This paper is prepared for staffuse and is not for publication.The views expressed are those ofthe author and not necessarilythose of the Banlc.

INTERNATICNAL BANK FOR RECONSTRUCTION AND DEVELOPWT

Economics Department Working Paper No. 41

a&n A.nalyi oCaital Flows Between the Agricultural

*tnd Non-agricultural Sectors of West Pakistan

April 1, 1969

This paper analyzes the generation of savings fromagricultural production in West Pakistan. It con-firms the view that substantial transfers of privatesavings were and are being made out of the agTicultur-al sector and briefly discusses the policy ixmlicaticrns

which follow. This paper originated as part of the

work undertaken in the Fiscal Policies of DevelopingCountries Division for the preparation of a paper on

"Capital Flowrs and Income Tranrfers Within and Between

Nations to Sustain the Agricultural Revolutions" which

Mr. i'cNarnara is to present to the Bellagio Conferenceon Agricultural Development. I am indebted in partic-

ular to Messrs. Jim Hendry and louter Tims for helpful

comments in the preparation of this paper.

Fiscal Policies of Developing Countries DivisiciPrepared by: Per Eklund

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A0t A TALYSI3 OF CAPrTALJ FLOWS BEJ Tt AG<XICULTURALAID NOQs-AGRICUULTURArSfd123 0' oF WT PAKCSTAN

I. INTRODUCTION

1. Economic growth models have enmphasized that industrial

development must be based on an outflow of savings from the agricultural

sector. . In recent years the emphasis has shifted. It is now enphasized

that before industrial development can proceed on any large scale increased

investment in agriculture in order to generatg a larger agricultural

surplus is essential. This has coincided with a technical revolution

in agriculture which makes the generation of such a surplus a physical

rTossibility. However, the aekploitation of this possibility is dependent

on an adequate availability of savings for financing agricultural develop-

ment, itself. In pursuing these broad questions we have inevitably been

drawn into an examination of the flows of funds into and out of the

agricultural sector and our study of the literature on this subject

ind-'icat6d that little factual knowledge is available. Moreover th6 few

stud.ies vwich are avilable emerge w.th conflicting conclusions. Recent

findings particularly on Japan indicate that the agricultural sector

has financed industrial development in Japan to a much lesser extent

than previously believed and maybe not at all.Y On the other hand,

a recent FAO regional study on Asia suggests that Iteven if the savings

rate in agriculture proves to be lower than postulated for the entire

economy, the agricultural sector could finance the industrial sector

to a sipnificant extept. "?I

I/ Ishilcawa Shigeru: Economic Development in Asian Perspective, Tokyo,Kinokuniya Bookstore Co., L>7, . 4.

2/ FA "Hamin Conclusions and Policy Inplications of the Indicative 'brld

plan Regional Study for Asia", Ninith FAQ Regional Conference for Asiaand The Far East, Bangkok, Thailand, Nov. 1568. P. 50.

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2. Is there a net outflow of private savings from the agricultural

sector in W;est Pakistan? Although not adequately documented,, the belief

has developed that farmers have tended to invest surplus funds outside

the agricultural sector. For instance the IBRD Study of Water and Power

Rcs-.uce: of West Pakistan asserted "that very little is known about

t,he extent of private savingq., but it has been thought for some time that

substantial transfers of private savings were being made out of the

agricultural sector."'tV Our own analysis confirms this assertion and dis-

cuases briefly the policy implicaticrs which follow.

i4odel

Investment

3. We want to estimate the investment-savings gap for agriculture

in West Pakistan, or the net inflow or outflow of capital for years

1%9/65. 1969/70 and 1974/75., in 1964L/65 prices. 'We define agrifultxre

as major, minor crops and livestock. To begin with, the agricultural

productiorn targets of the Thlird and the Fourth Plan can be translated

iIto total investment requirements through the use of an incremental

capital output ratio. Total investment in agriculture is, t1fprefore,

exogenously determined. Fomn the gross production data, we derive value

added (Vt) by multiplying with 0.72, which is the value added pro-

portion of agricultural production in the West Paksitan input-output

table for 1962/63. Total output in apriculture is projected to growth

at (g-l) percent or 5.1 percent annually 196/65 throughout 17/75/

WVe assume that the value added proportion of total output is constant

for the 196575 period, for which reason also value added will increaseannually py the same percentage.

I /I TBRD, study of the W4tter cLnd Power Resour,ps of West Pakistan - Eeonomic

.nnex, 1967, p. 138.2/ The agricultural production targets for the Third and tXie Fourth Plan

are tdken from the Porspectpve Plan projectiQns. Ibid, p. 12L4.

