CHAPTER 7 CONCEPT OF NATIONAL INCOME

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1 CHAPTER 7 CONCEPT OF NATIONAL INCOME 171

2 172

3 NATIONAL INCOME s CIRCULAR FLOW The concept of circular flow of national income involves two principles. In every economic exchange, the seller receives exactly the same amount that the buyer spends. Goods and services flow in one direction and money payments flow in the other. Households provide factors of production to the businesses, which in turn make payments to the households in the form of wages, rents, interest and profits etc. Households spend their income on the purchase of goods and services and make payments to the businesses, which in return supply final goods and services to the households. This whole process is called Circular Flow of National Income. Circular flow of income (counter clock wise) is from households to businesses and back again from businesses to households, it is an endless circular flow. National Income is the money value of all goods and services of a country produced in a period of one year. 1. Expenditure Approach. 2. Income Approach. 3. Value added approach. MEASUREMENT OF NATIONAL INCOME 1. EXPENDITURE APPROACH It is also known as GDP at market price. The equation is = C + I + G + X m. In order to increase the GDP government should increase expenditure on any or all the above variables and should try its best to improve the balance of payments position. Prices of goods and services are changed due to indirect taxes (sales tax, custom duties on the goods) and also by expenditure on subsidies by the government provided on fertilizers, supply of petroleum etc. Therefore GDP at market prices is converted into GDP at factor cost. Expenditure at market prices = Expenses of buyers on goods and services. Expenditure at factor cost=expenditure at market prices indirect taxes +subsidies GNP= GDP at factor cost + income from assets/property located abroad. NNP or Net National Product or National Income = GNP depreciation. 2. INCOME APPROACH It is also known as GDP at factor cost. The equation is = 1. Income from employment (wages before deducting tax) 2. Income from self-employment (before deducting tax) 3. Profits of the companies (before deducting tax) 173

4 4. Rent including rent of self owned house 5. Interest earned by individuals and firms 6. Employers national insurance contributions 7. Minus appreciation of value of stock 8. Pensions, Social security payments, services performed without monetary gain are not included/counted. 3. VALUE ADDED (OUTPUT) APPROACH In order to avoid double counting, we should add the value added at each stage of production process. In this method following are added. 1. Agriculture 2. Mining 3. Manufacturing, 4. Construction, 5. Transport and communication 6. Electricity, gas and water supply, 7. Wholesale and retail trade, hotels 8. Financial, real estate and business services 9. Defense, education, health, social work and other services GROSS DOMESTIC PRODUCT (GDP) It measures the value of output of final goods and services produced by the factors of production in one year s time within nation s borders, whether these resources are citizen-supplied or foreign-supplied. Output of Lever Brothers, Procter & Gamble, ICI etc, are included in the GDP of Pakistan but profits of these companies, if remitted from Pakistan, are included in the GNP of their respective countries. It means that with the efforts of these foreign companies GDP of Pakistan will increase whereas GNP of their countries will increase. Likewise Services/salaries of Pakistanis working in foreign countries such as in Saudi Arabia are included in the GDP of Saudi Arabia but the amounts of their salaries if remitted to Pakistan are included in the GNP of Pakistan. The GDP is the measure of all final goods and services produced in one year. However there are many more transactions occur which have nothing to do with final goods and services produced. These are financial transactions, transfer of the ownership of used goods, as well as other transactions, which are not be included in the measurement of GDP. GROSS NATIONAL PRODUCT (GNP) It measures the value of output of final goods and services produced by the factors of production within a period of one year, owned by a nation s 174

