Incremental Capital Output Ratio (ICOR): Definition and Formula

What Is the Incremental Capital Output Ratio (ICOR)?

The incremental capital output ratio (ICOR) is a frequently used tool that explains the relationship between the level of investment made in the economy and the subsequent increase in the gross domestic product (GDP). ICOR indicates the additional unit of capital or investment needed to produce an additional unit of output.

Understanding the Incremental Capital Output Ratio (ICOR)

ICOR is a metric that assesses the marginal amount of investment capital necessary for a country or other entity to generate the next unit of production.

Overall, a higher ICOR value is not preferred because it indicates that the entity's production is inefficient. The measure is used predominantly in determining a country's level of production efficiency.

Some critics of ICOR have suggested that its uses are restricted because there is a limit to how efficient countries can become based on available technology. For example, a developing country can theoretically increase its GDP by a greater margin with a set amount of resources than its developed counterpart can.

This is because the developed country is already operating with the highest level of technology and infrastructure whereas a developing country has room to improve. Any further improvements in a developed country would have to come from more costly research and development (R&D), whereas the developing country can implement existing technology to better its situation.

ICOR can be calculated as:

 $ICOR=\frac{\text{Annual Investment}}{\text{Annual Increase in GDP}}$ICOR=Annual Increase in GDPAnnual Investment​

For example, suppose that Country X has an incremental capital output ratio (ICOR) of 10. This implies that $10 worth of capital investment is necessary to generate $1 of extra production. Furthermore, if country X's ICOR was 12 last year, this implies that Country X has become more efficient in its use of capital.

Limitations of the Incremental Capital Output Ratio (ICOR)

For advanced economies, accurately estimating ICOR is subject to many issues. A primary complaint of critics is its inability to adjust to the new economy—an economy ever-more-driven by intangible assets—such as design, branding, research and development (R&D), and software—which are difficult to measure or record.

Intangible assets are more challenging to factor into investment levels and GDP than tangible assets, like machinery, buildings, and computers.

On-demand options, such as software-as-a-service (SaaS), have greatly driven down the need for investments in fixed assets. This can be extended even further with the rise of "as-a-service" models for nearly everything. It all adds up to businesses increasing their production levels with items that are now expensed, and not capitalized, and thus, considered an investment.

Example of the Incremental Capital Output Ratio (ICOR)

Between 1947 and 2017, the Indian economy was premised on the concept of planning and carried out through the Five-Year Plans. The 12th Five-Year Plan of the Government of India was India's final Five-Year Plan.

The Planning Commission of India determined the required rate of investment that would be needed to achieve different growth outcomes in the 12th Five-Year Plan. For a growth rate of 8%, the investment rate at market price would need to be at 30.5%, while for a growth rate of 9.5%, an investment rate of 35.8% would be required.

Investment rates in India dropped from the level of 36.8% of the gross domestic product (GDP) in the year 2007 to 2008 to 30.8% from 2012 to 2013. The rate of growth during the same period fell from 9.6% to 6.2%.

Clearly, the drop in India’s growth during this period was more dramatic and steeper than the fall in the investment rates. Therefore, there must have been reasons beyond savings and investment rates that would explain the drop in the rate of growth in the Indian economy. Otherwise, the economy is getting increasingly inefficient: In 2019, India's GDP growth rate was 4.23% and its rate of investments as a percentage of GDP was 30.21%.