Short Notes: National Income Accounting

Measurement of National Income

Income is generated in the process of production. The aggregate measure of this income is known as national income. Technically speaking national income is the sum total of factor incomes accruing to the residents of a country from their contribution to production activity both within and outside the domestic territory. It is NNPFC National income (NNPFC ) of a country can be measured in three alternative ways:

(i) As a flow of goods and services, i.e., net value added by the different producing sectors of the economy.

(ii) As a flow of factor income, i.e., the income generated during the production process in the domestic territory of the country and net flow of factor income from abroad.

(iii) As a flow of expenditure, i.e., the disposition of income by the spending units in the economy.

Value Added Method or Product Method

In the process of production, all the final goods and services produced by public and private enterprises in the domestic territory of the country in an accounting period of one year are measured at their money value.

 

Some important points to be noted in this regard are as follows:

(a) This method is also known as Net Output Method or Industrial Origin Method.

(b) It measures the contribution of all the producing enterprises in the domestic territory of a country within the accounting year. So it gives us GDP, i.e., Gross Domestic Product.

In this method, only the value of final goods is to be included; otherwise there arises a problem of double counting.

Problem of double counting means measuring the value of goods or services produced more than once. Suppose the value of cotton produced is added in national income and at the same time value of readymade garments is also included in national income. But value of readymade garments includes in itself the value of cotton used to make a fabric and which must not be counted again. This duplication can be avoided in two ways: Firstly by including the value of only final goods avoiding the value of intermediate good.

Secondly by using the value added method in case of each enterprise. It is value added that is included, not the value of output. These concepts are discussed in detail as follows:

(a) Value of Output: It is estimated at current prices prevailing in the market.

Value of output = Sales + Change in stock

or Sales + (Closing stock – Opening stock)

(b) Value Added: Every production unit uses primary inputs (land, labour, capital, and entrepreneurship) and secondary inputs (raw materials, fuel, etc.) to produce goods and services. Value added is the excess of the value of output produced over the value of secondary inputs.

Value added = Value of output – Value of secondary inputs

Or

Value added = Value of output – Value of intermediate consumption

Or

Value added = Sales + Change in stock – Intermediate consumption

Value added has two aspects:

(i) Value added at market price.

(ii) Value added at factor cost.

 

Value Added at Market Price

(i) Gross Value Added = Value of output – Value of intermediate consumption

The value of intermediate consumption is deducted from value of output, because value of goods used for intermediate consumption is reflected in the value of output.

Net Value Added at Market Price

Net Value Added = Gross Value Added at Market Price – Consumption of fixed capital/depreciation

i.e.,                NVAMP = GVAMP – CFC

Value Added at Factor Cost

GVAFC = GVAMP – Net Indirect taxes(NIT)

Similarly,

NVAFC = GVAMP – NIT

Income Generated: Income generated is identical with net value added at factor cost.

National Income = Sum total of net value added at factor cost of all producing enterprises within the domestic territory of a country plus net factor income from abroad.

 

NY by Value added= Gross Value Added (GVA) by primary sector within the domestic territory + GVA by secondary sector within the domestic territory + GVA by tertiary sector within the domestic territory – Depreciation – Net indirect tax + Net factor income from abroad

Steps involved in Value Added Method

Value added method involves three steps of estimation:

(i) Identification and classification of productive enterprises.

(ii) Estimation of net value added.

(iii) Net factor income from abroad.

 

I. Identification and Classification of Productive Enterprises: Different productive enterprises are broadly classified in following three sectors:

(a) Primary Sector

(b) Secondary Sector

(c) Tertiary Sector.

(a) Primary Sector: It produces goods by exploiting natural resources like land, water, forests, rivers, etc. It includes all agricultural and allied activities like fishing, forestry, mining and quarrying.

(b) Secondary Sector: It is also known as manufacturing sector. It transforms one type of commodity into another using men, machines and materials. For example, manufacturing of fabric from cotton and sugar from sugarcane.

(c) Tertiary Sector: It is also known as services sector which provides services like banking, insurance, transport, communication, trade and commerce, etc, to primary and secondary sectors.

 

II. Estimation of Net Value Added: To arrive at net value added the following three things are deducted from the value of output:

(i) Value of intermediate consumption.

(ii) Consumption of fixed capital.

(iii) Net indirect taxes (Indirect taxes – Subsidies).