-3-

Investment in agriculture doos not include cuxrent irputs, e.g.,

fertilizers, seeds, pesticides, etc. It is also obvious that growth Of

value added is caused by current inputs as well as by investment il

irrigation, farm mechanization, etc. Since we are concerned riiwely with

ui>vestrrmnt in the investment-savings gap arialysis, the propdrtion of

value added which results from investment must be found. Data from

West Pakistan indicate that the proportion of crop output which results

from "invrestment inuts" is axpected to be of the magnitude of 60 per-

cenit for the Third Plan./ Since agriculture in our case also comprises

livestock, we increase this figure. We assess that 65 percent (r) of

value added in agricultural output between 1964/65 and 197T/75 is due to

investawnt inputs. The value added is corrected with this factor. In

the absence of this correction there would have been an upward bias in

tlih investment requirement.

5. To translate growth in value added into investment, two more

parameters must be known: the time lag between investment and output in

agriculture., and the caital/output ratio. We assume that there is a

1I year lag between the investment year and the full output year for

total investment in agriculture.&/ When investment in period to is

related to the production increase between period to and to + 1, a time

lag of half a year is implicit. It is assumed that invrestment expendi-

1/ Government of Pakistan, Planning Commission, Reort of the ConsistenyComrittee on the Third Five-Year Elan, July 1 p 7 ep. st imated by alcon and Gotsch).

2/ See Wouter Tims., P flytical T1chnilues for Development Plarling. Acase study of Pak -Year Plan, Pakistan ;slt-uteof Development Econondcs, 1968, p. 88.

tures are spread evenly over the year. 1irith a 2½ year lag We r te

the investmerit in to to the increase in output from t, to t2 ' Final1l

in regard to the incremental cpital output ratios a), they are

assumed to be 2.2 and 2.5 for the Third nd sthe urth Plans, 13spectiVe3>-

These capital output ratios exclude the costs of the Indus Basin orks

(See footnote on p. 9. below).

6. Total investment in agriculture required to produce a fixed

output can now be written:

IA - Vt-r (g_l)g.A (1)

Total investment in agriculture and irrigation, A, caAn be split up into:

IA - Ip + Pr (2)

where I is public and Ipr is private investment.1 Ii 1964/65, Ip was

PRs. 415 mi<lion. p is composed of:

Ip = ? pd + E( g3)

where IPd represents publ-ic domestic irnvestment and Ep foreign finaced

investment. We estimate the annual average of foreign aid disbursed to

agriculture and irrigation over the Second Five-Year Plan at US$ 13.6

million. If two-thirds of the foreign aid into this sector goes into

investment, Ep 64/65 is t4e equivalent of some PRa. Lo ml,llion. Of

total actual investment, public and private, in 1964/65 PRs 712 million,

foreign aid thus represents 6 percent, which is about one-third of the

import comnponent of total investment, if this coxmponeiit is assumed at

_ Th analysis assumes that private and public investment are substitut;-able not complementary. This assumption appears justified in particu-lar for investment in water, tubewells, etc.

/ Source of data: Central Statistical Office, Kafachi, Pakistan

20 percont. IFor tlie projections for 1969/70 and 1971475, public in-

vestmenit (Ir) is takeni as a given magnitude. By deducting (Ip) from

total investment in agriculture (IA), wet derive private investme1nt as

a residual.

SayvingFs

7. In our model, savings in the agricultural sector are a f'unc-

tion of the average propensity to save (s) of the preVious years income

(Vt_j), net of taxes (T), but including subsidies. The average pro-

pensity to save (s) in the agricultural sector is not equal t6

self-financing of investment in agriculture. For both Plae periods,

it is assumed that the average propensity to save is 10 parcentr and

that the average and the marginal propensity to save are the same.

8. Value added is measured at factor cost which mean:b that it

excludes indirect taxes on factor inutls but includes subsidies on

these inputa. For this reas4dn in deriving income net of taxes but

gross of subsidies, we merely deduct direct taxes and indirect taxes

on the consumption of the farm household. Sale and excise taxes on

agricultura'L produce are not deducted. We accept the widely held

notion that the incidence of these taxes falls upon the consumers,

mainly the non-agricultural sector and not upon the producers.s/ The

taxes considered by us are in addition to direct taxes, therefore only

indirect taxes upon products consumed by farm households, i.e., gasoline.,

kerosene and clothing, etc. On the basis of Inidian data., we estimate these

1/ This corresponds with the estimate given for 11962/63 in the IBRD

Stu of the Water and Power Resources of West Pakistan, Op. cit.p.138 .

