SESSION 4: NATIONAL INCOME ACCOUNTING
Accurate measurement of economic activity is important as a basis for sound decision-making. No one would sensibly attempt to drive a car without reliable information about its direction and speed.
Likewise, governments and others (especially businesses) affected by economic information would be unwise to make decisions in the absence of sound information about the state of the economy.
Clearly, decisions will be different according to whether the economy is in a boom period or in a recession, or whether it is growing or declining in size. In this session, we shall provide a detailed guide
to the standard methods used throughout the world to measure and track the level of economic activity. The procedures involved are commonly known as national income accounting.
Objectives By the end of this session, you should be able to:
- (a) understand how economic activity is measured, based on national income accounting methods
- (b) appreciate the importance of the various sectors of the economy and their contribution to economic activity (c) adjustments to national income statistics
- (d) recognize the problems in measuring economic activity
- (e) identify the uses of national income statistics
Now read on …
- Session 1: Macroeconomics and Business
- Session 2: Macroeconomic Policies and Economic Policies
- Session 3: Government and the Economy
- Session 5: Factors Influencing the Size of National
- Session 6: Circular Flow of Income
4.1 The Flow of National Income, A Nation’s Stock of Wealth, and Capital Stock.
At the outset, it is important to appreciate the key relationships between the flow of national income within an economy, a nation’s stock of wealth, and a nation’s capital stock.
National wealth is a stock concept that represents all of the physical assets or things that have value and are owned by the citizens of a country.
The capital stock of a nation is the part of national wealth that can be used to generate more wealth. This will include all the capital goods and raw materials within the country – as well as social capital representing the general physical infrastructure such as roads, schools, hospitals, etc. which are usually mainly owned by the state.
Note that capital does not include consumer goods which are a subset of national wealth but not of the capital stock. In contrast, national income is a flow concept.
It measures statistically the financial value of the flow of new wealth resulting from the productive use of the nation’s capital stock, i.e. the output of goods and services produced.
As a continuous flow, national income is measured per time period. Hope you can differentiate the three concepts in your own words now?
4.2 Meaning of Economic Activity
By economic activity, we mean the level of production of goods and services over a particular time period, usually measured quarterly and annually.
Changes in the level of economic activity from one-time period to another thus provide estimates of the growth of the economy.
For example, a sustained rise in economic activity will lead to an increase in household incomes and a resultant rise in consumer spending. This will directly impact corporate sales, production, and profitability as well as future capital investment expenditure.
At the same time, government tax revenues can be expected to rise because of higher household incomes and spending as well as larger corporate profits. Decisions by the government about how and where this tax revenue should be spent will have important implications for the future growth of the economy.
In addition, changes in economic activity can be expected to influence as well as be affected by ‘official’ policy measures taken by the government (and the central bank).
Measurement of economic activity is also important in order to determine the trend rate of growth over a long-time period which can be used as a benchmark against which to assess any short-run volatility – giving rise to ‘booms’ and ‘recessions’.
Finally, international comparisons will have particular significance, for example for international investment decisions by corporates as well as for foreign aid contributions.
4.3 National Income Accounting Methods
National income is a statistical measure of the total money value of the output of goods and services produced by an economy over a specified period of time.
Calculation of the size of the national income provides the basis for comparing changes in economic activity although, of course, we need to adjust nominal money values to allow for inflation if we are to arrive at what has happened to real national income between different years.
This distinction between nominal and real values will be dealt with later in this material. The flow of national income around the economy can be measured in any one of three ways, collectively known as national income accounting.
- output (or production) method;
- income method;
- expenditure method
In theory, national income measured by the output method should equal national income measured by the income or expenditure methods.
As the output method measures national output, the income method measures national income and the expenditure method measures national expenditure.
However, in practice discrepancies (sometimes very large) arise in the collection of the relevant statistics by the government.
These differences arise for many reasons, including errors, omissions, and timing differences.
Perhaps the most significant omission, when the income method is used, is that relating to undeclared earnings by those people working in what is commonly referred to as the underground economy (alternative terms used include the hidden, shadow, informal, parallel, or black economy).
Consequently, statistical discrepancies or residual errors feature in countries’ national income accounts to make the three totals balance.
These residual errors would not exist in a world of perfect statistics. For practical purposes, given that errors will inevitably exist in all three methods of measurement, an average of all three totals is sometimes used as the appropriate indicator of economic activity.
A fuller discussion of the problems associated with measuring economic activity is covered later in this session.
Before describing each of the three methods of measuring national income, we identify the sectors of the economy in which economic agents are responsible for generating economic activity, in terms of output, income, and expenditure.
There are five such sectors namely, the household sector; the firm sector; the government sector; the financial sector; and the foreign sector.
4.4 Measuring National Income
4.4.1 The Output Method
The output method calculates the total value of the final output of goods and services produced in the economy over a specified period of time, giving rise to the gross domestic product (GDP).
