Top 6 Difficulties Faced in Computation of National Income

Here we detail about the six major difficulties faced by a country during computation of national income.

1. Types of Goods and Services:

The kinds of goods and services which should be included in national income pose a problem.

Goods and services having money value are included in the national income but there are goods and services which may have no corresponding flow of money payments.

Services which are performed for love, kindness and mercy and not for money have an economic value but have no money value.

The difficulty is whether these services should be included in national income and how to measure their money value, e.g., a paid maid servant’s services are included in the national income but later when she marries the master, she is not paid any more, though she continues to perform the services. There is, thus, a reduction in the national income.

Similarly, when a housewife cooks for the family, her activity is not included in the GNP. But when she cooks in a restaurant and gets paid, her services are included in GNP. Much of the activity, goods and services which have money value and are considered economic in U.K. and U.S.A. on the basis of their marketability, are treated as non- economic in India because they are carried on in the household sector.

However, it is a general principle to exclude such household activities of housewives, home repairs, washing, cleaning, shaving or ‘do it yourself activities from national income because of the great practical difficulties in valuing the output resulting from these activities.

It is for this reason that any comparison of the GNP between highly developed market economy and an under-developed economy (in which a good part of the national product remains outside the market) is rendered useless. It is, therefore, impossible to include the value of personal services rendered to oneself in the national product or income accounts.

2. Problems of Double Counting:

Another difficulty is of double counting usually associated with the inventory method. Double counting implies the possibility of a commodity like raw material or labour being included in national income more than once, e.g., a farmer sells maize worth rupees two hundred to a mill-owner, the mill owner further sells the maize flour to a wholesale dealer, who further sells it to consumer; if we calculate it at every stage, its money value will increase to eight hundred rupees but actually the increase in national income has been to the extent of two hundred rupees only.

The best way to avoid this difficulty is to calculate only the value of all goods and services that enter into final consumption. The problem of differentiating intermediate and final products is very complex and acute in the computation of national income. For example, expenditure incurred on the purchase of goods and services by the government like expenditure on wages and salaries of government employees who perform services like police, military, fire protection etc. are all included in GNP estimates.

Some economists, however, argue that the purchase of these services or expenditures incurred on such services is actually intermediate to the production of final goods and should not be included in GNP estimates because they are not final products. Such expenditure are essential simply to create and provide the conditions under which the business and other sectors could perform day-to-day productive activities. It is very difficult to separate and distinguish between government services which are of intermediate nature and which are in the nature of final product. On this ground alone, the national income accounts include practically product.

On this ground alone, the national income accounts include practically all services provided to the business and other sectors by the government as part of final product and the value of these services in any period is in effect measured by the total amount of government expenditure during the period for the purchase of goods and labour used to provide governmental services. The same problem arises in classifying all purchases of consumer goods and services as final product.

Expenditures by persons on food, clothing, education, medical, transportation, recreation etc. are in part necessary to the performance of their jobs as producers in the economy. Therefore, some of these expenditures, at least, in a sense, are really for intermediate product; but it is impossible to draw a line of separation. It is for this reason that all purchases of goods and services by persons are classified as final product in actual practice in the income accounts. We thus see that final product is not some definite quantity that is available awaiting measurement by statisticians.

3. Excluded Market Transactions:

Certain transactions that take place in the market are excluded from the computation of national income because they violate the general rule for the recognition of income—the good or service must be currently produced and must use up currently available scarce resources. Many transactions are such that represent merely the transfer of wealth (or claims to wealth) or the exchange of commodities produced in some previous accounting period.

These excluded transactions relate to transfer payments, capital gains, illegal activities, second hand sales etc.:

(a) Transfer Payments:

Transfer payments are associated with the income method of national income calculation. A person receives income of say Rs. 1,000 per year; part of it may have been received as interest payments on government loans. This part is in the nature of transfer payments and may be taken either as the income of the individual or of the government. If it figures under both the categories, aggregate national income will be unduly inflated.

Therefore, the transfer of money from one person or group to another person or group should be avoided and the best way to solve this difficulty is to consider only the disposable income of individuals or groups i.e., personal incomes minus all transfer payments. Transfer payments or receipts refer to those income payments which are not the result of any current productive activity on the part of income receivers. These transfer payments are made by individuals, business firms and government in an economy.

For example, when a business firm distributes Rs. 1,000 in prize money in a competition contest held by it to popularize its product, the prize money is income for the prize winners—this prize income, however, is different from factor income. Similarly, the expenditure of Rs. 1,000 does not represent the factor cost of production for the firm because it has not been paid to the factors of production against the productive services rendered by them.

Transfer payments represent merely a transfer or redistribution of income from person to person, from firms to persons or government and from government to persons and business firms. These transfer payments do not represent payments made for productive services rendered in the production of final goods and services, they are, therefore, excluded from national product. Examples are social security payments like pension, direct relief payments like unemployment allowances, prize, money of business firms, interest on government debts gifts, charity payments, awards, scholarships etc.

(b) Capital Gains:

Capital gains or losses represent increases in the value of the capital assets resulting from a rise or fall in the market prices of such assets. These gains or losses which are caused by changes in the valuation of assets are excluded from national income accounts because they do not represent any increase or decrease in the national product flow stream on account of productive activity rendered. If the market value of land or buildings rises on account of inflation, the owners no doubt will gain.

