1 Review of Literature

In economics, the theory of savings has traditionally focused on private savings, and the division of private savings between corporate and household has been left indeterminate, even though e mpirical tests of the theory have generally been on data of p ersonal savings rather than on data of private savings.

In an empirical study of companies in the United States (US), Lintner (1956) suggested the existence of systematic relationships between dividends and other variables such as corporate income. The explanation for this observed relationship appears to be based on treatment of the corporation as an economic unit with special behavioural characteristics that are not typically recognised in economic theory. Thus, Lintner suggests that directors usually set a target dividend pay-out ratio for the long run and adjust dividends slowly towards this target as income changes. He, therefore, treats dividends and corporate savings as a f unction of current income and dividends of the previous period.

Smith (1963) argued that the proportion saved out of corporate income in a given period would depend on both the previous level of dividends and on demand and supply conditions for corporate funds. For Canadian firms he concluded that in addition to income, previous dividend levels play a very important role in the short run in influencing corporate savings, and the indicator for the demand for investment funds had a smaller impact.

In a study of the relationship between tax policy and corporate savings, Poterba et al (1987) explained how tax policy effectively influences the allocation of profits into dividends and corporate savings. In this study, the major conclusion was that a higher corporate tax rate provides a device for extracting free cash flow

50 from firms and tightens the external capital market’s control on new corporate investments. But tax policies that limit the availability of internal finance exacerbate pre-existing capital market distortions (ibid: 503).

For medium and large non-financial non-government Indian public limited companies during the period 1951-52 to 1973-74, Kishor (1980) identified net income, reserve requirements, expansion requirements, and dividend requirements as the determinants of corporate savings. It was observed in this study that the lagged dividend variable had an inverse relationship with retentions, i e, an increase in dividends in any year should reduce retentions in the next year. Net income emerged as the next most important variable influencing retentions. Need for expansion measured by incremental operating assets as a percentage of the volume of operating assets at the beginning of the period, turns out to be a relatively weaker explanatory variable with a small coefficient and a very large standard error.

In a study of South African companies, Aron and Muellbauer (2000) examined the determinants of annual net corporate savings relative to national income for the period 1966-97, by disaggregating this ratio into two components, and investigated the determinants separately for net corporate savings with respect to net corporate income and for gross corporate profits relative to national income. The major findings from the profit equation were that the share of profits in national income increased with the ratio of wholesale prices to unit labour costs, the gold terms of trade, the difference between the highest tax rate on individuals and the rate of corporation tax and capacity utilisation, but declined with the ratio of company taxes to profits and with import tariffs. From the corporate savings equation, the authors found that the rise in the inflation rate between the late 1960s and late 1980s was an important factor in explaining the rise in the share of corporate savings in net profits; while with the d ecline of inflation in the 1990s, the corporate savings rate has been b olstered by high real interest rates and financial liberalisation in consumer credit markets. It was also concluded in the study that changes in personal tax rates on dividends play no role in explaining the rise in the corporate savings rate out of net profits.

Bhole and Mahakud (2005) studied the trends and determinants of private corporate savings in India using panel data pertaining to 330 public limited companies for the period 1966-67 to 2000-01. This was divided into three time periods and studied individually, i e, 1987-88 to 1999-2000, 1987-88 to 1991-92 and 1995-96 to 1999-2000. The authors employed the generalised method of moments technique for the estimation. They found profit after tax, investment opportunities, availability of external funds, cost of borrowings, and cost of equity to be the major d eterminants of corporate savings in India as evidenced from the empirical results of the panel data model. They also found that retention ratio of the companies was positively related with profit after tax ratio, level of investment, cost of borrowing, and the growth rate of the firm, and negatively related with external sources of funds, corporate tax rate, and cost of equity.

