Unit 3.2 - National Income Accounting

 Concept of National Income Accounting

The national income accounting was first introduced in England in 1676. It was based on the book "Political Arithmetic" written by William Petty. It was continuously developed in 18^th and 19^th century. By  20^th century, it was properly developed. After the Second World War "Simon Kuznets" developed national income systematically. National income accounting is defined as the method or technique used in construction of national income accounts. 

Concept of National Income

The term national income is used to denote money value of the aggregate production of goods and services of a country during a specific period, usually one-year. It is used inter-changeably with national dividend, national output and national expenditure. 

Definition of National Income

According to Marshall, " the labor and capital of a country acting in its natural resources produce annually a certain net aggregate of commodities, material and immaterial including services of all kinds. This is the true net annual income or revenue of the country or national dividend". 

In this definition, the word "net" means the deduction of depreciation from gross national income. 

In the words of A. C. Pigou, "National income is that part of objective income of the community including of course income derived from abroad which can be measured in money". 

According to A. C. Pigou, a woman's service as teacher in school is included in national income but excluded when she teaches her children. 

According to Fisher, " The true national income is that part of annual net produce which is directly consumed during the year". 

But from the practical point of view, this definition is less useful as there are difficulties in getting monetary value of net consumption. 

Simon Kuznets has defined national income as, "the net output of commodities and services flowing during the year from the country's productive system in the hands of ultimate consumers". 

Feature of National 

1. Flow Concept
2. Measured in Monetary Term
3. Periodic (Usually 1 year)
4. Triple Identity (NI=NP=NE)
5. Macroeconomic Indicator

Various Concepts of National Income

In modern time, a number of concepts have come to be associated with the study of national income. These concepts have made the study of national income broad-based and comprehensive. Some of the important concept of national income are explained below:

1. Gross Domestic Product (GDP)

It is defined as the money value of final goods and services produced within the boundary of the nation during a year by all production units inclusive of indirect taxes and depreciation. Goods and services include all types of agricultural and commercial goods. In order to calculate GDP, all goods and services produced within the country are multiplied by their respective prices and summed up. 

Symbolically, 

GDP = P₁Q₁ + P₂Q₂ + P₃Q₃ + ........ + P_nQ_n

or,

Features

1. Flow Concept: GDP is calculated during a year time period not the any particular point of time. 
2. GDP include those commodities which have market value and brought in the market for sale. 
3. Measured in current market price: Base year or constant price
4. Market value of final goods: To avoid double counting
5. Whether the resources located within the country are domestically-owned or foreign-owned does not matter.
6. Exclude value of intermediate consumption
7. Exclude transfer payments (pension, allowances), capital gains, illegal income (gambling), black money (corruption), financial transactions (from share and debenture), value of second-hand goods
8. Exclude net factor income from abroad (receipt minus payment)

2. Gross National Product (GNP)

It is defined as the money value of all final goods and services produced within a nation during a year plus net factor income from abroad (NFIA). NFIA is the income earned by the domestic people living in abroad minus income earned by foreigner in domestic nation. It is assumed as a broad concept than GDP. Thus, GNP estimates national product of all the normal residents of a country, no matter in which part of the world they are. 

In case of Nepal, NFIA would be the difference between the earning of Nepalese people in abroad and the earning of foreigners living in Nepal during a year. 

Symbolically, 

GNP = GDP + NFIA

NFIA may be positive or negative. 

If NFIA is positive then GNP>GDP 

If NFIA is negative then GNP<GDP

Features

1. Calculated in monetary terms
2. Flow Concept: GDP is calculated during a year time period not the any particular point of time. 
3. GNP include those commodities which have market value and brought in the market for sale.
4. Measured in current market price: Base year or constant price
5. Market value of final goods: To avoid double counting
6. GNP estimates national product of all the normal residents of a country, no matter in which part of the world they are. 
7. It includes income earned by the residents of a country within a country and abroad.
8. It does not include factor payments to the foreigners by the country. 
9. It exclude value of intermediate consumption.
10. It also exclude transfer payments (pension, allowances), capital gains, illegal income (gambling), black money (correction), financial transactions (from share and debenture), value of second-hand goods. 