It is important to note that all final goods and services must be included regardless of whether they are sold to consumers, government, foreigners or to other firms in the form of capital equipment.
To avoid the problem of double-counting, and hence overestimation of the country’s total output, intermediate production of goods and services (e.g. components and materials) must not be included in the final total.
Alternatively, the problem of double-counting can be avoided by summing only the value added by each firm at the different stages of production, rather than the final outputs.
4.4.2 The Income Method
Since national income arises from the production of goods and services by the factors of production, another way of calculating the value of total output is to sum all of the incomes that these factors receive for their services – wages and salaries, rent, interest, profits, and dividends.
This method is referred to as the income method of measuring the level of economic activity in any time period. It is important to note that only incomes that have been received in return for productive services should be included.
Transfer payments, therefore, must be excluded because they merely represent a redistribution of income, for instance from taxpayers to pensioners.
Including these payments would lead to double counting and therefore overestimation of national income.
In other words, if transfer payments were not excluded, raising pensions, unemployment benefits or similar welfare payments would lead to a statistical increase in national income when the actual (real) output of the economy had not changed.
4.4.3 The Expenditure Method
By adding up all the money values of expenditures on final goods and services produced in an economy, we arrive at the measurement of national expenditure.
It should be noted that this will only be equal to national output if we allow for net changes in the value of the physical increase in stocks (inventories) and work in progress.
Therefore, national expenditure is the sum of the consumption of domestically produced goods (C), investment expenditure (I) (including an allowance for changes in stocks and work in progress), expenditure by the government (G), and net receipts from foreign trade (Xn). ‘C’ represents Personal Consumption Expenditure.
It is what households buy (except houses). It is made up of durables (cars, appliances), nondurables (clothing, food), and services (haircuts, doctor visits, airline tickets) A convention is made on nondurables to be all items which last less than a year, including clothing. Nondurable expenditure is the most stable component of personal consumption expenditure. ‘I’ represents Gross Private Domestic Investment.
It is made up of
- new construction,
- new capital (machines, trucks, and equipment) and
- changes in inventory.
It excludes investments made by the government and investments made outside the country.
New construction includes all forms of new buildings, be it for rental purposes or for private residential purposes. And changes in inventory capture goods produced in one year and sold in future years. ‘G’ represents Government Purchases.
It combines all goods and services bought by all forms of government: from paper clips to bridges and hospitals. This does not include any transfer payments.
‘Xn’ represents the difference between total exports and total imports. It is equal to the trade or merchandise balance of payments. As before, to avoid double-counting, only expenditure on final goods and services (i.e. sold to final consumers or as investment goods to firms) should be included.
4.5 Danger of Double-counting
Consider a situation in which Firm A supplies components valued at GHC10m to Firm B, which in turn sells its output valued at GHC14m to Firm C, which then sells its output valued at GHC17M to the final consumer.
Schematically: Firm A → Firm B → Firm C = Total output Output GHC10m → GHC14m → GHC17m = GHC41m.
Double-counting gives a total output for the economy (i.e. GDP) of GHC41m. However, using the value-added or final output method produces a very different total Value added method: GHC10m + GHC4m + GHC3m = GHC17m Final output method: GHC17m = GHC17m
In other words, the accurate figure for total output is GHC17m by either the value added or final output methods – and not GHC41m.
4.6 Adjustments to National Income Statistics
A number of adjustments are required when calculating the economy’s total flow of national income using the above three methods: These involve:
- The inclusion of net income from abroad;
- allowance for capital depreciation and stock appreciation;
- valuation of output at market prices or factor (i.e. production) costs
4.6.1 Net income from abroad
Part of an economy’s measured output may have been produced by foreign-owned firms. Likewise, some domestically-owned firms may be contributing to the production of output in other countries.
How much of the income resulting from these activities should be included when measuring output depends upon the purpose for which we are calculating national income.
Do we wish to measure only domestic output (literally produced within the country), or do we wish to measure the output of the economy’s factors of production wherever they are located? In the former case, we arrive at measurements of gross domestic output, gross domestic income, and gross domestic expenditure. In the latter case, we can allow for net income from abroad.
This represents the difference between the income (i.e. earnings) received by the domestic economy from the production of its firms located overseas minus that income paid to overseas residents from their production in the domestic economy.
For instance, profits earned by GIHOC Distilleries outside Ghana and remitted back to Ghana would be included to arrive at Ghana’s gross national product and gross national income.
Similarly, profits earned by Nissan from producing cars in the USA and remitted to Japan would be excluded from US national income.
4.6.2 Capital depreciation and stock appreciation
During any given period, some investment expenditure will merely be replacing a capital, both equipment and buildings, that has worn out during the production of income and output in that period.