The review of literature indicates that private corporate sector savings plays an important role in economic development. While some studies have analysed the necessity of savings for a firm,

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others have been concerned with the fundamentals or the main determinants of savings behaviour of the private corporate

Figure 1: Trends inDomestic Saving Rate

Saving as a percentage of GDP atCurrent Market Prices

35

25

15

5 0 -5

Savings rate Household sector Private Sector Public Sector

1951 1957 1963 1969 1975 1981 1987 1993 1999 2005 2008 Source: RBI (2010).

sector. More specifically, studies have shown that profits after tax, dividend policy, tax policy, investment opportunities, reserve requirement, expansion requirement, availability of external funds, cost of borrowing and cost of equity are the major factors which determine private corporate savings in India.

2 Private Corporate Sector: Performance and Trends

While India’s savings rate has steadily increased over time, its composition has undergone considerable change. Savings rate of both the private corporate sector and the public sector has gone up, offsetting the decline witnessed in the household sector (Figure 1). The share of public sector savings in the total savings has increased to 4% in recent years from -1% in 1999-2000. The private corporate sector, which had a stagnant savings rate till 2002-03, has only recently emerged as the sector with the most rapidly rising savings rate in the country. Its contribution to the overall savings rate has been increasing and comprised 25% of total domestic savings in recent years.

Recognising the importance of corporate savings for economic growth, policymakers worldwide have become increasingly interested in developing effective strategies for stimulating thrift. Concerns over low level of savings have led to a variety of policy proposals designed to stimulate thrift through the tax system, ranging from narrowly focused tax deferred savings accounts to broad-based consumption taxation. Economic research has played an important role in the resulting public policy debates, and economists have weighed in on virtually all sides of the pertinent issues.

The corporate sector has responded well to the increased global competition by improving its productivity and efficiency through increased application of technology and better financial and human resource management. The economic reforms process has helped greatly in making the policy environment more conducive for efficient entrepreneurial activity. The corporate tax rate was steadily reduced from 45% in 1992-93 to 30% in 2005-06 and was kept stable thereafter. Monetary policy has contributed to the sustained moderation in inflation leading to a r eduction in nominal interest rates. Financial restructuring of firms has also led to the reduction in overall debt equity ratios in the corporate sector. The substantial reduction in debt servicing costs has thereby added to the corporate sector’s competitiveness and profitability.

Profits after tax recorded an annual growth of 26% in 2007-08 (Table 1). Profit margins have recorded large gains, while the i nterest burden has witnessed a significant decline. In fact, the

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ratio of interest expenditure to sales revenues fell from around 6% in the 1990s to about 2% in 2007-08, thereby contributing greatly to the enhanced profit growth (Table 2). The profit after tax (PAT) to net worth ratio, after declining from 14.4% in 1995-96 to 5.1% in 2001-02, increased to 17.5% in 2007-08. Another notable feature of the performance of the corporate sector in the recent period is the progressive increase in retained profits, which as a share of PAT, increased from 30.9% in 2001-02 to 79.9% in 2007-08, which directly contributed to the corporate savings. The improved profitability, reflecting improved productivity and l owering of tax rates, enabled corporates to deleverage their balance sheets. This was reflected in the sharp decline in the debtequity ratio. The improved corporate financial performance resulted in a more than doubling of the private corporate sector savings rate as a percentage of GDP (from 3.4% in 2001-02 to 8.8% in 2007-08), which has also contributed to the pick-up in the overall savings rate.

Table 1: Corporate Financial Performance: Select Growth Rates (in %)

Gross Profits Interest Interest Interest Debt to Internal Bank Profits Profits

Profits to after Coverage to Sales toTotal Equity Sources of Borrowings after Tax Retained Sales Tax to Ratio Expenditure Funds to toTotal to Net to Profits Sales (number) Total Sources Borrowings Worth after Tax

of Funds

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From the long-term perspective, it is interesting to observe that the rate of savings of the private corporate sector has increased from around 1% in the 1950s, 1.7% in the 1980s and 3.8% in the 1990s, to almost 9% now. Higher retained profits, availability of greater credit from the banking sector, lower financing requirement of the government and the increased access to the domestic and international capital markets have led to a sharp increase in the investment rate of the corporate sector from 5.4% of GDP in 2001-02 to 15.9% in 2007-08. Thus, despite the increased savings rate, the savings-investment gap of the corporate sector widened from 2.1% of GDP in 2001-02 to 7.1% in 2007-08.