5 residents, even when the production takes place outside the national borders. It includes the net factor income from abroad. While calculating GNP, income from the business operations, which are owned by the citizens of domestic country but are setup and operating in foreign counties, is included, for example profits of these Pakistani citizens owned factories/business operating in Dubai, UK or Africa when sent to Pakistan will be included in the GNP of Pakistan. But the salary and wages paid to the nationals of these countries will be included in the GDP of countries where these factories/business are located. ITEMS, WHICH ARE NOT INCLUDED WHILE MEASURING GDP 1. BUYING AND SELLING FINANCIAL SECURITIES When you purchase a share of Rs 100 of existing stock of PIA, someone else has sold it to you, which is a transfer of ownership of rights. No producing activity is done. Therefore the transaction of Rs.00 will not be included in GDP. However the rupee value of the services of stockbroker will be included. 2. GOVERNMENT TRANSFER PAYMENTS Transfer payments are payments for which no productive services are provided in exchange, such as social security benefits, old age payments and unemployment allowance, and pensions etc. Since the recipients contribute nothing to current production in return, therefore to include such payments in GDP would be to overstate the year s output. Hence these payments are not included in GDP. 3. PRIVATE TRANSFER PAYMENTS The value of pocket money, stipends, gifts, donations etc. is not included in GDP, such payments produce no output, and this is merely a transfer of funds from one individual to another. 4. TRANSFER/SALE OF USED GOODS With the sell of used goods (sell of old television) no productive activity is performed. Second hand sales contribute nothing to current production and for that reason are excluded from the GDP. It is simply a transfer of the ownership of item from one person to another. The original purchase price was included in the GDP of that year when it was purchased. However the value added by the broker for its sell is counted in GDP. 5. HOUSEHOLD PRODUCTION Home cleaning, childcare and other tasks performed by homemakers (husband or wife) within their own houses for which they are not paid through the marketplace are not included in GDP. It may be due to some practical reasons. 175

6 6 LEGAL UNDERGROUND TRANSACTIONS Transactions that are legal (for example all those small shopkeepers buying and selling activities and home made goods) but not reported to the government and hence not taxed are not included in GDP. 7. ILLEGAL UNDERGROUND ACTIVITIES Illegal gambling and sale of illicit drugs smuggling etc. are not included in GDP. 1. MEASUREMENT OF G.D.P. BY EXPENDITURES APPROACH Expenditures approach Rs in billions Formula:- GDP = C + I + G + ( X m ) 1 Consumption expenditures by households C Private domestic investment I Government purchases G Net exports (exports - imports) X-m (-) Gross Domestic Product GDP 10,446 Following separate components of expenditures are added together: - 1. CONSUMPTION EXPENDITURE (C) This includes all expenditures by households on durable consumers goods (automobiles, refrigerators, video recorders), non-durable consumer goods (bread, milk vitamins, pencils, toothpaste) and consumer expenditures for services (of lawyers, doctors, barbers, and mechanics) etc. the expenditure on the house-rent, whether we live in a rented house or in an owned house. It means rent of the self-owned house which is called Imputed rent is also added in GDP. 2. PRIVATE INVESTMENT EXPENDITURE It includes fixed investment in plant and machinery and inventory investment, which consist of all finished goods on hand, goods in process and raw materials. It also includes new residential structures because aparment buildings and houses, like factories and stores earn income when they are rented or leased. Owner-occupied houses are treated as investment goods because they could be rented to bring in an income return. Finally increases in inventories (unsold goods) are considered to be investment because they represent, in effect, unconsumed. 3. GOVERNMENT EXPENDITURE (G) Government expenditures have two components firstly, expenditures for goods and services that government consumes in providing public services 176

7 and secondly expenditures for social capital such as schools and highways which have long life times. Government expenditures do not include government transfer payments because they do no generate any productive activity. 4. FOREIGN EXPENDITURE ( X M ) In order to get net expenditures from the foreign sector, the value of imports are subtracted from the value of exports in order to get net exports for a year. The net exports are equal to total exports minus total imports. 2. MEASUREMENT OF NDP FROM GDP Net Domestic Product Rs in billions Formula: - NDP = GDP - Depreciation 1 Gross domestic product GDP 10,446 2 Depreciation Dep (-) 1,393 Net Domestic Product NDP 9,053 NDP As a measure of total output, GDP does not make allowances for replacing the capital goods used up in each year s production. As a result, it does not tell us how much new output was available for consumption and for additions to the stock of capital. To determine that, we must subtract from GDP the capital that was consumed in producing the GDP and which had to be replaced. That is, we need to subtract depreciation from GDP. The result is the measure of net domestic product (NDP). NDP is simply GDP adjusted for depreciation. It measures the total annual output that the entire economy, households, businesses, government and foreigners, can consume without impairing its capacity to produce in ensuing years. 3. MEASUREMENT OF NATIONAL INCOME FROM NDP National income from NDP In Billion Rs. 1 Net domestic product NDP 9,053 2 Net foreign factor income earned (-) 10 3 Indirect business taxes (sales tax) (-) National income N.I. 8,348 Sometimes it is useful to know how much Pakistanis earned for their contributions of land, labor, capital and entrepreneurial skills. The Pakistan s national Income (N.I) includes all income earned through the use of Pakistani-owned resources whether they are located at home or abroad. To derive national income from NDP, we must make two adjustments. 177

