National income can be defined as the part of the objective income of the community including income derived from abroad which can be measured in money i.e the money value of goods and services which is produced and made available for consumption in an economy for a particular period which is usually a year. National income, also known as Gross Domestic Product (GDP) is very helpful to the economists to track the economic growth’s rate, average living standard in one country as well as the distribution of income between different groups of population (i.e. inequality gap).
For measuring the national income, the national economy is viewed as follows:
- The national economy is considered as an aggregate of producing units combining different sectors such as agriculture, mining, manufacturing and trade and commerce.
- The whole national economy is viewed as a combination of individuals and household owning different kinds of factors of production, which they use themselves or sell-their factor services to make their livelihood.
- National economy is also viewed as a collection of consuming, saving and investing units (individuals, households and government).
The above notions of a national economy helps to measure National Income by following three different methods:
- Net output method
- Factor-income method
- Expenditure method
These methods are followed in measuring national income in a ‘closed economy’,
1. Net Output Method
This is also called as net product method or value-added method. This method is used when whole national economy is considered as an aggregate of producing units. In its standard form, this method consists of three stages:
1. Measurement of gross value of domestic output in the various branches of production: For measuring the gross value of domestic product, output is classified under various categories on the basis of the nature of activities from which they originate. The output classification varies from country to country depending on (i) the nature of domestic activities, (ii) their significance in aggregate economic activities and (iii) availability of requisite data. For example, in USA, about seventy-one divisions and sub-divisions are used to classify the national output, in Canada and Netherlands, classification ranges from a dozen to a score and in Russia, only half-a-dozen divisions are used. According to the CSO publication, fifteen sub-categories are currently used in India. After the output is classified under the various categories the value of gross output is is computed in two alternative ways by:
- Multiplying the output of each category of output factor by their respective market price and adding them together.
- Collecting data regarding the gross sales and changes in inventories from the account of the manufacturing firms to compute the value of GDP. If there are gaps in data then some estimates are made to fill the gaps.
2.Estimation of cost of materials and services used, arid depreciation of physical assets: The next step in estimating the net national income is to estimate the cost of production including depreciation. Estimating cost of production is, however, a relatively more complicated and difficult task because of non-availability of adequate and requisite data. Much more difficult task is to estimate depreciation since it involves both conceptual and statistical problems. For this reason, many countries adopt factor income method for estimating their national income. However, countries adopting net-product method find some means to calculate the deductible cost. The costs are estimated either in absolute terms (where input data are adequately available) or as an overall ratio of input to the total output. The general practice in estimating depreciation is to follow the usual business practice of depreciation accounting. Traditionally, depreciation is calculated at some percentage of capital, permissible under the tax-laws. In some estimates of national income, the estimators have deviated from the traditional practice and have instead estimated depreciation as some ratio of the current output of final goods. Following a suitable method, deductible costs including depreciation are estimated for each sector. The cost estimates are then deducted from the sectoral gross output to obtain the net sectoral products. The net sectoral products are then added together. The total thus obtained is taken to be · the measure of net national products or national income by product method.
3. Deduction of these costs and depreciation from gross value to obtain the net value of domestic product: Net value of domestic product is often called the value added or income product. Income product is equal to the sum of wages, salaries, supplementary labor incomes, interest, profits, and net rent paid or accrued.
2. Factor-Income Method
This method is also known as income method and factor-share method. Factor income method is used when national economy is considered as a combination of factor-owners and users. Under this method, the national income is calculated by adding up all the incomes accruing to the basic factors of production used in producing the national product. Factors of production are classified as land, labor, capital and organisation. Accordingly,
National income = Rent + Wages + Interest + Profits
However, it is conceptually very difficult in a modern economy to make a distinction between earnings from land and capital and between the earnings from ordinary labor and organisational efforts including entrepreneurship. Therefore, for estimating national income factors of production are broadly grouped as labor and capital. Accordingly, national income is supposed to originate from two primary factors, viz., labor and capital. However, in some activities, labor and capital are jointly supplied and it is difficult to separate labor and capital from the total earnings of the supplier. Such incomes are termed as mixed incomes. Thus, the total factor-incomes are grouped under three categories:
- Labor incomes
- Capital income
- Mixed incomes.
Labor Income: Labor incomes included in the national income have five components:
- Wages and salaries paid to the residents of the country including bonus, commission and social security payments.
- Supplementary labor incomes including employer’s contribution to social security and employee’s welfare funds and direct pension payments to retired employees.
- Supplementary labor incomes in kind such as free health, education, food, clothing and accommodation.
- Compensations in kind in the form of domestic services and other free of cost services provided to the employees are included in labor income.