3 Data and Empirical Model

Besides the published data of yearly studies on the finances of public limited companies, the data set used in this study is firmlevel data from Company Finances Studies of the Reserve Bank of India (RBI). The RBI collects annual data from audited annual a ccounts of private sector companies operating in India. From the standpoint of coverage, the RBI collects data on nearly 3,000 companies, representing approximately 30% in terms of the p opulation paid-up capital.

To construct the panel used in this study, several modifications to the original sample were made. The RBI systematically covers data on large firms, but its coverage of smaller firms is sporadic. As such, “entries” and “exits” in and out of the sample tend to be smaller firms that do not submit data rather than actual entries and exits. We eliminated most of the sporadic entries and exits by restricting our sample to common firms included during the whole time period (1998-99 to 2006-07).

The literature review suggests a number of factors that may influence the corporate savings. Here we assume a linear relationship between corporate savings and its determinants. That is,

k RRit = Ȉ‰kXkit + —L + İLW N

where RR = retention ratio, firms are represented by subscript i=1, 2,…,n and time by t=1,2,…,T. K represents the number of explanatory variables. X represents the explanatory variable

—L= firm specific effects, and İLW=disturbance term having the properties, E (İLW and Var (İLW ı2.

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the net income or the profit after tax of a firm is expected to be positively related with profits retained. The use of external funds involves cash outflows in the form of either interest or dividend payments; retained profits as the internal funds would reduce the firm’s dependence on external funds. All these considerations suggest a positive relationship between the retention ratio and profit after tax ratio.

Corporate tax rate is measured as the ratio of total tax payments to total profits after tax. The taxation policy of the government negatively affects the retained profits of the firm. The high corporate tax rate increases the total tax payments of the firm and reduces its net income, which in turn reduces the retained profits of the firm. The corporate tax rate is expected to be negatively related with the retention ratio.

External sources of funds ratio is measured as the ratio of total borrowings and share capital to total assets. It is argued that the availability of external funds would be negatively associated with the retained profits of the firm due to cash outflow in the form of dividend and interest. Further, the easy availability of external funds may enable firms to distribute higher dividends to keep certain shareholders happy. However, with the availability of external funds, firms can expand their business activities and enhance their profits, which may boost their savings capacity.

Cost of borrowing is measured as the ratio of interest payments to total outstanding borrowings of the firm. When the cost of borrowing increases, the outgo in the form of interest payments increases. As a result, the retention ratio is expected to have a negative relationship with the cost of borrowing.

Capital formation ratio is measured as the ratio of fixed assets and inventory to total assets of the firm. Capital may increase either from internal funds in the form of retained profits or from external funds in the form of borrowings. The sign is expected to be positive.

Interest burden is measured as the ratio of interest payments to gross profits of the firm. Interest burden may be softened either by an increase in profits or due to a sustained reduction in inflation and domestic and foreign interest rates. If the decrease in interest burden is purely due to higher profits, it may have a positive relationship with retained earnings; however, if the decrease is due to reduction in inflation and interest rates, it may have a negative relationship with retained earnings.

Depreciation ratio is measured as the ratio of depreciation to total assets of the firm. Companies will provide depreciation on various fixed assets and will be used as internal funds. Hence, the retention ratio is expected to have a negative relationship with depreciation ratio.

Value of production ratio is measured as the ratio of value of production to manufacturing expenses of the firm. When the ratio increases, there is a high propensity to get more profits and hence retained profits will improve. As a result, the retention ratio is expected to have a positive relationship with the value of production ratio.