Therefore, some allowance should be made for depreciation or capital consumption when calculating national income since this investment expenditure does not represent an increase in the economy’s productive capacity or wealth.
Only net investment (i.e. investment expenditure after depreciation) represents the true increase in the country’s capital stock during the period.
Where no allowance is made for depreciation the resulting totals are referred to as gross output, income, or expenditure; when depreciation is deducted from the gross sum we arrive at the corresponding net figures.
Official estimates of depreciation in the economy are made when adjusting national income figures from gross to net.
Nevertheless, when discussing national income, it is common to use the gross rather than the net amounts even though the latter provides a more accurate reflection of the growth in national well-being.
This is done for two reasons: first because depreciation tends to change relatively slowly over time and hence gross and net figures move closely together and, second because it is difficult to make an accurate estimate of depreciation at the national level. In other words, the gross figures are usually more accurate than the net figures.
4.6.3 Market prices and factor costs
National expenditure as described above is measured initially on the basis of market (i.e. retail) prices, prices paid across the counter.
These prices, however, may be distorted by the inclusion of indirect taxes and subsidies. Indirect taxes, such as sales tax and excise duties, increase the prices of goods and services, while subsidies have the opposite effect.
At the same time, national income and national product are both measured at factor costs, that is, with respect to the amounts paid to factors of production for their services excluding indirect taxes and subsidies.
In order to ensure equivalence across the three methods of measuring economic activity, market prices must be converted to factor costs by subtracting indirect taxes and adding subsidies.
Therefore, we can write: Gross national expenditure at factor cost = gross national expenditure at market prices-indirect taxes+ subsidies It is conventional to measure national output at factor cost rather than at market prices, otherwise any changes in indirect taxes or subsidies would distort the estimate of total output irrespective of whether there was a change in the actual quantity of goods and services produced.
4.7 Problems in Measuring Economic Activity
The calculation of the economic activity is a complicated statistical process and generally, difficulties arise for a number of reasons.
- It excludes work done by a person for her/himself (personal home maintenance)
- Data from which the national income figure is estimated (eg. Income tax returns) are likely to be full of errors and are often incomplete.
- Official statistics do not take into account the value of the unmeasured underground economy.
- Double counting
4.8 Economic Activity and the Underground Economy
The existence of an underground economy is of great concern to many governments.
An underground economy represents undeclared incomes and hence a loss of tax revenue to the state.
It creates a distortion to the official statistics relative to economic activity, which may make it more difficult to identify current and future trends upon which base policy decisions. The underground economy develops all the time adjusting to changes in taxation and regulations. Some economists argue that the relative size of the underground economy grows when the tax burden becomes heavier, all other things being equal.
Types of Underground Economic Activities:
|TYPES OF ACTIVITY||MONETARY TRANSACTIONS||NON-MONETARY TRANSACTIONS|
|ILLEGAL ACTIVITIES||Trade in stolen goods; drug dealing and manufacturing; prostitution; gambling; smuggling; fraud||Barter of drugs, stolen, or smuggled goods. Producing or growing drugs for own use. Theft for own use|
|LEGAL ACTIVITIES||Tax evasion – unreported income from self-employment. Wages, salaries, and assets from unreported work related to legal services and goods Tax avoidance- employee discounts, fringe benefits.||Tax evasion – barter of legal services and goods. Tax avoidance – all do-it-yourself work and neighbor help.|
4.9 Uses of National Income Statistics
National income statistics are calculated for many purposes, the most important ones being:
- to measure the total income (standard of living) of a country for this purpose national income is commonly measured in terms of national income per head (per capita) of population;
- to measure the improvement (deterioration) in national wealth and the standard of living over time;
- to compare the economic activity of different countries;
- to identify trends in consumer expenditure; e. to identify trends in industrial production; f. to assist central government in its economic planning
This session has been concerned with the measurement of economic activity based on national income accounting methods.
As we have discussed, the output, income, and expenditure methods should, in theory, provide the same estimates of economic activity but, in practice, a number of measurement problems are inevitable.
It is important, therefore, to be cautious in comparing and interpreting national income statistics and to be aware of the inherent shortcomings and pitfalls. However, such statistics are nevertheless of considerable value to all of us individuals, firms, and governments since they impact directly on decisions concerning corporate investment, government expenditure, taxation, interest rates, household savings, etc.
Answer the following questions as a way of assessing what you have learned in this session.
- Differentiate between factor costs and market prices
- Explain what is meant by national income
- Explain any five uses of national income statistics.
- Distinguish between the types of underground activity
- List four ways of measuring economic activity
- Outline the difference between Capital depreciation and stock appreciation 7. Mention the problems associated with measuring economic activity.
- Explain factor income from abroad,
- What do you think the growth of the underground economy is dependent on? Explain your answer.
- Explain double counting and any two dangers associated with it.