Measuring National Income

1. Compensation of employees. Wages and salaries in cash and in kind, plus the employer's contribution to social security and pension.
2. Operating surplus. Rent and royalty from property, interest on capital lent, and profit. Profit itself divides into corporation tax, dividends and undistributed profits, and an answer that shows that split scores well.
3. Mixed income of the self employed. In India this matters more than anywhere, because a farmer, a shopkeeper or a rickshaw driver earns wages, rent, interest and profit at once and no separation is possible. The national accounts therefore have a separate category for it.

Adding these three gives net domestic product at factor cost. Add net factor income from abroad for national income.

What is excluded, and why.

• Transfer payments, such as pensions, scholarships and unemployment relief, because nothing was produced in return.
• Illegal incomes, because they cannot be recorded.
• Windfall gains such as a lottery prize, because no production accompanies them.
• Capital gains on the sale of an asset, because the asset was not produced this year.
• Corporate tax and personal income tax counted twice. These are parts of the incomes already counted, not additions to them.

Method three: expenditure

The rule. Sum all final expenditure on domestically produced goods and services.

The formula, which should be memorised:

GDP at market price = C + I + G + (X minus M)

• C, private final consumption expenditure: households and non profit institutions serving households.
• I, gross domestic capital formation: business investment in plant, machinery, buildings and the change in stocks, plus household investment in housing.
• G, government final consumption expenditure: what the State spends on goods and services for current use, valued at cost. Transfer payments are excluded.
• X minus M, net exports: exports minus imports. Imports are deducted because they were produced abroad and are already inside C, I and G.

Only final expenditure counts. Expenditure on intermediate goods is excluded, on the same reasoning as double counting in the production method.

The same economy measured three ways

The setting. An island economy for one year, in crore rupees. There are three producing units: a farm, a mill and a bakery, exactly as in the table above, with the numbers scaled up.

Production method. Farm value added 100, mill 60, bakery 100. Total value added 260.

Income method. The three units together paid wages of 150, rent of 30 and interest of 20, and their owners retained profit of 60. Total factor income 260.

Expenditure method. Households spent 240 on bread; the bakery added 20 to its stock of flour and equipment, which counts as investment. Total final expenditure 260.

Why the three agree. Because everything produced was either sold to a final buyer or added to stocks, and everything received for it was paid out to somebody as wages, rent, interest or profit. That is the circular flow. If in a real calculation the three differ, the difference is a measurement error and is recorded as errors and omissions, or discrepancies, in the published accounts, never suppressed.

Which method is used for which sector

No country uses one method for the whole economy, and knowing this is worth a paragraph.

• The production method is used where output is measurable in physical units: agriculture, mining, manufacturing, electricity.
• The income method is used where output cannot be measured directly but incomes can: public administration, defence, banking, education, health, professional services. The output of a government school is valued at what it cost to run.
• The expenditure method is used as a cross check on the whole, and it is the only one that gives the composition of demand, which is why the Economic Survey uses it to say how much of growth came from consumption, from investment and from net exports.

India's practice. The Ministry of Statistics and Programme Implementation, through the National Statistical Office, compiles the national accounts. Since the base year revision to 2011-12, the headline production side measure is gross value added at basic prices by industry of origin, and the headline demand side measure is GDP at market prices. Estimates are released as Advance, then Provisional, then First, Second and Third Revised, and the Statistical Appendix to the Economic Survey labels each. A figure quoted without its vintage is an unreliable figure.

The historical note an examiner sometimes wants. The first attempts to estimate India's national income were made by Dadabhai Naoroji in Poverty and Un-British Rule in India, whose estimate was part of his drain of wealth argument, and later by V. K. R. V. Rao. After independence the National Income Committee was appointed in 1949 under P. C. Mahalanobis, with D. R. Gadgil and V. K. R. V. Rao as members, and it produced the first official estimates. The Central Statistical Organisation, now part of the Ministry of Statistics and Programme Implementation, has done the work since 1954.

A worked example: what to include and what to leave out

Decide for each item whether it enters national income, and why. This is the commonest short question on the topic.

What beginners get wrong

"Add the sales of every firm." That is double counting. Add value added, or add final expenditure.

"National income is what the government collects." That is revenue, an entirely different quantity, and the subject of [The Sources of Public Revenue].

"The three methods sometimes give different answers, so one must be wrong." In principle they are identical. In practice the data come from different sources with different errors, and the published accounts carry a discrepancy line. That is honesty, not failure.

"Depreciation can be ignored." It is the difference between gross and net, and net is the figure that says what the economy actually has available.

Limits and criticism

It is only as good as the data. [The Difficulties of Measuring National Income in India] is the chapter on that.

Imputation is unavoidable and arguable. The imputed rent of owner occupied houses and the imputed value of a farmer's own produce are estimates, and different assumptions give different national incomes.

