Measuring Total Income

21.2 Measuring Total Income

Learning Objectives

Define gross domestic income and explain its relationship to gross domestic product.
Discuss the components of gross domestic income.
Define disposable personal income and explain how to calculate it from GDP.

We saw in the last section that the production of goods and services generates factor incomes to households. The production of a given value of goods and services generates an equal value of total income. Gross domestic income (GDI)The total income generated in an economy by the production of final goods and services during a particular period. equals the total income generated in an economy by the production of final goods and services during a particular period. It is a flow variable. Because an economy’s total output equals the total income generated in producing that output, GDP = GDI. We can estimate GDP either by measuring total output or by measuring total income.

Consider a $4 box of Cheerios. It is part of total output and thus is part of GDP. Who gets the $4? Part of the answer to that question can be found by looking at the cereal box. Cheerios are made from oat flour, wheat starch, sugar, salt, and a variety of vitamins and minerals. Therefore, part of the $4 goes to the farmers who grew the oats, the wheat, and the beets or cane from which the sugar was extracted. Workers and machines at General Mills combined the ingredients, crafted all those little O’s, toasted them, and put them in a box. The workers were paid part of the $4 as wages. The owners of General Mills and the capital it used received part of the $4 as profit. The box containing the Cheerios was made from a tree, so a lumber company somewhere received part of the $4. The truck driver who brought the box of cereal to the grocery store got part of the $4, as did the owner of the truck itself and the owner of the oil that fueled the truck. The clerk who rang up the sale at the grocery store was paid part of the $4. And so on.

How much of the $4 was income generated in the production of the Cheerios? The answer is simple: all of it. Some of the money went to workers as wages. Some went to owners of the capital and natural resources used to produce it. Profits generated along the way went to the owners of the firms involved. All these items represent costs of producing the Cheerios and also represent income to households.

Part of the $4 cost of the Cheerios, while it makes up a portion of GDI, does not represent ordinary income actually earned by households. That part results from two other production costs: depreciation and taxes related to the production of the Cheerios. Nevertheless, they are treated as a kind of income; we will examine their role in GDI below.

As it is with Cheerios, so it is with everything else. The value of output equals the income generated as the output is produced.

The Components of GDI

Employee compensation is the largest among the components of factor income. Factor income also includes profit, rent, and interest. In addition, GDI includes charges for depreciation and taxes associated with production. Depreciation and production-related taxes, such as sales taxes, make up part of the cost of producing goods and services and must be accounted for in estimating GDI. We will discuss each of these components of GDI next.

Employee Compensation

Compensation of employees in the form of wages, salaries, and benefits makes up the largest single component of income generated in the production of GDP. In the second quarter of 2008, employee compensation represented 57% of GDI.

The structure of employee compensation has changed dramatically in the last several decades. In 1950, virtually all employee compensation—95% of it—came in the form of wages and salaries. The remainder, about 5%, came in the form of additional benefits such as employer contributions to retirement programs and health insurance. In 2008, the share of benefits was roughly 19% of total employee compensation.

Profits

The profit component of income earned by households equals total revenues of firms less costs as measured by conventional accounting. Profits amounted to 15.6% of GDI, or $2,226.7 billion in 2008, down sharply from five decades earlier, when profits represented about 25% of the income generated in GDI.Although reported separately by the Department of Commerce, we have combined proprietors’ income (typically independent business owners and farmers) with corporate profits to simplify the discussion.

Profits are the reward the owners of firms receive for being in business. The opportunity to earn profits is the driving force behind production in a market economy.

Rental Income

Rental income, such as the income earned by owners of rental housing or payments for the rent of natural resources, is the smallest component of GDI (less than 0.5%); it is the smallest of the income flows to households. The meaning of rent in the computation of GDI is the same as its meaning in conventional usage; it is a charge for the temporary use of some capital asset or natural resource.If you have studied microeconomics, you know that the term “rent” in economics has a quite different meaning. The national income and product accounts use the accounting, not the economic, meaning of “rent.”

Net Interest

Businesses both receive and pay interest. GDI includes net interest, which equals interest paid less interest received by domestic businesses, plus interest received from foreigners less interest paid to foreigners. Interest payments on mortgage and home improvement loans are counted as interest paid by business, because homeowners are treated as businesses in the income accounts. In 2008 net interest accounted for 6.3% of GDI.

