Incentives for Saving and Incentives for Investment!

Type # 1 Incentive for Saving:

The importance of capital formation, hence, of the saving/Investment rate for economic deve­lopment, has been pointed out.

But many deve­loping countries score rather little in raising the rate of capital formation—thereby vindicating Nurkse’s statement: “A country is poor because it is poor.” But if the development record of these countries is read with all-seriousness, the low volume of capital accumulation is not to be attributed to low income or poverty of the masses.

This is attributed to institutional failure and is argued today that “a country is poor because of poor policies”. It is the institutional environment that influences savings and investment. Develop­ment is rather impossible without an effective government, market, and civil society. Sound state policies with good governance contribute real per capita income to go at a higher rate, and not bad policies and bad governance. Institutional change is now considered as a central force or input affecting growth and development.


By creating the incentive structure in the economy, institutions can strongly influence savings and investment. In developing countries, institutional setting is dichotomised. In the money market, one finds predominance of informal credit markets that act as a drag on development.

Because of the lack of formal financial sector, lending is mostly confined to meet consumption needs. Further, because of high interest rate charged by the informal money market, total investment is discouraged. Further, the lack of formal financial institutions is an incentive on the part of the savers to put their money in real assets as opposed to the monetary assets.

Obviously, in this institutional setting, investment does not pick up. Like the money market, the institution of capital market in the developing countries is also underdeveloped. A developed capital market is a prime requisite for the countries’ initiative towards industrialisation as it acts as a vehicle for investment. Thus, deve­lopment strategy demands an improvement in institutional ambience.

How to Raise Savings:

The capital formation depends on :


(i) creation of savings,

(ii) mobilisation of savings, and

(iii) investment of savings.

What is of great importance is how to raise aggregate savings. In developing countries, informal financial institutions play a great role in the generation of savings. In these economies, many transactions take the form of barter. People save in real assets. Moneylenders charge high interest rates while loans are mostly given to meet consumption needs of the borrowers.


Given these savings-investment patterns, banking and credit institutions need to be developed as these institutions act as stimulus to savings and investment. A large investible surplus is available only when institutional arrangements of an economy are broad and wide. The greater use of money releases both resources and helps in savings and in generating resources. A formal organised money market charges a lower interest rate which helps in raising the volume of savings.

Above all, savings in these institutions are risky and, hence, unsafe. Informal savings or deposit-accepting institutions often harass customers in one pretext or another. Some of the owners of these institutions, in the past, pulled down their shutters without returning back the hard-earned savings of the customers.

Further, lending of the formal money market is meant mainly for investment purposes and that too is available at a cheaper rate compared to the informal credit market. Thus, developing a well- organised formal banking institution is one of the first priorities to incentivise savers.

Along with this, the fragmented capital market that allocates capital in a distorted and in an inefficient way also needs to be developed. Like the money market, capital market also mobilises savings of big inves­tors and such are invested in industries, trade and commerce. It is also important that capital market should be integrated with the money market so as to have a unified interest-rate structure.

At the time of independence, both informal and formal sectors coexisted in which the former predominated. Over the years—and particularly after the nationalisation of commercial banks in 1969—the banking sector has developed in length and breadth. As a result, the volume of household savings as a percentage of GDP that stood at 9.5 p.c. of gross domestic savings in 1970-71 rose to 22.6 p.c. in 2008-09.

Further, India’s capital market is now on a sound footing. That is why people are encouraged to invest their money in shares, debentures, bonds, small savings schemes, etc. To strengthen the country’s monetary structure, capital formation has been made institution-elastic. Household savings are now being channelized not only through banking institutions but also through non-banking financial intermediaries like the UTI, LIC, GICI, mutual fund, special development banks, and micro-credit institutions. These institutions also promote corporate savings.

Fiscal policy and taxation also play an important role in raising savings capacity of the economy. This demands designing an appropriate policy so that the MPS exceeds APS. The volume of household savings depends on income el and the interest rate on savings. A higher interest rate is an incentive to the savers. But investors find little incentive to invest if banking situations charge higher rates of interest.

