ECONOMIC ANALYSIS

Module 6. National income

Lesson 25
PERSONAL INCOME

25.1 Introduction

We can measure the GDP for a particular year using the actual market prices of that year; this gives us the nominal GDP or GDP at current prices. But we are usually more interested in determining what has happened to the real GDP, which is an index of the volume or quantity of goods and services produced. Real GDP is calculated by tracking the volume or quantity of production after removing the influence of changing prices or inflation. Hence, nominal GDP is calculated using changing prices, while real GDP represents the change in the volume of total output at constant price changes are removed.

The difference between the growth of nominal GDP and real GDP is the growth in the price of GDP, sometimes called the GDP deflator.

Now that we have an overview of the GNP both at product and income accounts in an open economy. The Following Table 25.1 shows a set of accounts for both the product and the income sides. The structure of the table and the definitions of the terms in it will able to understanding the GDP and its components.

Table 25.1 Overview of the national income and product accounts

This table presents the major components of the two sides of the national accounts. The left side shows the components of the product approach (or upper loop); the symbol C, I, G and X are often used to represent these four items of GDP. The right side shows the components of the earnings or cost approach (or lower loop). Each approach will ultimately add up to exactly the same GDP.

We have graphically depicted GDP by second bar in Figure 25.1

Fig. 25.1 Various concepts of national product

(Note: By adding Factor Income from Abroad to NDP_MP and NDP_FC we get NNP_MP and NNP_FC (respectively).

25.2 Net National Product (NNP)/ National Income at Market Prices

The second important concept of national income is that of net national product (NNP). In the production of gross national product of a year, we consume or use up some fixed capital i.e., equipment, machinery etc. The capital goods, like machinery, wear out or fall in value as a result of its consumption or use in the production process. This consumption of fixed capital or fall in value of fixed capital due to wear and tear is called depreciation. When charges for depreciation are deducted from the gross national product we get national product. Clearly, it means the market value of all final goods and services after providing for depreciation. Therefore, it is also called ‘national income at market prices’. Therefore,

25.3 National Income (NI)/ National Income at Factor Cost (NNP_FC)

National Income at factor cost which is also simply called national income means the sum of all incomes earned by resource suppliers for their contribution of land, labour, capital and entrepreneurial ability which go into the year’s net production. In other words, national income (or national income at factor cost) shows how much it costs society in terms of economic resources to produce per net output. It is really the national income (or national income at factor cost) and net national product (national income at market prices) arises from the fact that indirect taxes and subsidies cause market prices of output to be different from the factor incomes resulting from it. Suppose for instance, a metre of mill cloth sold for Rs. 200 includes Rs. 25 on account of the excise and the sales tax. In this case while the market price of the cloth is Rs. 200 a metre, the factors engaged in its production and distribution would receive Rs. 175 a metre. The value of cloth at factor cost would thus be equal to its value at market price less the indirect taxes on it. On the other hand, a subsidy causes the market price to be less than the factor cost. Suppose handloom cloth is subsidized at the rate of Rs. 10 per metre and it sells at Rs. 90 per metre. Then while the consumer pays Rs. 90 per metre, the factors engaged in the production and distribution of such cloth will receive Rs. 100 per metre (Rs. 90 + 10 = Rs. 100). The value of handloom cloth at factor cost would thus be equal to its market price plus the subsidies paid on it. It follows, therefore, that the national income (or national income at factor cost) is equal to net national product minus indirect taxes plus subsidies.

Net of indirect taxes and subsidies is called Net Indirect Taxes. Therefore,

National Income = Net National Product — Net Indirect Taxes

25.4 Personal Income (PI)

Personal Income is the sum of all incomes actually received by all individuals or households during a given year. National income, that is total incomes earned and personal income, that is, total incomes earned and personal income, that is, total incomes received must be different become some incomes which are earned such as social security contributions, corporate income taxes and undistributed corporate profits are not actually received by households, and conversely, some incomes which are received like transfer payments are not currently earned (examples of transfer payments are old-age pensions, unemployment compensation, relief payments, interest payments on the public debt, etc.) Obviously in moving from national income as indicator of income earned to personal income as an indicator of income actually received, we must subtract from national income those three types of income which are earned but not received and add those income which are received but currently not earned. Therefore,

Fig. 25.2 From national income to disposable income

Personal Income = National Income – Social Security Contributions – Corporate Income Taxes – Undistributed Corporate Profits + Transfer Payments.

25.5 Disposable Income (DI)

Even whole of the incomes which are actually received by the people are not available to them for consumption. This is because governments levy some personal taxes such as income tax, personal property taxes. Therefore, after a part of personal income is paid to government in the form of personal taxes like income tax, personal property taxes, etc., what remains of personal income is called disposable income. Therefore,

Disposable Income = Personal Income – Personal Taxes.

Disposable Income can either be consumed or saved. Hence,

Disposable Income = Consumption + Saving.

How do we get personal income and disposable income from national income is illustrated in Figure 25.2.

25.6 Measurement of National Income

Since factor incomes arise from the production of goods and services, and since incomes are spent on goods and services produced, three alternative methods of measuring national income are possible.

25.6.1 Value added method

This is also called output method or production method. In this method the contribution of each enterprise to the generation of flow of goods and services is measured. Under this method, the economy is divided into different industrial sectors such as agriculture, fishing, mining, construction, manufacturing, trade and commerce, transport, communication and other services. Then the net value added at factor cost (NVA_FC) by each productive enterprise as well as by each industry or sector is estimated. Measuring net value added at factor cost (NVA_FC) by each industry requires first to find out the value of output. Value of output of an enterprise is found out by multiplying the physical output with market prices of the goods produced.

