National Income: Accounting, Importance and Treatment (With Example)

Let us make an in-depth study of the National Income. After reading this article you will learn about: 1. National Income Accounting 2. Importance of National Income 3. The Circular Flow Model of the Economy 4. GDP and GNP 5. Avoidance of Double-Counting 6. Meaning of a Final Good or Service 7. Treatment of Raw Materials Vs Treatment of Capital Goods — Double Counting Vs Depreciation.

National Income Accounting:

There is a great desire to measure the success, or performance of our economy.

Are we getting ‘bigger’ (and better) or ‘smaller’ (and worse) over time? The need to evaluate the magnitude of our economic performance is important to planners and policy-makers, who want to know how well the economy is performing so that they can set goals and make policy recommen­dations.

An accurate measurement of the economy’s performance is also important to private businesses because failure to do that can lead to wrong decision making.

Stock traders are continuously checking economic data — buying and selling in response to the latest economic statistics. The object is to show how the national income of a country is measured.

In that context we shall refer to some conceptual and practical difficulties associated with the measurement of national income. Various measures of national income and output have been developed, the most important of which is gross domestic product (GDP). We shall examine GDP and other indicators of national economic performance in detail.

After reading this article, you will be able to answer the following questions:

1. What is national income?

2. What are the different ways of measuring a country’s national income?

3. What is the difference between national income at market price and national income at factor cost?

4. What are the difficulties of measuring a country’s national income?

5. Does an increase in national income lead to an increase in social welfare?

To fulfill the desire for a reliable method of measuring economic performance, national income accounting was born early in the 20th century. Pioneering work in this area was done by the Nobel Laureate economist Simon Kuznets. He established a uniform method of accounting for measuring the economic performance of a nation.

Importance of National Income:

The level of economic activity that is taking place in an economy is vitally important because it determines the quantity of goods and services that will be produced in the economy.

This, in turn, gives an indication of the material well-being of the people of a country. Every year, the Indian economy produces a large number (and a wide variety) of goods and services wheat, tomato, banana, apple, cars, shoes, clothing, buildings, houses, medical services, legal services, banking service, electricity, textbooks, etc.

The more of these goods and services that the economy produces, the more we will have available for consumption and the better off we will be.

National income accounts provide information on the pattern of economic activity. These statistics explain various economic and social phenomena. These also help policy-makers in formulating good economic policies both in government and in private industry. This is why national income statistics are closely watched by businesses and governments at all levels.

Just as a business firm comes to know how it is doing by looking at its accounting figures, national income accounting provides us with useful information about how well the economy is performing. E. M. James defines national income accounting as “the whole process of measuring and recording various economic aggregates which give some indication of the economic health of a country over time.”

The Circular Flow Model of the Economy:

There is a continuous flow of goods and payments between the producers of goods and services, which we call businesses, and individuals, who typically live in family units called households. The nature and direction of these exchanges are presented in the circular flow model of Income and output. This model is presented in Fig. 2.1.

Income and output are flow concepts; that is, they are measured over a span of time. The flow of incomes from businesses to households and vice-versa will continue unabated at a stable, or equilibrium, magnitude if income received is utilised or spent at the same rate, and if there is no siphoning of funds (resources) out of the flow.

For example, a teacher’s supply of services brings in income that can be used to buy automobiles, vacations, food and other goods. In sum, the total spending is the total amount that households spend and that equals the total amount that buyers of factors had to pay. In other words, total spending equals total income.

Total Output:

A good measure of a country’s economic well-being is its total production of goods and services. The most widely reported measure throughout the world of a nation’s economic performance is gross domestic product (GDP). It is defined as the market value of all final goods and services produced in an economy in an accounting year.

Gross Domestic Product (GDP):

GDP is the market value of all final goods and services produced within the domestic territory of a country in an accounting year. The following key terms can be identified from this definition. However each phrase in this definition has to be considered with care.

(i) GDP is the Market Value:

It is not possible to compare apples and oranges. But GDP adds together various different types of product into a single measure of the value of economic activity. To do this, it uses market prices of different goods and services. Since market prices measure the amount people are willing to pay for different goods, they reflect the value of those goods. If the price of an apple is twice the price of an orange, then apple contributes twice as much to GDP as does an orange.