Depreciation

Over time the machinery and buildings that are used to produce goods and services wear out or become obsolete. A farmer’s tractor, for example, wears out as it is used. A technological change may make some equipment obsolete. The introduction of personal computers, for example, made the electric typewriters used by many firms obsolete. DepreciationA measure of the amount of capital that wears out or becomes obsolete during a period. is a measure of the amount of capital that wears out or becomes obsolete during a period. Depreciation is referred to in official reports as the consumption of fixed capital.

Depreciation is a cost of production, so it represents part of the price charged for goods and services. It is therefore counted as part of the income generated in the production of those goods and services. Depreciation represented about 13% of GDI in 2008.

Indirect Taxes

The final component of the income measure of GDI is indirect business taxes.The adjustment for indirect business taxes includes two other minor elements: transfer payments made by business firms and surpluses or deficits of government enterprises. Indirect taxesTaxes imposed on the production or sale of goods and services or on other business activity. are taxes imposed on the production or sale of goods and services or on other business activity. (By contrast, a direct taxTaxes imposed directly on income. is a tax imposed directly on income; the personal income and corporate income taxes are direct taxes.) Indirect taxes, which include sales and excise taxes and property taxes, make up part of the cost to firms of producing goods and services. Like depreciation, they are part of the price of those goods and services and are therefore treated as part of the income generated in their production. Indirect business taxes amounted to 7.6% of GDI in 2008.

Table 21.2 "GDP and GDI, 2008" shows the components of GDI in 2008. Employee compensation represented the largest share of GDI. The exhibit also shows the components of GDP for the same year.

In principle, GDP and GDI should be equal, but their estimated values never are, because the data come from different sources. Output data from a sample of firms are used to estimate GDP, while income data from a sample of households are used to estimate GDI. The difference is the statistical discrepancy shown in the right-hand column of Table 21.2 "GDP and GDI, 2008". Some of the difficulties with these data are examined in the Case in Point feature on discrepancies between GDP and GDI.

Table 21.2 GDP and GDI, 2008

Gross domestic product	$14,420.5	Gross Domestic Income	$14,260.0
Personal Consumption Expenditures	10,169.5	Compensation of Employees	8,089.8
Gross Private Domestic Investment	2,013.6	ProfitsProfit is corporate profit ($1,146.1) plus proprietors’ income ($1,080.6), both with inventory valuation and capital consumption adjustment.	2,226.7
Government consumption expenditures and gross investment	2,943.9	Rental income of persons	63.1
Net exports of goods and services	- 706.5	Net interest	903.8
		Taxes on production and importsIndirect taxes include taxes on production and imports of $1,042.5 plus business transfer payments ($92.8) less subsidies ($50.4) and current surplus of government enterprise ($8). Prior to the 2003 National Income and Product Accounts (NIPA) revisions, the category “taxes on production and imports” was, with some technical and other minor adjustments, referred to as “indirect business taxes.”	1,076.9
		Consumption of fixed capital (depreciation)	1,899.7
		Statistical discrepancy	160.5

The table shows the composition of GDP and GDI in the third quarter of 2008 (in billions of dollars at an annual rate). Notice the rough equality of the two measures. (They are not quite equal because of measurement errors; the difference is due to a statistical discrepancy and is reduced significantly over time as the data are revised.)

Sources: Bureau of Economic Analysis National Income and Product Accounts, Tables 1.10 and 1.1.5 (November, 2008). See Brent R. Moulton and Eugene P. Seskin, “Preview of the 2003 Comprehensive Revision of the National Income and Product Accounts,” Bureau of Economic Analysis, Survey of Current Business, June 2003, pp. 17–34.

Tracing Income from the Economy to Households

We have seen that the production of goods and services generates income for households. Thus, the value of total output equals the value of total income in an economy. But we have also seen that our measure of total income, GDI, includes such things as depreciation and indirect business taxes that are not actually received by households. Households also receive some income, such as transfer payments, that does not count as part of GDP or GDI. Because the income households actually receive plays an important role in determining their consumption, it is useful to examine the relationship between a nation’s total output and the income households actually receive.

