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| The Income Approach to GDP Calculation |
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| GDP USING THE INCOME APPROACH - QUICK REFERENCE FORMULA: COMPENSATION OF EMPLOYEES (WAGES) plus NET INTEREST plus RENT plus PROFITS (PROPRIETORS' INCOME PLUS CORPORATE PROFITS) equals NATIONAL INCOME (NI) plus INDIRECT BUSINESS TAXES (SALES TAX PLUS EXCISE TAX) equals NET NATIONAL PRODUCT (NNP) plus CAPITAL CONSUMPTION ALLOWANCE (DEPRECIATION) equals GROSS NATIONAL PRODUCT (GNP) minus NET FACTOR INCOME FROM ABROAD (NET FOREIGN FACTOR INCOME, WHICH IS INCOME RECEIVED BY CITIZENS OUTSIDE THE NATION'S BORDERS MINUS INCOME RECEIVED BY FOREIGNERS WITHIN THE NATION'S BORDERS). equals GROSS DOMESTIC PRODUCT (GDP) ======================== |
The previous section showed how to calculate GDP using the expenditures
approach. If you recall from the circular flow model, the flow of expenditures
in the economy has a corresponding flow of income. Since these flows are
equal in equilibrium, Gross Domestic Product, or GDP, can also be computed
from the incomes received by the factors of production. This method of
computing GDP is called the income approach.
Recall that the income received by the factors of production is as follows:
Labor earns wages (sometimes called compensation of employees)
Capital earns interest
Land earns rent
Also, firms earn profits, which remain within the circular flow. Sometimes,
economists consider entrepreneurship to be a separate factor of production
(rather than a special category of labor), and profit would be listed as the
income received by entrepreneurs. Profit as an income category is in turn
divided into two categories: proprietors' income (sole proprietorships and
partnerships) and corporate profits (corporations).
Total income received by the segments of the economy, then, would be:
Wages + Interest + Rent + Profits
This sum of income received by the segments of the economy do not add up
to GDP, however, and will not match the GDP amount calculated using the
expenditures approach. Some adjustments need to be made in order to get
from this number to GDP. However, this number does have a name: National
Income, or NI. It follows that the formula for national income is:
NI = Wages + Interest + Rent + Proprietors' Income + Corporate Profits
From national income, three more adjustments are needed in order to get to
GDP.
First, you may notice that government receipts are not part of this equation.
That is because income tax receipts include money that is part of the
incomes of the other segments of the economy. They are already being
counted elsewhere. However, some taxes are collected from consumers by
businesses, who have to turn this money over to the government. These
taxes include state and local sales taxes, and excise taxes. Together, they
are called indirect business taxes. In order to balance income and
expenditures, this amount needs to be added to NI. This yields a number
that is called net national product, or NNP.
NNP = NI + Indirect Business Taxes
This number (NNP) still does not equal GDP. GDP using the expenditures
approach includes an item called 'gross private domestic investment'. Not
all of this amount is received as income. Some of it is used to replace
worn-out equipment, plus the replacement of damaged or accidentally
destroyed equipment. This replacement value is called capital consumption
allowance. The routine replacement of worn-out equipment is called
depreciation, and is computed and allocated over the lifetime of the
equipment using an accounting procedure at each individual firm. Since
depreciation makes up the vast majority of the capital consumption
allowance, often this allowance is simply referred to as depreciation. In
order to balance income and expenditures, this amount needs to be added
to income. Adding the capital consumption allowance (or depreciation) to
NNP will yield a number that is called Gross National Product, or GNP.
GNP = NNP + Capital Consumption Allowance (or Depreciation)
approach. If you recall from the circular flow model, the flow of expenditures
in the economy has a corresponding flow of income. Since these flows are
equal in equilibrium, Gross Domestic Product, or GDP, can also be computed
from the incomes received by the factors of production. This method of
computing GDP is called the income approach.
Recall that the income received by the factors of production is as follows:
Labor earns wages (sometimes called compensation of employees)
Capital earns interest
Land earns rent
Also, firms earn profits, which remain within the circular flow. Sometimes,
economists consider entrepreneurship to be a separate factor of production
(rather than a special category of labor), and profit would be listed as the
income received by entrepreneurs. Profit as an income category is in turn
divided into two categories: proprietors' income (sole proprietorships and
partnerships) and corporate profits (corporations).
Total income received by the segments of the economy, then, would be:
Wages + Interest + Rent + Profits
This sum of income received by the segments of the economy do not add up
to GDP, however, and will not match the GDP amount calculated using the
expenditures approach. Some adjustments need to be made in order to get
from this number to GDP. However, this number does have a name: National
Income, or NI. It follows that the formula for national income is:
NI = Wages + Interest + Rent + Proprietors' Income + Corporate Profits
From national income, three more adjustments are needed in order to get to
GDP.
First, you may notice that government receipts are not part of this equation.
That is because income tax receipts include money that is part of the
incomes of the other segments of the economy. They are already being
counted elsewhere. However, some taxes are collected from consumers by
businesses, who have to turn this money over to the government. These
taxes include state and local sales taxes, and excise taxes. Together, they
are called indirect business taxes. In order to balance income and
expenditures, this amount needs to be added to NI. This yields a number
that is called net national product, or NNP.