 

Symbolically:

Net Value Added (NVA or NDPFC ) = Value of output – Intermediate consumption – Consumption of fixed capital – Net indirect taxes

To avoid double counting in calculating Value of output only the value of final goods and services is included in the national income.

III Adding Net Factor Income from Abroad: The net factor income earned from abroad constitutes the following:

(i) net compensation of employees.

(ii) net income from property and entrepreneurship.

(iii) net retained earnings of resident companies abroad.

Net factor income from abroad is added to net value added to make it national income.

National Income = Net Value Added + Net factor earnings from abroad

Or

NNPFC = NDPFC + NFYFA

Formulae used in Value Added Method

(i) GVAMP = VOO(Value of output) in primary sector

+ VOO in secondary sector + VOO in tertiary

sector – cost of intermediate consumption

(ii) NVAFC(NDPFC) = GVAMP – CFC – NIT

(iii) National income(NNPFC) = NDPFC + NFYFA

Difficulties involved in calculating NIT by Value Added Method

A very important problem faced while calculating national income by value added method is the error of double counting. To avoid it, two things must be taken care of. Firstly the value of intermediate goods should not be included and secondly only net value added should be calculated.

 

Precautions involved in calculating National Income by Value Added Method:

The following precautions should be taken while estimating national income by product or value added method:

(i) The sale and purchase of old goods and property should not be included in national income. But commission earned by the brokers of these goods should be included in national income.

(ii) The value of intermediate goods should not be included in national income. Only the value of final goods should be included.

(iii) The value of goods retained for self-consumption like wheat kept by farmer for self-use should be included in national income.

(iv) Imputed rent of owner occupied houses or buildings should be included in national income.

(v) Own-account production of fixed capital by firms, households and government should be included in national income.

(vi) Domestic services are not included in national income. However production of services by paid employees should be included.

(vii) Voluntary work done for its own sake or for the community should be excluded.

Items included and excluded in National Income Estimation by Value Added Method

Items Included

Items Excluded

1. Service of free government dispensary (it is a productive service). 1. Receipt from sale of land (only ownership has changed, no addition to national product has been made).
2. Production done for self-consumption. 2. Intermediate goods (as they cause double counting).
3. Final goods produced in an accounting year. 3. Sale of second hand goods (it also leads to double counting).
4. Rent paid by the tenant (it is a factor income). 4. Purchase of rented house by the tenants (only ownership changes like those of financial transactions).

 

 

Income Method

The factors of production involved in producing goods and services are rewarded for their services. Their income is known as factor income. Thus income generation takes place during the course of production process. And point to be noted here is that income generated is just equal to the value of goods and services produced.

Classification of Factor Income

Different factor incomes are broadly classified into three categories:

1. Compensation of employees.

2. Operating surplus and

3. Mixed income of self-employed.

1. Compensation of employees: Whatever payments are made by resident producers to their employees in the form of

(a) Wages and salaries in cash

(b) Payment in kind

(c) Employers contribution to social security schemes on behalf of employees.

(d) Pension on retirement.

It also includes pay and allowance paid by the general government to its officials from the president of India to the clerks and peons.

2. Operating surplus: The operating surplus refers to the income from property and entrepreneurship. Income from property can be rent and interest while income from entrepreneurship are profits and dividend etc. Operating surplus originates in all public and private sector enterprises. But there is no operating surplus in general government sector. The items included in operating surplus are (a) rent (b) interest (c) profit (dividend + corporate tax + undistributed profits of enterprises).

3. Mixed income: It refers to income of self-employed persons who are using self-owned factors in the process of production. It is partly labour and partly capital income.

These incomes add up to domestic factor income. In order to find national income, another item net factor income from abroad should be added to the domestic factor income.

Steps involved in Income Method for Calculating National Income:

Step 1: Identification and classification of producing enterprises. First of all different enterprises employing factor inputs are identified and then these are classified into:

(a) Primary sector (b) secondary sector (c) tertiary sector.

Step 2: After classifying the various enterprises, the factor incomes originating in those are further classified into following categories:
(a) Compensation of employees, (b) Operating surplus, (c) Mixed income and (d) Net factor income from abroad.