Revisions are large. An advance estimate can move by a percentage point when revised, which is why a growth rate should always be quoted with its vintage.

The base year matters. Changing the base year changes the level and sometimes the growth rate of the whole series, which is why the 2011-12 revision produced so much argument.

Quick revision

1. Three methods: production or value added, income, and expenditure. They measure the same circular flow at three points and must agree.
2. Production method: value of output minus intermediate consumption, summed over all units. The rule is avoid double counting.
3. Income method: compensation of employees plus operating surplus (rent, interest, profit) plus mixed income of the self employed, which matters most in India.
4. Expenditure method: GDP at market price = C + I + G + (X minus M). Only final expenditure; imports are deducted.
5. Excluded from all three: transfer payments, second hand sales, financial transactions, windfalls, illegal income, non marketed output.
6. In practice: production method for agriculture and industry, income method for services and government, expenditure method as a cross check and for the composition of demand.
7. India: compiled by MoSPI through the NSO, base year 2011-12, GVA at basic prices by industry of origin on the production side. Estimates run Advance, Provisional and Revised, and the vintage must be quoted.
8. History: Dadabhai Naoroji's estimate, then V. K. R. V. Rao, then the National Income Committee of 1949 under P. C. Mahalanobis, with the Central Statistical Organisation doing the work from 1954.

Test yourself

1. Describe the production method of measuring national income. The economy's producing units are classified into primary, secondary and tertiary sectors. For each unit the gross value of output is estimated as quantity multiplied by price, adjusted for the change in stocks, and the value of intermediate goods and services purchased is deducted to give gross value added at basic prices. Summing over all units and adding product taxes net of product subsidies gives GDP at market prices; deducting depreciation gives net domestic product, and adding net factor income from abroad gives national income. The essential precaution is to count only value added or only final goods, so as to avoid double counting.

2. What is double counting, and how is it avoided? Illustrate. Double counting is the error of including the value of the same output more than once by counting intermediate goods separately from the final good in which they are embodied. If a farmer sells wheat for 100, a miller sells flour for 160 and a baker sells bread for 260, adding all three gives 520 while the economy produced only 260. It is avoided either by counting only the final good, the bread at 260, or by counting the value added at each stage, which is 100 plus 60 plus 100 and comes to the same 260.

3. State the components of national income under the income method. Compensation of employees, comprising wages and salaries in cash and in kind and the employer's contribution to social security; operating surplus, comprising rent and royalty, interest and profit, with profit further divisible into corporation tax, dividends and undistributed profit; and mixed income of the self employed, which is important in India because farmers, shopkeepers and other own account workers earn wages, rent, interest and profit inseparably. Their sum is net domestic product at factor cost, to which net factor income from abroad is added to reach national income.

4. Give the expenditure method formula and explain each term. GDP at market price equals C plus I plus G plus exports minus imports. C is private final consumption expenditure by households and by non profit institutions serving them. I is gross domestic capital formation, that is investment in plant, machinery, buildings and housing together with the change in stocks. G is government final consumption expenditure on goods and services for current use, valued at cost, and it excludes transfer payments. Exports minus imports is net exports, imports being deducted because goods produced abroad are already included in C, I and G but were not produced domestically.

5. Why must the three methods give the same result? Because they measure the same circulation at three points. Whatever is produced is either sold or added to stocks, so the value of production equals the value of final expenditure. And the whole of the value produced accrues to somebody as wages, rent, interest, profit or mixed income, so the value of production also equals total factor income. In practice the three estimates are built from different data sources with different errors, so a residual difference appears and is published as errors and omissions rather than concealed.

6. Which method is used for which part of the Indian economy, and who compiles the accounts? The production method is used where physical output can be measured, in agriculture, forestry, fishing, mining, manufacturing and electricity. The income method is used where output cannot be measured directly, in public administration and defence, banking, education, health and professional services, whose output is valued largely at cost. The expenditure method serves as a cross check on the total and is the only one that shows the composition of demand. The accounts are compiled by the National Statistical Office in the Ministry of Statistics and Programme Implementation, with the base year 2011-12, and estimates are published as advance, provisional and revised.

7. Classify the following and give reasons: an old age pension, the imputed rent of an owner occupied house, the purchase of a government bond, and a farmer's own consumption of his grain. An old age pension is excluded, because it is a transfer payment made without any current production in return. The imputed rent of an owner occupied house is included, because the house yields a housing service which is consumed and which can be valued at the market rent of a comparable dwelling. The purchase of a government bond is excluded, because it is a financial transaction that transfers a claim rather than producing a good or service, although the interest later paid is treated separately. A farmer's own consumption of his grain is included by imputation, because it is production, it is measurable in physical units and it can be valued at market price.