Inventory to sales ratio is measured as the ratio of stock in trade to sales of the firm. When the stock in trade increases, there is a tendency to drop profits and hence retained profits will

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m oderate. Thus the retention ratio is expected to have a negative relationship with the inventory to sales ratio.

The basic statistical properties of the variable used in our model are presented in Table 3. The mean value of the retention

Table 3: Statistical Properties of the Variables

ratio increased from 80% in 1998-99 to 83.5% in 2002-03 and then it moderated to 81.8% in 2006-07. Average profits after tax ratio improved to 11.1% in 2002-03 from -2.2% in 1998-99 and then declined to 3.5% in 2006-07. Though the corporate tax rate was steadily reduced from 45% in 1992-93 to 30% in 2005-06 and was kept stable thereafter, average corporate tax as a percentage of profits before tax improved from 15.9% in 1998-99 to 16.9% in 2002-03 and then to 21.3% in 2006-07. The external sources of funds ratio, on the average, improved over the years suggesting that corporates are more dependent on external funds than i nternal funds. Though average cost of borrowing was higher in 2002-03 compared to 1998-99, it declined significantly in s ubsequent years.

4 Empirical Results

s imultaneity would make the random effects estimator inconsist-covariance matrices of the two models, then the correlations of ent. As a consistent alternative to the random effects estimator, a the random effects with the regressors are statistically insignifidummy variable can be included for each firm. This estimation cant. The Hausman test is a kind of Wald Ȥ2 test with k degrees of approach, known as fixed effects, yields consistent estimates re-freedom (where k=number of regressors) on the difference magardless of correlation between firm-specific error components trix between the variance-covariance of the fixed effects model and the regressors. However, it is less efficient than the random with that of the random effects model. There is no evidence to effects estimator. The inefficiency arises because the fixed effects reject the hypothesis that random effects would be consistent estimator requires a separate pa-

Table 5: Estimates of the Regression Model for Different Set of Firms

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5 Summary and Conclusions

In this paper we have studied the determinants of private corporate savings in India using a panel regression model. We used firm level data of public limited companies, which contribute a major proportion of corporate savings in India. Though gross corporate savings in the NAS equals undistributed corporate profits, we primarily focused on net savings, which is retained profits. The productivity and efficiency of the private corporate sector has improved in recent years through increased application of technology. The liberal policy environment has unleashed entrepreneurship and improved efficiency of firms. Monetary policy has contributed to sustained moderation in inflation, reducing nominal interest rates, which further leads to reduction in debt servicing costs and a higher profitability of the firms. The gross profitability improved to 14.2% in 2006-07 with gross profits growing at 44.7% in the same year. The improved corporate financial p erformance has resulted in a more than doubling of the private corporate sector savings rate, which has also contributed to the pick-up in the overall savings rate.

The empirical results of the panel regression model showed that corporate tax rate, cost of borrowings, depreciation ratio and inventory to sales ratio are negatively associated with retained earnings of the firm, whereas, profits after tax ratio, external sources of funds ratio, capital formation ratio, interest burden and value of production ratio are positively associated with retained earnings. It is observed from the model that corporate tax rate, availability of external funds, cost of borrowings, interest burden and value of production as a percentage of manufacturing expenses are the major determinants of the corporate savings for the period 1998-99 to 2006-07.

Dividing our sample into large and small firms based on their sales we found that the signs of coefficients in these sets of firms are the same, though their significance varied considerably. Corporate tax rate, availability of external sources of funds, cost of borrowings and inventory to sales ratio were found to be significant determinants in case of large firms, whereas corporate tax rate and value of production ratio were significant in case of small firms.

Our results show that reduction in corporate tax rate would boost corporate savings, and making funds available in the s ystem with moderate interest rates would encourage firms to develop their business activities and raise higher profits and more savings.

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Hausman, J A (1978): “Specification Tests in Econometrics”, Econometrica, Vol 46, No 6, November, 1251-71.

Kishor, Braj (1980): “Corporate Internal Finance: A

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