In this article, we will try to explain the concept of national income accounting, methods of measuring national income and the problems associated with the measurement of national income. Before reading this article, we recommend to read and understand about the important concept of gross domestic product and GDP growth rate.
The flow of this article goes in the following manner.
- Concept of National Income Accounting
- Measurement Methods of National Income
- Important Measures of National Income and Product Account
- Difficulties/Problems in Measurement of National Income
Concept of National Income Accounting
It is an accounting system to measure economic activities in a logical and consistent framework. National income accounting rests upon the fundamental identity of national income accounting. This very fundamental identity of national income accounting is,
Total Production = Total Expenditure = Total Income
This way national income accounting shows the relationships among expenditure, income, and production methods of measuring national aggregates. The identity is self satisfactory because we can consider one’s expenditure to be other’s income if we view it from the national perspective. Similarly, output of a nation implies income of that nation. The famous classical theory in macroeconomics, Say’s law of market, provides some sort of rationale behind this logic.
Measurement Methods of National Income
Based on the national income accounting identity, there are three approaches or measurement methods of national income accounting. They are income method as Gross Domestic Income (GDI), expenditure method as Gross Domestic Product (GDP) and product method as Gross Value Added. All of these methods are same and produces the equivalent result subject to statistical discrepancy, which mainly results from data sources, timing differences, and estimation techniques.
As we know that GDP and GDI are the most famous measures of national income accounting, definitions and calculation methods center around these measures. The concepts employed in the measurement of GDP and GDI will also equally apply in the measurement of other important measures of national income (we will explain later on) with slight adjustment to the measures under consideration.
Now lets explain each of the methods one by one.
Measuring Gross Value Added: Production Method
GDP is the current market value of final products currently produced within the economy. Practically, GDP is obtained as the sum of gross value added by all the industries classified as per the industrial classification system adopted in the economy. As this method sums gross value added by industries, GDP shows the industrial composition of final output.
Since GDP is the market value, it excludes non-market values in the GDP measure primarily for the sake of simplicity. For example, GDP excludes non-market values such as household services, production for self-consumption, and government provided services (national defense, police protection, firefighting and education). Similarly, GDP measure excludes goods and services produced in underground economy or black market economy. These facts result in GDP as the imperfect measure of domestic output.
However, imputed value (an estimate of equivalent market value of non-traded goods and services) rescues to the imperfection of GDP as domestic output measure. The standard practice to impute the government provided services is to value these services at the cost of providing them.
Now, let go through the two method under production method of measuring GDP.
Final Product Method
Under this method, we can measure GDP by summing up the final value of outputs of each industries in the economy. However, this method suffers from the problem of double counting while differentiating which one is final or intermediate product. This final product method is more or less equivalent concept to gross output of industries. Note that GDP only includes value of final products.
Value Added Method
It is the value added method to find the value of final product by surpassing the problem of double counting found in final product method. Under this method, total value of output minus cost of intermediate consumption provides the value of final product. In other terms, GDP is the sum of gross value added by industries. The gross value added of a industry, in turn, is the difference between gross output and its intermediates inputs. Where gross output refers to sales plus other operating income and change in inventory, intermediate inputs refer to value of goods and service consumed in production.
Also note that GDP includes newly produced capital goods and inventory investment, and change in inventory during a period. In addition, GDP includes final products produced only on current period, but not produced in previous period. Lastly, GDP takes into account the time period in which production takes place, so it is a flow variable.
Measuring GDP: Expenditure Method
In terms of expenditure method, GDP is the total spending on currently produced final products within an economy. More specifically, GDP is the national aggregate of consumption expenditure, private investment expenditure, government expenditure, and net export. This approach identifies the purchases of goods and services by persons, businesses, governments and foreigners. Mathematically,
Y = C + I + G + NX
C = consumption expenditure made by public
I= private investment made by firms
G= government purchase of goods and services
NX = net exports (exports – imports)
Consumption expenditure also referred as personal consumption expenditure or consumption, and it includes values of goods and services purchased by persons. Specifically, it includes –
- Consumer durables – goods that last a long time such as automobiles, electronic goods, appliances and so on
- Nondurables – short-lived goods such as foods, housing rent service, gasoline, clothing and so on
- Services – such as financial services, haircuts, medical care, education, air travel, and so on
Private Investment or Investment is spending on currently produced goods that are used to produce goods and services over an extended period of time. It includes the following items:
- Nonresidential fixed investment (also called business fixed investment on structures, equipment and intellectual property products)
- Residential fixed investment – expenditure by household on new houses and apartments
- Inventory investment – change in inventory during accounting period valued at average prices of that period
We do not include purchase of existing housing in GDP because it was produced in earlier periods. Housing and apartments are capital goods, so we do not include it in personal consumption expenditure.
Government consumption expenditures and gross investment is the alternative term to government purchases. This heading consists of two components viz current consumption expenditures (spending on goods and services for the sake of public) and gross investment (spending on fixed assets). Put simply, purchases or spending by the government falls under this heading.
Value of currently produced goods and services exported, or sold to other countries minus value of goods and services imported, or purchased from abroad. Note that exported goods and services must be currently produced within the economy. We also refer to net exports as the trade balance.