(ii) Of All:

GDP includes the market value of all items produced in an economy and sold legally through the markets. It measures the market value of bananas, onions, potatoes, books, grapes, movies, health care, haircuts, etc.

GDP also includes the market value of the housing services provided by the economy’s existing housing stock. For rental housing this value is equal to both the tenant’s expenditure and the landlord’s income. Yet many people stay in the houses which are owned by them. So they did not pay any rent.

But government includes these owner-occupied houses in GDP by estimating their rental value. This means that GDP is based on the assumption that the owners, in effect, pay rent to themselves. For this reason such notional rent is included both in their expenditure and in their income.

There are some products, however, which cannot be included in GDP because it is very difficult to measure them. For example GDP excludes illegal drugs which are produced and sold in most countries. It also excludes those items which are produced and consumed at home and are not sold in the market (such as tomatoes grown by a housewife in her kitchen garden).

Vegetables which we buy from the market are part of GDP. But vegetables we grow in our garden are not.

Such exclusions from GDP often lead to paradoxical results. For example, when Mr. X pays Miss Y to work in his house, that transaction is part of GDP. If Mr. X were to marry Miss Y the value of her service is no longer a part of GDP because it is not sold in the market. Thus when an individual marries his domestic maid India’s GDP falls.

(iii) Final:

When Balarpur makes paper, while Archies then uses paper to make greeting card, the paper is an intermediate good, and the card is called a final good. The reason is that the value of intermediate goods is already a part of the prices of final goods. Adding the market value of the paper to the market value of the card would lead to double counting.

There is an important exception to this general principle. Suppose an intermediate good is produce and added to a firm’s inventory of goods to be used or sold later, rather than being used now. In this case the intermediate good is taken to be the ‘final good’ for a short period and its value as inventory investment is added to GDP.

When the inventory is later used or sold, the firm’s inventory investment becomes negative and there is a corresponding fall in GDP in the later period.

(iv) Good and Services:

GDP includes both tangibles (such as food, cloth, houses, cars, etc.) and intangibles (such as haircuts, health care, housecleaning). When an individual buys a book from a shop, he is buying a good and its purchase price is a part of GDP. When an individual pays to hear a music by a famous group he is buying a service, and the ticket price is also a part of GDP.

(v) Produced:

GDP includes goods and services produced currently. It does not include transactions in goods produced in the past. When Maruti Udyog Limited produces and sells a new car, the value of the car is included in GDP. When an individual or a company sells a used car to another person, the value of the used car is not included in GDP.

(vi) Within a country:

GDP measures the value of production within the domestic territory of a country. When a Indian citizen works temporarily in Britain, his production is part of Britain’s GDP. When an Indian citizen owns a cement factory in Nepal, the production at his factory is not a part of India’s GDP. It is part of Nepal’s GDP. Thus, items are included in a country’s GDP if these are produced domestically, regardless of the nationality of the producer.

(vii) In given period of time:

GDP measures the value of production that takes place within a specific time period, usually an accounting year. GDP measures the economy’s flow of income and expenditure per annum.

It should now be clear that GDP is a sophisticated measure of the value of economic activity. It contains several key terms. Each term in the definition of GDP has meaning.

GDP and GNP:

GDP is a flow concept. It refers to the flow of output during the year and not to the stock of goods and services measured at some fixed point of time. The concept may now be explained.

The Indian economy produces a wide variety of goods and services every year. We add all these millions of different goods and services together to arrive at a single figure which indicates total output (GDP). We do this by using money as the yardstick or the measuring rod of everything and add the value in monetary terms of all the items produced during the year.

This is known as the market value of output. Gross domestic product (GDP) is the market value of all the final goods and services produced in a nation during a period of time, usually a year. GDP, therefore, excludes production abroad by Indian businesses. Gross national product (GNP) is the market value of all final goods and services produced by a nation’s residents, no matter where they are located.

Thus, the distinction between the two concepts is based on the physical location of the producing units. GDP is the output of all Indian enterprises located in India and GNP is the output of all Indian enterprises — whether located in India or abroad.

