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6.2: Measuring Total Income

  • Page ID
    17239
  • Learning Objectives

    1. Define gross domestic income and explain its relationship to gross domestic product.
    2. Discuss the components of gross domestic income.
    3. 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) 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 third quarter of 2011, employee compensation represented 55% 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 2011, the share of benefits was nearly 20% 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 about 17% of GDI in 2011, down sharply from five decades earlier, when profits represented about 25% of the income generated in GDI.[1]

    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 3%); 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.[2]

    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 businesses, because homeowners are treated as businesses in the income accounts. In 2011, net interest accounted for about 5% 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. Depreciation 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 2011.

    Indirect Taxes

    The final component of the income measure of GDI is indirect business taxes.[3] Indirect taxes are taxes imposed on the production or sale of goods and services or on other business activity. (By contrast, a direct tax 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 nearly 8% of GDI in 2011.

    Table 6.2 “GDP and GDI, 2011” shows the components of GDI in the third quarter of 2011. 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 6.2 “GDP and GDI, 2011”. Some of the difficulties with these data are examined in the Case in Point feature on discrepancies between GDP and GDI.

    Table 6.2 GDP and GDI, 2011

    Gross domestic product $15,176.1 Gross domestic income $15,214.8
    Personal consumption expenditures $10,784.5 Compensation of employees 8,347.3
    Gross private domestic investment $1,906.6 Profits[4] 2,633.0
    Government consumption expenditures and gross investment $3,047.3 Rental income of persons 406.3
    Net exports of goods and services −$562.3 Net interest 710.3
    Taxes on production and imports[5] 1,155.1
    Consumption of fixed capital (depreciation) 1,962.8
    Statistical discrepancy −38.7

    The table shows the composition of GDP and GDI in the third quarter of 2011 (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.)

    Source: Bureau of Economic Analysis, National Income and Product Accounts, Tables 1.10 and 1.1.5 (revised February 29, 2012).