Worked example 7 — Climbing the national income ladder, aggregate by aggregate

Examiners set this topic by definition and by formula. The safest way to hold nine aggregates in the head is not to memorise nine sentences but to compute one worked example from top to bottom, so that each aggregate is remembered as the previous one, adjusted by one item. That is what follows.

A continuous flow of production, income and expenditure is known as the circular flow of income. It is circular because it has neither any beginning nor an end. Households supply land, labour, capital and enterprise; the business sector makes payments in the form of rent, wages, interest and profits; households spend that income on consumption; the business sector supplies the goods and receives the income back. The expenditure of one sector becomes the income of the other.

Because the flow is circular, the same total can be measured at three points on the circle, which gives the identity on which all national accounting rests:

National Product = National Income = National Expenditure

That is why the three methods of measuring GDP must yield the same result, and it is the first sentence of any answer on measurement.

Illustrative figures. Units: crore rupees. Not data.

(a) Expenditure method. GDP at market prices = C + I + G + (X – M).

| Item | Amount | |---|---| | Private consumption expenditure, C | 6,000 | | Investment, including inventories, I | 3,000 | | Government expenditure on final goods and services, G | 1,000 | | Exports, X | 2,100 | | less Imports, M | (2,100) | | GDP at market prices | 10,000 |

Note that net exports may be positive or negative; here they cancel, which keeps the arithmetic clean.

(b) Income method. GDP is the sum of all factor incomes: wages and salaries (compensation of employees) + rent + interest + profit.

| Factor payment | Amount | |---|---| | Compensation of employees | 5,200 | | Rent | 700 | | Interest | 900 | | Profit | 1,400 | | Sub-total, factor incomes = GDP at factor cost | 8,200 | | add Indirect taxes | 2,000 | | less Subsidies | (200) | | GDP at market prices | 10,000 |

The bridge between the two totals is the net indirect tax of 1,800. Factor incomes are what producers received; market prices are what buyers paid; the difference is the tax wedge, which is also the difference between GVA and GDP in worked example 6.

(c) Product, or value added, method. Add the value of all goods and services produced in the different industries during the year. In India the items included are agriculture and allied services; mining; manufacturing, construction, electricity, gas and water supply; transport, communication and trade; banking and insurance, real estate and ownership of dwellings and business services; and public administration and defence and other services. It is the sum of gross value added — and by the identity of step 1 it must also come to 10,000 at market prices.

Three routes, one number. If a question gives you data on two of the three routes, use the third as a check.

Now walk down and across. Same illustrative figures; add depreciation of 800 and net factor income from abroad of –200, meaning residents pay out more than they receive.

| Aggregate | Identity | Working | Result | |---|---|---|---| | GDP at market prices | C + I + G + (X – M) | from step 2 | 10,000 | | GDP at factor cost | market prices – indirect taxes + subsidies | 10,000 – 2,000 + 200 | 8,200 | | Net Domestic Product | GDP at factor cost – depreciation | 8,200 – 800 | 7,400 | | Gross National Product | GDP + net income from abroad | 10,000 + (–200) | 9,800 | | Net National Product at market prices | GNP – depreciation | 9,800 – 800 | 9,000 | | NNP at factor cost = National Income | NNP at market prices – indirect taxes + subsidies | 9,000 – 2,000 + 200 | 7,200 |

Four remarks, each of which is a mark.

Domestic against national is a question of who, not where. GDP counts what is produced inside the territory; GNP counts what is produced by the nation's residents wherever they are. Here net income from abroad is negative, so GNP is below GDP — the country pays out more factor income than it earns. That is the same primary income item that appears as a debit in the balance of payments in Module 4.

Gross against net is depreciation. Some of a country's capital equipment wears out or becomes obsolete each year; the value of this capital consumption is deducted. Depreciation appears exactly twice in the table above and nowhere else.

Market prices against factor cost is the tax wedge. Indirect taxes deducted, subsidies added. It also appears exactly twice.

NNP at factor cost is National Income. That is the aggregate the phrase national income properly denotes, and the one Marshall, Pigou and Fisher were defining.

Three further steps take the aggregate down to what a family can actually spend.

| Aggregate | Identity | Working | Result | |---|---|---|---| | Personal income | Private income – undistributed corporate profits – profit taxes | 7,600 – 300 – 500 | 6,800 | | Disposable income | Personal income – direct taxes | 6,800 – 900 | 5,900 | | Per capita income | National income ÷ population | 7,200 ÷ 120 (crore persons) | 60 per head |

The private income figure of 7,600 and the population of 120 are invented for the arithmetic.

Personal income is never equal to national income, and the reason is worth stating rather than asserting: it excludes undistributed corporate profits, which are earned by the economy but not received by anyone personally, and it adds transfer payments, which are received personally but earned by nobody. It is the total income received by individuals from all sources before payment of direct taxes.

Disposable income is the actual income which can be spent on consumption by individuals and families — and not all of it is spent; part is saved. That saving is the S in the absorption identity of Module 4.

Per capita income is obtained by dividing national income by the population of that year, and is computed at both current and constant prices. It lets us know the average income and the standard of living.

But only on average. Where income is unequally distributed, the income of the common man is lower than the per capita income.

That single sentence is the reason poverty is measured separately, by consumption expenditure surveys and a poverty line, rather than being read off a per capita figure — which is the subject of worked example 9. An answer that computes per capita income without stating this limitation has done the arithmetic and missed the economics.

Two further cautions belong to any answer using an aggregate.

Nominal or real. Measured at current prices it is nominal GDP; measured at the fixed prices of some base year it is GDP at constant prices, or real GDP. This distinction is what stops a country claiming growth that is only inflation. Every share and every growth rate must be labelled one or the other.

Advance, provisional, revised. Indian national income figures come in stages — advance estimates, then provisional, then revised. Never present an advance estimate as a settled fact.

The Expert Group convened for green national accounting in India rejected the phrase Green GDP as an utter misnomer, and its reasoning is the natural close to this example. Start from net domestic product as GDP minus the depreciation of capital assets, then widen depreciation to include the loss of human capital and the physical depletion and quality degradation of natural capital. Once depreciation is understood that widely, the object of interest is no longer a gross figure at all but net investment, and development is sustained if and only if aggregate net investment per capita is positive — meaning the social value of the change in per capita stocks of assets. Attaching the word green to a gross product measure therefore describes something that does not exist.

The ladder above computes six of the seven rungs by adding and subtracting depreciation and taxes. The Expert Group's point is that the depreciation line is far too narrow, and that correcting it changes the whole object of measurement from a flow of product to a change in wealth.

Every rupee figure above is invented for the exercise. The current Indian aggregates are not stated here — where a current figure is needed, use the sector shares in the chapter on structural change in the Indian economy and say which estimate stage they belong to. The identities, definitions and the three measurement methods are sourced and may be quoted.

1. National Product = National Income = National Expenditure, because the flow is circular — hence three methods, one answer.
2. GDP at market prices = C + I + G + (X – M); income method = wages + rent + interest + profit; product method = sum of gross value added.
3. Two adjustments do all the work: depreciation (gross → net) and indirect taxes less subsidies (market prices → factor cost).
4. GNP = GDP + net income from abroad. NDP = GDP at factor cost – depreciation. NNP = GNP – depreciation. NNP at factor cost = National Income.
5. Personal income = private income – undistributed corporate profits – profit taxes. Disposable income = personal income – direct taxes. Per capita income = national income ÷ population — and where income is unequal the common man's income is below it.