P A RT - I V

DOMESTIC MEASURES FOR ECONOMIC DEVELOPMENT

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Capital Forma ormation Capital Formation and Dev Economic Development
MEANING OF CAPITAL FORMATION
Almost all economists lay emphasis on capital formation as the major determinant of economic growth. 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 making of capital goods: tools and instruments, machines and transport facilities, plant and equipmentall the various forms of real capital that can greatly increase the efficacy of productive effort. The essence of the process then, is the diversion of a part of societys currently available resources to the purpose of increasing the stock of capital goods so as to make possible an expansion of consumable output in future.1 Nurkses definition relates only to the accumulation of material capital and neglects human capital. A proper definition must include both material and human capital. According to Singer, capital formation consists of both tangible goods like plants, tools and machinery and intangible goods like high standards of education, health, scientific tradition and research. The same view has been expressed by Kuznets in these words: Domestic capital formation would include not only additions to constructions, equipment and inventories within the country, but also other expenditure, except those necessary
1. R. Nurkse, op. cit., p. 2.

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to sustain output at existing levels. It would include outlays on education, recreation and material luxuries that contribute to the greater health and productivity of individuals and all expenditures by society that serve to raise the morale of employed population. Thus the term capital formation covers material as well as human capital. IMPORTANCE OF CAPITAL FORMATION Capital formation (or accumulation) is regarded as one of the important and principal factors in economic development. According to Nurkse, the vicious circle of poverty in underdeveloped countries can be broken through capital formation. Due to low level of income in such countries, demand, production and investment are deficient. This results in the deficiency of capital goods which can be removed by capital formation. The supplies of machines, equipment and tools increase. The scale of production expands. Social and economic overheads are created. It is capital formation that leads to fuller utilisation of available resources. Thus capital formation leads to increase in the size of national output, income and employment thereby solving the problems of inflation and balance of payments, and making the economy free from the burden of foreign debts. We will discuss below the importance of capital formation in detail. The main purpose of economic development is to build capital equipment on a sufficient scale to increase productivity in agriculture, mining, plantations and industry. Capital is also required to construct schools, hospitals, roads, railways, etc. In fine, the essence of economic development is the creation of economic and social overhead capital. This is possible only if there is a rapid rate of capital formation in the country, that is, if a smaller proportion of the communitys current income or output is devoted to consumption and the rest is saved and invested in capital equipment. As aptly pointed out by Lewis, the central problem in the theory of economic development is the process of raising domestic saving and investment from 4-5 per cent to 12-15 per cent of national income. Investment in capital equipment not only increases production but also employment opportunities. Capital formation leads to technical progress which helps realise the economies of large-scale production and increases specialisation. It provides machines, tools and equipment for the growing labour force. Thus capital formation also benefits labour. Capital formation leads to expansion of market. It is capital formation which helps remove market imperfections by the creation of economic and social overhead capital, and thus breaks the vicious circles of poverty both from the demand side and the supply side. Further, capital formation makes development possible even with increasing population. In overpopulated underdeveloped countries the increase in per capita output is related to the increase in capital-labour ratio. But countries aiming at raising the capital-labour ratio have to face two problems. First, the capital-labour ratio falls with increase in population so that large net investment is needed to overcome the diminution of capital-labour ratio. Second, when population is increasing rapidly, it becomes difficult to have sufficient savings for the required quantity of investment, reason being that a low per capita income keeps the propensity to save at a low level in such a country. The only solution to these problems is a rapid rate of capital formation. Under-developed countries are faced with the problem of balance of payments because they mostly export primary products like raw materials and agricultural products, and import almost all types of manufactured, semi-manufactured and capital goods. Domestic capital formation is one of the important solutions to this problem of adverse balance of payments. By establishing

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import-substitution industries, the import of manufactured and semi-manufactured goods are reduced. On the other hand, with increasing production of all types of consumer and capital goods the composition of exports changes. Alongwith agricultural products and industrial raw materials, the exports of manufactured articles also start. Thus capital formation helps in solving the problems of balance of payments. A rapid rate of capital formation gradually dispenses with the need for foreign aid. In fact, capital formation helps in making a country self-sufficient and reduces the burden of foreign debt. When a country borrows from foreign countries for long periods, it imposes a heavy burden on the future generations. With every loan the debt charges increase day-by-day which can only be repaid by levying more or/and higher taxes. The burden of taxes increases and money flows out of the country in the form of debt repayments. Therefore, it is capital formation that brings freedom from foreign aid, reduces the burden of foreign debt and makes the country self-sufficient. The strains of inflationary pressure on a developing economy can be removed to a considerable extent by increased capital