V V.P. Gandhi, Tax Burden on Indian Ariculture, Hearvard Law School,

1966, p.. 77.

-6-

taxes to be 10 percent of all inidirect taxes upon agriculture Which

in their turn constitute 27 percent of total indirect taxes.

9. Savings generated from agricultural production become

SA = s(Vt_j - T) (4)

The investment-savings gp (K) becoms

1= IA Ip - SA (5)

which now can be written

Kt = Vt.r (g-I)gA - s(Vt-1 T)- (6)

If savings which arise from agricultural production SA are larger than

private capital formation in agricultural (IA - Ip) there will be a net

outflow of private savings from the agricultural sector. To fu1lw under-

stand this net concept., it should be clear that the, savings out of agri-

cultural product.ion do not represent total funds available for pbysica1

cdLtal formation and/or financial savings in the agricultural sector.

Total funds theoretically available for investment in the glOulti:a:l

sector in addition comprise:

(i) Savings from non-agricultural production of farmhouseholds (Sl); and,

(ii) Capitul transfers from thei non-agricultural sector (SF).

10. Ilence, equation (5) can be reformulated:

AI Ip - SA - S. K (8)

It is seen that if SA are targer than (IA - Ip), i.e. there is a net

outflow of private savings from agricultural production, the total out-

flow now becomes larger by amounts SA and Sp.. The magnitudes of Sq and

Ibid. p. 87.

2/ Equation (6) can aiso be e)ressed:Kt ' vt.1 /(g.-l)g A- s7 + sT - Ip

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S are unlknoim to us. For this reason, wre are solely interested in to

what extent savings from axcultural p,ductiofl are in excess of ihat

is needed to reach the production targetzs, or are deficient for which

reason these savings must be supplementecd throtgh increased public in-

vestment from the government, and/or through capital transfers from the

non-dgricultural st3ctor. The relevant equation iL (6) in which we com-

pare savings from agricultural production with private investment.

Analysis

11. To begin with, we will calculate K64/65 with actual data for

public investment (Ip) and private irvestment (Ipr). The value added

in agriculture (major, minor crops and livestock) is estimated at PRs.

7,055 million for 1963/64 and at PRs. 7,425 million for 1964J65.V For

1964/65, direct taxes and indirect taxes on the consumption of the

agricultural sector (T) are assessed at PR.s. 510 million. On the tax

side, tile important- items are land revenue and water charges, each amounts

to some 160 million and indirect taxes on farm household consumption

crude,y assessed at PRs. 1LO nlillion..2/ For l96b/65 we get:

K61/65 =IA- lp - s(Vt_l - T) (5)

W1V/65 - 712 - 15 - O.10(7055 - 5o0)

'¢64/65 -360

IL is soon thiaL the net outflow of private savings o.f Pfls. 360 million

1 Value added estimates are derived from the gross production value3

presented in the iconommic Amnex of the IlRD Study of tho Water and

Power Resources of West Pakistan. Op. cit.

g, Water charges are taken gross of operating expenses. They do not

include land revenue from irrigation.

-8

is nearly of' the same magnitude as public inwestmet in agriculture (i.e

PRs. 415W It follows that if there e no net outflow th8 prvPensity to

save would hve to be 4.6 percent or less, instead of the estimated if percent.

12. For 1969/70 and l974t75, we estimate totkl iVestuOrrt in agri-

culture (IA) with our formula

IA - Vt.4r (g-l) gAlt1Tho incremental caital output ratio is set at 2.2 for 1969/70 ard 2.5 for

1974/75. However, in regard to the govement sector we assume that the

1961/65 siituation, where taxes (T) are PRa. 510 millon will remain. This

assumption appears reasonable for both taxes as well as for subsidies. The

lkiellhood of auy increase in agricultural taxation, in particular the lad'

tax is not very great. With regard to subsidies, which are alread included

in the v'aJ.ue a&dced at factor cost, we assume that the subsidisa will re-

fnain constant in relation to production costs. In fact this may be a con-

servative assumption since the larget subsicdy,, the one on waterg/ nw

well decrease. As regards fertilizer, although conswption is rqpidly

increasing, production costs are faLing so that the sxbsidy can be ax-

pected to be reduced or even removed.

13. Moreover, if we start by asund.ng that public inrestment in

agriculture zazO remaina at the 1964/65 level, we obtain the follawing

results for 196/7o and 1974/75:

Kt ' IAt 1 1p64/65 SCVt-1 - T64/65] (6)

K6 9/ 70 - 785 - 415 00(9163 - 51Q)

K6/0- -. 1,

9/ Additions to stock, in the form of inrewes of stocks of fertilizers193/64 - 1964/65 would not amaun;, to more than some PRs. 60 mli=n .If correction is made for this, tae 1l96/65 outflow is rCeded toPRs. 300 million.