8 1. SUBTRACT NET FOREIGN FACTOR INCOME FROM NDP Net foreign factor income is factor (resource) income earned by foreigners in Pakistan in excess of factor income earned by Pakistani abroad. Since foreigners earn this income it is not included in Pakistan s national income 2. SUBTRACT INDIRECT BUSINESS TAXES FROM NDP Because government is not an economic resource, the indirect business taxes it collects do not qualify as payments to productive resources and thus are not included in national income. We can calculate National Income (8,348) through the income approach by simply adding up employee compensation, rent, interest, proprietor s income and corporate profit. 4. PERSONAL INCOME ( P.I ) FROM NATIONAL INCOME Personal income from national income In Billion Rs. 1 National income 8,348 2 Social security contributions Corporate income tax Undistributed corporate profits Transfer payments + 1,683 6 Personal Income 8,929 Personal income includes all income received whether earned or unearned. It is likely to differ from national income (income earned) because though some income earned such as Social Security taxes (Pay roll taxes), corporate income taxes and undistributed corporate profits---is not received by households. Conversely, some income is received, such as social security payments, unemployment compensation payments, welfare payments, and disability and education payments to veterans and private pension payments though it is not earned. These transfer payments must be added to obtain Personal Income. In moving from national income to personal income we must subtract the income that is earned but not received and add the income that is received but not earned. 7. DISPOSABLE INCOME FROM PERSONAL INCOME DISPOSABLE INCOME FROM In Billion Rs. PERSONAL INCOME 1 Personal Income 8,929 2 Personal taxes - 1,113 3 Disposable income 7,

9 Disposable income is personal income less personal taxes. Personal taxes include personal income taxes, personal property taxes and inheritance taxes. Disposable income is the amount of income that households have left over after paying their personal taxes. They are free to divide that income between consumption and saving 8. DISTRIBUTION OF DISPOSAL PERSONAL INCOME INTO CONSUMPTION AND SAVINGS Formula = D. I. = C + S = 7,876 = 5, ,000 Distribution of disposal personal income into In Billion Rs consumption and savings Disposal income 7,876 Consumption 5,867 Savings 2, NNP or National income at market price = GNP- depreciation 2. National income at factor cost = NNP - indirect taxes plus subsidies 3. Personal income = National income social security contributions corporate Income taxes undistributed corporate profits + transfer payments. 4. Disposable personal income = PI income tax. 5. Disposable personal income = Consumption + savings. 6. GDP does not include transactions that do not officially pass through the market 7. The ups and downs in real GNP are called trade cycles. 8. GNP at factor cost is to subtract taxes and add subsidies. 9. GNP minus foreign remittance is equal to GDP. 10. GNP can be calculated by subtracting foreign remittances from the GNP. 11. Market value of all final goods and services produced annually with the domestic resources is called GDP. 12. GDP is the most comprehensive measure of a nations production of goods and services. 13. To convert nominal GNP, we deflate, dividing by GDP deflator. 14. Net national product is arrived by subtracting depreciation from GDP. 15. To avoid double counting in the estimation of GDP, we calculate value added a stage of production. GDP does not include the figures of intermediate goods 179