formation. The output of agricultural products and manufactured consumer goods tends to increase with a rise in the rate of capital formation. On the other hand, when income increases with capital formation, it raises the demand for goods. In the short run, it is not possible to match this increased demand by increase in supply and this results in the development of inflationary pressure in the economy. It is, however, a steady rise in the rate of capital formation in the long-run that augments the supply of goods, controls inflation and brings stability in the economy. Capital formation also influences the economic welfare of a country. It helps in meeting all the requirements of an increasing population in a developing economy. When capital formation leads to proper exploitation of natural resources and the establishment of different types of industries, levels of income increase and the varied wants of the people are satisfied. They consume a variety of commodities, their standard of living rises and their economic welfare increases. Lastly, an increase in the rate of capital formation raises the level of national income. The process of capital formation helps in raising national output which in turn raises the rate and level of national income. Thus the rise in the rate and the level of national income depends on the increase in the rate of capital formation. Thus capital formation is the principal solution to the complex problems of underdeveloped countries, and is the main key to economic development. REASONS FOR LOW RATE OF CAPITAL FORMATION The rate of capital formation is low in LDCs. The reason is that they lack in those factors which determine capital formation. In fact, capital formation depends upon savings, on the institutions mobilising these savings and on the investment of these savings. The failure of these three stages of capital formation to operate properly is responsible for the low rate of capital formation in such countries. The rate of capital formation in LDCs is about 5 per cent, whereas in America it is 15 per cent and in West Germany and Australia about 25 per cent. The main reasons for low rate of capital formation in LDCs are the following: Low Income. Large savings are essential for capital formation and savings depend upon the size of income. Since agriculture, industry and other sectors are backward in underdeveloped countries, the national output is low and so is the national income. As a result, per capita income is also low. On the other hand, the propensity to consume is very high, it is near unity. So almost

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the entire income is spent on consumption. Thus saving is not possible and the rate of capital formation remains low. Low Productivity. Since the level of productivity is very low in such countries, the rate of growth of national income, saving and capital formation are also low. Their natural resources are either unutilised or misutilised due to lack of efficient labour and technological knowledge, non-availability of capital, etc. These factors stand in the way of increasing the income of the resource-owners so that they are unable to save and invest more and the rate of capital formation does not rise. Demographic Reasons. LCDs possess such demographic features which keep the rate of capital formation at a low level. The growth rate of population is very high. On the other hand, the per capita income is low. As a result, the entire income is spent on bringing up the additional numbers, and little is saved for capital formation. Besides, the rapid increase in numbers aggravates the shortage of capital because large investments are required to equip the growing labour force even with obsolete equipment. Moreover, in such economies a large percentage of children in the total population entails a heavy burden on the parents in bringing them up and they are unable to save for capital formation. Lastly, such countries have a shorter life expectancy which means a smaller fraction of their population is available as an effective labour force. Since workers die in the prime of their lives, there are few adults to provide for large number of children. This brings down the per capita income further. Thus demographic reasons inhibit the rate of capital formation. Lack of Enterprise. The lack of entrepreneurial ability is another factor responsible for low rate of capital formation in LDCs. In fact entrepreneurship is regarded as the focal point in the process of economic development. But in LDCs the small size of market, deficiency of capital, lack of private property and contract, etc., retard enterprise and initiative, thus there is low rate of capital formation. Lack of Economic Overhead. Existence of economic overheads is essential to make fruitful investment and to encourage enterprise, for capital formation depends on them to a considerable extent. But economic overheads like power, transport, communications, water, etc., are lacking in LDCs which retard enterprise, investment activities and the path of capital formation, Lack of Capital Equipment. In such countries the rate of capital formation also remains low due to lack of capital equipment. Here, not only the capital stock is low, but even capital is deficient. The total capita! investment is hardly 5 to 6 per cent of the national income in LDCs whereas it is 15 to 20 per cent in developed countries. Due to shortage of capital, it is not possible to replace the existing capital equipment and even to cover its depreciation in such countries. As a result, the rate of capital formation remains at a low level. Inequalities in Income Distribution. There are extreme inequalities in income distribution which keep the rate of capital formation low in such countries. But income inequalities do not imply larger savings. In fact, larger savings are possible only in the case of the top 3 to 5 per cent of the people in the income-pyramid. But these people invest in unproductive channels like gold, ornaments, precious stones, real estates, foreign currency, etc. This distorts real investment and, the rate of capital formation is low. Small Size of the Market. The small size of the market is another reason for the low rate of capital formation in LDCs. It is a big hindrance in the way of enterprise and initiative. People are poor in such countries. The demand for goods is limited due to their low income. Hence it is the small size of the domestic market to absorb the supply of new products. This keeps the rate of capital formation at a low level.