In 1964/65, total subsidies ar estimatod at around PRs. hl million;the water suhicdy 1 estimted at not tess than PRa. 330 million.

-9

K7 4/ 7 5 1160 - 4 - o0.0(ll,9i8 - 510)

K7h/ 7 5

With our assuptions, the projected net outflow of private savings is

90o million in 1969/70 and 4oo million in 1974/756 The marginal pro-

pensity to save between 1964/65 and 1974/75, would need to be as low as

2 percent to m6re4y finance the level of investment in agriculture pro-

Ject.ed for the later year. If in 1969/70 the incremental capital output

ratio were 2.5 instead of 2.2, total required inrvestment increases from

PRs. 785 to 890 rall:ion. The 1969/70 outflow is then reduced to PRs.

390 million. In fact, with the higher capital output ratio$ the outlflow

would disappear and there would be a necessity of a inflow of PRs. 40

million to supplement private savings, were the average propensity to save

0.'.) instead of 0.10. In 2!97L/75, the lower propensity to save would re-

quire an iniflow of not less than PRs. 175 nidlljzn. However, we prefer to

adhere to the 10 percent assumption, since this figure is based upon em-

pirical data from West Palistan.

14. To increase the realism of our analysis, we must allow for the

fact that in the Third Plan, public inve'tment in agriculture is planned

to double over the 1964/65 level, to sone PRs. 8o million. per year and

in the Fourth Plan it may increase by another 50 percent.2/ what are the

1/ Indus Basin investment is not included in these projections. Rightly

public investment should be increased by the assessed cost for theamount of irrigation water(additional water), which will be generatedby the Induus Basin works before 197b/75. In our model, a higher levelof public investment increases the savings outflow. But on the otherhand if the relevant part of the cost for the Indus Basin Works isconsidered in our analysis, the capital output ratio should be higherthan 2.5 for the Fourth Plan period. For the purpose of our analysisbecause of the difficulty of' estimating production costs for additionalwater, it is assumed that the opposite effect of a :aigher level of public investmiient and a higher capital output ratio cancel out leavingthe derived savings outflow unchanged.

-10 -

implications of these projections? Obviously the net outflow will in-

crease. For 1969/70 with a capital output ratiio of 2.2, the net out-

flows wouul be of the magnitude of PRs. 500 million ; the 197L/75 out-

f1ow would increase by some 800 million to some 1,200 million.

15. Throughout this analysis we have taken the planned 5.4 percent, rate

of growth of agricultural production anid value added as given. To modify this

assurption suppose that in 1969/70 vith a public ivrestment of PRs. 800

million instead of 415 million, the net outflow will remain at PRs. 500

million. The additional investment of Pls. 40: million will yield a

7.2 percent g-rowth of value added, between 1971 and 1972. It nmst be

bborne in mind that the large net outflows for 1969/70 and 1974/75 will

be reduced if value added will start., to grow by more than the 5.4 percent

per year which is the original assuxptiorL. A 7.2 percent growth of value

addled in agyiculture might not surprise us unduly, but a much higher

rate of growth does not seem likel.

16. A sizeable net outflow of private savings from agricultural

production would still remain, even if value added indedesEs eWt more

than 5*4 percent per year. laiilst the assumptions of this analysis

may be disputed, it must be enmhasized that the net outflow is insensi-

tive to any plausible changes ir the basic parameters of the model.

Increases in the average proppnsity to save and the proportion of value

added which is due to current inputs conitribute to even larger outflows

than those we have derive4.A/ The sarie is true if the lag between invQst-

1/ In fact, savings of farrm households may well increase partic-41arlyif prices of' farm output continue to rise relatively to prices onindustrial goods.

,nent and output were shorter than 1. years. IL -year lag instead of alkyer

lag in 1969/70 ineans PRa. 40 miillion less of total investmnent for this year.

On the other hand, increases i.n the capital output ratio obviously wJill reduce

the outilows. In 1974/75 with the "nomninal1 ' public investment of PRs. 415

njillion, the residual outflow was 500 million with a capital output ratio of

2.5. In this situation a capital output ratio of 3.4 reduces this c1utflow to

zero. However, increases in the ratio of this magnitude appear unlikely.