Avoidance of Double-Counting:

In adding up the value of all goods and services produced in a year, we want to make sure that we count each good or service once, and once only. Counting an item more than once is called double counting. It may be noted that in closed economy, sales and purchase of inter­mediate goods and services by all producers effectively cancel out.

In an open economy, however, sales and purchases of intermediate goods and services do not normally cancel out, A country could be a net exporter or importer of intermediate goods.

Sales of intermediate goods and services to foreign producers are treated as exports, and purchases by domestic producers of intermediate goods and services from foreign producers are recorded as imports. So the problem of double counting does not arise in case of imports.

The reason is easy to find out. Any intermediate good used by a domestic firm is not the output of another domestic firm. The same is true of any raw material imported by a domestic firm to produce a final good. Let us consider an example which shows how double counting arises.

Example:

Suppose farmers produce Rs. 60 worth of wheat. The farms then sell the wheat to flour mills. The flour mills produce flour, which they sell to bakeries for Rs.100. The bakeries produce bread, which they sell for Rs. 150 to retailers (grocers). The grocers sell the bread to consumers for Rs.180. Table 2.1 illustrates the process.

Table 2.1 Value Added in Production:

If we add the value of output (goods and services) at each stage of production, we arrive at a value of Rs. 490. The figure overestimates the value of output because of double counting. The flour, for instance, was made for Rs. 60 worth of wheat that we had already counted. In fact, then, the flour producers added only Rs. 40 to the production process.

In a like manner, the Rs. 150 worth of bread sold by the bakeries contains Rs.100 worth of flour which we had already counted in the output of flour mills. This means that the bakeries added only Rs.50 of production. In other words, value added (that is, the difference between output value and input value) by the flour producers is Rs. 40 and by the bakeries Rs. 50.

The wheat bought by the flour mills and the flour bought by the bakeries are called intermediate products. These are outputs of one firm or industry but are used as inputs by other firms or industries. The bread sold by the retail groceries is a final product.

So the value added is the difference between a firm’s sales and its purchases of materials and services from other firms. In calculating the factor earnings or the value added by a firm, the statistician includes all costs except the payments made to other business firms.

Hence business costs in the form of wages, salaries, interest payments and dividends are included in value added, but purchases of wheat, flour, steel or electricity are excluded from the value added. In truth, all purchases from other firms are excluded from value added to arrive at GDP. The reason is that those purchases are properly counted in GDP in a different way — in the values added by other firms.

Meaning of a Final Good or Service:

The word “final” means that the good is ready for its designated ultimate use. Many goods and services that are produced are intermediate goods or services, goods that are used in the production of other goods.

For example, suppose Steel Authority of India produces some steel that it sells to Maruti Udyog Ltd. for use in making an automobile or service bought for final use and not intended for resale or to be subjected to further processing.

If we include the values of both intermediate and final goods in computing GDP, we face the problem of double counting. This is because the value of final goods includes all intermediate trans­actions. To avoid double counting, we must calculate only the value added at each stage of production, or the total value of the final products.

Here value added is either the sum of the last column or the difference between the sum of col. (1) and that of col. (2).

To avoid double counting care has to be taken to include only final goods in GDP and to exclude the intermediate goods that are used to produce the final goods. By measuring the value added at each stage, taking care to subtract expenditures on the intermediate goods bought from other firms, the income (earnings) approach properly avoids all double counting and records wages, interest, rent and profit exactly once.

Alternatively stated, the sum-total of the value added by all producing units in an economy is identically equal to the sum of all factor payments. In short, from the gross value of output of a firm we first subtract all cost payments to find out its value added figure.

This is equal to all factor payments (including the returns to the owners of the firm):

Gross value of output – all costs of raw materials and intermediate goods (produced and supplied by other firms) = rent + wages + interest + profit.

Treatment of Raw Materials Vs Treatment of Capital Goods — Double Counting Vs Depreciation:

Raw materials are to be deducted from the value of final goods in order to derive the value of GNP. Otherwise there will be a problem of double counting. However, a similar problem does not arise when the value of a capital good purchased by a firm is added to the value of final good.

