6.2 Measuring Total Income

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 (Y) 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 (or Y). 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 (or Y), 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 (or Y) 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 (or Y)

Employee compensation is the largest among the components of factor income (called ‘wages and salaries’). Factor income also includes profit (the payment to entrepreneurs), rent (the payment to natural resources), and interest (the payment to capital). In addition, GDI (or Y) 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 (or Y). We will discuss each of these components of GDI (or Y) 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 approximately 57% of GDI (or Y).

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 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 16% of GDI, or $2,332.2 billion in 2010, down sharply from five decades earlier, when profits represented about 25% of the income generated in GDI1.

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 (about 2%); 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 resource2.

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 2010 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. 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 2008.

Indirect Taxes

The final component of the income measure of GDI is indirect business taxes3Indirect 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 7.7% of GDI in 2010.

Table 6.2 “GDP and GDI (or Y), 2010” shows the components of GDI (or Y) in 2010. 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 (or Y) 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, 2010”. 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 (or Y), 2010, USA

Gross domestic product $14,750.2 Gross Domestic Income $14,584.8
Personal Consumption Expenditures 10,383.6 Compensation of Employees 8,040.8
Gross Private Domestic Investment 1,895.3 Profits4 2,332.3
Government consumption expenditures and gross investment 3,023.5 Rental income of persons 304.7
Net exports of goods and services – 552.2 Net interest 913.9
Taxes on production and imports5 1,121.0
Consumption of fixed capital (depreciation) 1872.1
Statistical discrepancy 165.4

The table shows the composition of GDP and GDI in the third quarter of 2010 (in billions of dollars at an annual rate) for the USA. 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.)

Key Takeaways

  • Gross domestic product, GDP, equals gross domestic income, GDI (or Y), 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 (or Y) 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

A simplifying assumption can be made for the purposes of this course. That is, to simplify, one can think of indirect taxes and depreciation as technical adjustments to reconcile the expenditure approach to measuring GDP with the Income Approach to measuring GDP. Simplifying allows us to see the Income Approach as the sum of the factor payments:

                                                                         Y = W + R + i + π

Answer to Try It! Problem

GDI (or Y) 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.

1Although reported separately by the Department of Finance, we have combined proprietors’ income (typically independent business owners and farmers) with corporate profits to simplify the discussion.

2If 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.”

3The adjustment for indirect business taxes includes two other minor elements: transfer payments made by business firms and surpluses or deficits of government enterprises.

4Profit is corporate profit ($1,274.7) plus proprietors’ income ($1,057.6), both with inventory valuation and capital consumption adjustment.

5Indirect taxes include taxes on production and imports of $1,060.6 plus business transfer payments ($133.1) less subsidies ($58.5) and current surplus of government enterprise ($14.1). 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.” 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.

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