In order to arrive at the net value added at factor cost by an enterprise we have to subtract the following from the value of output of an enterprise:

1. Intermediate consumption which is the value of goods such as raw materials, fuels purchased from other firms

2. Consumption of fixed capital (i.e., depreciation)

3. Net indirect taxes

Summing up the net values added at factor cost (NVA_FC) by all productive enterprises of an industry or sector gives us the net value added at factor cost of each industry or sector. We then add up net values added at factor cost by all industries or sectors to get net domestic product at factor cost (NDP_FC). Lastly, to the net domestic product we add the net factor income from abroad to get net national product at factor cost (NNP_FC) which is also called national income. Thus,

NI or NNP_FC = NDP_FC +Net factor income from abroad

This method of calculating national income can be used where there exists a census of production for the year. In many countries, the data of production of only important industries are known. Hence this method is employed along with other methods to arrive at the national income. The one great advantage of this method is that it reveals the relative importance of the different sectors of the economy by showing their respective contributions to the national income.

25.6.2 Precautions

The following precautions should be taken while measuring national income of a country through value added method.

The first important part of GDP is consumption or “personal consumption expenditures.” Consumption is by far the largest component of GDP, equaling about two-third of the total in recent years. Consumption expenditures are divided into three categories: durable goods such as automobiles, nondurable goods such as automobiles, nondurable goods such as food , and service such as medical care. The most rapidly growing sector is services.

Investment is an essential economic activity because it increases the capital stock available for future production. One of the most important points about national accounting is the identity between saving and investment. Under the accounting rules, measured saving is exactly equal to measured investment. This equality is an identity, which means that it must hold by definition.

In the simplest case assume for the moment that there is no government or foreign sector. Investment is that part of the national output which is not consumed. Saving is that part of national income which is not consumed. But since national income and output are equal, this means that saving equals investment. In symbol:

I = product-approach GDP minus C

S = earning-approach GDP minus C

But the measures always give the same measure of GDP, so

I = S the identity between the measured saving and investment

That is the simplest case. On the saving side, total or national saving (S^T) is composed of private saving by households and businesses (S^P) along with government saving (S^G). Government saving equals the government’s budget surplus or the difference between tax revenues and expenditures.

On the investment side, total or national investment (I^T) starts with gross private domestic investment (I) but also adds net foreign investment, which is approximately the same as net foreign investment, which is approximately the same as net export (X). Hence, the complete saving investment identity is given by

National Investment = Private Investment + net exports

= private saving + government saving = national saving

For this discussion, we consider only private investment and therefore treat all government purchases as consumption. In most national accounts today, government purchases are divided between consumption and tangible investments. If we include government investment, then this amount will add to both national investment and the government surplus.

Or

I^T = I + X = S^P + S^G = S^T

National saving equals national investment by definition. The components of investment are private domestic investment and foreign investment (or net exports). The sources of saving are private saving (by households and businesses) and government saving (the government budget surplus). Private investment plus net exports equals private saving plus the budget surplus. These identities must hold always, whatever the state of the business cycle.

Fig. 25.3 From GDP to national to disposable income

In the accounts, investment consists of the addition to the nation’s capital stock of buildings, equipment, software and inventories during a year. The national accounts include mainly tangible capital (such as buildings and computers) but omit most intangible capital (such as research-and-development or educational expenses). How does investment fit into the national accounts? If people are using part of society’s production possibilities for capital formation rather than for consumption, such outputs must be included in the upper-loop flow of GDP. Investments represent additions to the stock of durable capital goods that increase production possibilities in the future. Investments represent additions to the stock of durable capital goods that increase production possibilities in the future. Gross domestic product is the sum of all final products. Along with consumption goods and services, we must also include gross investment.

Measuring government’s contribution to national output is complicated because most government services are not sold on the marketplace. Rather, government purchases both consumption-type goods (like food for the military) and investment-type items (such as electricity or roads). In measuring government’s contribution to GDP, we simply add all these government’s contribution to GDP; we simply add all these government purchases to the flow of consumption, investment, and as well as net exports.

Hence, all the government payroll expenditures on its employees plus the costs of goods its buys from private industry (lasers, roads and airplanes) are included in this third category of flow of flow of products, called “government consumption expenditures and gross investment.” This category equals the contribution of central, state and local government to GDP.

Government transfer payments are government payments to individuals that are not made in exchange for goods and services supplied. Examples of government transfers include unemployment insurance, veterans’ benefits and old-age or disability payments. These payments meet important social purposes, but, since they are not purchases of current goods or services, they are omitted from GDP.

Thus if we receive a salary our salary from the government because we are the Scientists, our salary is a factor payment and would be included in GDP. If we receive a welfare payment because we are poor, that payment is not in return for a service but is a transfer payment and would be excluded from GDP.

One peculiar government transfer payment is the interest on the government debt. Interest is treated as a payment for debt incurred to pay for past wars or government programs and is not considered to be purchase of a current good or service. Government interest payments are considered transfers and are therefore omitted from GDP.

Finally, do not confuse the way the national accounts measure government spending on goods and services (G) with the official government budget.

The basic GDP accounts are of interest not only for themselves but also because of their importance for understanding how consumers and businesses behave. National Income (NI) represents the total incomes received by labour, capital and land. It is constructed by subtracting depreciation from GDP. National income equals total compensation of labor, rental income, net interest, income of proprietors and corporate profits.

The relationship between GDP and national income is shown in the first two bars of Figure 6-1. The left-hand bar shows GDP, while the second bar shows the subtractions required to obtain NI.

To get disposable income, you calculate the market and transfer incomes received by households and subtract personal taxes.