Capital formation

Capital formation is a term used in national accounts statistics and macroeconomics. It basically refers to the net additions to the capital stock, or, to the value of the increase of the capital stock; though it may occasionally also refer to the total stock of capital formed.

In the USA, statistical estimates for capital formation were pioneered by Simon Kuznets in the 1930s and 1940s.

Wrong definition

According to one popular macro-economic definition, capital formation refers to "the transfer of savings from households and governments to the business sector, resulting in increased output and economic expansion". This definition is wrong on two counts.

Firstly, many larger corporations engage in corporate self-financing, i.e. financing from their own reserves, or through loans from (or share issues bought by) other corporations. In other words, this definition ignores that the largest source of investment capital consists of financial institutions, not individuals or households or governments. Admittedly, financial institutions are, in the last instance, mostly owned by individuals, but those individuals have little control over this transfer of funds, nor do they accomplish the transfer themselves. Few individuals can say they "own" a corporation, anymore than individuals "own" the public sector. (Poterba (1987) found that changes in corporate saving are only partly offset (between 25% and 50%) by changes in household saving in the United States).

Secondly, the transfer of funds to corporations may not result in increased output or economic expansion at all; given excess capacity, a low rate of return and/or lacklustre demand, corporations may not invest those funds to expand output, and engage in asset speculation instead, to obtain property income that boosts shareholder returns.

To illustrate, New Zealand's Finance Minister Michael Cullen stated (NZ Herald, 24 February 2005) that "My sense is that there are definite gains to be made, both economic and social, in increasing the savings level of New Zealanders and in encouraging diversification in assets away from the residential property market."

This idea is based on a wrong understanding of capital formation, ignoring the real issue - which is that the flow of mortgage repayments by households to financial institutions is not being used to expand output and employment on a scale that could repay escalating private sector debts. In reality, more and more local capital value drains to foreign share-holders and creditors.

Types of capital formation

Economists often use "capital formation" synonymously with Gross fixed capital formation (GFCF) but strictly speaking this is incorrect, because capital formation may include assets which are not fixed capital assets, for example, financial assets and land.

In modern econometrics, attempts are sometimes also made to estimate the formation of human capital, and expenditure on research & development (R&D) may also be regarded as capital formation. Likewise, Goodwill may be regarded as a form of capitalisation.

Gross and net capital formation

Capital formation can be valued gross (without deductions for depreciation) or net (adjusted for depreciation write-offs).

Measurement issues

Capital formation is notoriously difficult to measure statistically, mainly because of the valuation problems involved in establishing the value of capital assets. Capital assets can for instance be valued at historic (acquisition) cost, current replacement cost, current sale value, average market value, or scrap value. A business owner may in fact not even know what his business is "worth" as a going concern, in terms of its current market value. The "book value" of a capital stock may differ greatly from its "market value", and another figure may apply for taxation purposes. The value of capital assets may also be overstated or understated using various legal constructions.

During an accounting period, additions may be made to capital assets (including those which are of a type that disproportionately increase the value of the capital stock) and capital assets are also disposed of; at the same time, physical assets also incur depreciation or Consumption of fixed capital. Also, price inflation may affect the value of the capital stock.

In national accounts, there is an additional problem, since the sales/purchases of one enterprise can be the investment of another enterprise. Therefore, to obtain a measure of the total net capital formation, a system of grossing and netting of capital flows is required. Without this, double counting would occur. Capital expenditure must be distinguished from intermediate expenditure and other operating expenditure.

Perpetual Inventory Method

A method often used in econometrics to estimate the value of the physical capital stock is the so-called Perpetual Inventory Method (PIM). Starting off from a benchmark stock value for capital held, and expressing all values in constant dollars using a price index, additions to the stock are added, and disposals as well as depreciation are subtracted year by year (or quarter by quarter). Thus, an historical data series is obtained for the growth of the capital stock over a period of time. In so doing, assumptions are made about the real rate of price inflation, realistic depreciation rates, average service lives of physical capital assets, and so on.

Example of capital estimates

In the 2005 Analytical Perspectives document, an annex to the US Budget (Table 12-4: National Wealth, p. 201), estimates are provided for the value of total tangible capital assets of the USA, which doubled since 1980 (stated in trillions of dollars, at September 30, 2003):

Publicly owned physical assets: Structures and equipment . . . . . . $5.6 federally owned or financed . . . $2.2 Federally owned . . . . . . . . $1.0 Grants to state and local govt . $1.0 funded by state and local govt . . $3.3 Other federal assets . . . . . . . . $1.4

Subtotal (1). . . . . . . . . . . . . . . . . . . . . . . . $6.9 trillion

Privately owned physical assets: Reproducible assets . . . . . . . . $28.7 Residential structures. . . . . . $12.4 Nonresidential plant & equipment $11.8 Inventories . . . . . . . . . . . $1.5 Consumer durables . . . . . . . . $3.1 Land . . . . . . . . . . . . . . . $10.2

Subtotal (2). . . . . . . . . . . . . . . . . . . . . . . . $38.9 trillion

Education capital: federally financed . . . . . . . . . $1.4 financed from other sources . . . . $44.0

Subtotal (3) . . . . . . . . . . . . . . . . . . . . . . . $45.4 trillion

Research and development capital: federally financed R&D . . . . . . . $1.1 R&D financed from other sources . . $1.7

Subtotal (4). . . . . . . . . . . . . . . . . . . . . . . . $2.9 trillion

TOTAL ASSETS . . . . . . . . . . . . . . . . . . . . $94.1 trillion

Net claims of foreigners on US . . . . . . . . . . $4.2 trillion

Net wealth . . . . . . . . . . . . . . . . . . . . . . . . .$89.9 trillion

(Note: this data obviously does not include financial assets, only "tangible" assets in US territory).

References

Simon Kuznets, "Proportion of capital formation to national product". American Economic Review, 1952.

Simon Kuznets et al., National income and capital formation, 1919-1935. National Bureau of Economic Research, 1937.

Simon Kuznets, Capital in the American Economy Princeton: Princeton University Press, 1961.

Simon Kuznets, Commodity flow and capital formation. New York: National Bureau of Economic Research, 1938.

Simon Kuznets, Gross capital formation, 1919-1933. New York: National Bureau of Economic Research, 1934.

James Poterba, "Tax Policy and Corporate Saving", in Brookings Papers on Economic Activity, 2, 1987, pp. 455-503.

Richard Ruggles and Nancy D. Ruggles, National Income Accounts and Income Analysis. New York: McGraw-Hill, 1956.

M. Yanovsky, Anatomy of Social Accounting Systems.

London; Chapman & Hall, 1965.

"Analytical Perspectives"

Review of Income and Wealth^*

Capital

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