Difference Between GDP and GNP

Basis	GDP	GNP
Stands for	Gross Domestic Product	Gross National Product
Definition	An estimated value of the total worth of a country’s production and services, on its land, by its nationals and foreigners, calculated over the course on one year	An estimated value of the total worth of production and services, by citizens of a country, on its land or on foreign land, calculated over the course on one year
Concept	Narrow concept	Broad concept
NFIA	Does not include	Include
Territorial & national concept	Concerned with the domestic territory of a nation.	Related with the normal residents of a nation.
Formula	GDP = C + I + G + (X-M)	GNP = GDP + NFIA
Uses	Business, Economic Forecasting	Business, Economic Forecasting
Application	To see the strength of a country's local economy	To see how the nationals of a country are doing economically

3. Net National Product (NNP)

NNP is defined as the market value of output of final goods and services produced by national residents of an economy during an accounting year exclusive of depreciation. So, GNP minus depreciation is NNP. In other words, by deducting the value of depreciation (wear and tear of machineries and fixed capital) from the value of GNP in a year, we get the value of NNP. 

Symbolically, 

NNP = GNP - Depreciation

4. National Income (NI)

NI refers to the monetary value of total flow of goods and services over a given period of time. The NI at market price includes taxes in it but excludes subsidies. 

NI_MP =  NI_FC + Indirect Taxes - Subsidies

But when the value of goods and services is assessed in terms of prices actually received by the entrepreneurs after payment of taxes levied by the government, we get NI at factor cost. 

NI_FC = NNP_MP  - Indirect Taxes + Subsidies

5. Personal Income (PI)

PI is the income received by an individual of a country from all possible sources before direct tax in one year. This is due to the fact that income earned by firms is distributed among factors. A part of the income is retained as undistributed profit. Firms also need to pay corporate taxes and contribute for the social security. Similarly, factors also receive transfer income. Thus, 

PI = NI - undistributed corporate profits - corporate income taxes - social security contribution + Transfer payments

The concept of personal income is useful to assess purchasing power of household in an economy. It is also helpful to measure welfare of the people. 

6. Disposable Income (DI)

DI is defined as the income remaining with individuals after deduction of all taxes levied against their income and their property by the government. 

Symbolically, 

DI = PI - Personal Taxes

DI is that part of PI which the households can spend the way they want. It refers to the purchasing power of the households. They can either spend it or save it. Thus, 

DI = C + S 

Where, 

C = consumption

S = Saving

7. Per Capita Income (PCI)

It is an average income of any nation or income earned by an individual during a year. It is derived by dividing the national income of a country by it's total population in a given period of time. It is usually measured in dollar. 

Symbolically, 

PCI = NI (2020) / Total Population (2020)

Nominal GDP, Real GDP and GDP Deflator

Nominal GDP

Nominal GDP is the final value of goods and services produced by a nation during a year. It is calculated at current or existing market price. So, it includes all changes in market price. Generally, GDP rises from one year to the next, it is due to (i) the economy is producing a larger output of goods and services or (ii) goods and services sold at higher prices. 

Symbolically, 

GDP = P₁Q₁ + P₂Q₂ + P₃Q₃ + ........ + P_nQ_n

or,

Where, 

P_i = current year price

Real GDP

Real GDP is the final value of goods and services produced by the nation during a fiscal year, measured at constant price or base year price. Real GDP is used to have a correct estimate of the living standard and economic performance of the country. Without any change in quantity produced, if the price of some goods and services changes, nominal GDP change but not the real GDP.  

