No Such Thing as a Free Lunch: Principles of Economics (Part 99)

A country's economic growth may be defined as a long-term rise in capacity to supply increasingly diverse economic goods to its population, this growing capacity based on advancing technology and the institutional and ideological adjustments that it demands.

Simon Kuznet

Measuring National Output and National Income (Part C)

by

Charles Lamson

The Income Approach

The income approach to calculating GDP looks at GDP in terms of who receives it as income, not who purchases it.

The income approach to GDP breaks down GDP into 5 components: national income, depreciation, indirect taxes minus subsidies, net factor payments to the rest of the world, and "other":

GDP = national income + depreciation + (indirect taxes - subsidies) + net factor payments to the rest of the world + other

As we examine each, keep in mind that total expenditures always equals total income.

National Income National income is the total income earned by factors of production owned by a country's citizens. National income is the sum of 5 items (1) compensation of employees, (2) proprietors' income, (3) corporate profits, (4) net interest, and (5) rental income. Compensation of employees, the largest of the five items by far, includes wages and salaries paid to households by firms and by the government, as well as various supplements to wages and salaries such as contributions that employers make to social insurance and private pension funds. Proprietors income is the income of unincorporated businesses, and corporate profits are the income of corporate businesses. Net interest is the interest paid by business. (Interest paid by households and by government is not counted in GDP because it is not assumed to flow from the production of goods and services.) Rental income, a minor item, is the income received by property owners in the form of rent.

Depreciation When Capital assets wear out or become obsolete, they decline in value. The measure of that decrease in value is called depreciation. This depreciation is a part of GDP in the income approach.

It may seem odd that we add depreciation to national income when we calculate GDP by the income approach. To see why depreciation is added, let us go back to the example in the last post in which the economy is made up of just one firm and total output (GDP) for the year is $1 million. Assume that after the firm pays wages, interest, and rent, it has left $100,000. Assume also that its capital stock depreciated by $40,000 during the year. National income includes corporate profits, and then in calculating corporate profits the $40,000 depreciation is subtracted from the $100,000, leaving profits of only $60,000. When we calculate GDP using the expenditure approach, depreciation is not subtracted. We simply add consumption, investment, government spending, and net exports. In our simple example, this is just 1 million dollars. When we calculate GDP using the income approach, we must add depreciation because it has been subtracted from the amount that corporations actually receive (the full $100,000). This is necessary to balance the income and expenditure sides. In other words, national income includes corporate profits after depreciation has been deducted, and so depreciation must be added back.

Indirect Taxes Minus Subsidies In calculating final sales on the expenditures side, indirect taxes---sales taxes, customs duties, and license fees, for example---are included. Because these taxes are counted on the expenditure side, they must also be counted on the income side.

To see why indirect taxes are added, let us again go back to the example of the one firm economy, where total output is $1 million. If the sales tax rate were, say, 7 percent, total sales taxes would be $70,000. These taxes would go to the government, and so the firm would receive only $930,000, to be allocated to wages, interest, rent, profits, and depreciation. Therefore, to measure total income, we must add to these items the sales taxes of $70,000.

Subsidies are payments made by the government for which it receives no goods or services in return. These subsidies are subtracted from national income to get GDP. (Remember, GDP is indirect taxes minus subsidies.) For example, farmers receive substantial subsidies from the government. Subsidy payments to farmers are income to farm proprietors and are thus part of national income, but they do not come from the sale of agricultural products, so are not part of GDP. To balance the expenditure side with the income side, these subsidies must be subtracted on the income side.

Net Factor Payments to the Rest of the World Net factor payments to the rest of the world equal the payments of factor income (income to the factors of production) to the rest of the world minus the receipts of factor income from the rest of the world. This item is added for the following reason. National income is defined as the income of factors of production owned by the country. GDP, however, is output produced by factors of production located within the country. In other words, national income includes some income that should not be counted in GDP---namely, the income all countries' citizens earn abroad---and this income must be subtracted. In addition, national income does not include some income that is counted in GDP---namely, the foreigners' income in the country whose GDP we are calculating---and this income must be added. When the value of net factor payments to the rest of the world is positive, this means that U.S. payments of factor income to the rest of the world exceeds U.S. receipts of factor income from the rest of the world.

Other "Other" includes business transfer payments and the statistical discrepancy. Business transfer payments are deducted from corporate profits and are not included as income elsewhere. Therefore, they need to be included to get total income. The statistical discrepancy adjusts for errors in the data collection.

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 398-399*

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