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Lack of Financial Institutions. Another reason for the low rate of capital formation in such countries is the lack of financial institutions to procure funds for investment. Larger capital expenditure is required for productive purposes. But this is not possible because of the lack of properly developed capital and stock markets, and credit and banking institutions. As a result, sufficient savings cannot be mobilised for investment purposes and the rate of capital formation remains low. Economic Backwardness. Economic backwardness is also responsible for the low rate of capital formation in LDCs. Low labour efficiency, factor immobility, limited specialisation in occupation and in trade, economic ignorance, traditional values and social structure retard saving and investment, and prevent the rate of capital formation from increasing. Technological Backwardness. Technological backwardness also stands in the way of capital formation. Obsolete techniques of production are used in such countries. As a result, per unit labour productivity and per unit capital productivity remain low. This situation keeps the national output and income low, and the rate of capital formation fails to rise. Deficit Financing. One of the important sources of capital formation in such countries is deficit financing. But if it crosses the limits of safety then it tends to lower the rate of capital formation. It happens when deficit financing leads to an inflationary situation in the country. When prices rise, goods become dearer. As a result, consumers are required to spend a larger portion of their income on buying goods, and it becomes difficult to save. This retards capital formation. Increase in Taxes. Taxes also retard and reduce capital formation. When governments increase the number and rates of taxes as a means of forced savings, the income of consumers is reduced. This may be due to both direct and indirect taxes. Direct taxes reduce income directly while indirect taxes reduce income by raising their prices. Thus savings and capital formation are retarded. Demonstration Effect. According to Nurkse, one of the important reasons for low rate of capital formation in LDCs is the demonstration effect. Everybody has an urge to imitate the standard of living of his prosperous neighbours. Similarly, there is a tendency on the part of the people of such countries to emulate the higher consumption standards of advanced countries. This demonstration effect is usually caused by foreign films, magazines and visits abroad. As a result, the rise in income is spent on increased expenditure on conspicuous consumption and thus savings are almost static or negligible. Thus, the rate of capital formation fails to rise. SOURCES OF SAVINGS The rate of voluntary private savings is extremely low in LDCs because of the low level of income and a high propensity to consume. Even dissaving is common among low income households in India, Ceylon and Thailand as well as among working families in Mumbai, British Honduras and the Philippines.2 However, there are some groups which receive very high income. They are the merchants, the landlords and the speculators. The savings of these upper income groups are seldom channelled into investment projects. Instead, they are utilised for speculative purposes and for hoarding in the form of gold and jewellery and for giving short-term loans at as high as 30 to 100 per cent interest rates per annum. They are spent in ways most likely to enhance prestige, i.e., on conspicuous consumption, on traditional items, on palatial buildings fitted with luxury gadgets in western style and on luxury automobiles. Besides the few rich, there are the limitless cultivators. Given the same income, they save more
