Capital Formation

Business, Legal & Accounting Glossary

Definition: Capital Formation



Full Definition of Capital Formation


Capital formation is a term used in national accounts statistics and macroeconomics. It basically refers to the net additions to the (physical) capital stock in an accounting period, or, to the value of the increase of the capital stock; though it may occasionally also refer to the total stock of capital formed. Thus, in UNSNA, capital formation equals fixed capital investment, the increase in the value of inventories held, plus (net) lending to foreign countries, during an accounting period. Capital is said to be “formed” when savings are used for investment purposes, often investment in production.

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, any more 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 shareholders and creditors. The concept of “household saving” must also be looked at critically, since a lot of this “saving” in reality consists precisely of investing in housing, which, given low-interest rates and rising real estate prices, yields a better return than if you kept your money in the bank (or, in some cases, if you invested in shares). In other words, a mortgage from a bank can effectively function as a “savings scheme” although officially it is not regarded as “savings”.

Types Of Capital Formation

  • Saving drives
  • Setting up financial institutions
  • Fiscal measures
  • Public borrowings
  • Development of capital market
  • Privatization of financial institutions
  • Development of secondary financial markets

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, but the boundaries are sometimes difficult to draw.

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.


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Definition Sources


Definitions for Capital Formation are sourced/syndicated and enhanced from:

  • A Dictionary of Economics (Oxford Quick Reference)
  • Oxford Dictionary Of Accounting
  • Oxford Dictionary Of Business & Management

This glossary post was last updated: 18th April, 2020 | 2 Views.