Table 21.3 "From GDP to Disposable Personal Income" traces the path we take in going from GDP to disposable personal incomeThe income households have available to spend on goods and services., which equals the income households have available to spend on goods and services. We first convert GDP to GNP and then subtract elements of GNP that do not represent income received by households and add payments such as transfer payments that households receive but do not earn in the production of GNP. Disposable personal income is either spent for personal consumption or saved by households.

Table 21.3 From GDP to Disposable Personal Income

GDP + net factor earnings from abroad	=	gross national product (GNP)
GNP − depreciation (consumption of fixed capital)	=	net national product (NNP)
NNP − statistical discrepancy	=	national income (NI)
NI − income earned but not received [e.g., taxes on production and imports, social security payroll taxes, corporate profit taxes, and retained earnings] + transfer payments and other income received but not earned in the production of GNP	=	personal income (PI)
PI − personal income taxes	=	disposable personal income (DPI)

GDP, a measure of total output, equals GDI, the total income generated in the production of goods and services in an economy. The chart traces the path from GDP to disposable personal income, which equals the income households actually receive. We first convert GDP to GNP. Then, we subtract depreciation to obtain net national product and subtract the statistical discrepancy to arrive at national income (i.e., gross national income [GNI] net of depreciation and the statistical discrepancy). Next, we subtract components of GNP and GNI that do not represent income actually received by households, such as taxes on production and imports, corporate profit and payroll taxes (contributions to social insurance), and corporate retained earnings. We add items such as transfer payments that are income to households but are not part of GNP and GNI. The adjustments shown are the most important adjustments in going from GNP and GNI to disposable personal income; several smaller adjustments (e.g., subsidies, business current transfer payments [net], and current surplus of government enterprises) have been omitted.

Key Takeaways

Gross domestic product, GDP, equals gross domestic income, GDI, which includes compensation, profits, rental income, indirect taxes, and depreciation.
We can use GDP, a measure of total output, to compute disposable personal income, a measure of income received by households and available for them to spend.

Try It!

The following income data refer to the same economy for which you had output data in the first part of the previous Try It! Compute GDI from the data below and confirm that your result equals the GDP figure you computed in the previous Try It! Assume that GDP = GNP for this problem (that is, assume all factor incomes are earned and paid in the domestic economy).

Employee compensation	$700
Social Security payments to households	40
Welfare payments	100
Profits	200
Rental income	50
Net interest	25
Depreciation	50
Indirect taxes	175

Case in Point: The GDP–GDI Gap

Figure 21.8

GDP equals GDI; at least, that is the way it is supposed to work. But in an enormously complex economy, the measurement of these two variables inevitably goes awry. Estimates of the two are never quite equal. In recent years, the absolute value of the gap has been quite sizable. For 2007 and 2008, for example, GDI has differed from GDP by −$81.4 and $160.5 billion per year, respectively.

Although the gap seems large, it represents a remarkably small fraction of measured activity—around 1% or less. Of course, 1% of a big number is still a big number. But it is important to remember that, relative to the size of the economy, the gap between GDI and GDP is not large. The gap is listed as a “statistical discrepancy” in the Department of Commerce reporting of the two numbers.

Why does the gap exist? From an accounting point of view, it should not. The total value of final goods and services produced must be equal to the total value of income generated in that production. But output is measured from sales and inventory figures collected from just 10% of commercial establishments. Preliminary income figures are obtained from household surveys, but these represent a tiny fraction of households. More complete income data are provided by income tax returns, but these are available to the economists who estimate GDI only after a two- to four-year delay.

The Department of Commerce issues revisions of its GDP and GDI estimates as more complete data become available. With each revision, the gap between GDP and GDI estimates is significantly reduced.

While GDP and GDI figures cannot provide precise measures of economic activity, they come remarkably close. Indeed, given that the numbers come from entirely different sources, the fact that they come as close as they do provides an impressive check of the accuracy of the department’s estimates of GDP and GDI.

Answer to Try It! Problem

GDI equals $1,200. Note that this value equals the value for GDP obtained from the estimate of output in the first part of the previous Try It! Here is the computation:

Employee compensation	$700
Profits	200
Rental income	50
Net interest	25
Depreciation	50
Indirect taxes	175
GDI	$1,200

Once again, note that Social Security and welfare payments to households are transfer payments. They do not represent payments to household factors of production for current output of goods and services, and therefore are not included in GDI.