2. UN, World Economic Survey, 1966, pp. 29-30.

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than the labourers working in urban areas. Peasants learn to be thrifty because they know how near they live to the brink of disaster. Similarly, the money-lenders save more because their incomes are very high as compared to their consumption level. Rural sayings also arise in some of the underdeveloped countries from urban remittances or from overseas remittances. People belonging to rural areas but working in towns, in the armed forces or living in foreign countries remit large sums to their dependents. The wage and salary earning classes, better known as the middle class, are also a source of savings. But they save little because their inclination is more towards spending rather than saving, since their income is very low. Whatever little they save is spent on conspicuous consumption, to educate their children, to build a house or to meet unforeseen circumstances, etc. However, the very fact that these savings are merely a postponement of future consumption, and are thus largely offset by other postponed consumption means that they are not important in the context of productive investment.3 Another important source is the business and corporate savings in the form of distributed and undistributed profits. The profit-making classes, having an ambition for power, save more and thus invest more in productive enterprises. They are an important source of capital formation in the agricultural and industrial sectors. But they lack confidence in the security of long-term investments due to socialist leanings of the majority of underdeveloped countries. In fact, the problem of mobilizing domestic private savings is twofold: firstly, it is one of increasing business savings, and facilitating their most effective use: secondly, it is to stimulate individuals to, save more and make their savings available for financing of appropriate growth promoting investment. On the whole however, the expansion of private saving has been sufficient except in a few developing countries. But if national saving rates are to increase, it is from the private sector; that the resources ultimately have to come.4 Last but not the least is the role of the government as a saver. One of the inexorable features of economic growth seems to be a rise in the share of the government, in the national income. At the lowest level of national income per head the share of the government in under-developed countries may be as little as 5 per cent whereas advanced industrial governments use upto 10 per cent or so of real resources for current purposes, apart from what they use for military purposes and for transfers (pensions, insurance payments, interest payments, etc.).5 So the capacity of the government to save in an LDC is limited due to the low level of income and large administrative expenses. SOURCES OF CAPITAL FORMATION The process of capital formation involves three steps: (i) increase in the volume of real savings, (ii) mobilisation of savings through financial and credit institutions, and (iii) investment of savings. Thus the problem of capital formation in underdeveloped countries becomes twofold; one, how to increase the propensity to save of the people in the lower income groups, and two, how to utilise current savings for capital formation. This leads us to the sources of capital formation which are classified as domestic and external. The domestic sources from which savings can be mobilised.for capital formation are: increase in national income, reduction in consumption, savings drives, establishment of financial institutions, mobilisation of gold hoards, perpetuation of income inequalities, increasing profits, fiscal and monetary measures, by utilising
3. Lewis, op. cit. 4. World Economic Survey, op. cit., p. 26. 5. W.A. Lewis, op. cit.. p. 239. Italics mine.

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disguised unemployed; etc. The external sources are: foreign capital, restriction of consumptionimports and favourable terms of trade. We discuss these internal and external sources of capital formation below: (1) Domestic Sources. The various domestic sources of capital formation are as follows: (i) Increase in National Income. The first important step is to increase the national output or income which will tend to raise the income of the people. This can be done by utilising the existing techniques and employing resources more efficiently, by utilising unused resources productively, and by increased division of labour. (ii) Savings Drive. Savings drives will also help solve the problem of augmenting savings. They require concerted efforts in the form of propaganda and social education. Savings is a matter of habit which can be inculcated by propaganda. People can be persuaded to save in their own interest or in the interest of the family, for imparting education to their children, for marrying them, for building a house or as a safeguard against old age, sickness or emergency. Similarly, issuing of savings certificates in the form of government bonds and annuities carrying a high rate of interest may be helpful in mobilizing savings. Further incentive to savings can be in the form of business gifts, lottery prizes and tax exemptions on the purchase of government bonds. (iii) Establishment of Financial Institutions. It is common knowledge that much of the unspent current income is hoarded in cash, jewels, gold, etc., by the people in underdeveloped countries. Therefore, the need is to establish financial institutions where small savers can safely deposit their money with confidence. The setting up of a well-developed capital and money market by the Central bank can give further impetus in this direction. In order to stimulate small savings among the masses, attention should be paid to the starting of life insurance, compulsory provident