Symbolically, 

GDP = P₀Q₁ + P₀Q₂ + P₀Q₃ + ........ + P₀Q_n

or,

Where, 

P₀ = base year price or constant price 

Difference Between Real and Nominal GDP

Basis	Real GDP	Nominal GDP
Constant & market Price	Calculated at constant price	Calculated at market price
Effect of change in price and output	The change in real GDP is due the change in the output	The change in nominal GDP is due to the change in the price
Economic performance	It reflects the actual performance of the economy	It does not reflect the actual performance of the economy
Calculation	Real GDP = P0Q1 + P0Q2 + … + P0Qn	Nominal GDP = P1Q1 + P2Q2 + … + PnQn

GDP Deflator

GDP deflator is defined as the measure of relative changes in the current level of prices in comparison to the level of prices in the base year. GDP deflator is the ratio between nominal GDP and real GDP of that year multiplied by 100. 

Symbolically, 

GDP Deflator = (Nominal GDP / Real GDP)ｘ 100

Similarly, 

Real GDP = (Nominal GDP / GDP Deflator)ｘ 100

Nominal GDP = (Real GDP ｘ GDP Deflator) / 100

Circular Flow of Income and Expenditure

The circular flow of income and expenditure refers to the process whereby the national income and expenditure of an economy flow in a circular manner at a given period of time. In other words, circular flow of income is defined as the integrated flow of economic resources and goods & services among different sectors of the economy. It shows the interdependence between different economic activities and economic sectors. 

The concept of circular flow of income and expenditure is abstract and complex. To simplify the concept, circular flow of income and expenditure in a two-sector model (hypothetical model) is described below. 

Assumptions

1. The two-sector model which consists of only household and business sector,
2. There are no government and foreign sector (no import and export) in the two sector economy,
3. In this economy, GDP is the sum of consumption expenditure made by household sector and investment expenditure made by the business sector. i.e. GDP = C + I
4. There is no government intervention. So, no tax,
5. All prices remain constant,
6. supply of capital and technology are given,
7. Only autonomous investment,
8. Marginal propensity to consume remains constant,
9. All income should be spent,
10. All factors of production taken from household sector to business sector, and 
11. All goods and services are taken from business to household sector. 

Above diagram shows the economic transaction among the household and business sector. In two-sector closed economy, business sector receives the factor of production (land, labor, capital and organization) from household sectors and pays price for factor of production in the form of rent, wage, interest and profit to the household sector. Since, all factor incomes are paid in terms of money, the flow of factor income represents money flow. From the figure, it is clear that services and money flow in opposite direction. 

As shown in the lower panel of the figure, the goods and services produced by the business sector, flow from business sector to household sector. The payment made by the household sector to the business sector for goods and services creates money flow. It is clear that real (goods) flow and money flow in the product market also flow in the opposite direction. 

In closed (two-sector) economy, we assume that all the saving of household comes in to the bank and financial institutions (financial market) and business sector can borrow for investment in capital goods. 

Measurement of National Income

Production of goods and services rise to income; income gives rise to demand for goods and services; demand gives rise to expenditure, and expenditure gives rise to expenditure, and expenditure gives rise to further production. 

 Production ↑⟶ Y↑⟶ Qd↑⟶ Exp. ↑⟶ Production↑

Thus, there is circular flow of production, income, and expenditure. Based on these three related flows, national income can be measured by the following three methods. 

1. Product Method

2. Income Method

3. Expenditure Method

Product Method

Product method measures NI from the total sum of the market value of all final goods and services produced in the economy. In this method, economy is divided into three sectors- 

Primary Sector: Agriculture, forestry, fishing, mining etc. 

Secondary Sector: Manufacturing, construction, electricity, gas, water supply etc. 

Tertiary or Service Sector: Banking, transport, insurance, communication, trade and commerce etc. 

The money value of the total product of every sector is calculated and summed up to find out GDP. Thus, 

GDP = Value added in the primary sector at MP + Value added in the secondary sector at MP + Value added in the tertiary sector at MP

Symbolically, 

GDP = P₁Q₁ + P₂Q₂ + P₃Q₃ + ........ + P_nQ_n

GNP = GDP + NFIA

NNP = GNP = Depreciation

NI = NNP - Net Indirect Taxes

(i) Final Product Approach

In this approach, NI is estimated by finding the value of final goods and services produced in the economy in a given period.