Measuring GDI : Income Method
Note that GDP equivalent measure obtained using income approach is called Gross Domestic Income (GDI). This method adds up all the incomes domestically received by households and firms, including profits and tax revenue to the government. More clearly, GDI is “the sum of income payments and other costs incurred in the production of goods and services”. Thus, adding up below mentioned five income categories form the GDI measure based on income method.
Categories of Income for GDI
- Compensation of employees -includes wages and salaries in cash (mainly monetary remunerations), wages and salaries or fringe benefits in kind (such as transit subsidies, meals and lodging) and supplements to wages and salaries (such as employer’s contribution for pension and insurance) of employees in return for their work. It excludes incomes of self-employed individuals or of proprietors.
- Taxes on production and imports – incomes of government in the form of income tax, sales tax, real estate property tax, excise taxes, custom duties, and so on.
- Subsidies – negative incomes (like expenses) of government paid to households, businesses and government enterprises; so it is a subtraction item in the sum.
- Net operating surplus – It is income earned by government enterprises and private sectors from the current production before deducting interest, rent and other property income. More specifically, it is the sum of incomes of private enterprises and of current surplus of government enterprises. Again, private enterprises include corporate profits and proprietors’ income (a measure similar to mixed income in SNA 2008).
- Consumption of fixed capital (also depreciation) – It is a loss of value of capital either from wear and tear or from the scrapped value of obsolete capital. We have to add depreciation back to GDI in order to get gross income. The reason is that net income of business is obtained by subtracting depreciation. We call the measure as net domestic income without adding back the depreciation.
Important Measures of National Income and Product Account
The consolidation of both DGP and GDI and their components make up the Domestic Income and Product Account, which excludes the treatment of net income payments to the rest of the world. Net income payments to the rest of the world is current payments (income paid on investment in domestic assets) to rest of the world less current receipts (income received on investment in foreign assets) from the rest of the world.
Inclusion of net income payments to the rest of the world in Domestic Income and Product Account results in National Income and Product Account (NIPA). Both GDP and DGI produce the consistent and parallel measures; however, due to differences in data sources, timing, and estimation methods, DGP and DGI differ in amount. The difference in amounts of DGP and GDI is the statistical discrepancy.
In addition, GDP amounts to GDI plus statistical discrepancy, which may be result of reliability of expenditure data sources over income data sources. Despite GDP and GDI, there are other important NIPA measures. These measures difference in terms of product or income, gross or net, and domestic or national.
Generally, one can move from one measure to another measure with the following adjustments:
- Product to Income by subtracting statistical discrepancy
- Gross to Net by subtracting depreciation or consumption of fixed capital (CFC)
- Domestic to National by subtracting net income payments to the rest of the world or adding the net income receipts from the rest of the world
Relationships Between Important NIPA Measures
Gross National Product (GNP)
GNP is equal to GDP minus net income payments to the rest of the world, or equivalently equal to GDP plus net income receipts from the rest of the world. GNP measures production activities attributable to national residents.
Net Domestic Product (NDP)
It is equal to GDP minus consumption of fixed capital, and measures the output available for consumption and saving.
Gross National Income (GNI)
It is equal to GNP minus statistical discrepancy, and measures the income payments earned and cost incurred in the production of GNP.
Net National Product (NNP)
NNP is equal to GNP minus consumption of fixed capital, or NDP minus net income payments to the rest of the world.
Net Domestic Income (NDI)
It is equal to GDI minus consumption of fixed capital, or NDP minus consumption of fixed capital.
National Income (NI)
This is one of the important measures of national income (NI), and show how much everyone in the economy has earned. We can get this figure by summing up all the net incomes earned in production. NI can also be referred to as Net National Income. It is also equal to GNI minus CFC, or NDI minus net income payments to the rest of the world, or NNP – statistical discrepancy.
Difficulties/Problems in Measurement of National Income
Despite the importance of national income accounting, there are inherent difficulties and problems in the measurement of national income and its components. The difficulties are as under:
- Non traded transactions – Existence of non traded transaction prevents the precise measurement of national income. Production for self consumption, service rendered by housewives, rental income of self owned houses and the likes not traded in market. So, it becomes difficult in determining the market value of goods and services that are not traded.
- Problem of double counting – As we know that national income measures include only the final products. However, it is not so easy to differentiate final products from intermediate product, because the same product can became intermediate product at one circumstance and final product at the other. For example, sugarcane is final product to produce juice, and it is intermediate in the production of sugar.
- Existence of black market – Transactions that are conceded from government falls under black market or underground economy. It exists either because the goods and services produced are illegal or the transactions are hidden to avoid tax. If such market exists, government cannot figure how large the size of black market is.
- Error on imputation – As the value of non traded transactions are imputed to provide the precise measures of national income, statistical error on estimation results in poor estimation of national accounts.
- Portfolio investment and second hand transactions – Such transactions are not included in the national income, because they only reflect the transactions transferring ownership of already produced goods and services but not the additional production.
- Changes in prices – As the national income is measured in terms of monetary value, the change in price of goods and services may result in change in national income without being changed the final products.
- Lack of reliable and adequate data – Reliable and adequate are the precondition for perfect measurement of national accounts. However, availability of such data remains scanty in the face of under development state of nation, improper accounting practice and illiteracy.