- Bonuses, pensions, service grants are not included in labor income as they are regarded as ‘transfer payments’. Certain other categories of income such as incomes from incidental jobs, gratuities and tips are ignored because of non-availability of data.
Capital Incomes: Capital incomes include following Incomes:
- Dividends excluding inter-corporate dividends
- Undistributed profits of corporation before-tax
- Interests on bonds, mortgages and savings deposits (excluding interests on bonds and on consumer credit)
- Interests earned by insurance companies and credited to the insurance policy reserves
- Net interest paid by commercial banks
- Net rents from land and buildings including imputed net rents on owner occupied dwellings
- Profits of government enterprises.
The data for the first two incomes is obtained from the firms accounts submitted for taxation purposes. There exist difference in definition of profit for national accounting purposes and taxation purposes. Therefore, it is necessary to make some adjustments in the income-tax data for obtaining these incomes. The income-tax data adjustments generally pertain to (i) Excessive allowance of depreciation made by tax authorities, (ii) Elimination of capital gains and losses since these do not reflect the changes in current income, and (iii) Elimination of under and overvaluation of inventories on book-value.
Mixed Income: Mixed incomes include income from (a) farming (b) sole proprietorship (c) other professions such as legal and medical practices, consultancy services, trading and transporting. Mixed income also includes incomes of those who earn their living through various sources such as wages, rent on own property and interest on own capital.
All the three kinds of incomes, viz., labor incomes, capital incomes and mixed incomes added together give the measure of national income by factor income method.
3. Expenditure Method
The expenditure method, is also known as final product method. This method is used when national economy is viewed as a collection of spending units. It measures national income at the final expenditure stages. In other words, this method measures final expenditure on ‘GDP at market prices’ at the stage of disposal of GDP during an accounting year. In estimating the total national expenditure, any of the following two methods are followed:
- First method: Under this method all the expenditure factors are computed and added up to arrive at total national expenditure. The items of expenditure which are taken into account under the first method are (a) Private consumption expenditure, (b) Direct tax payments, (c) Payment to the non-profit-making institutions and charitable organisations like schools, hospitals and orphanage, and (d) Private savings.
- Second Method: Under this method the value of all the products finally disposed of are computed and added up to arrive at the total national expenditure. Under the second method, the following items are considered (a) Private consumer goods and services, (b) Private investment goods, (c) Public goods and services and, (d) Net investments from aboard. This method is extensively used because the requisite data required by this method can be collected with greater ease and accuracy.
Treatment of Net Income from Abroad
We have so far discussed the methods of measuring national income of a ‘closed economy’. However, most modem economics are ‘open economy’. These open economics exchange goods and services with rest of the world. In this exchange of goods and services, some nations make net income through foreign trade through exports while some lose their income to the foreign nations through imports. These incomes are called as Net Factor Income from Abroad (NFIA), the net earnings or losses in foreign trade affect the national income. Therefore, in measuring national income the net results of external transactions are adjusted to the total national income arrived through any of the three methods. The total income from abroad is added and net losses to the foreigners are deducted from the total national income. All the exports of merchandise and of services such as shipping, insurance, banking, tourism and gifts are added to the national income. On the contrary, all the imports of the corresponding items are deducted from the value of national output to arrive at the approximate measure of national income.
Choice of National Income Measurement Methods
As discussed above, there are standard methods of measuring the national income such as net output method, factor-income method and expenditure method. All the three methods would give the same measure of national income, provided requisite data for each method arc adequately available. Therefore, any of the three methods can be adopted to measure the national income. However, not all the methods are suitable for all economies and purposes.
The two main considerations on the basis of which a particular method is chosen are:
- The purpose of national income analysis.
- Availability of necessary data.
If the objective is to analyse the net output, then the net output method would be more suitable. In case, objective is to analyse the factor-income distribution then, suitable method would be factor income method. If objective at hand is to find out the expenditure pattern of the national income then the expenditure method is more suitable. However, availability of adequate and appropriate data is relatively more important considerations in selecting a method of estimating national income.
However, the most common method is the net output method because of the following reasons:
- It requires classification of economic activities and output, which is much easier to classify than the income or expenditure.
- The most common practice is to collect and organize the national income data by the division of economic activities. Therefore, easy availability of data on economic activities is the main reason for the popularity of the output method.
However, it should he borne in mind that no single method can give an accurate measure of national income. This is because no country’s statistical system provides the total data requirements for a particular method. The usual practice is therefore, to combine two or more methods to measure the national income. The combination of methods again depends on the nature of required data and the sectoral breakdown of the available data.