National Income Accounts

What is National Income Accounting?

National income accounting is a term which is applied to the description of the various types of economic activities that are taking place in the community in a certain institutional framework.  In national income accounting, we are concerned with statistical classification of the economic activity so that we are able to understand easily and clearly the operation of the economy as a whole.  In national income accounting the following distinctions are drawn between:

(a)    forms of economic activity, namely, production, consumption, and accumulation of wealth;

(b)   sectors or institutional division of the economy; and

(c)    types of transactions, such as sales and purchases of goods and services, gifts, taxes, and other current transfers.

In national income accounting, a transactor is supposed to keep a set of three accounts in which transactions are recorded:

(i)                  In the first account, incomes and outgoings relating a productive activity of the transactor are brought together.  The difference between the two shows the profit or gain.

(ii)                The second account seeks to show how this profit and any other income that accrues to the transactor are allocated to different uses.  The excess of income over outlay is saving.

(iii)               The third account shows how this saving and any other capital funds are used to finance the capital expenditure or to give loans to other transactors.

Since in an economy, there are numerous transactors, therefore, they are grouped into sectors.  In a sector, accounts of a same type are consolidated.  The ‘sector accounts’ form the units in a system of national income accounting.

Comparison of National Income Accounting and Individual Income Accounting:

(a)   Double entry book-keeping: Both national income accounting system and individual income accounting system are based on the method of double-entry book-keeping.  For example, under individual income accounting, a cash sale is recorded as a debit in Cash Account and as a credit in Sales Account.  Whereas, in national income accounting, the cash transactions are not separately presented.  Cash balances are recorded in the capital transaction account.  The difference is that the national income accounting does not record the second entry in detail.

(b)   Individual vs. collective individuals: Individual income accounts or private accounts relate to an individual businessman or a corporate firm.  Whereas, the national income accounts are closely related to all the businessmen or corporate firms in the community.

(c)    Profit and loss account: Individual income accounts are usually presented in the form of a Profit and Loss Account or Income Statement which shows the flow of income and its allocation during a year.  The Balance Sheet shows the stock of assets and liabilities at the end of the year.  The Profit and Loss Account of a private businessman resembles in national income accounting to what is called the Appropriation Account.  The only difference is that in private accounting, the profit often includes some elements of costs such as depreciation on plant and machinery and fees paid to the directors of the company.  On the other hand, in national income accounting, these incomes are shown net.  There is no counterpart at all of a Balance Sheet in national income accounting since there is a great difficulty in collecting such a huge bank of data accurately and completely especially on uniform basis.

Income Statement of a Typical Firm

For the year ended on December 31, 2005

Debits

Rs.

Credits

Rs.

To Sales Account

(50,000 units @ Rs. 25)

 

1,250,000

By Cost of Sales:

Wages

Rent

Interest

Profit (residual)

 

750,000

150,000

150,000

200,000

Total

1,250,000

Total

1,250,000

National Product Account 2004-05

(Millions of rupees)

Flow of Product

Rs.

Flow of Earning

Rs.

Final Output

(500 million units @ Rs. 25)

 

12,500

Costs or Earnings:

Wages

Rent

Interest

Profit

 

7,500

1,500

1,500

2,000

Total

12,500

Total

12,500

Uses of National Income Accounting:

(a)   Clear picture of the economy: The national income accounts or social accounts give a clear picture of the economy regarding the GDP, national income, per capita income, saving ratio, production, consumption, disposable income, capital expenditure, etc.  It gives a clear view of the health of the economy and the way in which it functions.  It also gives a view on the living standard of the people.

(b)   Promotion of efficiency and stability of the economy: To foster the economic growth, any government has to see what she has achieved in the past and what has to be done in the future.  For this purpose, the preparation of national income accounts is quite inevitable for the promotion of economic efficiency and stability.  It helps the government to set the national priorities, such as education, inflation, unemployment, defence, social development, and industrialisation, etc., in long-term and medium-term planning.  It also helps the planner to set the economic objectives to be achieved in the near future.  Thus it serves the purpose of planning and controlling tool for public administrators.

(c)    Measurement of economic welfare: Measurement of economic welfare is another purpose of the preparation of social accounts.  Through social accounting, we can know at a glace to what extent the masses are better off than at the time when planning started.

(d)   Interrelationship of different sectors of the economy: Through the study of national income accounts, the reader is in a position to inter-relate different sectors of the economy.  For example, through the study of national income accounts, we can know that Pakistan’s industrial sector is largely dependant on agriculture sector, because most of the raw materials like cotton, silk, leather, sugarcane, milk, poultry, etc. are supplied from agriculture.

(e)   Monetary, fiscal and trade policies: The national income accounts are very essential for the statesmen, governments, and politicians, because they help them to efficiently formulate different economic policies, including monetary policy, fiscal policy and trade policy.  In the absence of national income accounts, the economic planning would be disastrous.

