There are several different methods of calculating an economy’s GDP. Theoretically, all the different techniques should give you the same number, but that’s rarely the case due to the massive amount of data that needs to be dealt with in addition to all the points in the process where errors can creep in. That being the case, the real world results still tend to be pretty similar to each other.
Another method of calculating an economy’s GDP is to use the income approach. If goods are being produced and services are being rendered, then somebody is being paid for it. If we sum up this income then add and take away a few things, we’ll have GDP.
Note: The actual methodology of the income approach goes way beyond the scope of what I’m covering here. There are many line items that I’m leaving out for simplicity’s sake. Some textbooks use a less complicated form for the income approach while others get much more advanced. Keep that in mind.
To calculate GDP this way, the first thing we need to do is figure out our national income. Since different people get paid in different ways, there are six separate categories that we have to look at: compensation of employees, rents, interest, proprietors’ income, corporate profits, and taxes on production and imports.
Compensation of Employees
This includes all the wages and salaries that are paid out to employees, both public and private. Note that this number includes the full compensation of employees, so taxes paid by employers on the employees behalf (social security, unemployment, Medicare, etc.), health benefits, pension funding, and the like are all included in this category.[break]
This is income that is received by those who loan out their land and/or capital resources. For example, rent that a tenant pays to a landlord for an apartment or payments a farmer makes for borrowing a tractor falls under rent. Recipients of rent can either be private households or businesses. An important thing to note is that we are talking about net rent, which is rent after depreciation of the rental property. You’ll see why this is important later.[break]
Money received as payment for loans is interest. So interest paid on things like bonds, mortgages, and savings accounts all fall under this group. [break]
Profits made by small businesses that are sole proprietorships or partnerships or any business that isn’t incorporated (we have a separate segment for that) is considered proprietors’ income. The mom and pop shop on the corner, your favorite family restaurant, and the owner of the local landscaping company are all examples of businesses whose income would likely fall under this category. [break]
Profits made by businesses that are incorporated have their own category. There are three separate subsections to corporate profits:
-Corporate Income Tax: Because corporations are considered entities of their own, separate from their owners, they have to pay their own version of income tax based on the profits they make.
-Dividends: After paying taxes, one option that corporations have available to them is to pay out a portion or all of the left over profits to its owners, the people who own shares of the company’s stocks.
-Undistributed Corporate Profits: Whatever remains after taxes and dividend distributions are called retained earnings. This money usually gets reinvested back into the business to help the company grow.[break]
Taxes on Production and Imports
Taxes are the government’s form of “income” and this category covers a broad array of taxes, ranging from the general sales tax to customs duties. This gets a lot more detailed and complicated than what we need, so I’ll just leave it at that.
Going from National Income to GDP
Once we sum up the value of these six categories, we’ll have what economists refer to as national income, which is the income that flows from all of a nations’ resources, whether it be located domestically or abroad. While national income is an important economic indicator in its own right, that’s not the topic of discussion; we’re looking for GDP. To get there from national income, we have to adjust for a few things.[break]
Net Foreign Factor Income
National income counts the income earned based on nationality, not based on region. So for example, the United States national income figure would include all income made by Americans both here in the States and in foreign countries. GDP is concerned only with thing that happen domestically, inside of a country, so we need to account for the income earned abroad. The net foreign factor income statistic corrects for the income made by American abroad and the income earned by foreign owned resources here in the United States. We subtract the net foreign factor income from national income as a step to calculate GDP. [break]
Consumption of Fixed Capital
Nothing lasts forever. This is especially true with capital resources; everything has a useful lifespan before it becomes obsolete or broken beyond repair and needs to be replaced. One well known accounting principle is that the cost of capital must be allocated across its useful lifespan, not when the capital was purchased. The concept of allocating the cost of capital throughout its life is called depreciation. We do this to keep profits a bit more accurate and relevant. By accounting for depreciation throughout the years rather than all at once, profits aren’t understated when the capital is purchased and aren’t overstated in the following years.
Businesses and the government set aside money specifically for the upkeep and replacement of capital The money that is spent here is part of the overall GDP, but it isn’t found anywhere in national income so it needs to be added in.[break]
Like I said at the beginning, in a perfect word, the different methods used to calculate GDP would all result in the same number, but that’s hardly ever the case. To get the value of GDP that’s calculated from the income approach to match the number calculated from the expenditures approach, accountants add a “statistical discrepancy,” which is nothing more than the difference in value between the two approaches.
And with that, we have GDP via the income approach. Easy right? (Not really.) It helps to take a look at some numerical examples, which I’ll post up later.
Compensation of Employees plus Rents plus Interest plus Proprietors Income plus Corporate Profits plus Taxes on Production and Imports equals National Income
National Income less Net Foreign Factor Income plus Consumption of Fixed Capital plus Statistical Discrepancy equals Gross Domestic Product
Next economics post: Calculating GDP: Expenditures Approach
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