Compensatory Aspect of Public Debt Policy

Over the period of time, government borrowing as an instrument of fiscal policy has gained greater significance. It is used from a broader perspective, from financing war expenditures to the mobilization of savings for economic growth and for aiding monetary policy in fighting inflation. It is a tool used for containing fluctuations in the business cycle.

The Keynesian theory advocates public borrowing as an effective tool for fighting economic depression when aggregate demand fails to accelerate employment and output. He has well explained the compensatory aspect of debt.

Government borrowing enables the creation of effective demand through the government’s expenditure on infrastructure, social development, and economic activities. The government, through its fiscal policy, aims for three-development objectives, namely- growth, poverty reduction, social inclusion and equity and economic stabilization.

Musgrave (1959) has identified three rationales for fiscal policy: Achievement of Macroeconomic stabilization, improvement of resource allocation and address of distributional disparities.

In this light, there are three Principles of Fiscal Policy:

• High employment and price stability require sufficient expenditure and demand to take high output off the market.
• However, it is difficult to achieve, given the fluctuations in demand and an economy prone to inflation or deflation.
• And compensatory budget policy is one of the tools for stimulating aggregate demand. Stimulating private investment through increased public expenditure can counteract deflationary tendencies. Inflation can be ceased by deterring private expenditures.

The government can aid in stimulating economic growth during the period of recession and depression by increasing its expenditure and thus achieving higher income and employment growth through the multiplier process. It can also control inflationary and deflationary pressures in the economy.

The government borrows to compensate for the shortfall of private savings in the economy. It borrows to undertake expenditure on productive infrastructure and social programs to make up for the decline in private investment.

During the depression, the marginal efficiency of capital and aggregate demand is low, and the economy would not move automatically to full employment level as propounded by the Classists. In the absence of any compensatory action by the government, the economy may move to under-employment.

There are two variants of public expenditure:

● Pump Priming

It refers to the initial push provided to the economy through enhanced government expenditure. The aim is to revive the depressed economy and stimulate economic activity through an increase in investment.

● Compensatory spending

It refers to government borrowing to finance expenditures with the aim to compensate for the decline in private investment. Growing public expenditure due to the massive increase in government activity has meant a growing gap between revenues and expenditure. This shortfall is met by raising public debt. Through deficit financing, the government creates an additional money supply. Deficit financing takes place when the government borrows from the public or from the central bank.

Hence deficit financing is a particular manner of financing income-creating expenditures. Such expenditures will increase the national income, and out of the enlarged income, savings will increase by an amount equal to the deficit.

An economy under depression faces low marginal efficiency of capital, low confidence in the economy, low aggregate demand and thus low private investment. The government stimulates investment in the economy, stimulating the process of income generation through the multiplier process.

In order to have an expansionary impact, public expenditure must be financed through borrowings or through both increased borrowings and cuts in tax rates rather than through increased taxes only. Increased taxes merely leads to a transfer of resources from one party to the other, i.e. reduction in disposable income and private spending and an increase in public expenditures.

Government borrowing will fight depression better through an increase in overall investment and corresponding multiple increases in income. The aim is to put idle resources into productive use. The corresponding increase in aggregate demand leads to a rise in the price level and generates optimism in investors and businesses. Increased prices lead to an increase in profits and create an incentive to invest more. This pushes the economy back onto the growth path through increased employment, output and income.

The expansionary effect of the budget deficit can be explained through an example. The government deficit represents the net government expenditure which increases national income by the multiplier times the increase in net expenditure. Suppose the MPC is 1/4, the multiplier will be 4, and if the government expenditure is increased by Rs. 200 crores, the national income will increase by Rs. 800 crores (= 200×4).

The expansionary effect of a budget deficit is shown diagrammatically in Figure 1. C is the consumption function. C+I+G represent consumption, investment and government expenditure (the aggregate demand function) before the budget is introduced. Equilibrium is at point A, corresponding to income level Y. Suppose government expenditure is increased by ∆G (E₁B) and taxes are kept intact.

As a result, the aggregate demand function shifts upward to C+1+G₁. Equilibrium Income increases from OY to OY, when the equilibrium position moves Income from E to E₁. We can see that the increase in income YY₁ is greater than the increase in government expenditure E₁B. BA(E₁A–E₁B) represents the increase in consumption expenditure. Thus the rise in national income being (YY₁) is greater than the increase in government expenditure (∆G=E₁B).

We can also analyze the effect of tax reduction without any increase in government expenses. Reduction in taxes tends to increase disposable income in the hands of the people and thus stimulates consumption expenditure. This, in turn, would lead to an increase in aggregate demand output, income, and employment. In Figure 2, where С is the original consumption function. The consumption function shifts upwards to C₁ as a result of a fall in taxes by ET. Equilibrium income rises from OY to OY₁.

