GDP growth increases personal disposable income

A couple of weeks ago, someone from this newspaper phoned and asked if I felt up to explaining, in somewhat greater detail, a throwaway sentence in a book review I had written. The sentence was, “I found something I had been planning to look up just last week — the 16 items I need to add and subtract to move from GDP at market prices to personal disposable income!” It didn’t seem like the most fun thing to do on a hot summer day. But since there are worse things than this, I have decided to try.

Growth in gross domestic product (GDP) is important because it translates into higher personal disposable incomes for households. This, then, leads to higher spending by them, which makes everyone, especially businessmen, very happy because the more people buy, the more profits there are to be made. In India, the personal disposable income (PDY) of households is around 83 per cent of GDP.

PDY is a measure of the volume of all goods and services produced within the domestic territory of a country during that year. The sum of the value of the final use goods sold in the market is referred to as GDP at market prices.

It is an unduplicated value of output, that is, only the value of production of the final use good is accounted in GDP. (This number can also be obtained as a sum of the “value addition” — value of output minus value of intermediate inputs — at all stages of production).

Clear as mud, right? Well, it gets worse because market prices of goods are affected by all kinds of taxes producers pay at the time of production, sale, purchase and the use of goods and services such as sales tax, excise, custom duties, etc. These are known as indirect taxes.

But life is not quite as horrendous for businessmen as it sounds because simultaneously, they also receive subsidies from the government usually for a combination of honest and dishonest reasons. This, too, affects prices.

This, therefore, yields the notion of “net” indirect taxes, that is, indirect taxes minus subsidies. Their inclusion in the market price makes the price different from what the “factors of production” (land, labour, entrepreneurship and capital) actually receive as income. When we add up all these “factor” incomes, we find that it is equal to the net value added by each of them.

Thus, GDP at factor cost can be obtained by adding the sum of factor incomes. It equals GDP at market prices minus net indirect taxes. This is what’s commonly referred to as GDP.

Next comes the idea of net product, which is gross product minus depreciation. As it is usually difficult to assign a value to depreciation, a fixed sum that seems likely to cover it is set aside. Subtracting this from GDP at factor cost gives net domestic product at factor cost.

But the whole of domestic production does not accrue to inhabitants of the country. A part of it goes abroad in the form of profits on foreign investment. Equally, however, some residents may receive factor incomes from abroad. The difference between these inflows and outflows constitutes “net factor income from abroad”. In India this is negative — just over 1 per cent of GDP — indicating that the outflow is larger than the inflow.

So we now come to net national income at factor cost. This is the income accruing to the residents of a country and is arrived at by adding net factor income from abroad to net domestic product at factor cost. It is commonly referred to as national income. It is, as you can see, a very clever name for the income earned by the nationals of a country.

Next, if we subtract from national income the income that accrues to the public sector, we get the national income that accrues to the private sector which also receives transfers. These are from three sources.

The first is from the government. These consist of unemployment benefits, old age pensions, state scholarships, etc. The second is current transfers from abroad that are received by residents from abroad but not in return for factor services provided. This includes gifts, grants, remittances, etc.

The third is interest on public debt received by the private sector from the government. This includes interest on small savings like the public provident fund, post office savings, national saving schemes, etc and constitutes about 5 per cent of household income. Add these transfers to the income accruing to the private sector and you get the income of the private sector.

The private sector, however, includes the private corporate sector as well. A part of income of the private sector is not paid to households as profits and dividends but kept within the corporate sector as undistributed profits. And another part is paid to the government in the form of corporate taxes.

If the savings of the private corporate sector and corporate taxes are subtracted from private income, you get the income that accrues to the household sector. It is defined as comprising individuals, unincorporated establishments like sole proprietorships, that is, all producer units which cannot be separated from the persons or households owning them and partnership and non-profit institutions serving households like charitable trusts, religious bodies, educational institutions, etc.

Personal income is the current income receipt of all persons from all sources. By deducting direct taxes such as income tax paid by households to government, we get what we were looking for — the personal disposable income of households.

Household personal disposable income is either saved or spent. The CSO does not provide data for household consumption expenditure. But data are available for private final consumption expenditure (PFCE), that is, the consumption expenditure of the private sector as a whole, including the corporate sector.

In this expenditure, four different categories of goods are distinguished, depending on the length of their physical lives. These are durable, semi-durable and non-durable commodities, and services. In India, about 20 per cent of private final consumption expenditure is on services while durables and semi-durables comprise less than 15 per cent. Most of the expenditure, around 65 per cent, is on non-durables.

Policies to push growth through an increase in consumption demand are therefore often aimed at raising personal disposable income by reducing direct taxes. Though durables constitute only about 12 per cent of the total consumption expenditure, tax cuts affect the incomes of those sections who spend far more on durables. Consequently, tax cuts are expected to have a significant positive impact on demand for consumer durables.

Why is all this important? Because recessions are caused by people spending less than industry thought they would, which leaves it with excess capacity, leading to either lower profits or actual losses. When, therefore, it tries to cuts costs, it further reduces PDY and the whole thing becomes a vicious circle.

That was why Keynes suggested that if the problem was deficient demand, it might be a good idea to let people dig holes and fill them up. Paying them for this highly creative effort would increase PDY and, therefore, demand. As a result, the economy would come out of recession.

I am sure Yashwant Sinha will not accept Keynes’ solution for industry’s current problems. He already has too many people engaged in the equivalent of an activity as futile as digging holes, namely, government service.