fund, provident fund-cum-pension-cum-life insurance schemes, opening up of savings banks and mobile banks in rural areas, and promoting savings through cooperative societies, including the establishment of service cooperatives and strong apex institutions like the central and state cooperative banks. Such agencies will not only permit small amounts of saving to be handled and invested conveniently but will allow the owners of savings to retain liquidity, individually and finance long-term investment collectively.6 (iv) Rural Savings. Another important measure is to encourage rural savings for local needs which are understood and approved of by the savers. Government securities might be attached to particular development projects in rural areas. As the All India Rural Credit Survey Committee proposed, These rural debentures should as far as possible be for specific projects of development in which the villager is interested in different degrees, according as they are of direct benefit to him, or to those with whom he shares fellowship of interest because of their belonging to his district or region or state.7 The guiding policy should, therefore, be to link rural savings with local development projects. In this way, mobilization of rural savings might lead to more rapid development. Such voluntary savings can even lead to that critical minimum which is so essential for a take-off. (v) Gold Hoards. Another method is the mobilization of gold hoards. This is a useful, though a neglected method of capital formation. The government should issue gold certificates carrying a high rate of interest in lieu of the gold surrendered by the public. But people are not prepared to part with gold and jewellery and are thus reluctant to invest in gold bonds or certificates voluntarily. It is, therefore, essential that hoarding of gold, above a stipulated quantity, should
6. E. Nevin, Capital Funds in Underdeveloped Countries, p. 75. 7. All India Rural Credit Survey (abridged, ed.,) p. 267

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be prohibited by law; private trading in gold should be regulated; and the use of pure gold for manufacturing ornaments should be banned in the country. Alongwith these measures, smuggling of gold into the country should be stopped. These measures are not likely to be successful unless gold is sold in the country at the international price. (vi) Perpetuation of Income Inequalities. This is also regarded as one of the measures to achieve high rates of saving and investment. Since the mass of the people have a low marginal propensity to save in underdeveloped countries, it is the higher income groups with a high marginal propensity to save that can do saving and investment for capital formation. This had been one of the major sources of capital formation in 18th century England and early 20th century Japan. But widening of income inequalities is not feasible under the prevailing political climate in underdeveloped countries. Moreover, it is not definite that the wealthy classes may utilise their savings for productive investments, as was done by the British entrepreneurs of the 18th century. Rather the tendency is to spend on conspicuous consumption re-inforced by the international demonstration effect. In some of the African and Latin American countries where the governments are not watchful, the declining influence of the wealthy classes has led to the flight of domestic capital into the safe vaults of banks in developed countries. (vii) Increasing Profits. Prof. Lewis8 is of the view that the ratio of savings to national income is a function not just of inequality, but precisely of the ratio of profits to national income. He maintains that voluntary savings form a significant large share of national income only where inequality of income distribution is such that profits are a relatively large share of national income. If there is unequal distribution of income and the societys upper level income accrue to the landlords or traders, there is little chance of providing voluntary savings to finance investments. Lewis believes that even if profits, interest and rental incomes as a whole are a small share of national income in an underdeveloped country, savings can be increased from 5 to 12 per cent by raising the profit rate. The share of profits in the national income can be increased by expanding the capitalist sector of the economy. In the first place, some legal safeguards should be provided to private investors against arbitrary depredations. Secondly, the technique of borrowing by private enterprise should be changed in order to minimize the risk of capital loss. Industrial banks and other specialized institutions like the government sponsored finance and development corporations and investment trusts should be set up. Thirdly, the capitalist sector is likely to expand rapidly if investment opportunities are very profitable. In the initial stages of development, a rise in productivity goes into profits. Productivity increases due to an unlimited supply of labour at low wages, technological progress, expansion of the market, geographical discoveries and the expansion of social overheads. The more rapidly the opportunities for productive investments expand, the faster the profits grow, and the greater is the capital formation. Fourthly, this process is also accelerated by mild and intermittent doses of inflation. A mild dose of inflation increases profits relatively to other incomes. So when profits rise, there is increased investment which increases the rate of capital formation. But profit can grow even in the absence of inflation due to other institutional and technological changes mentioned above. Therefore, says Prof. Lewis, The correct explanation of why poor countries save so little is not because they are poor but because their capitalistic sectors are so small. They can increase