10 FROM NATIONAL INCOME UP TO PERSONAL DISPOSABLE INCOME (1) Expenditures approach Rs in billions Formula: - GDP = C + I + G + (X m) 1 Consumption expenditures C Gross private domestic investment I Government purchases G Net exports (exports - imports) X-m (-) Gross Domestic Product GDP 1 0,446 (2) Net Domestic Product from GDP Formula:- NDP = GDP - Depreciation 1 Gross domestic product GDP 10,446 2 Depreciation Dep (-) 1,393 3 Net domestic product NDP 9,053 (3) National Income from NDP 1 Net domestic product NDP 9,053 2 Net foreign factor income earned (-) 10 3 Indirect business taxes (sales taxes) (-) National income N.I. 8,348 (4) Personal Income from National Income 1 National income N.I. 8,348 2 Social security contributions (-) Corporate income tax (-) MEASUREMENT Undistributed corporate OF G.D.P. profits BY INCOME APPROACH (-) Transfer payments (+) 1,683 6 Personal Income P.I. 8,929 (5) Disposable Income from Personal income 1 Personal Income 8,929 2 Personal taxes (-) 1,113 3 Disposable income D.I. 7,876 (6) Division of Disposal income 7,876 Consumption C 5,867 Savings S 2,

11 2. MEASUREMENT OF G.D.P. BY INCOME APPROACH Income approach Rs in billions 1 Wages/compensations of employees Rents Interest Proprietors income (from S.4 to 7 is profit) Corporate income taxes Dividends Undistributed corporate profits 141 National Income Indirect business taxes (sales tax) Depreciation Net foreign factor income earned in Pakistan + 10 Gross Domestic Product GDP 10, WAGES /COMPENSATION OF EMPLOYEES The above table shows that the largest share of national income was paid as wages and salaries by business and government to their employees. This figure also includes payments by employers into social security, pension, health and welfare funds for workers. 2. RENTS Rents consist of the income received by the households and businesses that supply property resources. They include the monthly payments tenants make to landlords and the lease payments companies pay for the use of office space. The figure used is net rent that is gross rental income minus depreciation of the rental property. 3. INTEREST Interest consists of the money paid by private businesses to the suppliers of money capital. It also includes such items as the interest households receive on savings deposits, certificates of deposit and corporate bonds. 4. PROPRIETOR S INCOME Proprietors income consists of the net income of sole proprietorships, partnerships and other unincorporated businesses and corporate profits Proprietors income flows to the proprietors. 181

12 5. CORPORATE PROFITS Corporate profits means profits of registered limited companies. Corporate profits are the earnings of owners of companies. These profits are divided into three categories; - (a) Corporate income taxes. These taxes are levied on corporation s net earnings and flow to the government. (b) Dividends, These are the part of corporate profits that are paid to the company s shareholders and thus flow to households. (c) Undistributed corporate profits: These are monies saved by the companies to be invested later in new plants and equipment. They are also called retained earnings. FROM NATIONAL INCOME TO GDP National Income Indirect business taxes (sales tax) Depreciation Net foreign factor income earned in Pakistan + 10 Gross Domestic Product GDP 10,446 The national income accountants add together employee compensation, rents, interests, proprietor s income and company profits and get national income. that is all the income that flows to Pakistani-supplied resources, whether resources/factors of production are here in Pakistan or abroad. But the figure for national income shown by income approach is Rs.8348 billion, which is less than GDP of Rs billion shown by expenditure method. Account is balanced by adding following three items to national income. 1. INDIRECT BUSINESS TAXES These are general sales taxes, excise taxes, business property taxes, license fees and customs duties. Why do we add indirect business taxes to national income as a way of balancing expenditures and income? Assume that a firm produces a product that sells for Rs.100.The production and sale of that product create Rs.100 of wage, rent, interest and profit income. But now the governments imposes a 5 percent sales tax on all products sold at retail. The retailer adds the tax to the price of the product and shifts it along to consumers and this become part of consumption expenditures. But Rs.5 is clearly not earned income because the government contributes nothing to the production of the product in return for it. Only Rs.100 of what 182

