Project on Capital Formation: Concept, Role, Determinants and Measures to step up Capital

Formation

INDEX

Capital Formation: Meaning and Definition............................................................5

Role of Capital Formation in the economy..............................................................6

1. Increases productivity...................................................................................6

2. Boosts employment and income...................................................................7

3. Promotes innovation.....................................................................................7

4. Improves infrastructure.................................................................................7

5. Reduces poverty............................................................................................7

Determinants of Capital Formation.........................................................................8

1. Volume of Saving.........................................................................................8

2. Ability to Save..............................................................................................8

3. Willingness to Save......................................................................................9

4. Profit of Public Sector Enterprises...............................................................9

5. Market Conditions........................................................................................9

6. Facilities of Investment.................................................................................9

7. Modifying Income Tax Policies...................................................................9

8. Monetary Policy..........................................................................................10

9. Commodity Taxation..................................................................................10

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Process of Capital Formation.................................................................................10

1. Step 1: Savings Creation.............................................................................10

2. Step 2: Savings Mobilization......................................................................11

3. Step 3: Savings Investment.........................................................................11

Measures to step up Capital Formation.................................................................12

1. Encourage savings......................................................................................12

2. Attract foreign investment..........................................................................12

3. Improve access to finance...........................................................................13

4. Promote innovation and technology...........................................................13

5. Invest in infrastructure................................................................................13

6. Reduction in Consumption.........................................................................13

7. Improve education and skills......................................................................14

8. Provide policy support................................................................................14

Bibliography..........................................................................................................16

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Capital Formation: Meaning and Definition

Capital formation refers to the process of creating new capital, either through the
accumulation of savings or through investments in productive activities. It is the
process of increasing the stock of capital goods, such as machinery, equipment,
buildings, and infrastructure, in an economy over time.

Capital formation is essential for economic growth and development because it

enables the production of more goods and services, which, in turn, creates jobs,
generates income, and increases living standards. Capital formation can occur
through various means, such as savings, investment in physical assets, research
and development, and education and training.

There are two main types of capital formation: physical capital formation and
human capital formation. Physical capital formation involves the accumulation of
tangible assets, such as machinery, buildings, and infrastructure, while human
capital formation involves the acquisition of knowledge and skills through
education and training. Both types of capital formation are important for
economic growth and development.

Capital formation is a long-term process that requires sustained efforts to save,

invest, and innovate. The government plays a crucial role in promoting capital
formation by providing a favorable policy and regulatory environment, promoting
savings and investment, and investing in infrastructure and human capital
development. In addition, the private sector also has an important role to play in
capital formation by investing in new projects, developing new technologies, and

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creating new employment opportunities. Overall, capital formation is essential for

sustained economic growth, job creation, poverty reduction, and improvement in
the standard of living.

Here are some definitions of capital formation given by economists:

According to John Maynard Keynes, capital formation is "the process of

producing additional capital goods, which themselves yield a flow of consumer
goods over time."

Joan Robinson defines capital formation as "the transfer of resources from

consumption goods to investment goods."

Harrod and Domar define capital formation as "the addition to the capital stock of
an economy during a period of time."

In general, economists define capital formation as the process of creating new

capital assets, such as machinery, buildings, and infrastructure, either through
savings or investments in productive activities. Capital formation is crucial for
economic growth and development because it enables the production of more
goods and services, which, in turn, creates jobs, generates income, and increases
living standards.

Role of Capital Formation in the economy

Capital formation is a process that involves the creation of new capital goods,
such as machinery, equipment, buildings, and infrastructure, either through
savings or investment in productive activities. Capital formation is crucial for
economic growth and development because it leads to the following benefits:

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1. Increases productivity: Capital formation leads to an increase in the stock of

physical and human capital assets, which increases productivity and
efficiency. This, in turn, enables the production of more goods and
services with the same or fewer resources, resulting in economic growth.

2. Boosts employment and income: Capital formation leads to increased

production, which creates new jobs and generates income for workers. The
increased income, in turn, leads to higher savings and investment, further
fueling the process of capital formation.

3. Promotes innovation: Capital formation enables firms to invest in research

and development, leading to the development of new technologies,
products, and services, which further stimulate economic growth.

4. Improves infrastructure: Capital formation enables the construction of new

infrastructure, such as roads, ports, and airports, which promotes trade and
facilitates economic activity. This, in turn, attracts more investment,
leading to further economic growth.

5. Reduces poverty: Capital formation leads to increased employment

opportunities and higher wages, reducing poverty and improving living
standards for individuals and families. This, in turn, creates a more stable
and prosperous society.