8. W.A. Lewis, op. cit., pp. 227-29.

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their rate of capital formation by raising profits relatively to national income; possibly without inflation. To this end, Lewis suggests that those who live on earned incomes particularly on ground rents, should be taxed heavily and the proceeds given to capitalists who live on profits unless the former agree to change themselves into the latter like the Japanese landed aristocracy. Thus profits can be increased by giving subsidies and tax rebates, by providing adequate supply of raw materials and capital equipment, by restricting imports of competitive products, by controlling wages and trade unions and by government purchases of the goods of the industries. These measures might, however, create vested interests and lead to maldistribution of resources within the economy. Prof. D.R. Gadgil believes that the raising of profits to increase savings for capital formation may lead to social unrest and may even fail to produce socially desirable investment since the profit making classes are not necessarily interested in the welfare of the masses.9 (viii) Fiscal Measures. Since sufficient voluntary savings are not forthcoming for capital formation in an underdeveloped economy, the government is in a better position to mobilize them through various fiscal and monetary measures. These measures may be in the form of a budgetary surplus through increase in taxation, reduction in government expenditure, expansion of the export sector, raising money by public loans and even by deficit financing. Besides, the government can increase savings by running public undertakings more efficiently so that they show larger profits. Above all, the government should evolve a growth-oriented long-term savings policy so that savings should increase automatically as development gains momentum. Let us discuss these measures briefly. Taxation is one of the major and most effective instrument of fiscal policy for reducing private consumption and transferring resources to the government for productive investment. Taxation helps capital formation in two ways: (i) by transferring private resources to the state for utilisation in the desired channels; and (ii) by providing incentives to the private sector to increase production. The first point further raises two problems: how much taxation should be raised and how should it be allocated? According to Prof. Lewis, an underdeveloped country should raise at lest 20 per cent of its national income through taxation. Out of this, 12 per cent should be utilised on current expenditure and 8 per cent on capital investments in the public sector. The second purpose of taxation (of providing incentives to private enterprise) involves the types of taxation and the rates to be levied. Progressive direct taxes on personal incomes, wealth, expenditure, etc. should be so levied that they do not adversely affect the incentive to work, save and invest. They should aim at reducing the tendency of the wealthy class to conspicuous consumption, capital flight, hoarding, and speculation. The decision about rates of taxes is, however, the most ticklish problem, for it cannot be said with definiteness which rate will encourage or discourage private enterprise. Indirect taxes also provide incentives for development by reducing consumption and encouraging the masses to save more. Moreover, such taxes help in collecting funds which cannot be otherwise collected from the mass of the people. High rates on luxuries and low rates on articles of consumption are the most accepted principles of indirect taxes. Besides, import duties on luxury articles restrict their consumption and at the same time bring revenue to the state for productive investment. Taxation of export incomes and levying of export duties on agricultural and industrial raw materials are other fruitful sources of development finance. Public borrowing is also a useful tool for diverting resources from unproductive to productive