Thus, banks need to balance these two aspects. Further, cut in tax rate enables individuals to save more. Higher tax rate acts as a deterrent to savings and investment. To give boost to investment, corporate tax rates may be cut; tax exemptions or tax holidays in different investment projects may be given.

But often the revenue needs force the government not to adopt such soft-pedalling, however, the efficacy of getting larger resources or investment depends on the tax administration, t is the poor governance or laxity in tax administration that causes tax evasion—thereby frittering the country’s resources away from productive investment.


Another component of gross savings is government or public savings which are generated from profits of public sector enterprises. Besides social welfare objectives, these enterprises also run on commercial basis. Profits made by public sector enterprises are reinvested. But public sector enterprises in India suffer from limitations like excess manpower, rising overhead costs, inappro­priate price policy, poor management, etc.

Above all, neo-liberal economic policy introduced in 1991 aims at privatisation of these enterprises. Anyway, public sector industries need to be expanded and should also run on commercial basis. What is needed is the designing of an appro­priate policy so that these enterprises generate profit on a sustainable basis.

Type # 2. Incentives for Investment:

Development in developing countries is associated with industrialisation—and industrialisation and capital accumulation go hand in hand. It is not necessarily true that an increase in savings will lead to an increase in investment. Even if investment rises the institutional prerequisites for development may be lacking. In other words, because of lack of proper investment incentives, capital formation tends to be low in the developing countries.

To push the investment rate up, the following steps need to be taken:


(i) Increase in the supply of investible resources,

(ii) Opening up of investment opportunities. These, in turn, require favourable institutional environment, that is, primarily, an appropriate industrial policy that affects industrial investment and production.

Industrial policy focuses on lot of things other than fiscal and financial policies. It defines the scope of state participation in economic activity. It specifies the attitude of the government towards private capital (both domestic and foreign), technology import, a whole range of financial and fiscal policy which pertain to the provision of industrial finance, development of the capital market, fiscal incentives/disincentives to invest­ment, etc.

Thus, what is recommended is the sub­stantial role of the government. Recently, there has developed a trend of ‘minimalist’ government and hence economic reforms and the market is assumed to pursue the goal of efficiency. It then suggests that incentives for investment may be addressed both by the market and the state. We are not interested in elaborating the debate between market and the government.


Capital market or the share market is an important institution through which the flow of funds is generated in an economy. Share market is characterised by booms and slump consequent upon so many domestic and external factors. A boom in the share market on a sustainable basis encourages people and foreign institutional inves­tors to participate in the market. This then pushes investment up.

However, boom-slump pheno­menon provides a signal for macroeconomic stability. Macroeconomic stability refers to manageable fiscal deficit and the balance of payments deficit in tandem with low inflation. When such stability is ensured it encourages holding of finan­cial assets and required funds for investment be­come available to the private sector. To give a boost to investment, governmental investment is also required to be steeped up—but not at the cost of fiscal slippage. To encourage investment, tax exemptions, lower rate of taxes, etc., may be given.

However, capital accumulation demands an improvement in economic and social infrastructure Just as the productivity of physical capital depends on investment in human capital, so it depends on the infrastructural investments, say, on road, power, irrigation, etc. The need for different types of infrastructure changes with economic development. As this investment is lumpy in character, it is mostly undertaken by the govern­ment. However, inefficiency and waste may creep in such infrastructural investment. To minimise waste and to improve efficiency, commercial principles need to be applied. Managerial autonomy may be given.

Finally, foreign direct investment needs to be pumped in to increase capital formation. This then requires liberalisation of industrial licensing policy. Reforms in the capital market are required so that foreign institutional investors can participate. Truly speaking, this requires a combination of restrictions and incentives. Government regulations may be imposed on the participation of foreign investment in certain ‘key’ sectors.

It may also restrict foreign participation in ownership or management, limit the volume of profits, impose exchange controls on the repatriation of capital or profit. On the other hand, a slew of investment incentive measures— like protective tariffs on domestic commodities that compete with those produced by the foreign investors, exemptions from import duties on necessary equipment’s, machines, etc., tax conce­ssion schemes, special legislation for the protection of foreign investments and the like—may be taken up.