Gross National Product (GNP):

GNP is the basic national income accounting measure of the total output or aggregate supply of goods and services.  It has been defined as the total value of all final goods and services produced in a country during a year.  GNP is a ‘flow’ variable, which measures the quantity of final goods and services produced during a year.  For calculating GNP accurately, all goods and services produced in any given year must be counted once, but not more than once.

Approaches of Measuring GNP/GDP:

The primary purpose of national accounts is to provide a coherent and comprehensive picture of the economy. To be concise, these estimates tend to answer questions such as:

(a)    What is the output of the economy, its size its composition, and its uses? And

(b)   What is the economic process by which this output is produced and distributed? These questions are addressed below in relation to estimation of GDP/GNP and final uses of the GNP.

The gross national product (GNP) is the market value of all final goods and services, produced in the economy during a year. GNP is measured in Rupee terms rather than in physical units of output. Gross domestic product (GDP) is a better idea to visualize domestic production in the economy. GDP may be derived in three ways or in combination of them.

(i)     Production Approach: It measures the contribution to output made by each producer. It is obtained by deducting from the total value of its output the value of goods and services it has purchased from other producers and used up in producing its own output, i.e.:

VA = value of output – value of intermediate consumption.

Total value added by all producers equals GDP.

(ii)   Income/Cost Approach: In this approach, consideration is given to the costs incurred by the producer within his own operation, the income paid out to employees, indirect taxes, consumption of fixed capital, and the operating surplus. All these add up to value added.

(iii) Expenditure Approach: This approach looks at the final uses of the output for private consumption, government consumption, capital formation and net of imports & exports.  According this approach, GDP is the sum of following four major components:

The concepts of expenditure approach and cost approach have been illustrated in the following diagram of circular flow of a simplified two-sector economy:

In the above diagram, the upper loop represents the ‘expenditure’ side of the economy.  Through this loop, all the products flow from business sector to household sector.  Each year the nation consumes a wide variety of final goods and services: goods such as bread, apples, computers, automobiles, etc.; and services such as haircuts, health, taxis, airlines, etc.  But we include only the value of those products that are bought and consumed by the consumers.  In our ‘two-sector economy’ illustration, we have excluded the investment expenditure, government expenditure and taxes from GDP calculation.

The lower loop represents the ‘cost or revenue’ side of the economy.  Through this loop, all the costs of doing business flow.  These costs include wages paid to labour, rent paid to land, profits paid to capital, and so forth.  But these business costs are revenues that are received by households in exchange of supplying factors of production to the business sector.

Precautions in Measuring GNP/GDP / Problems in National Income Measurement / Dangers of National Income Accounts:

The federal statisticians and economists have to be very careful in measuring GDP or preparing national income accounts.  The following precautionary measures should be taken:

(a)   Reliable source of data: All the data for national accounts are collected from different sources, including surveys, income tax returns, retail sales statistics, and employment data.  Inaccurate or incomplete data can severely damage the integrity of the national accounts.  The economists have to be very careful in collection and selection of national income accounting data.

(b)   Difficulties of Measuring Some Services in Money Terms: National Income of a country is always measured in money terms, but there are some goods and services, which cannot be measured, in monetary terms.  Such goods include, the services of the housewife, housemaid and the singing as a hobby by an individual.  Exclusion of these services from the national income, underestimate the national income account.

(c)    Illegal Activities in the Economy/The Growth of “Black Economy”: The “Black Economy” refers to that part of economic activity, which is undeclared and therefore unrecorded for tax purposes and is therefore deemed to be ‘illegal’.  Many illegal activities in the economy generally escape both the law and measurement in the national income.  Such illegal activities include, smuggling, drug trafficking and all parallel market transactions.  Since such activities are outlawed, income earned, through them are not captured in the national income, thus, under estimating the national income account.

(d)   Danger of double counting: While measuring GDP, we have to distinguish between the three forms of goods:

(i)     Final product: A final product is one that is produced and sold for consumption or investment.

(ii)   Intermediate good: Intermediate goods are semi-finished goods or goods-in-process.

(iii) Raw material: Raw materials are unfinished and unprocessed goods.

To avoid double or multiple counting, it is necessary to add the value of only those goods which have reached their final stage of production, i.e., final goods, and to not add the value of intermediate goods and raw materials, which are already included in the value of final goods.  GDP, therefore, includes bread but not wheat, cars but not steal.

(e)   Problem of Including All Inventory Change in GNP: Firms generally record inventories at their original cost rather than at replacement costs.  When prices rise, there are gains in the book value of inventories but when prices fall, there are losses.  So, the book value of inventories overstates or understates the actual inventories.  Thus, for correct computation of GNP, inventory evaluation is required.  This is achieved when a negative valuation of inventory is made for inventory gains and a positive valuation is made for losses.