GDP = P₁Q₁ + P₂Q₂ + P₃Q₃ + ........ + P_nQ_n

GNP = GDP + NFIA

NNP = GNP = Depreciation

NI = NNP - Net Indirect Taxes

(ii) Value Added Approach

In this approach, instead of taking market value of final product, the value added or created at different stages of production is counted for estimating NI. Value added means the addition to the value of raw materials and other inputs during the process of production. To calculate value added, the cost of intermediate product is deducted from the total value of output. Thus, 

Value added = Value of output - Cost of intermediate goods

Precautions

1. The sale and purchase of second-hand goods, should not be included in NI.
2. The value of intermediate goods should not included in NI.
3. Domestic services are not include in NI.
4. Voluntary work done for its own sake or for the community should be excluded. 
5. The value of goods retained for self-consumption should be excluded. E.g. farmer consumes his own products. 

Income Method

Income method is also called factor payment method or distributed share method. Production generates income. Production is created with the combined effort of factors of production. That is why, owners of these factors have a claim on this income, which is distributed to them in the form of compensation of employees, rent, interest and profit. Income includes wage, salary, social security, contribution of workers, earning of self-employed persons, dividends of shareholders, undistributed profit, rent of land, factories and business premises and interest on capital. 

According to Paul Studenstki, "National income of a country can be calculated either by taking the sum of income paid out by the sum of income paid out by the producing units or by the income received by the factors". 

The calculation of NI by income method is done in three steps. They are: 

Step I: Identification and classification of producing enterprises which employ factor inputs. It requires (i) Identifying the producing enterprises which employ the factor inputs, (ii) classifying the producing enterprises (Primary, Secondary and Tertiary Sector)

Step II: Classification of factor income (Compensation to employees, operating surplus, mixed income, NFIA)

Step III: Estimation of NI

GDP = Rent + Wages + Profit + Interest

GNP = GDP + NFIA

NNP = GNP - Depreciation

Precautions

1. Only the net income of the individual and enterprises are taken. 
2. Payments due to the employer's own factors like own house, capital and labor are counted on the basis of market price. 
3. Transfer payments are not counted as income.
4. Income through illegal activities like smuggling, black marketing, theft, gambling, etc. are not included in the national income. 
5. Income or money received by way of selling second-hand goods or financial assets. For example, old scooter, old house, bonds, debentures, etc. are not included in NI. 
6. Since corporate tax is par of profit, it should not be separately included in the NI. 
7. In the NI windfall gains (income from lotteries) are not included. 
8. Death duties, gift tax, wealth tax, etc. should not be included in the NI. 
9. Goods and services for which no money payment is made must not be counted. For example, work of housewives and children's help to parents. 

Expenditure Method

The expenditure method of measuring NI is also called income disposal method or consumption and invest method. Final expenditure means expenditure on final product. According to this method, the sum of private consumption expenditure, private investment expenditure, private investment expenditure, government expenditure and net exports (total exports - total imports) gives the GDP. 

According to expenditure method, GDP is the aggregate of all the final expenditure in an economy during a year, i.e., 

GDP = C + I + G + (X-M)

GNP = GDP - NFIA

NNP = GNP - Depreciation

Precautions

1. Expenditure on second-hand good should be excluded because such expenditure is not one currently produced goods. 
2. Expenditure on the purchase of new or old shares and bonds should be excluded because they are not payments for goods. 
3. Government expenditure in the form of transfer payments should be excluded because these payments do not make any contribution to the flow of goods and services. 
4. Expenditure on intermediate goods and services should be excluded; otherwise, this will lead to the problem of double counting. 