NNP = NI + Indirect Business Taxes
This number (NNP) still does not equal GDP. GDP using the expenditures
approach includes an item called 'gross private domestic investment'. Not
all of this amount is received as income. Some of it is used to replace
worn-out equipment, plus the replacement of damaged or accidentally
destroyed equipment. This replacement value is called capital consumption
allowance. The routine replacement of worn-out equipment is called
depreciation, and is computed and allocated over the lifetime of the
equipment using an accounting procedure at each individual firm. Since
depreciation makes up the vast majority of the capital consumption
allowance, often this allowance is simply referred to as depreciation. In
order to balance income and expenditures, this amount needs to be added
to income. Adding the capital consumption allowance (or depreciation) to
NNP will yield a number that is called Gross National Product, or GNP.
GNP = NNP + Capital Consumption Allowance (or Depreciation)
Notice the distinction in terms here. GNP, NNP. The difference is gross vs net. Gross refers to gross
investment and net refers to net investment, which is total investment net of the allowance for
depreciation. You may need this information for exercises in economics class. The formula is:
Gross investment minus depreciation equals net investment
Okay, we are almost there, but not quite. We are looking for GDP, and we now have GNP. GNP includes
income received by citizens, regardless of whether the income was earned on production within the
country or not. It excludes income earned within the country's borders by non-citizens. GDP is a measure
of production that occurs within a nation's borders, regardless of the nationality of whoever it is that
produces it. An adjustment needs to be made to GNP to account for this difference. This adjustment is
called net factor income from abroad, or net foreign factor income. It is found by taking income received
by citizens outside the nation's borders, and subtracting income received by foreigners within the
nation's borders. Subtracting net factor income from abroad will yield GDP. Finally!!
GDP = GNP - Net Factor Income from Abroad
This GDP amount, found using the income approach, should be equal to GDP using the expenditures
approach. Since compilation of figures in the real world is imperfect, there may be a difference for
routine error and rounding.
This explanation of the income approach to calculating GDP is rather lengthy. It begins with income
received by the factors of production, makes several adjustments, and ends up with an amount equal to
GDP. Perhaps what you are looking for is a summary or a formula instead of the lengthy explanation. For
that reason, I have included a summary in the left-hand column at the top of this page. Since you are now
looking at the bottom of the page, here it is again. This is a summary that simply takes all of the
intermediate steps together (the adjustments) into one formula:
GDP = Wages (compensation of employees) + Interest + Rent + Profits (proprietors'
income plus corporate profits) - Net Factor Income from Abroad + Capital
Consumption Allowance (depreciation) + Indirect Business Taxes (sales tax plus
excise tax)
Besides GDP, other important measurements of the overall economy are part of national income
accounting. Some of them are mentioned on this page: GNP, NNP, and NI. There are others, and they are
listed in the next section. Also in the next section is a discussion of per capita measurements, and
nominal and real values. To continue with this discussion of these measurements, click here.
investment and net refers to net investment, which is total investment net of the allowance for
depreciation. You may need this information for exercises in economics class. The formula is:
Gross investment minus depreciation equals net investment
Okay, we are almost there, but not quite. We are looking for GDP, and we now have GNP. GNP includes
income received by citizens, regardless of whether the income was earned on production within the
country or not. It excludes income earned within the country's borders by non-citizens. GDP is a measure
of production that occurs within a nation's borders, regardless of the nationality of whoever it is that
produces it. An adjustment needs to be made to GNP to account for this difference. This adjustment is
called net factor income from abroad, or net foreign factor income. It is found by taking income received
by citizens outside the nation's borders, and subtracting income received by foreigners within the
nation's borders. Subtracting net factor income from abroad will yield GDP. Finally!!
GDP = GNP - Net Factor Income from Abroad
This GDP amount, found using the income approach, should be equal to GDP using the expenditures
approach. Since compilation of figures in the real world is imperfect, there may be a difference for
routine error and rounding.
This explanation of the income approach to calculating GDP is rather lengthy. It begins with income
received by the factors of production, makes several adjustments, and ends up with an amount equal to
GDP. Perhaps what you are looking for is a summary or a formula instead of the lengthy explanation. For
that reason, I have included a summary in the left-hand column at the top of this page. Since you are now
looking at the bottom of the page, here it is again. This is a summary that simply takes all of the
intermediate steps together (the adjustments) into one formula:
GDP = Wages (compensation of employees) + Interest + Rent + Profits (proprietors'
income plus corporate profits) - Net Factor Income from Abroad + Capital
Consumption Allowance (depreciation) + Indirect Business Taxes (sales tax plus
excise tax)
Besides GDP, other important measurements of the overall economy are part of national income
accounting. Some of them are mentioned on this page: GNP, NNP, and NI. There are others, and they are
listed in the next section. Also in the next section is a discussion of per capita measurements, and
nominal and real values. To continue with this discussion of these measurements, click here.
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