The below mentioned article provides an overview on Capital Formation. After reading this article you will learn about: 1. Introduction to Capital Formation 2. Process of Capital Formation 3. Capital Formation in a Socialist Economy.

Introduction to Capital Formation:

Capital formation or accumulation plays a predominant role in all types of economics whether they are of the American or the British type, or the Chinese type. Development is not possible without capital formation. Capital formation refers to all the produced means of further production, such as roads, railways, bridges, canals, dams, factories, seeds, fertilisers, etc.

According to Professor Nurkse, “The meaning of ‘capital formation’ is that society does not apply the whole of its current productive activity to the needs and desires of immediate consumption, but directs a part of it to the tools and making of capital goods: tools and instruments, machines and transport facilities, plant and equipment— all the various forms of real capital that can so greatly increase the efficacy of productive effort. The essence of the process, then, is the diversion of a part of society’s currently available resources to the purpose of increasing the stock of capital goods so as to make possible an expansion of consumable output in the future.”

Saving and investment are essential for capital formation. According to Marshall, saving is the result of waiting or abstinence. When a person postpones his consumption to the future, he saves his wealth which he utilizes for further production, If all people save like this, the aggregate savings increase which are utilised for investment purposes in real capital assets like machines, tools, plants, roads, canals, fertilizers, seeds, etc.


But savings are different from hoardings. For savings to be utilised for investment purposes, they must be mobilised in banks and financial institutions. And the businessmen, the entrepreneurs and the farmers invest these community savings on capital goods by taking loans from these banks and financial institutions. This is capital formation.

Process of Capital Formation:

The process of capital formation involves three steps:

(1) Increase in the volume of real savings;

(2) Mobilisation of savings through financial and credit institutions; and


(3) Investment of savings.

Thus the problem of capital formation becomes two-fold: one, how to save more; and two, how to utilise the current savings of the community for capital formation. We discuss the factors on which capital accumulation depends.

1. Increasing Savings:

(a) Power and Will to Save:

Savings depend upon two factors: the power to save and the will to save. The power to save of the community depends upon the size of the average income, the size of the average family, and the standard of living of the people.


Other things being equal, if the income of the people increases, or the size of the family is small, or people get accustomed to a particular standard of living which does not lean towards conspicuous consumption, the power to save increases.

The power to save also depends upon the level of employment in the country. If employment opportunities increase, and existing techniques and resources are employed fully and efficiently, incomes increase, and so do the propensity of the people to save.

Savings also depend upon the will to save. People may themselves forego consumption in the present and save. They may do so to meet emergencies, for family purposes, or for social status. But they will save only if certain facilities or inducements are available.

People save if the government is stable and there is peace and security in the country. People do not save when there is lawlessness and disorder, and there is no security of life, property and business.

The existence of banking and financial institutions paying high rates of interest on different term-deposits also induces people to save more. The taxation policy of the government also affects the savings habits of the people.

Highly progressive income and property taxes reduce the incentive to save. But low rates of taxation with due concessions for savings in provident fund, life insurance, health insurance, etc. encourage savings.

(b) Perpetuation of Income Inequalities:

Perpetuation of income inequalities had been one of the major sources of capital formation in 18th century England and early 20th century Japan. In most communities, it is the higher income groups with a high marginal propensity to save that do the majority of savings.

If there is unequal distribution of income, the society’s upper level incomes accrue to the businessmen, the traders and the landlords who save more and hence invest more on capital formation. But this policy of deliberately creating inequalities is not favoured now either in developed or developing economics when all countries aim at reducing income inequalities.


(c) Increasing Profits:

Professor Lewis is of the view that the ratio of profits to national income should be increased by expanding the capitalist sector of the economy, by providing various incentives and protecting enterprises from foreign competition. The essential point is that profits of business enterprises should increase because they know how to use them in productive investment.

(d) Government Measures:

Like private households and enterprises, the government also saves by adopting a number of fiscal and monetary measures. These measures may be in the form of a budgetary surplus through increase in taxation (mostly indirect), reduction in government expenditure, expansion of the export sector, raising money by public loans, etc.


If people are not saving voluntarily, inflation is the most effective weapon. It is regarded as hidden or invisible tax. When prices rise, they reduce consumption and thus divert resources from current consumption to investment. Besides, the government can increase savings by estab­lishing and running public undertakings more efficiently so that they earn larger profits which are utilised for capital formation.

2. Mobilisation of Savings:

The next step for capital formation is the mobilisation of savings through banks, investment trusts, deposit societies, insurance companies, and capital markets. “The kernal of Keynes’s theory is that decisions to save and decisions to invest are made largely by different people and for different reasons.” To bring the savers and investors together there must be well-developed capital and money markets in the country.

In order to mobilise savings, attention should be paid to the starting of investment trusts, life insurance, provident fund, banks, and cooperative societies. Such agencies will not only permit small amounts of savings to be handled and invested conveniently but will allow the owners of savings to retain liquidity individually but finance long-term investment collectively.

3. Investment of Savings:

The third step in the process of capital formation is the investment of savings in creating real assets. The profit-making classes are an important source of capital formation in the agricultural and industrial sectors of a country.


They have an ambition for power and save in the form of distributed and undistributed profits and thus invest in productive enterprises, besides, there must be a regular supply of entrepreneurs which are capable, honest and dependable.

To perform his economic function, the entrepreneur requires two things, according to Professor Schumpeter, first, the existence of technical knowledge to produce new products; second, the power of disposal over the factors of production in the form of bank credit.

To these may he added, the existence of such infrastructure as well-developed means of transport, communications, power, water, educated and trained personnel, etc. Further, the social, political and economic climatic conditions in the country must be conducive for the emergence of a growing supply of entrepreneurs.

Domestic sources for capital formation are required to be supplemented by external sources. There are two reasons for external borrowing, according to Professor A.J. Brown. One is that it may be the easiest way of getting hold of capital funds at all, and the other that it may be the easiest way of getting foreign currency with which to buy imports which are needed for development.

The countries which have borrowed most from abroad for development purposes are those which have at some stage had a colonial status, have been developed by European immigrants, or have traded heavily with the highly developed countries, or have satisfied all these conditions.

For instance, the United States, in spite of its high rate of internal saving was a heavy foreign borrower in the earlier part of its development, with a net foreign indebtedness which in the eighteen-nineties perhaps reached 4 or 5 per cent of its already very large capital.

Capital Formation in a Socialist Economy:


The above description is of the process of capital formation in a capitalist economy. In a socialist economy, capital formation is entirely done by the state. Since all capital and land is owned by the state and all products are produced by it, all rent, interest and profits are received by the state which invests them for creating capital assets.

The state fixes the rate of capital formation to be achieved for each year and takes away a part of the income of the people through fixation of higher prices for products and taxation. In a socialist state, savings are done on a much larger scale by the state than in a capitalist economy.

It is the government which saves out of the proceeds of taxation, and profits of enterprises. The main source is the turnover tax on consumers’ goods. Then there are the profit-margins, as the difference between the prices of consumers’ goods fixed and their costs of production.

After allowing some percentage of these profit-margins to enterprises for approved capital purposes, the rest are allocated for investment purposes along with the revenue from the turnover tax. Personal savings lying in banks or subscribed to state loans also account for about 15 to 20 per cent of the total savings which are utilised for capital formation in a socialist economy.