Formulae used in Income Method

1. NDPFC = Compensation of employees + Operating surplus + Mixed income

2. NNPFC = NDPFC  + Net factor income from abroad

3. GNPFC = NNPFC  + Depreciation

4. GNPMP = GNPFC  + Net indirect tax

Precautions in the Estimation of National Income by Income Method

The following precautions must be taken in order to have correct estimation of national income by income method:

1. Sale proceeds of second hand goods should not be included. However the commission charged by the broker is very much part of the national income because it is service provided in the current year and creating a market is a legal activity.

2. Illegal incomes of all kinds, e.g., from black marketing, smuggling, etc, should be excluded.

3. Windfall grains as from the draw of lotteries should also be excluded as these are not due to the employment of different factor inputs.

4. Imputed rent of owner occupied accommodation should be included.

5. Transfer payments should be excluded as these are not due to any contribution in the production process.

6. Corporation tax, as well as undistributed profit is part of the profit so that must not be separately added to national income.

7. Wealth tax, death duties, gift tax are paid out of the current income, so these should not be separately added to national income.

Items included and excluded in National Income while Calculating it by Income Method

Items Included

Items Excluded

1. Wages received by Indian employees working in foreign embassies in India (it is reward for a factor service). Remittances by NRI to his family in India .
2. Bonus (it is a part of COE.) Windfall gains.
3. Free meals to worker (these are payment in kind). Unemployment allowance (it is a transfer payment.)
4. Money received by a worker working abroad for a period of less than one year. Illegal income from gambling, struggling, etc.
5. Net factor income from abroad. Gift to red cross society (these are transfer payments)
6.

Allowances of MPs and MLAs (these legislative bodies are considered as general government enterprises).

Sale proceeds from second hand goods.

 

Expenditure Method

This is also called consumption and investment method. Disposition of national income occurs in two ways:

Firstly, by way of consumption by the households and general government and secondly by way of investment expenditure by the producers, also called capital formation.

Y = C + I

i.e. , Income = Consumption + Investment.

Classification of final expenditure

The final expenditure in GDP (Gross Domestic Product) consists of the following items:

1. Private final consumption expenditure (C).

2. Government final consumption expenditure (G).

3. Gross fixed capital formation.

4. Inventory investment or change in stock.

5. Net exports of goods and services.

1. Private Final Consumption Expenditure

It consists of expenditure on durable goods (e.g., furniture, cars, etc), non-durable goods (e.g., food items and toiletries) and services (e.g., hotels, educational institutions, hospitals, public transport, etc.,) by the household consumers.

The figures of private consumption expenditure may be collected from retail trade activities during an accounting period.

But the purchases made by non-residents and foreign visitors should be deducted from the final consumption expenditure in the domestic market whereas direct purchases made by resident households abroad during foreign travel should be included in consumption expenditure.

2. Government Final Consumption Expenditure

The government final consumption expenditure refers to the final consumption expenditure by the general government and it can be arrived at by summing up (a) value of net purchases in the domestic market, (b) net purchases abroad.

3. Gross Fixed Capital Formation

If consists of (a) purchases of new assets within the domestic market like building, machinery, broking stock, etc., (b) import of new assets like those of rail engines, wagons, trucks, aeroplanes, farm machinery, breeding of fish and cattle by the enterprises, (d) purchase of new houses by consumers,
(e) purchase of second hand physical assets from abroad.

4. Change in Stock as Inventory Investment

Change in stock is the difference between the opening stock and closing stock. All enterprises and trading companies incur expenditure on stock of raw materials, semi finished goods or finished goods.

5. Net Exports of Goods and Services

It is the difference between the value of exports and imports of a country during an accounting period. What the foreigners spend on a country?s exports is the part of expenditure on the Gross domestic product.

Steps involved in Expenditure Method for the Calculation of National Income

Step 1: Identification of economic units from among different sectors of an economy incurring final expenditure.

These different sectors are:

(a) household sector (b) producing sector (c) government sector
(d) rest of the world sector.

Step 2: The final expenditure is classified into following three categories:

(a) Final consumption expenditure:

(i) Private final consumption expenditure

(ii) Government final consumption expenditure

(b) Gross Domestic capital formation:

(i) Gross domestic fixed capital formation or investment

(ii) Inventory investment or change in stock

(c) Net exports.

 

Formulae used in Calculating National Income by Expenditure Method 

1. GDPMP = Private final consumption expenditure + Government final consumption expenditure + Gross domestic fixed capital formation + Change in stock + Net exports(Exports – Imports)

2. GNPMP = GDPMP + NFYFA

3. GNPFC = GNPMP + NIT

4. NNPFC = GNPFC – Depreciation

 

Precautions while using Expenditure Method for Calculating National Income

1. Only expenditure on current final goods should be included so expenditure on second hand goods must not be added in aggregate expenditure.