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Governments and policymakers play a crucial role in promoting capital formation

by creating a favorable policy and regulatory environment that encourages
savings and investment, providing incentives for firms to invest in research and
development, and investing in infrastructure and human capital development.
Private sector firms also have an important role to play in capital formation by
investing in new projects, developing new technologies, and creating new
employment opportunities.

Determinants of Capital Formation

The term "determinants of capital formation" refers to the various factors that
influence the level of investment in an economy. This can occur through
investment in machinery, equipment, buildings, infrastructure, research and
development, education and training, and other forms of productive assets.

1. Volume of Saving: The accumulation of capital directly depends upon

saving. Saving means the difference between income and consumption.
The difference can be utilized for capital formation. According to
MARSHALL- “Larger the volume of savings, larger the size of capital,
smaller the volume of saving, smaller is the size of capital.” The amount
saved as money is mobilized and then converted to capital assets.

2. Ability to Save: It directly depends upon the income of the individuals and
the taxation policy of the government. Higher income and low taxation
leads to higher rate of capital formation.

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3. Willingness to Save: It depends upon many personal, family and national

considerations like family affection, desire to start a business, old age
consideration and unforeseen emergencies.

4. Profit of Public Sector Enterprises: A public sector enterprise is a very

important form of business organization. Since these are owned by the
government rather than by individuals, all the profits of these enterprise
can be used for capital formation by the government.

5. Market Conditions: The prosperity encourages and enhances the saving but
depression reduces the saving of people. Capital formation is highly
affected by market conditions of boom and depression.

6. Facilities of Investment: When the people are provided with more facilities
to mobilize the savings, the people save more and invest more. The
commercial banks, mutual funds, etc., encourage the people to save more.
More saving leads to more capital formation.

7. Modifying Income Tax Policies: The government may provide a boost to

capital formation by extending assistance to potential investors in various
ways. For instance, by conducting techno-economic surveys of various
lines of production, giving tax benefits to newly set up production unit, or
by granting income tax benefits to people who wish to save (e.g.,
exempting from income tax that part of income which is saved). These
steps are particularly useful when investment is constrained, not by the

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policy of saving, but by the unwillingness of the producers to invest the

savings that are available in the economy.

8. Monetary Policy: The economic policies pursued by the government also

constitute an important factor affecting capital formation in the country.
While these policies, by themselves, do not act as sources of capital
formation, they act as factors affecting the sources.

9. Commodity Taxation: Commodity taxation can also be used to raise the rate
of savings. If items of consumption, i.e., especially items of luxury
consumption are subjected to high rates of sales taxes, this will raise the
prices of the consumption goods (because the sales taxes are added to the
prices of the goods). This will reduce consumption in the country.
Naturally, savings will increase if income remains unchanged.

Process of Capital Formation

There are the three steps to the process of capital accumulation:

1. Step 1: Savings Creation

The first step in capital accumulation is the creation of sound savings by

increasing the actual savings. People, i.e., the households, save more money than
spending on consumer goods. The level of real savings is directly related to the
citizen’s income. Savings are created by individuals, who defer their present

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consumption by curtailing their expenditures on consumer goods. These savings

by individuals depends upon the following factors as well:

(i) Ability (or power) to save

(ii) Willingness (or desire) to save
(iii) Opportunity to save.

2. Step 2: Savings Mobilization

Proper mobilization becomes paramount after the accumulation of savings.

Mobilization of savings means to direct the funds accumulated through the
savings of the government or household towards the businesses, entrepreneurs, or
government for further investment in producing goods and services.

Savers first deposit savings into financial institution. They then provide them to
business persons or firms for use in manufacturing products and services.
Moreover, the extent of savings mobilization depends on the ease of availability
of funds, hassle-free access to funds, secure financial systems, and savings plus
banking practices of the citizens. Thus, institutions like banks, insurance
companies, improvement trusts, finance corporations, etc., play a very important
role in bringing individual savers and investors together. All these financial
institutions constitute a capital market in the country and ensure that the savings
of the society are mobilized and transferred to entrepreneurs who require them.

3. Step 3: Savings Investment.

Although savings are necessary, they do not directly produce capital goods until
savers invest them wisely. Therefore, one must make appropriate savings-
investment decisions after the savings and mobilization. The savings-investment

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is the investment of funds collected and capital borrowed from banks into buying
tangible capital like plant machinery for future uses. Moreover, the fund made
available for investment also depends on the rate of interest, government policies,
degree of economic development, demand in the market, and marginal efficiency
related to capital.