Video Link: Measurement of National Income

Difficulties in Measuring National Income

There are many difficulties encountered in measuring NI of a country. The difficulties involved are both conceptual and statistical in nature. Some of these difficulties encountered in the measurement in NI are as follows: 

(1) Problems of Double Counting

It refers to the possibility of a commodity being included in NI estimates more than once. Only final goods should be included in the NI accounting. But it is very difficult to distinguish between final good and intermediate goods. To solve this problem, only the value of final goods and services should be included in the national income accounting. The value of intermediate goods and services should be excluded from the calculation. The best way of avoiding double counting is value added method. 

(2) Calculation of Depreciation

Capital depreciation should be deducted to find the NNI. But, it is difficult to calculate present depreciation rate of capital goods. The depreciation charge differs from product to product. Sometimes, similar capital goods are treated differently by the different firms. It becomes further complicated in the value of capital assets changes every year. 

(3) Frequently Changes in Price

NI is the money value of goods and services. It depends on market price, which often changes with change in price of goods, NI also changes frequently. This creates problem to calculate national income because national income changes even without change in the output. 

(4) Choice of Method

It is difficult to decide which method is to be used in the calculation of NI. All three methods such as production, income and expenditure depend on the availability of data. 

(5) Transfer Payment

Individual get pension, unemployment allowance and interest on public loans but these payments create difficulty in the measurement of NI. These earnings are a part of individual income and they are also part of government expenditure. 

(6) Illegal Income

Existence of non-monetized sector makes another difficulty in the way of Ni calculation. This difficulty is specially related to the underdeveloped countries where a sizable part of total output does not come to the market for sale. A major portion of the product is either retained for self-consumption or bartered for other goods. This may result in overestimation or underestimation of the national income. 

(7) Non-availability of Reliable Data

Non-availability of statistical data is another difficulty regarding the calculation of NI. This difficulty is not particular to the underdeveloped countries, but even advanced countries face the lack of adequate and reliable data. 

(8) Non-monetized Sector

Existence of non-monetized sector makes another difficulty in the way of NI calculation. This difficulty is specially related to the underdeveloped countries where a sizable part of total output does not come to the market for sale. A major portion of the product is either retained for self-consumption or bartered for other goods. This may result in overestimation or underestimation of the national income. 

(9) Non-market Production

NI fails to account for household production because such production does not involve market transactions. As a result, the household services of millions of people are excluded from the national income accounts. For instance, housework done by housewives is not included, but the same work done by a paid servant is. Their exclusion results in some peculiarities (unusual/odd) in nation income accounting and underestimates our national income. 

(10) Choice of Goods

There is problem of choice of goods and service having money value are included in NI, but there are goods and services which do not have corresponding flow of money payments. The services performed out of love or mercies do have economic value, but not money value. 

(11) Unreported Income

Sometimes, people don't provide all the right information about their income to evade taxes. This causes disparities in the counting of national income. 

Difficulties in Measuring National Income in Developing Countries

In the underdeveloped or developing countries like Nepal, a conceptual and statistical difficulty of NI calculation becomes more difficult. Major difficulties of computing NI in under-developed countries are: 

1. Non-monetized Sector: A large portion of the product, particularly in the agricultural sector, is not brought  to the market for sale, It is either directly consumed by the producers or is exchanged for other goods. 
2. Illiteracy and Ignorance: People are socially backward. They are superstitions and do not disclose their incomes easily and correctly. 
3. Most of the producers do not keep accounts of their products because of illiteracy. 
4. Lack of Occupational Specialization: It is difficult to estimate NI by industrial origin because there is little specialization of function. People are engaged in a number of economic activities simultaneously. 
5. Adequate Statistical data are not available, and, if available, they are not reliable. 
6. There is lack of trained and efficient statistical staff. 
7. Problems of calculating NI also arise due to regional disparities of language, customs etc. 
8. In many developing countries, tax evasion is rampant. This leads to underestimation of national income. 

Video Link: Difficulties in Measuring National Income