But from a macroeconomic accounting viewpoint, such gains are immaterial and do not matter because the real estate of the economy, thereby, does not increase. The increase in the value of land due to a mere rise in prices is basically different from the increase in the value of land resulting from improvements made on it. These improvements like planting, digging a well, leveling etc. represent current flow of productive activities as such the increase in the value of land will be included in the national income accounts but not otherwise; if it is merely a change gain or a windfall. Capital gains, which do not accrue to asset owners against productive services rendered are not included in the national income.

(c) Illegal Activities:

All unlawful and illegal activities, whether economic or not, are omitted from national income accounting. Income earned through illegal activities like smuggling, black- marketing, gambling, betting, adulteration, bribery etc. are excluded on the ground that these activities are illegal and, therefore, cannot be included in the national income accounts. However, it is very difficult to estimate such activities because their definitions or notions may change from generation to generation or from society to society. In a free market economy—who is going to say or decide— what is a socially desirable or lawful activity? Thus, it is the larger issue of what constitute a lawful or socially desirable activity that demands closer examination.

(d) Second-hand Sales:

The most obvious item for exclusion from the national income and product accounts is second-hand sales. In such sales the individual or the economic units merely exchange ownership of an already existing good, when no income is created in the process from current production. Even if a profit is made, there is no income generated in the accounting sense, for the gain is offset by the recording of the good at the transaction price by the buyer.

In short, the entire transaction has to be ignored—gain or loss. If, however, a reward is offered to someone who brings the buyer and seller together, the reward is recorded as income. The function of creating a market is a legitimate economic activity, uses scarce resources, hence the reward for this function is clearly income. The functions of the broker, used car salesmen, dealers of many kinds, auctioneers, are a few examples.

4. Problem of Imputed Values:

There are certain goods and services which do not appear in or cannot be brought to the market. In such cases we have to impute values to them. It means to give or to fix their values, in case they had been brought to the market. The procedure although very logical yet is beset with number of practical difficulties because the task of imputing or fixing values is not easy. But, values, once they are imputed or fixed are included in the national income accounts.

Crops raised on the farm like wheat, rice, etc. and consumed by the farmer and his family on the farm, person living in his own house, services rendered by commercial banks, insurance companies and other financial institutions, ‘fringe benefits’ enjoyed by the well paid top business executives of big companies and corporations like a managing director—receiving in addition to his salary, ‘fringe benefits like free residence, future, conveyance, medical allowances etc.

The true monthly income of the managing director will be the imputed money value of fringe benefits enjoyed by him plus the monthly salary. Thus, when some goods and services, representing current economic activity in the economy do not appear on the market, an imputed value equal to the market value of similar goods and services is assigned to them for purposes of including the value of these goods and services in the national product and income accounts.

But, it is easier said than done. The problem of imputing values is not easy. For example, how the fringe benefits are to be valued because their value is different under different circumstances and the prices at which these benefits are available also keep on changing. Again, the services of a judge, a police officer, street lighting etc. cannot be purchased because they are not placed in the market as such.

5. Inventory Adjustments:

Inventory adjustments i.e., changes in the stock of capital goods or final products are also to be taken into account while computing national income. If a jute mill adds to its inventory of jute products during the year, it represents an increase in output and must, therefore, be included in GNP. The difference between the officially published figures and the figures obtained from the business accounting data calls for inventory valuation adjustment. On account of the change in the physical volume of inventories and the change in the prices at which these inventories are valued by business units, inventory valuation adjustment becomes essential.

The main purpose of this adjustment on the product side of the national income and product account is to avoid understating or overstating the change in inventories and, therefore, to avoid understating or overstating the gross domestic investment and the gross national product. The difficulty arises on account of the fact that all business units do not keep a record of the changing inventories, and even those who do maintain the record not in physical units but in terms of value. Since inventories have to be carried over several periods, their valuation presents a difficult problem due to frequent changes in prices also. Moreover, business units keep their records of inventories in terms of original cost.

6. Depreciation:

Depreciation implies a reduction in the value of capital stock or capital goods due to wear and tear, constant use etc. During the process of production the wear and tear or capital consumption occurs, resulting in, at the same time, a decline in the relative efficiency of the plant and equipment on account of obsolescence. However, the problem of correctly estimating depreciation is equally a difficult task e.g., a machine may be used more intensively in one year than the other. But the rate of depreciation remains the same, though it should differ between two years. Again, the depreciation of similar equipment may differ between two business units.

Moreover, a good part of the annual depreciation may actually represent obsolescence rather than the physical wear and tear of capital equipment. In periods of rising prices, the amount of depreciation may fall short of the amount needed to replace capital, which in turn, may mean under-statement of depreciation and over-statement of profits, thereby, unduly inflating the NNP.

Therefore, the estimates of depreciation on the basis of replacement cost of the assets are superior because they provide better estimates of net investment in the community. It is, therefore, clear that once the difficult problems like double counting, inventory valuation, depreciation etc. are resolved satisfactorily, accurate estimates of national income and product account become easier.