In order to raise capital formation in the economy we have first to raise ratio of surplus to capital or rate of surplus to national income and then measures have to be adopted to mobilize this surplus for purposes of productive investment.

1. Raising the Ratio of Surplus to Capital:

In this connection the distinction between potential economic surplus and actual economic surplus should be borne in mind. Potential economic surplus is the difference between the national income of a country and the essential or basic consumption (which includes also capital replacement), while the actual economic surplus is the surplus actually achieved after spending on essential and non-essential consumption and also unproductive investment.

Now, if the ratio of actual surplus to capital is to be raised, non-productive uses of potential surplus, namely, non-essential consumption and unproductive investment have to be prevented. In developing countries wasteful use of potential economic surplus in the form of non-essential consumption and unproductive investment is quite enormous both among private individuals and the Government.

The unproductive consumption is indulged in by property owners such as big landlords and rich farmers, rich businessmen and industrialists when they spend a part of their income on luxuries such as purchase of expensive motor cars, air conditioners, construction of palatial houses, gold and jewellery, etc. The high wage earners and self-employed also indulge in luxurious consumption when they spend a good part of their income on relatively luxurious items such as costly sofa sets and other furniture, expensive clothes, wine, unnecessary entertainments and lavish expenditure on births, marriages and death ceremonies, etc. Even the Government spends a lot on unnecessary or unproductive consumption expenditure when it spends excessively on police and other administrative services, defence, large size of the ministries, liberal travelling allowances and other facilities to the officers and ministers, etc.


Productive surplus is also reduced by the various forms of unproductive investment made both by the private sector and the Government. The unproductive investment by the private sector takes place when the rich businessmen and landlords invest their incomes in real estate (i.e., land), palatial houses, gold and jewellery. Likewise, even Government makes unproductive type of investment when it spends money on the construction and maintenance of luxurious hotels, office buildings, houses, parks, etc. It, therefore, follows that if the actual and productive surplus is to be raised the magnitudes of non-essential and unproductive investments are to be considerably reduced.

It may be noted that the propensity of the people of underdeveloped countries to use the economic surplus for conspicuous consumption has become stronger in recent years because of the international demonstration effect. The concept of international demonstration effect is that people of poor developing countries try to copy the high consumption standards of the people of affluent developed countries. As a result, unproductive or non-essential consumption of these countries increases and as a result surplus available for productive investment falls.

This international demonstration effect has become quite strong these days because of the greater awareness on the part of the people in underdeveloped countries regarding the living standards of the people in rich nations. This greater awareness has emerged because of wide travel by the people of the poor countries in Western countries, propaganda and advertisement in radio, television and newspapers. Therefore, if the ratio of surplus to capital is to be raised significantly, the operation of the demonstration effect should be overcome by educating the people and also by providing various incentives for saving.

2. Incentives for Saving:

An important measure to encourage savings and raise ratio of surplus to capital is that savings be exempted wholly or substantially from income taxes. When people know that they will not have to pay income taxes on the saved portion of their income, they will be greatly tempted not to consume a good part of their income and thereby save it. Secondly, in order to encourage savings, rates of interest on savings and time deposits with the banks be raised. In order to be able to earn more income because of higher interest rates, people will be induced to save more and make deposits in the banks. Thirdly, a great incentive for saving can be provided if the prices are prevented from rising. When the prices are continuously rising and as a result value of money is rapidly falling, it will not be worthwhile to save, for the money saved will greatly depreciate with the rise in the prices of goods.


We thus see that if proper fiscal, monetary and price policies are adopted incentives to save can be greatly increased and in this way ratio of surplus to capital can be raised. But contrary to what is required to raise the rate of saving, in India in recent years liberal loans for non-essential commodities such as purchase of cars, air conditioners, refrigerators and construction of luxury houses are being given by banks at cheap rates of interest. This tends to reduce the ratio of saving to national income.