Policy -icaion

17. The .. nprecision of the estimates relating to levels of pubxlic invest-

nent, the marginal propensity to save, etc. nakes it impossible to give

anything other than a range for the net outflow of private svings, from the

agricultural sector in 1969/70 and 1974/75. It appears likely that these

net outflows would amount to PRs. 500-900 millions in 1969/70 and 600-1200

nillions in 1974/75; the lower figure is applioable if the annual rate of growth

of value added ' increases to 7.2 instead of 5.4 percent per year. If in

1969/70 tota.".ffipub1ic imv 6stmefit 1n West ?akistan is of the magnitude of PRa.

27 million in constant to 1964/65 prices, the outflow in this year would

represent 20 to 30 percent of this irwesatment.

18. What are the policy implications? To answer., firstly it must be

ascertained where these funds are used. Are they partially hoarded and used

for the purchase of gold or precious stones? iLre they used for investment

or for consumption in the non-agricultural sector? Unfortunately little appears

to be known about this. However, there are indi.cations that substantial amunts

of deposits are made with rural branches of commercial banks and that these

funds are used for urban credit expansion. Secondly what is the development

objective? Is priority accorded to agriculture or to industry? If the

- 12 -

latter is the case, and it is rea.sonable to believe that some significant part

of the outflows axe used for productive investment in industry, then this

flow coniforms to the economic needs of the country. In fact there may be

a need to increase the flow. If on the other hand., the priority in development

is towards the agricultural sector, part or the whole of the savings which flow

out of this sector shoul:d be used for productive investment within the sector.

One solution is to mop up surplus savings in the agricultural sector through

increased taxation or reduced subsidies and to transfer these funds back to

agriculture. Whilst policy changes in these directions might be iesirable

for reasons of broad fiscal policy,xelating specificaly to the need to

mobilize inore budgetary funds for development from the agricultural sector,

the impact on the outflow of private savings from agriculture is likely to

be quite small. If we assume that the savirgs function is reversible, private

saving.3 will fall by only lu percent of the reduction in disposable incomes

resulting fron an increased tax imposition on farmers. The major impact will

be on their consumption and, to repeat the point made above, this might be

desirable for broader fiscal reasons,

19. There is an alternative to the tax approach which is perhaps more

realistuc$particularly in view of the fact that the prospects for increasing

taxes on agriculture in Pak;istan are not bright. This alternative approach

is to mobilize surplus funds through existing agricultural credit institutions.

Higher deposit rates and interest rates generkl2gwould be needed

for this mobilization. It has been established -that the majority of borrowers

in terms of loan volume of agricultural lending institutions in West Pakistan

are high income/commercial farmers. It is probable that these are the 8ame

farmers who are responsible for the bulk of the toransfer of soivings to thhe

13 -

non-agricultural sector. It is, therefore, reasoirable to eXpect that if

agricultural credit is to expand to those groups,even though this might be at

a higher lending rate than at, present, it is likely to result in a continuing

Jln growing net outflow of private savings. It private investment and/or the

application of current inputs does not increase as a result of this operation,

nothing has been gained. 2b repeat the objective is to increase agricultural

production.

20. In fact, evidence from Pakistan reflects the fact that the mdJPttyofbig

farmers may be iinovative entreprewa3urs in the Schumpeterian sense and that

increased public favors to them in the form of subsidies and/or public

invetAment solaly allows them to increase their consumption and/or the transfer

of surplus funds to th non-agricultural sector. In other wvrds, investment

decisions in the com;nercial farm sector are autonomous and largely independent

of government policy, as long as there is an adequate supply of inputs,

fertilizers, seeds, etc., and so long as the profitability of agricultural

production remains at its levels of recent years. To increase productivity

in agriculture, lt icould, therefore, be argued that the focus should switch

towards small farmers. It should be emphasized that this argument derives

.LIw L.ha economics of the problem; the equity aspect is another issue. At

present, both investment and the application of fertilizers, seeds3 etc., of

3small farmers appear much too low to reach those yields which have been made

possible by the new technology. Fbr instance, in India, it has been shown

that the annual average amount of capital expenditures was R9. 75 for small

farmers as against Rse. 716 for big f1rmers/ Tb further increase agricultural

1/ "All India Rurdl Debt and Investment Survey," Reserve Bank of IndiaBulletin, June 1965. Quoted in Wolf Ladejins yers"rINW Delhi Office, Feb. 1969, p 2.

a 14

output, the tirst priority in agricultural lernding should perhaps be in the

form of long-term supervised credit to smiall far-mer s who are capable of

producing marketable surpluses. One might even consider the imposition of

credit ceilings for large £frmers. It should be emphasized that supervision

ot credit use would be extremely important, far the evidence for Pakistan

as: well au for several other As-Ian countries is that well over one-half of

all borrowings by farm households goes to fin4nce current expenditures.