The above three steps are critical in capital accumulation as they add to the
increase of capital stocks. As a result, there is an addition to the economy’s
capital, so the economy’s production capacity increases.

Measures to step up Capital Formation

Capital formation is an essential component of economic development and

growth, and there are various measures that can be taken to step up capital
formation. Here are some of the measures that can be taken:

1. Encourage savings: To increase capital formation, it is necessary to

encourage savings among individuals and businesses. This can be done
through various measures such as tax incentives for savings, increasing
interest rates on savings deposits, and promoting the use of savings
instruments such as bonds and mutual funds.

2. Attract foreign investment: Foreign investment can help to increase the

level of investment in an economy. Governments can offer incentives such
as tax breaks and streamlined procedures for foreign investors to make it
easier for them to invest in the country.

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3. Improve access to finance: Access to finance is crucial for investment.

Governments can take steps to increase access to finance, such as creating
a more favorable business environment for financial institutions,
promoting the use of electronic payment systems, and improving credit
rating systems. In poor and less developed countries, people hoard their
unspent current income and invest in jewelry, gold property etc.
Therefore, such countries must have well organized financial institutions
where people may easily deposit their unspent money.

4. Promote innovation and technology: Innovation and technology play a key

role in increasing productivity and efficiency, which in turn drives capital
formation. Governments can support research and development initiatives
and provide incentives for businesses to invest in new technologies.

5. Invest in infrastructure: Infrastructure is a key determinant of investment,

and inadequate infrastructure can hinder capital formation. Governments
can invest in the development of infrastructure such as transportation
networks, power supply, and telecommunications, which can improve the
business environment and attract investment.

6. Reduction in Consumption: Prof. R. Nurkse and Prof. W. A. Lewis are of

the opinion that saving can be raised through restricting consumption. It is
argued that the level of consumption of the common people in under-
developed countries is extremely below the subsistence line. Therefore,
the rate of saving can be increased by curtailing the conspicuous

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consumption of the rich and by diverting an increasing percentage of the

increments in national income to capital formation

7. Improve education and skills: A skilled and educated workforce is essential

for capital formation. Governments can invest in education and training
programs to improve the skills of the workforce and attract investment in
high-skill industries.

8. Provide policy support: Governments can provide policy support such as tax
incentives, subsidies, and regulations to encourage investment in specific
sectors that are critical for economic development and growth. As
voluntary savings are not sufficient for capital formation in poor and
backward countries, the Govt., can mobilise the resources through fiscal
policy. These measures are in the form of budgetary surplus, taxation,
reduction in government expenditure, expansion of export sector, loans
and deficit financing. Besides, growth oriented long-term saving policy
should be evolved so that the process of development may get momentum.

Taxation is an effective instrument of fiscal measure for reducing

consumption and transferring resources for productive investment. By the
way of taxation, the government can take away a portion of the surplus
resources of the people and can either make it available to the private
investors or can itself utilise it for capital projects. Therefore, taxation
helps the capital formation in two ways (i) by transferring private
resources to the state for utilization in the desired channels and (ii) by
providing incentives to the private sector to increase production.

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Furthermore, public bowing is another method of diverting resources from

unproductive to productive channels. But, its scope is also restricted in
such countries as there is lack of organized capital and money markets.

Overall, stepping up capital formation requires a multifaceted approach that

involves addressing various factors such as savings, access to finance, innovation
and technology, infrastructure, education and skills, and policy support

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Bibliography

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and Why It’s Important’ (July 27, 2022)
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Empirical Analysis. The Review of Economics and Statistics, 44(2), 113–
122. https://doi.org/10.2307/1928194
3. Roy, B. (1967). Capital Formation in India: 1901-51. Economic and
Political Weekly, 2(17), 807–811. http://www.jstor.org/stable/4357874
4. Bhatt, V. V. (1959). Savings and Capital Formation. Economic
Development and Cultural Change, 7(3), 318–342.
http://www.jstor.org/stable/1151640
5. Khan, A. A. (1960). Disguised Unemployment and Capital Formation.
The Punjab University Economist, 1(3), 13–37.
http://www.jstor.org/stable/23006554
6. http://www.rdscollege.ac.in/studymaterial/1594392403.pdf?uid=
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in-an-economy-meaning-significance-and-process/12981
8. https://www.yourarticlelibrary.com/economics/capital-formation/
measures-to-be-followed-to-accelerate-capital-formation/38263

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