Some development economists, especially Professor Arthur Lewis says that the saving rate depends on the share of profit and wages have suggested that if the national income is distributed more in favour of profits, that is, if the share of profits in national income is greater, the saving ratio will be high and vice versa. This is because, according to them, recipients of profits, i.e., capitalists or entrepreneurs save a major part of their income, their propensity to consume being very little.

On the other hand, if share of wages in national income is relatively high, the saving ratio will be low as the propensity to consume of the workers is very high. Thus, according to growth models of Kaldor, Robinson and Arthur Lewis, the saving or surplus ratio of a community depends on the relative shares of profits and wages. In order to raise the savings or surplus ratio they have proposed that wages in the modern industrial sector should be kept at a certain minimum level so that with the development of the sector, profits share goes on rising and as a result growth of investment or capital accumulation becomes cumulative. In this way they have contended to achieve the growth and employment objectives in the shortest possible time.

Though the above mentioned relation between profit share and savings ratio is generally true, it may, however, be pointed out that a good part of the profits made by the capitalists in underdeveloped countries like India are spent on luxurious consumption and unproductive investment. Therefore, if rate of capital formation is to be raised through raising share of profits in national income, the tendency on the part of the capitalists to spend profits on luxurious consumption and unproductive investment has to be effectively curbed through taking suitable monetary and fiscal measures.


Mobilisation of resources for capital formation by the Government is of crucial importance in those underdeveloped countries where public sector plays an important role in the economic development.

The Government can raise the resources for capital formation in the following ways:

(a) By imposing taxes on the people,

(b) Borrowing from the people,

(c) By ploughing back the profits by the Government of public undertakings and

(d) By creation of new money or borrowing from the central bank of the country which is also known as deficit financing.

3. Taxation:

Taxation is an important method of raising resources by the Government formation. Taxation increases the amount of collective savings by restricting private consumption. Thus, as a result of taxation, the people are general or private sector is forced to save for accelerating capital formation. It should, however, be noted that the total tax revenue collected by the Government does not represent savings because a good deal of tax money is spent by the Government to meet its current expenditure such as defence, police and civil administration which is similar to the private consumption expenditure of the people.

Therefore, it is only the surplus of tax revenue over and above such current expenditure of the Government that represents the net savings of the Government sector. Further, even the extra government savings achieved through taxation may not constitute net addition to the aggregate savings of the country. Net addition to aggregate savings will occur only to the extent the tax payments are made by sacrificing consumption. On the contrary, if taxes are paid by the individuals and firms by reducing private savings, then the increase in public savings may not result in any net increase in overall savings.

On the other hand, it has been asserted by some economists that the marginal propensity to save of the Government out of tax revenue is lower than marginal propensity to save of the private individuals and firms. This is because the government uses a greater part of income from taxation to meet its ever increasing current expenditure. If this is so, then the taxation instead of raising overall saving will actually reduce it. If the Government is to mobilise resources for development, it has to check the growth of its non-productive expenditure.


Both direct and indirect taxes play an important part in augmenting the resources of the Government for developmental purposes. It is best to levy taxes on non-entrepreneurial incomes and goods of luxury consumption. Such taxes will curtail unnecessary consumption and will have no disincentive effect on business enterprise. Hence, in order to raise adequate amount of resources, it becomes necessary to bring increasing number of ‘services’ in the tax net. In addition, taxation of agricultural incomes has to play an important part in the mobilisation of resources for the public sector in a developing economy.

Taxation plays a double role in a developing economy. On the one hand, it mobilises resources for the public sector schemes and projects. On the other hand, if the taxation structure is well designed, it can direct the flow of the resources of the economy to productive channels of investment in the private sector. By discouraging speculative activity and other types of unproductive investment and also useless and luxury consumption, taxation promotes investment to accelerate economic growth.

