Capital formation and P&P sector the inconsistencies and adjustments

The Hindu business Line, Thursday, Aug 26, 2004

R. Vaidyanathan

The share of the government in capital formation has fallen from 41 per cent to 31 per cent, showing that it still appropriates significant portion of household savings to carry on its capital formation activities, which mostly provide negative returns. If this continues, it would create an extraordinary situation, wherein the States will become much more predatory and since they have no political will to increase their income by taxes, the Centre steps in, says R. Vaidyanathan. THE data on capital formation present the maximum challenge to any person analysing the economy. It is, to say the least, not very reliable and contain lots of inconsistencies and adjustments. Proprietorship and Partnership (P&P) firms are part of the household sector in the savings data and also in the data on domestic capital formation. In the savings data on household sector, the capital formation is presented as savings in physical assets by the households, which includes consuming or wage-earning households, agricultural households and partnership/proprietorship firms or mixedincomehouseholds. In the case of pure consuming or wage-earning household, the saving in physical assets consists of mainly house construction. In the case of mixed household, it can be construction or acquisition of plant and equipment or other type of assets such as transportation properties. Table 1 indicates the share of the household sector, private corporate sector and the Government in the savings and capital formation in the economy for selected periods from 1970-2000. First a caveat. The estimates of total savings plus net capital inflow from abroad and that of total domestic capital formation by type of assets do not tally. The latter is prepared using the measure of fixed capital formation in construction and machinery and equipment, and adding total estimated change in stocks across various industries. The estimates of saving are obtained for the public and private corporate sectors using published information and the financial saving of the household sector is got using information from banks, PF, LIC, etc. The saving in physical assets of the household sector is obtained as a residual after netting public and private corporate sectors from total capital formation by type of assets. The National Accounts Statistics (NAS) of the Central Statistical Organisation (CSO) treats the estimates of saving to be more reliable of the two and adjust for the difference (called errors and omissions) in the estimates of gross domestic capital formation. In the adjusted series on investments, the saving in the form of physical assets by the household sector is the same as that of unadjusted capital formation. This implies that the main burden of adjustment falls on the other two `organised' segments, that is, private corporate and government sector.

The NAS does not publish the adjusted GDCF series, sector-wise. In other words, the savings and capital formation of the household sector, particularly P&P firms, might be understated and, to that extent, our arguments will only be reinforced.

Table 1 shows that the share of household savings in total savings has risen from 70 per cent to more than 90 per cent between 1970 and 2000. The share of private corporate sector has risen from 10 per cent to 18 per cent and that of government fallen from 20 per cent to minus-10 per cent. Private corporate sector has shown consistently higher share in capital formation compared to savings, indicating flow of funds from the household sector through intermediation of banking and capital markets. The share of the government in capital formation has fallen from 41 per cent to 31 per cent, showing that it still appropriates significant portion of household savings to carry on its capital formation activities, which mostly provide negative returns. In other words, the government has become a dis-saver during this period, rapaciously appropriating the savings of the household sector through compulsory savings such as EPF and intermediation like banking. Table 2 gives the share of households in savings and the mix of physical and financial savings.

Household savings has risen from 60 per cent to 90 per cent of the total savings in the economy. The share of physical savings (capital formation) was of the order of 90 per cent in the 1950s, which is now around 50 per cent. In other words, substantial portion of household savings are taken away by the government and private corporate sector for their capital formation. Even then, nearly 48 per cent (52 per cent of the 92 per cent) of the capital formation in the economy is due to the household sector.

The proprietorship and partnership (P&P) firms constitute large portion of the eight activities, namely Unregistered manufacturing; Construction; Trade; Whole-sale and retail; Hotels and restaurants; Transport other than Railways; Storage; Real-estate ownership of dwellings and business services; and Other services. In other words, we can identify these activities with the P&P sector and these are the fastest growing in the last decade acting as engines of growth. If we consider these eight sectors and then the share of capital formation to the share of the unorganised sector NDP in these activities, we get a clue on the capital formation of the P&P sector. It is to be noted that the national income data for the unorganised sector is available at current prices and, hence, we use the capital formation figures also at current prices to get the percentages.

Table 3 gives the share of Gross Domestic Capital formation (GDCF) of these eight sectors to that of the unorganised NDP in these eight activities. It is to be remembered that only factor incomes, that is, net domestic product (NDP) at factor cost at current prices, are available for the `unorganised' activities. The rate of capital formation by the P&P sector is higher than the overall rate of capital formation in the economy. Also, these eight activities (unorganised sector) have grown by more than 14 per cent CAGR between 1993-94 and 2001-2002, which is one of the important reasons for the growth in the economy during the 1990s. The Government has become a dis-saver and its main role now is to feed its employees in the form of salary wages and pensions. In other words, a vast army of government employees (Centre, State and local government), of around 14 million, is taken care by the remaining 330 million of the work force, which also meets the extortion and rentseekingdemands of the government employees. The private corporate sector dependson the government to facilitate appropriation of the savings of the household sectorthrough instrumentalities of banking and capital markets.

Governments, both at the Centre and in the States, more so at the later, are broke and, hence, trying to find newer ways to appropriate household savings. The Central Government pension payments have gone up from Rs 3,300 crore in 1990 to Rs 22,400 crore in 2000, showing a CAGR of nearly 21 per cent much higher than revenue growth. In the case of State governments, the share of pension payments to own revenue rose from 3 per cent in 1980 to 17 per cent in 2001. (Report of the Group to study the Pension Liabilities of the State Governments" pp95, Reserve Bank of India October 2003.) Most State governments in the coming decade will be spending their entire revenue only on salary wages and pensions and interest payments. This would create an extraordinary situation, indications are already available, wherein the State will become much more predatory in trying to tax all "human endeavours" as when the governments go broke, they tend to become rapacious. Since the State governments have no political will to increase their income by taxes, the Centre steps in. The idea of service tax is arising out of such desperation, which only increases the dowry index for the male employees of indirect tax departments compared to income tax employees. Such types of taxes will increase and, in our tradition, it is called Vinasha Kale Viparidha Buddhi, assuming one associates buddhi with any government. Against this backdrop, the implications of the arrival of global corporations in sectors such as retail trade, construction, restaurants and other services, where the P&P sector is currently dominant will be dealt with later. (The author is Professor of Finance and Control, Indian Institute of Management, Bangalore, and can be reached at vaidya@iimb.ernet.in. The views are personal and do not reflect that of his organisation.)