However, the reduction in taxes is not so expansionary compared to the effect of the increase in government expenditure as increased consumption expenditure because of the tax economic downturn. The government should follow the policy of tax reduction along with increased government spending. The corresponding multiplier effect will be much higher.

Read More in: Theory of Public Finance

1. Public Finance: Meaning, Nature & Scope
2. Role of Government in Economy
3. Role of Government in Mixed Economy: Public & Private Sector
4. Role of Government under Cooperation and Competition
5. Role of Government in Economic Development and Planning
6. Concept of Public Goods, Private Goods, and Merit Goods
7. Concept of Market Failure and Functions of Government
8. Market Failure and Functions of Government: Decreasing Costs
9. Market Failure and Functions of Government: Externalities
10. Market Failure and Functions of Government: Public Goods
11. Future Market: Meaning, Role & Uncertainty
12. Concept of Information Asymmetry
13. Theory of Second Best: Concept & Explanation
14. Problem of Allocation of Resources: Public & Private Mechanisms
15. Preferences: Meaning, Types & Problems of Preference Revelation
16. Preference Aggregation & Its Mechanism
17. Voting Systems, Direct Democracy, Representative Democracy, Leviathan Hypothesis & Arrow’s Impossibility Theorem
18. Economic Theory of Democracy: Concept & Explanation
19. Politico Eco Bureaucracy: Concept & Explanation
20. Rent-Seeking and Directly Unproductive Profit-Seeking Activities
21. Rationale for Public Goods: Concept & Explanation
22. Benefit Theory or Voluntary Exchange Theory
23. Lindahl Model: Concept, Equilibrium & Limitations
24. Bowen Model: Concept, Advantages & Limitations
25. Samuelson’s Model of Public Expenditure
26. Musgrave’s Model of Public Expenditures
27. Demand Revealing Schemes for Public Goods
28. Vickery-Clarke-Groves Mechanism
29. Groves-Ledyard Mechanism
30. Tiebout Model: Concept, Assumptions Equilibrium & Simple Tiebout Model
31. Theory of Club Goods
32. Keynesian Principles of Stabilization Policy
33. Difference Between Keynesian Economic Thought and Others
34. Role of Expectations and Uncertainty in Formulating Stabilization Policy
35. Intertemporal Markets Efficiency & Failure
36. Liquidity Preference Theory
37. Diamond-Dybvig Banking Model
38. Preference Shocks, Adverse Selection & Central Bank
39. Equilibrium Deposit Contract
40. Social Goods and Its Effect on Stabilization Policy
41. Effect of Infrastructural Facilities on Stabilization Policy
42. Effect of Distributional Inequality on Stabilization Policy
43. Effect of Regional Imbalances on Stabilization Policy
44. Wagner’s Law of Increasing State Activities: Explanation, Graph & Criticism
45. Peacock-Wiseman Hypothesis: Explanation, Graph & Criticism
46. Public Expenditure: Concept, Objectives, & Public vs Private Expenditure
47. Pure Theory of Public Expenditure
48. Structure & Growth of Public Expenditure in India
49. Trends, Lessons & Priorities in Public Expenditure in India
50. Social Cost-Benefit Analysis: Project Evaluation, Estimation of Costs & Discount Rate
51. Performance Based Budgeting and Zero Based Budgeting
52. Theories of Tax Incidence: Concentration Theory, Diffusion Theory & Modern Theory
53. Tax System and Its Principles
54. Equity Principle and Efficiency Principle of Taxation: Meaning, Explanation & Examples
55. Ability to Pay and Benefits Received Principle of Taxation
56. Theory of Optimal Taxation: Excess Burden & Distortions of Taxation
57. Deadweight Loss of Taxation: Causes, Measurement & Example
58. Concept of Equity & Efficiency in Economics
59. Trade-Off Between Equity and Efficiency: Meaning & Example
60. Theory of Measurement of Dead Weight Loss
61. Double Taxation: Meaning, Desirability, Forms & Solution
62. Solution to Problem of Double Taxation: Intra-Country & International
63. Double Taxation Avoidance Agreement (DTAA) and Indian Policy
64. Classical View on Public Debt
65. Compensatory Aspect of Public Debt Policy
66. Public Debt or Borrowings: Concept, Need, Sources & Types
67. Concept of Public Debt or Public Borrowings
68. Need for Public Debt or Public Borrowing
69. Sources of Public Debt
70. Classification of Public Debt
71. Burden of Public Debt: Meaning, Types & Explanation
72. Debt Through Created Money or Deficit Financing
73. Public Debt (Public Borrowings) and Inflation (Price Level)
74. Crowding Out of Private Investment and Activity
75. Principle of Public Debt Management and Debt Repayment