repayment obligations of principal and interest for a particular year on
its external debt as a percentage of its exports of goods and services (i.e., its current receipts) in
that year.

i. Capital Levy

Capital levy refers to a very heavy tax on property and wealth. It is once- for-all tax on the
capital assets and estates. When the Government imposes levy on the capital assets owned by an
individual or any institution, it is called capital levy. This levy is imposed on capital assets above
a minimum limit on a progressive scale. The fund so collected can be used by the Government for
paying off war time debt obligations. This is the most controversial method of debt repayment.