The level of voluntary savings in underdeveloped countries is very low and the upper classes which are in a position to save prefer to invest these savings in real estate or jewellery or they simply hoard them. The result is that such savings are not available for productive investment. In these circumstances, compulsory saving enforced by taxation performs an essential function. By releasing resources from non-functional consumption and non-essential or unproductive investment, taxation makes these resources available for the public sector. In order to raise adequate resources for development, it may have to infringe on essential consumption too.

The role of taxation is not to be merely static. It has also to play a dynamic role in raising resources for capital formation. As economic development proceeds national output increases and new incomes are generated. The tax policy must make sure that these new incomes are not permitted to flow into unproductive channels. They must be directed towards productive investments. The tax structure should have built-in flexibility to perform this function automatically. As incomes grow, the tax base must also be deepened and broadened. For this purpose, the marginal rate of taxation will have to be kept high and Prof. Lewis suggests that the marginal rate of taxation should be considerably greater than the average rate.


Such a tax structure presupposes a progressive income tax and also high rates of indirect taxes on commodities having a large income elasticity of demand. In this way an increasingly larger proportion of increment in output would be converted into public savings. Considering that there is considerable non-monetised sector in backward economies and there are several institutional barriers, the tax structure will have to be considerably broadened, deepened and diversified. Otherwise there is no guarantee that adequate resources will be mobilised for developmental purposes.


But taxation as a method of mobilisation of surplus presents some difficulties. In developing countries, only a narrow range of population is affected by taxation to any appreciable extent. The reason is that only a small number of people have their income reaching the level of direct taxes; and the indirect taxes on luxuries, which are the main source of income in advanced countries, fall on a small number of people. Hence the yield from taxes is small owing to their limited coverage. And the per capita revenue collected in the country is very low.

While taxation increases involuntary savings, it decreases voluntary savings to enable the people to maintain the former standard of consumption. The result is that the resources available for the private sector are thereby diminished. Another major drawback of taxation is that it has disincentive effect on business enterprises and discourages savings. The taxes on wage-earners diminish their incentive to work harder; taxes on profits of higher income groups reduce their incentive to save and to make investment in new enterprise; taxes on output or incomes of farmers diminish their incentives to improve agricultural techniques. Hence taxation militates against the efforts of those who can make an important contribution to economic growth.


Thus saving extracted from taxation is not an unmixed advantage. It is, therefore, very necessary to devise a system of taxation which will not weaken the incentives to work, save and invest; nor should it violate the accepted notion of equity. Taxation should not impair the productivity of the economic system. A high marginal rate of taxation may have a considerable disincentive effect on private enterprise.

Role of Indirect Taxes:

It has been found that indirect taxes are better suited to the conditions obtaining in developing countries for reducing current consumption and mobilising resources for development because in such countries quite a large proportion of national income tends to be diverted to current consumption instead of being productively invested. The average propensity to consume in such countries is much higher than is the case in advanced countries. Therefore, in developing countries, indirect taxes must thus play a more important part.

They will raise the rate of savings which are so essential for economic growth. It may be noted that with the adoption of new economic policy of liberalisation since 1991 rates of customs duties and excise duties in India have been reduced in order to reduce the costs of industries and thereby to increase their competitiveness However, this has reduced the tax-revenue of the Government and has also lowered the tax-GDP ratio.

But, “High rates of taxes on commodities with a high income elasticity of demand are quite effective in siphoning a substantial proportion of increase in output into the resources of the public sector needed for development financing and a higher rate of commodity taxes on luxury articles tends to introduce an element of progressiveness in an otherwise predominantly regressive tax structure in developing countries”.

But in order to make sure that the resources raised through commodity taxes are adequate, it will be necessary to widen their base by withdrawing various exemptions from tariff duties and excise duties. In the poor countries, it is not possible to exempt entirely goods of general consumption, because they are the only goods that provide a base broad enough to assure an adequate amount of resources.


