VII. Debt Financing and Distribution

International Monetary Fund
Published Date:
September 1986
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Fund-supported programs (86 programs) nearly always look for a reduction of the budget deficit as a percentage of GDP, which in turn is usually associated with limits on the raising of new external public debt (80 programs) (Table 10). As these constraints clearly influence government revenue and expenditure policies, they obviously can have significant distributional consequences, but because the effect is indirect the distributional impact is difficult to identify. The subject is complex and is only touched on briefly to round off the discussion of fiscal policy (in regard to changes in the size and ownership of the debt).

Table 10.External Debt Policies Employed in Fund-Supported Adjustment Programs


External debt policies8691
Control of level and maturity of external debt:8085
Public or publicly guaranteed debt8085
Private sector debt2021
Other debt management policies5559
Debt relief/rescheduling3537
Source: Appendix III.
Source: Appendix III.

The distribution of income is affected both at the time the borrowing takes place and over time. If the government is to finance its deficit by domestic non-bank borrowing, it must induce wealth holders voluntarily to accept government-backed assets instead of private sector assets. The government obtains control over resources, and the effect of this on the distribution of wealth depends on what happens to prices in the different asset markets. The sale of assets in the private sector to finance purchases of government stocks may depress the asset prices, and the government has the choice of using its newly acquired resources to buy other assets (forcing up their price) or to purchase current services. No simple effect on distribution or allocation is identifiable. A popular thesis is that the private sector can be “crowded out” when the government competes for funds in the market. The implication is that saving remains unchanged and that funds are switched from private to public sector investment. Whether or not this is desirable in distributional terms depends, in the long run, on whether the returns from public sector deficit spending are higher than those which would have occurred from the use of the same funds in the private sector. If they are lower, there is a real loss of output for future generations and a real burden on the society is imposed even if the debt is financed domestically.56

Clearly, it would be impossible to evaluate all these alternatives in Fund-supported programs. However, in many instances it is possible to conclude that much public sector spending in the recent past has, as described above, caused more problems than it has solved. A further uncertainty is that bond purchases are often not completely voluntary; public and private sector agencies have nonmarket incentives to buy government bonds. This may have adverse consequences for those who actually own the funds, which are automatically invested in government securities; for example, the eventual recipients of social insurance may be severely penalized through their agency’s purchase of government long-dated bonds at negative real interest rates. In this case, the distributional aspects of state borrowing are likely to be regressive and measures in Fund-supported programs that move public sector borrowing toward genuine bond markets at positive real rates of interest are probably improving the long-run distributional characteristics of the economy.

There is a further dimension to this argument. When the government issues bonds instead of raising taxes, not only does it obtain command over real resources but it also creates an asset in the private sector. Bondholders may consider these bonds to be an increase in their wealth, and in response to the wealth effect raise their consumption at the expense of savings—once more affecting the future rate of output growth. There are at least three difficulties in this. First, although the range of assets may be expanding, the increasing number of bonds sold may cause a depression of the values of other assets, so that the total value of wealth may not increase. Second, some-where else in the system there are taxpayers who are worse off who must pay the interest on the debt and if the effect is symmetrical these (worse off) taxpayers would consume less and save more, offsetting the decisions of the bondholder. Finally, taxpayers may capitalize the future obligations that public debt issues embody and hence not view bonds as an increase in net wealth; therefore, there will be no difference between taxation and borrowing. Even if people behave rationally the effect is not certain for, as discussed earlier, it depends on the willingness of governments to run permanent deficits on average.

Compared with the alternative of taxation, it is clear that the distributional effects of debt financing are likely to be very different. Indeed, as taxation is required to finance both the interest payments and any eventual redemption of the debt, there are distributional implications over time as well as at specific times.

Any tax affects the efficiency of resource allocation within the economy. Even the smallest and most efficiently administered excise tax distorts the marginal conditions necessary for efficient resource allocation; the tax introduces a wedge in the price system so that producers face a different set of relative prices than that faced by consumers. Similarly, high marginal rates of income tax can affect the supply of labor. Also, all taxes have a frictional cost in the sense that their administration imposes a cost on society. Thus, if taxes have to be levied to finance the interest payable on previous borrowing, there must be some increase in the cost to society through misallocation and inefficiency. This is sometimes referred to as a deadweight loss. It should be emphasized, however, that if the choice is to meet the increase in expenditures by taxes rather than debt financing, the costs related to financing discussed above do not apply; thus the actual dead-weight loss to society owing to the tax should be compared with the alternative of debt financing.

Some advocates of low interest rates have argued that positive interest rates serve no useful purpose when the economy is operating below potential and the rate of return on idle resources is effectively zero. They thus view borrowing at a positive interest rate as a gratuitous subsidy to the bondholders, who receive interest at the expense of taxpayers who must pay the interest, and advocate printing currency or interest-free borrowing from the central bank to finance budgetary deficits incurred to promote full employment. Most countries entering a Fund-supported program, however, have exhausted these possibilities and their deficit financing has proved inflationary. While it is true that such inflation often erodes financial wealth and hence redistributes from bondholders to others, in most of the countries the wealthy commonly have their assets in real estate, commodities, and assets held abroad. In such circumstances, bondholders tend to be government or quasi-government agencies that hold assets on behalf of the general population, and the loss of purchasing power incurred by these bonds is a penalty borne by the population at large. In general, Fund-supported programs that try to ensure a more realistic return on government bonds will, in the long run, favor all sections of the population on whose behalf such assets are held. However, this is likely to favor the urban population compared with the rural, and within the urban population the effect may be regressive.

The problems of intertemporal resource use is most serious in the case of foreign borrowing, for in this case a country can obtain additional resources for current use through debt financing, but it must also return these resources, plus interest, in the future. Such borrowing must, therefore, be undertaken with extreme caution. Again, the cost-benefit principle applies. Individual projects which yield a stream of earnings that exceeds the costs of debt service and repayment of principal should be undertaken. In the aggregate, however, developing countries are faced with the problem that an effective development pro-gram may require a more or less steady transfer of resources from industrial countries. Unfortunately, such a steady flow may be impossible to achieve through portfolio investment.

The distributional consequences of this are so diffuse as to defy assessment. It may be maintained, however, that the policy recommendations in adjustment programs to limit public sector borrowing, to reduce external borrowing, to broaden the ownership of public debt, and to finance domestic borrowings at positive real rates of interest are likely to improve the allocation of capital, increase the long-term productive potential of the economy, secure better funding for social security, and reduce future needs for taxation. This environment is likely to be more favorable for distributional concerns than a system constrained by low levels of capital investment, an unvested social security program, and the need to increase taxation to finance domestic and foreign interest payments. Nevertheless, such financial policies are likely to favor urban house-holds and those with substantial savings. So this aspect of a Fund-supported program, although having allocational effects which will benefit all society, may involve regressive redistribution, which in turn suggests that these policies should be supported by effective income taxation, with explicit provisions to with-hold income to ensure that the appropriate tax is paid.

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