For example, the value of flour used in the production of bread is added together with the value of bread in estimating GNP in order to avoid the problem of double counting.

But the treatment in case of capital goods is different. Capital goods are durable goods which offer their services over a long period of time. Such goods make an indirect contribution to the production process. But they wear out through use and have to be replaced — once their economic life is over.

The economic life of a machine depends on the annual rate of depreciation. So, from the current output, a certain portion has to be set aside every year to provide for the wear and tear of capital so that an old machine can be replaced when it wears out completely.

Otherwise, output will fall because capital goods are the creators of other goods. However, if the economic life of a machine (such as oven) is less than one year the value of the oven purchased by a bakery is to be deducted from the value of bread to find out the net value of output produced by the bakery.

Treatment of Non-Productive Transactions:

The value of GDP measures the value of current output, not current sales. Thus purely financial transactions are excluded for GDP. It is because such transactions do not reflect current production.

Examples of such transactions are:

(a) Transfer payments — both government and private; and

(b) Purchase and sale of corporate stocks and shares.

Government transfer payments are payments made by the government to individuals — payments for which no goods or services are produced. Examples of such payments are employment compensation, pensions to retired people and freedom fighters, cash subsidies to producers and farmers, scholarships to students, and interest on government bonds.

Similarly a grant from a private organisation to a student or a gift made by one individual to another is a private transfer. Such transfers are not included in GDP because these do not represent payments for goods and services produced.

Similarly, buying and selling of stocks and bonds are excluded from GDP because such transactions merely represent exchange of financial instruments (certificates of debt) among people. They do not represent payment for production.

Treatment of Used (Second-Hand) Goods:

We know that GDP measures the value of goods and services produced in a year. When a car is produced, value is included in GDP. If the original purchaser of the new car sells it after 10 months, the resale value of the car should not be included in GDP. If we include this there will be double counting.

Current GDP does not include the sale of a used car or the sale of a home constructed some years ago. Such transactions are merely exchanges of previously produced goods and not current production of new goods that add to the existing stock of cars and homes.

However, the sales commission on a used car or a home produced in another GDP period counts in current GDP because the salesperson performed a service during the current year.

Synopsis for Learning:

1. Importance of NI data:

NI data give important information about the functioning of an economy.

2. GDP:

The GDP is the value of all output produced in a country during a year.

3. Double counting:

Double counting overestimates the value of total output. Double counting refers to counting the value of the same commodities (items) or incomes more than once. It is a potential danger in the estimation of national income.

4. VA:

Value added is the output value minus input value.

5. Intermediate Products:

IP are the output of one industry used as inputs in another industry.

6. Final products:

A final product is bought for final use, not for reuse or resale.

7. Non-productive transactions:

These are excluded because they are not parts of current output.

8. Transfers:

Government and private transfer payments do not represent payment for production.

9. Second-hand sales:

These do not represent current output.

Some Related Income Concepts:

There are other national income accounting concepts which are also used in different contexts. These may now be briefly discussed.

Gross National Product (GNP):

Students and teachers of economics are more familiar with the term gross national product (GNP) than they are with GDP. GDP measures the market value of all final goods and services produced within the domestic territory of India, regardless of who owns the productive resources.

GNP, on the other hand, is the market value of all goods and services produced by Indian factors, regardless of whether more factors are located in India or abroad.

Foreigners own some factors of production located in India. Payments to those factors do not accrue to Indians as income. They are included in GNP, but not in GDP. Thus, to-arrived at GNP from GDP, we must add factor (investment) income from abroad (FIFA) or from non­residents, and deduct investment income paid to non-residents, i.e., we must add net investment income received from non-residents:

GDP + net investment income from non-residents = GNP.

Net National Income at Factor Cost (National Income):

NNI at factor cost or just national income (NI) is the total income earned by factors of production owned by Indians. To obtain this figure, we must deduct from GNP those components which do not accrue to factor owners as income. These are indirect taxes, less subsidies (that is, net indirect taxes) and depreciation.

Thus,

NI = GNP – net indirect taxes – D.