Role of Taxation in Promoting Private Investment:

It is generally considered that taxation is meant to mobilise resources for the public sector. But a little thought will show that even in promoting investment in the private sector taxation plays an important role. It plays an allocative role by directing the resources to desirable and useful channels. A developing economy can adopt taxation measures which will check conspicuous and non-functional consumption, especially the consumption of luxuries.

Funds so saved will then be available for investment in the private sector. This role is played by import duties and excise duties on luxury or semi-luxury articles. A steady progressive tax on the upper income brackets also promotes saving. Diversion of savings into a real estate, jewellery or other prestigious but unremunerative investment can be checked by taxes and so also investment for speculative purposes. Taxes for these purposes can be imposed on land and buildings, capital gains or increments in land values.

Thus taxation can provide incentives for desirable investments and can check undesirable and unproductive investment. For instance, there is a tax holiday for new industrial undertakings. Liberal depreciation allowances can be given on new buildings, plant and machinery. Development rebates may be given for reinvesting profits in business, income tax may be imposed on profits declared as dividends. Substantial carry-overs of business losses may be allowed.

4. Government Borrowing:

Borrowing by the government is another method by which the savings of the community may be mobilised for economic development. In developing economies, the Governments resort to public borrowing in order to finance schemes of economic development. Public borrowing becomes necessary because taxation alone does not provide sufficient funds for economic development. Besides, too heavy taxation of income and wealth be avoided as it has an adverse effect on saving and investment.


Public borrowing takes following two forms:

(a) Market loans and

(b) Small savings.

In the case of market borrowing, the Government sells to the public negotiable Government securities of varying terms and duration and treasury bills. For financing capital projects long-term Government bonds are floated in the capital market. This form of public borrowing is more important for mobilising resources for development. The treasury bills which represent short-term borrowing are intended to meet only the current Government expenditure. New bonds may be issued for meeting old maturing bonds.

The small savings represent public borrowing which is not negotiable and are not bought and sold in the capital market. For mobilising small savings, various types of savings certificates are issued, e.g., National Savings Certificates, National Development Certificates, Rural Development Bonds, Postal Certificates and Postal Accounts, Compulsory Deposits, etc. A widespread campaign is necessary to attract small savings.

Borrowing is the Quickest Mode of Raising Funds:


On the other hand, tax finance is not so expeditious because passing of tax laws, assessment of taxes based on those laws and their collection involves considerable delay. Besides, public debt does not involve any burden if it is devoted to productive works. The subscribers to Government loans are able to find remunerative investment whereas the Government can pay the principal and interest out of the income yielded by investment financed from loans. Thus public borrowing is not only necessary but also desirable.

There is another advantage in public borrowing – Public borrowing in anti-inflationary. The underdeveloped countries are victims of inflation since they have to resort to deficit financing for finding funds for economic development. Since deficit financing is inflationary, public borrowing is preferable to deficit financing. Public borrowing mops up the surplus purchasing power with the people. It thus checks consumption and so a rise in prices. At the same time idle balances are absorbed in productive activity.

Public borrowing Generates Additional Productive Capacity:

The funds raised by public borrowing can be utilised for building up the infrastructure for the economy through schemes for the development of roads, ports, highways, irrigation, transport and power. They help in building up of the agricultural and industrial base of the economy. All such investments facilitate further economic growth. There is no doubt, that the public borrowing plays a very useful and important role in accelerating economic development of developing economies. Public debt promotes saving and investment, the two most crucial determinants of economic growth.

But there exist a number of obstacles which hinder the success of borrowing policy in an underdeveloped economy. In many such countries, there are no organized money and capital markets and in those where such markets exist, they constitute a very small proportion of total money market of the country. There may not exist any organic relationship between the organized and unorganized part of the money market. Moreover, the resources of the organized capital market may be too inadequate to fulfil the needs both of the private and of the public sector.