9. D.R. Gadgil, Economic Policy and Development, p. 181.

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channels. But its scope is limited in underdeveloped countries because of the low levels of income and savings, and high propensity to consume. Besides, there is lack of organised money and capital markets. To make public borrowing a success, concerted campaign by propaganda and social education is essential. Further, a network of intermediate agencies should be set up in the form of savings banks, commercial banks, insurance companies, unit trusts, social security institutions and a well-organised bill market. Nurkse also suggests froced loans if voluntary public borrowing does not succeed. (ix) Inflation. If sufficient funds are not forthcoming for capital formation, inflation is the most potent measure. It is regarded as a hidden or invisible tax. When prices rise, they reduce consumption and thus divert resources from current consumption to investment. The government creates inflation by issuing more currency into circulation to meet its requirements. But inflation raises savings at the cost of the standard of living of the masses. The fixed income groups are the most hard hit. Discontentment increases among the masses, unions fight for higher wages and productivity is adversely affected. Rising prices and costs also reduce exports to world markets. Thus, inflation, as a method for capital formation, brings more harm than benefit unless counter-inflationary measures are adopted by the government. (x) Profits of Public Corporations. The government can also mobilise domestic savings for productive investment by establishing public corporations. Public corporations receive funds in the form of equity capital and bonded debt from the open market, and in countries like India, directly from the government. They also obtain foreign loans or collaborate with foreign enterprises. Public corporations are a substitute for private enterprise in underdeveloped countries. They generally utilise their resources as a revolving fund. But in certain under developed countries where public corporations are established as state enterprises, their profits are utilised for capital formation. This is being done in the case of public enterprises set up by the Central and State Governments in India. In many underdeveloped countries like India, Philippines, Columbia and Brazil, public corporations have been set up for financing the establishment and running of private enterprises. Similarly, they have been formed as investment trusts. The establishment of such varied public corporations helps organise capital and money markets for the mobilisation of domestic savings for capital formation. (xi) Utilisation of the Disguised Unemployment. According to Nurkse, one of the important source of capital formation is the concealed saving potential contained in rural underemployment in overpopulated, underdeveloped countries. The disguised unemployed workers contribute practically little or nothing to output, i.e., their marginal productivity is zero or negligible. Such unproductive workers can be removed from the land without a fall in agricultural output and employed on various capital projects such as irrigation, roads, house building, etc., and they can be a fruitful source of capital formation. The newly employed workers can be provided simple tools from the farms by the reorganisation of agriculture or by importing them from abroad or by getting the same made by the workers. It is, however, assumed that food will continue to be provided to the newly employed workers by their relative-workers on the farms without any transport costs and at the same time maintaining their own consumption level. In this way, mobilization of the disguised unemployed as saving potential becomes self-financing. Nurkses view precludes the payment of wages to workers. If wages are paid to workers they will spend on foodstuffs and thus raise the incomes of the agriculturists working on the farms. This increased income can be taxed to finance the investment projects. When the investment projects are completed, they will tend to raise output and income which can also be taxed and utilised for further investment.

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(2) External Sources. Domestic sources for capital formation are required to be supplemented by the following external sources: (i) Foreign Aid. In the absence of adequate domestic resources for capital formation, it is necessary to import foreign capital in the form of loans and grants from advanced countries without any strings. But the best course is to start joint ventures whereby foreign investors bring technical know-how alongwith capital, and they train local labour and enterprise. Capital can also be imported indirectly by paying for through exports. This is the best policy because exports pay for imports. But it is not possible for a backward economy to increase its exports to the level of capital imports in the initial stage of development. (ii) Restriction of Imports. Another important external source of capital formation is the restriction of consumption imports. All luxury imports should be restricted and the foreign exchange so saved should be utilised in importing capital goods. This measure can be successful only if the domestic income saved on imported consumer goods is not utilised on luxury and semi-luxury goods manufactured at home. If consumers start spending more on domestic consumer goods, the increase in the import of capital goods will be offset by reduction in domestic investment because resources will be diverted from domestic capital production to increased spending on consumer goods. An increase in domestic saving is, therefore, essential if the restriction of luxury imports is to lead to increase in net capital formation. (iii) Favourable Terms of Trade. Similarly, if the terms of trade move in favour of an underdeveloped country, it is in a position to import large quantities of capital goods. To take advantage of the favourable terms of trade, it is essential that increase in domestic income due to larger export earnings should be saved and invested productively. If the extra income thus earned is spent on consumer goods, new saving will not take place for capital formation. Since improvement in the terms of trade is not an automatic source of capital formation, Nurkse suggests that this saving should be extracted through taxation to give the country a command over additional imports of investment goods. Conclusion. Capital formation is thus an important determinant of economic development. It would, however, be an over-simplification to regard economic development as a matter of capital formation alone, neglecting political, social, cultural, technological, and entrepreneurial factors.