Personal Income:

A discrepancy exists between the total income earned by individuals and total income received by individuals. Personal income is the income received by persons from all sources. Personal income includes wages, salaries, rental income, interest and dividends, and certain transfer payments from government and business.

The discrepancy between income earned and income received results from the fact that factor owners do not receive a part of the earned income. This includes undistributed profits or retained earnings (corporate savings) and corporation income taxes (taxes paid by companies).

Also, some households receive income that is not currently earned by them. This income comprises transfer payments such as grants and subsidies, pensions, unemployment compensation, etc. Therefore, we can calculate personal income by subtracting undistributed profits and corporation income tax from national income, and adding to its transfer payments.

Personal income is the measure of the income available to households in a given year. To arrive at personal income, the following subtractions from and additions to national income are to be made:

1. Subtract all net interest and corporate profits from national income because these accrue to businesses and not to households.

2. Subtract all personal taxes such as employment (professional tax) taxes. These taxes are not paid out to individuals and, therefore, are not available for households to spend.

3. Add all personal interest income. This income exceeds the net interest that is initially subtracted because much of the interest earned by individuals is not used to finance production. Included in personal interest income is the interest paid by government to individuals who own government securities.

4. Add personal dividend payments, the portion of corporate profits that is paid to individuals.

5. Add all payments that individuals receive through government and business transfer (such as unemployment benefit and pensions).

After making all these adjustments we arrive at a measure of the income from production that actually gets paid out to households during the year along with income that does not necessarily reflect the sale of productive services. Personal income exceeds national income because the additions we make to national income to derive it exceed the subtractions.

Personal income is a useful measure of the ability of households to make purchases, save, and pay taxes. Retail sales forecasters closely watch personal income figures which are of great importance in influencing consumption.

Disposable Income:

The income that individuals have to spend or save after payment of personal taxes is called personal disposable income. It is obtained by deducting personal tax and nontax payments to governments from personal income. Disposable income is a key determinant of consumer’s ability to spend and save.

Table 2.3 shows how GDP is related to NNP, national income, personal income and disposable income. By moving from the top line to the bottom, we see how disposable income is derived from GDP.

Personal Disposable Income:

Individuals have to pay taxes and make other contributions to the government. Personal transfers to the government include subsidies, pensions and unemployment benefit (compen­sation). Taxes include personal income taxes and personal property (wealth) taxes. These and certain other deductions from personal income result in a figure called personal disposable income (PDI). Thus,

PDI = PI – personal taxes – provident fund contribution – interest paid by households (consumers).

Personal disposable income is partly spent on consumer goods and services. The remainder is personal saving.

Personal disposable income = consumption + savings Fig. 2.3 shows how we arrive at disposable income from GDP and national income. We first subtract depreciation from GDP to arrive at national income. Then we subtract all taxes and net business savings (i.e., profits after depreciation less dividends) from national income.

Then we add the transfer payments that households receive from governments to arrive at disposable income. It is what households have at their disposal to spend and save. The term ‘disposable’ implies that individuals can dispose it off as they wish. (Here we ignore, for the sake of simplicity, net factor income from abroad).

Five Measures of the Macro-economy:

Fig. 2.4 Illustrates the transition from GDP to NDP and three other measures of national income. The five bars show five major measures of the macro-economy in crores of rupees. Beginning from GDP, depreciation is subtracted to obtain NDP. Removing net indirect taxes yields NI.

Next, personal income equals NI minus corporate profits and contributions for provident fund plus transfer payments, net interest, and dividends. Subtracting personal taxes from personal income yields disposable personal income.

Money Income and Real Income:

Due to price level changes (that is, inflation or deflation) it becomes necessary to draw a distinction between money income and real income. The reason is simple. GDP is expressed in monetary terms. Price level changes can affect one measure of the total output of the economy. In general, the formula for converting GDP to real GDP is

Real GDP = GDP/P x 100 where P is the price index (that is, the weighted average of all prices).

So by deflating the GDP by the price index we can easily express GDP in real terms. The figures for GDP, expressed at current prices, are called money (nominal) income. The figures for GDP at constant prices (say, with 2005-06 as the base year) are called real income.