Further, in the capital market the competition for funds between the government and the private sector will raise rate of interest and this will have a highly disincentive effect on the expansion of investment in the private sectors. Besides, for the mobilisation of savings it is necessary to check and regulate the diversion of savings into unproductive investment such as real estate, gold and jewellery and inventory accumulation.


It may be noted here that there is now ample evidence in India that the resources raised through borrowing by the Government are spent for public investment in infrastructure such as power, communication, railways, roads, highways, it crowds in private investment rather than crowding out private investment. This is because private sector investment is impeded by the non-availability of good infrastructure. Further, public sector investment creates demand for products of private sector such as cement, steel and others in addition to the expansion of aggregate demand in general.

Suitable techniques of borrowing must also be devised. For example, bonds issued by the Government should be adjusted to the preferences of the general public; bonds of large denomination and long maturity may be offered to the institutional investors, whereas those of small denomination and short maturity may be reserved for the non-institutional public. If properly devised and conducted small savings campaign can mobilise a sizable amount of resources. Further, the mobilisation of the hoardings of gold and jewellery through government programmes constitutes a highly desirable source of resource mobilisation. Of course, suitable techniques of public borrowing for the mobilisation of these resources have to be evolved.

Profits of Public Undertakings:

In developing countries with a mixed economy, the public sector has been expanded in the past especially when the objective was the establishment of a socialistic pattern of society in India. The result is that a large number of projects of irrigation, power and industrial projects in heavy and basic industries are being executed by the Government.

Commercial enterprises like steel plants, oil and petroleum enterprises fertilizer plants, machine tool factories and State trading organisation were set up by the Government. It was expected that these public undertakings would in course of time start yielding profits which would be available for reinvestment in the schemes of economic development. This is how public undertakings can make their contribution to self-generating growth.

The public undertakings are not to be run on no-profit no-loss basis known as the ‘break­even’ principle. But in the interest of a continuing process of economic growth they must be made to yield a reasonable return on investment. The price policy of State Trading Corporation must also be adjusted to mobilise resources in the form of trading profits. Like the private enterprises, they must pursue the principle of profitability implying efficiency and cost reduction to enlarge the profits accruing from such enterprises. Their working, therefore, has constantly to be reviewed and ordinary principles of accounting and auditing must be applied thereto. Thus, contrary to the usual conception, the public sector enterprises should not only pay their way but also make legitimate profits.

But it cannot be denied that the surpluses from public enterprises should constitute a reasonable proportion of the resources for development. In developing countries, where there is a paucity of investible resources, the process of accelerated economic development requires that these enterprises should make reasonable return on their investment and make their maximum contribution to capital formation. It is a very convenient and desirable method of resource mobilisation. The profit is concealed in the price charged. Thus it is administratively convenient and politically feasible.

The public enterprise is not now confined to providing environmental facilities or social and economic overheads but also extended to purely industrial and commercial business. They have, therefore, to pursue price-output policies which should generate enough resources for capital formation. Dr. V.K.R.V. Rao has rightly advocated that “price policies in the public sector should be such as to yield a planned profit which will include not only depreciation expenditure but also an element of surplus for capital formation”.

Raising Resources through Public Sector Disinvestment:

It may be noted that with the adoption of new economic policy of liberalisation and privatisation since 1991 role of public sector in Indian economy has been greatly diluted and Government has been making disinvestment in public sector enterprises in which it holds a large share of equity capital and thereby raising resources for its various future investment projects. Accordingly, Government has sold some of its share capital in many public enterprises such as BALCO, VSNL, CMC, Modern Foods, some oil companies, Maruti to private sector firms. Recently, Government sold a good part of its share capital in Maruti Car Company through open public offer in the market and raised Rs 900 crore.

In the Tenth Plan period (2002-07), it was planned to raise resources of the order of Rs 10,000 crore annually through public sector investment. Thus, disinvestment of public sector enterprises is yielding good revenue to the Government. Resources raised through public sector disinvestment if invested in infrastructure and social services such as education and health will accelerate economic growth in India.