13 consumers pay goes out as wage, rent, interest and profit income. So the national income accountants need to add the Rs.5 to the Rs.100 of national income in calculating GDP and make the same adjustment for the entire economy. 2. DEPRECIATION OR CONSUMPTION OF FIXED CAPITAL The useful lives of private capital equipment (such as bakery ovens and car assembly plants) extend far beyond the year in which they are produced. To avoid understating profit and income in the year of purchase and to avoid overstating profit and income in succeeding years, the cost of such capital must be allocated over its lifetime. The amount allocated is an estimate of how much of the capital is being used up each year. It is called depreciation. The depreciation allowance results in a more accurate statement of profit and income for the economy each year. Social capital such as Court Buildings and bridges also require a depreciation allowance in the national income accounts. The huge depreciation charge made against private and social capital each year is called consumption of fixed capital because it is the allowance for capital that has been consumed in producing the year s GDP. It is the portion of GDP that is set aside to pay for the ultimate replacement of those capital goods. The money allocated to consumption of fixed capital (the depreciation allowance) is a cost of production and thus included in the gross value of output. But this money is not available for other purposes, and, unlike other costs of production, it does not add to anyone s income. So it is not included in national income. We must therefore add it to national income to achieve balance with the economy s expenditure. 4. NET FOREIGN FACTOR INCOME National income is the total income of Pakistanis, whether it was earned in Pakistan, or abroad. But GDP is a measure of domestic output total output produced within Pakistan regardless of the nationality of those who provide the resources. So in moving from national income to GDP, we must consider the income Pakistanis gain from supplying Pakistanis resources abroad and the income foreigner s gain by supplying their resources in Pakistan. In the above table, foreign-owned resources earned Rs.10 billion more in Pakistan than Pakistani-owned resources earned abroad. That different is called net foreign factor income. For that reason it is not included in Pakistan s national income. We must add it to national income in determining the value of Pakistan s domestic output (output produced within the Pakistani borders) 183

14 NOMINAL GDP VERSUS REAL GDP Gross Domestic Product is a measure of the market or money value of all final goods and services produced by the economy in a given year. We use money in order to sum that too many heterogeneous output into a meaning full total. But that creates problem. How can we compare the market values of GDP fro year to year if the value of money itself changes in response to GDP m=by multiplying total output by market prices. The way around this problem is to deflate GDP when prices rise and to inflate GDP when prices fall. These adjustments give us a measure of GDP for various years as if the value of the rupee had always been the same as it was in some reference year. A GDP based on the prices that prevailed when the output was produced is called Nominal GDP. A GDP that has been deflated or inflated to reflect changes in the price level is called Real GDP. NOMINAL GDP VERSUS REAL GDP (At constant price and Current price) Year Nominal GDP As per Current prices (In billions) Price Index, Base year, 1987=100 Real GDP As per constant prices of 1987 Column 2 divided by column 3,Multiplied by 100 (In billions) 1985 Rs Rs Rs Rs Rs Rs Rs Rs Rs Rs Rs Rs Far from reality Very close to reality/factual position. GDP PRICE INDEX It is a measure of the price of a specified collections of goods and services, called a market basket, in a given year as compared to the price of an identical collection of goods and services in a reference year. That point of reference is known as the base period or base year. By convention the price ratio between a given year and the base year is multiplied by 100 to facilitate computation. For example, a price of 2/1 (=2) is expressed as price index of 200. A price ratio of 1/3 (=33) is expressed as price index of 33. To correct GDP for price changes we first have to pick up a price index (which is GDP deflator) with a specific year as its base year. Column 4 in the above table shows the real GDP position because it has been calculated keeping in view the changes in the price level from the base year In 184

