Capital Formation in Economic Development

Development of a nation without the availability of adequate capital either in the form of physical capital or in the form of human capital is not possible. The higher the rate of capital formation (physical as well as human), the faster is the pace of economic growth. On the other hand, deficiency of capital has been the primary cause of underdevelopment in the third world economies.

Capital, Saving, Investment and Capital Formation

Capital refers to the stock of all the produced means of production that an economy possesses at a point of time. Capital includes only those means of production which are produced by man. For example – Plant and machinery, tools and instruments. The capital formation means addition to the existing stock of capital. Capital formation may be defined as the process of adding to the stock of capital per year.

The part of income which is not spent on consumption is called saving. If our savings are spent on capital goods, such as, machines, instruments, factories, or on increasing the stock of raw material or finished goods, this expenditure is called investment. Investment results in the production of capital goods or in the increase in capital stock. The increase in capital stock is called capital formation. Physical capital formation means stock of physical capital. There are two aspects of capital formation viz. Gross Capital Formation (GCF) and Net Capital Formation (NCF).

• Gross Capital Formation: It means gross investment. It includes both replacement investment and net investment.
• Net Capital Formation: It means increase in net investment only. Net investment is estimated by deducting depreciation from gross investment.

Process and Sources of Capital Formation

Process of capital formation refers to the way addition of capital stock is done. It involves saving and mobilisation of savings, and conversion of savings into capital goods through investment.

Saving and Mobilisation of Saving (Supply of Capital)

Saving is the surplus of income after consumption. The savings are used for further generation of income through investment. Investment is an instrument of capital formation. Thus, higher the rate of saving, higher the rate of capital formation. Idle savings do not form part of capital formation.

Financial institutions play an important role in converting saving into investment. Supply of capital not only depends on the rate of saving but also depends on how savings are mobilised through various channels. There are broadly two sources of savings viz. Internal Sources and External Sources.

Internal sources include household savings, public savings and corporate savings. External sources include foreign investment, trade surplus, foreign borrowing, etc. Domestic savings can be either voluntary saving by people or forced saving by government through taxes and inflation.  An external source of saving comes in the form of foreign loan and grants, private foreign investment (FDI and FII) and international terms of trade.

Investment or Demand for Capital

Mobilised savings by the banking and other financial institutions need to be invested for capital formation. Higher investment implies higher capital formation. However, there should be demand for capital from entrepreneurs or from government. Government can use the investment to develop public infrastructure.

Role and Significance of Capital Formation in Economic Development:

Capital Formation ensures a Sustained Rise in Output

Higher capital formation ensures a continuous rise in economic growth. Higher economic growth means rise in the output of the country.

Capital Formation generates Employment

Generation of employment opportunities is a prerequisite for growth and development. Increase in capital formation generates more employment opportunities to produce more output.

Capital Formation facilitates Technical Progress

Capital formation creates an environment for technical progress with more spending on research and development.

Physical Capital Formation prompts Human Capital Formation

Human capital formation is possible only through physical capital formation. The expenditure incurred on health, education and social welfare, is the expenditure for the formation of human capital.

Capital Formation and Infrastructural Development

Capital formation provides the required capital for development of infrastructure.

Capital Formation and Self-reliance

Higher capital formation through domestic savings can create a self-reliance condition.

Capital Formation Facilitates Exploitation of Natural Resources

Capital formation facilitates exploitation of natural resources in the development process.

Factors responsible for lower capital formation

Low Per Capita Income

Low per capita income in less developed countries results in lower savingwhich is the primary source of capital formation.

Large Size of Population

Large size population is an impediment for capital formation. Because of large size population there is increase in consumption expenditure. Higher consumption expenditure means lower saving.

Inflation

Higher inflation means less surplus of income for further investment, implying a low rate of capital formation.

Demonstration Effect

Consumption expenditure tends to be high and the rate of capital formation tends to be low due to Demonstration Effect in the less developed countries. The low-income group people imitate high-income group’s way of life and start spending much of their income on expensive consumer durables. It causes lower rate of capital formation.

Lack of Investment-friendly Environment

Lack of investment-friendly environment suppress the investment.

Complex Tax-structure

Complex tax-structure in less developed economies lowers the capital formation.

Limited Extent of Market

Demand in small size market is low. Lower the demand, lower investment for capital formation.

Measures to Promote Capital Formation in Underdeveloped Countries

Increase in Voluntary savings

Increase in rate of voluntary savings is a prime requirement in less developed countries. Increase in interest rate can encourage more voluntary savings.

Expansion of Banking Institutions

Banking facilities expansion in rural areas can increase the savings in rural areas.

Forced Saving through Taxation

Government can increase the capital formation by imposing direct and indirect tax on economic activities.

Encouraging private Enterprises

Generally, private enterprises are efficiently run when compared to public enterprises. Encouraging private enterprises can increase the capital formation.

Reduction in Non-developmental expenditure

The government should reduce non-developmental expenditure related to administration and defence. Their reduction will result in more savings to be invested in the Public sector.

Price Stability

Price stability is conducive to both the supply of capital as well as demand for capital.

Liberal government Policies

Liberal fiscal and credit of the government encourages saving and investment for capital formation.

Surplus through International Trade

International trade can encourage the flow of capital to the less developed countries.