2. The intermediate expenditure also must not be included as it leads to double counting.

3. Expenditure on transfer payments should not be taken account of.

4. Gross domestic capital formation already has in it the replacement of machines as well as change in stock, therefore these two items should not be separately included in aggregate expenditure.

5. Expenditure on financial transactions, e.g., shares and bonds should not be included because these transactions do not add to the flow of goods and services but only change the ownership of financial assets.

6. Only expenditure on final goods and services should be included in aggregate expenditure.

7. The aggregate expenditure got by adding up various components includes in itself the cost of depreciation. Thus, we have the concept of GDPMP  so as to arrive at the Net Domestic Product at market price, depreciation should be deducted from it.

 

Items included and excluded in Calculation of National Income by Expenditure Method

Items Included

Items Excluded

1.

Fees paid to educational institutions by students (payment for a service received)

1.

Expenditure on the repair of fixed capital asset (intermediate consumption)

2.

Expenditure on electricity by a household (final consumption).

2. Expenditure on electricity by some enterprise (intermediate expenditure).
3. Expenditure on final goods and services. 3. Expenditure on transfer payments like scholarship, etc.
4.

Expenses of foreign visitors in India (it is a part of net exports).

4. Expenditure on a purchase of an old house.
5.

Expenditure on street lighting (it is final consumption expenditure by the government).

5.

Expenditure incurred by way of grants during natural calamities, e.g., earthquake, floods, etc. (it is a transfer payment).

 

 

 

Reconciliation of the Three Methods

The flow chart shows how estimation of national income using different methods is reconciled. We get triple identity in terms of the equality of estimation of national income using (i) value added method, (ii) income method, and (iii) expenditure method.

GNP at Current Prices and at Constant Prices (Nominal GNP and Real GNP)

Current market prices are the prevailing prices whereas constant/fixed prices are the prices of the base year. When final goods and services included in GNP are valued at prevailing prices of the year for which GNP is being measured, we get GNP at current prices or nominal GNP. On the contrary, when goods and services are measured at the prices of some base year the concept obtained is GNP at constant prices or real GNP.

Why the Real GNP is considered more Significant than Nominal GNP?

The answer to this pertinent question lies in the following points:

1. Real GNP (at constant prices) reflects change in the flow of goods and services. It shows the rise in GNP only on account of rise in physical output.

2. Yearwise comparison of changes in physical output can only be made with the help of real GNP. Rise in Real GNP over a long period of time shows economic growth while a continuous fall in it over a long period of time indicates recession.

3. International comparison can also be made with the help of Real GNP.

How to convert Nominal GNP into Real GNP?

Nominal national income or national income at current prices can be converted into real national income or national income at constant prices with the help of index numbers. We know, national income at constant prices is real national income of a country estimated at base year prices. We assume the price index (or the level of price) of this base year to be 100. So that if price level during the year of estimation shoots up to 200, it means that the price index during the current year has doubled compared to price index during the base year (which is the year of comparison). If national income at current prices is divided by the price index of the current year and multiplied by the price index of base year (which is always equal to 100), we obtain national income at constant prices or real national income.

GNP and Economic Welfare

For quite a long time, GNP was considered to be the best measure of economic welfare. It was due to the reason that per head availability of goods and services means rise in economic welfare. But this reason work only under certain conditions.

Limitations of GNP as an adequate index or measure of Economic Welfare

1. More production of dangerous goods like war material or narcotics cannot mean more welfare of the society.

2. GNP may rise due to the rise in prices rather than rise in physical output, in such a case, it will not measure welfare correctly.

3. Growth in GNP should also result in equitable distribution of income otherwise it might cause social unrest which is against welfare.

4. GNP often includes goods and services which are marketed, but some non-marketable services like those of housewives, also contribute to economic welfare.

Green GNP: This concept is used to denote sustainable economic development which means that sort of development which neither causes any pollution nor causes depletion of resources and at the same time promotes economic welfare for quite a long period of time.

Items excluded from GNP: The items excluded from GNP are as follows:

(a) Purely financial transactions, like the sale of shares.

(b) Sale or transfer of second hand or used goods.

(c) Illegal activities.

(d) Value of leisure or part-time activities.

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