15 the base year 1987 general prices were neither too high nor too low. In the year 1990 it seems that national income/gross domestic product has increased as high as Rs.180 billions but the fact is not so, this amount is an inflated amount because of high level of prices in the year There is an increase in the price by 13.2 percent. If we ignore this price increase then national income comes to Rs billions only. Money national income is a misleading indicator of economic growth, For the growth rate to be calculated, money national income of each year, expressed in current prices of that year, must be deflated to show real income in the constant prices of a single year. An index number, such as the Retail Price Index, used to deflate GNP to constant prices is known as GNP deflator. Formula for measuring Real GDP = Nominal GDP x 100 Price Index IMPORTANCE OF NATIONAL INCOME STATISTICS IMPORTANCE OF NATIONAL INCOME STATISTICS 1 National income statistics are the main source of data on what has Happened and what is happening in the economy. 2 These are frequently used as indicators of economic growth and economic and social welfare development 3 These are used for the comparison with other countries economic position 4 This shows as to which sector of the economy is progressing and which one is lagging behind, so that appropriate action and policies may be adopted for its improvement 5 This data helps in calculating the per capita income and standard of living of people. 6 These help to check and control the downward swings of trade cycles 7 National income estimates indicate the distribution of national income among different income groups of the society, such as landlords capitalists and workers. DIFFICULTIES & PROBLEMS IN THE MEASUREMENT OF GDP 1. NON-MARKET ACTIVITIES Certain productive activities do not take place in any market for example services of housewives, and the labor of carpenters who repair their own homes. Such activities never show up in GDP. Consequently GDP understates a nation s total output. 185

16 2. IMPROVED PRODUCT QUALITY GDP is a quantitative measure rather than a qualitative measure; it fails to take into account the value of improvements in product quality. There is a very real difference in quality between a Rs 20,000 personal computer with monitor purchased today and a computer that cost the same amount just 10 years ago. Obviously quality improvement has a great effect on economic well being, as does the quantity of goods produced. The vast majority of such improvement for the entire range of goods and services does not get reflected in GDP. 3. THE UNDERGROUND ECONOMY In the economy some of the people who conduct business are gamblers, smugglers, drug growers and drug dealers. They have good reason to conceal their incomes. Most people in the underground economy are engaged in perfectly legal activities but choose not to report their full incomes to the Government. Storekeepers may report only a portion of their sales receipts. Workers who want to hold on to their unemployment compensation benefits may take an off-the-books job. A brick mason may agree to rebuild a neighbor s fireplace in exchange for the neighbor s repairing his boat engine. 4. Transaction carried out by barter system in villages. 5. Lack of keeping records of output due to illiteracy. 6. Inefficiency of Government s statistical departments. 7. To avoid taxes people show less production in their records.. 186

17 NATIONAL INC OME OF PAKISTAN Source: Pakistan Economic Survey EXPENDITURE APPROACH Rs. Million 1 Private Consumption expenditure 5,235,382 2 Government expenditure 512,926 3 Gross domestic fixed capital formation expenditure 999,306 4 Change in stocks (increase) 103,299 5 Export of goods and non factor services 1,001,011 7,851,924 6 Less Import of goods and non-factor services 1,304,334 (-) 7 GDP 6,547,590 8 Plus income from assets located abroad 125,224 (+) 9 GNP 6,672, Less indirect taxes 501,470 (-) 6,171, Plus subsidies 83,556 ( + ) 12 GNP at factor cost 6,254,900 Source: Pakistan Economic Survey FORMULA OF MEASURING NATIONAL INCOME GDP at market price = C + G + I + Change in stocks + X m 5,235, , , , ,001,011-1,304,334 = 6,547,590 GNP at market price = GDP + income from assets located abroad GNP at factor cost = 6,547, ,224 = 6,672,814 = GNP at market price indirect taxes + subsidies = 6,672, , ,556 = 6,254,900 National Income at factor cost or NNP = GNP at factor cost - depreciation = 6,254,900 54,900 = 6,200,

18 NATIONAL INCOME OF PAKISTAN Source: Pakistan Economic Survey VALUE ADDED (OUTPUT) APPROACH Rs. Million 1 Agriculture 1,322,641 2 Mining & quarrying 121,836 3 Manufacturing 1,118,391 4 Construction 143,936 5 Electricity & gas distribution 156,301 6 Transport, storage and communication 902,247 7 Wholesale and retail trade 1,107,296 8 Finance and insurance 210,683 9 Ownership of dwellings 165, Public administration and defense 337, Services 543,349 GDP at factor cost 6,129,676 Indirect taxes (sales tax) + 501,470 Subsidy - 83,556 GDP at market price 6,547,590 GDP at factor cost 6,129,676 Net factor income from abroad + 125,224 GNP at factor cost 6,254,900 GDP at market price 6,547,590 Net factor income from abroad + 125,224 GNP at market price 6,672,

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