(f)     Problem of Price Instability: Since national income is measured in money terms, fluctuation in the general price level will render unstable the measuring rod of money for national income.  When prices are rising, the national income figures are rising even though production might have gone down.  On the other hand, when prices are falling, GNP is declining even though the production might have gone up.  To solve this problem, economist and statisticians have introduced the concept of real income.

(g)   Exclusion of Capital Gain or Losses from GNP: Capital gain or losses accruing to property owners by increase or decrease in the market value of their asset are not included in GNP computation because such changes do not result from current economic activities.  Such exclusions underestimate or overestimate the GNP.

(h)   Value added: ‘Value added’ is the difference between a firm’s sales and its purchases of materials and services from other firms.  In calculating GDP earnings or value added to a firm, the statistician includes all costs that go to factors other than businesses and excludes all payments made to other businesses.  Hence business costs in the form of wages, salaries, interest payments, and dividends are included in value added, but purchases of wheat or steel or electricity are excluded from value added.  The following table illustrates the concept of value addition in GDP:

Table 1

Bread Receipts, Costs, and Value Added

Rupees Per Loaf

Stages of

Production

(1)

(2)

(3)

Sales

Receipts

Cost of

Intermediate

Materials

Value

Added

(wages,

profit, etc.)

(1 – 2)

Wheat

2.00

0

2.00

Flour

5.50

2.00

3.50

Baked dough

7.25

5.50

1.75

Delivered bread

10.00

7.25

2.75

Total

24.75

14.75

10.00

(i)     Non-productive transactions are excluded from GDP: The non-productive transactions are excluded from GDP measurement.  There are two types of non-productive transactions:

(i)     Purely financial transactions: Purely financial transactions are:

(ii)   Sale proceeds of second-hand goods.

Difference between GDP and GNP:

GDP is the most widely used measure of national output in Pakistan.  Another concept is widely cited, i.e., GNP.  GNP is the total output produced with labour or capital owned by Pakistani residents, while GDP is the output produced with labour and capital located inside Pakistan.  For example, some of Pakistani GDP is produced in Honda plants that are owned by Japanese corporations.  The profits from these plants are included in Pakistani GDP but not in Pakistani GNP.  Similarly, when a Pakistani university lecturer flies to Japan to give a paid lecture on ‘economies of under-developed countries’, that lecturer’s salary would be included in Japanese GDP and in Pakistani GNP.

Net National Product (NNP):

Net national product (NNP) or national income at market price can be obtained by deducting depreciation from GNP. NNP is a sounder measure of a nation’s output than GNP, but most of the economists work with GNP.  This is so because depreciation is not easier to estimate.  Whereas the gross investment can be estimated fairly-accurately.

NNP equals the total final output produced within a nation during a year, where output includes net investment or gross investment less depreciation.  Therefore, NNP is equals to:

NNP = GNP – Depreciation

It is the net market value of all the final goods and services produced in a country during a year.  It is obtained by subtracting the amount of depreciation of existing capital from the market value of all the final goods and services.  For a continuous flow of money payments it is necessary that a certain amount of money should be set aside from the GNP for meeting the necessary expenditure of wear and tear, deterioration and obsolescence of the capital and ‘it should remain intact’.

In the above definition, the phrase ‘maintaining capital intact’ is meant to make good the physical deterioration which has taken place in the capital equipment while creating income during a given period.  This can only be made by setting aside a certain amount of money every year from the annual gross income so that when the income creating equipment becomes obsolete, a new capital equipment may be created out.  If the depreciation allowance is not set aside every year, the flow of income would not remain intact.  It will decline gradually and the whole country will become poor.

National Income or National Income at Factor Cost:

National income (NI) or national income at factor cost is the aggregate earnings of all the factors of production (i.e., land, labour, capital, & organisation), which arise from the current production of goods and services by the nation’s economy.  The major components of national income are:

(i)                  Compensation of employees (i.e., wages, salaries, commission, bonus, etc.);

(ii)                Proprietors income (profits of sole proprietorship, partnership, and joint stock companies);

(iii)               Net income from rentals and royalties; and

(iv)              Net interest (excess of interest payments of the domestic business system over its interest receipts and net interest received from abroad).

National income can be calculated as follows:

National Income = NNP – Indirect Taxes + Subsidies

Personal Income:

Personal Income is the total income which is actually received by all individuals or households during a given year in a country.  Personal income is always less than NI because NI is the sum total of all incomes earned, whereas, the personal income is the current income received by persons from all sources.  It should be noted here that all the income items which are included in NI are not paid to individuals or households as income.  For instance, the earnings of corporation include dividends, undistributed profits and corporate taxes.  The individuals only receive dividends.  Corporate taxes are paid to government, and the undistributed profits are retained by firms.  There are certain income items paid to individuals, but not included in the national income, commonly known as ‘transfer payments’.  Transfer payments include old age benefits, pension, unemployment allowance, interest on national debt, relief payments, etc.  Personal income can be measured as follows:

Personal Income = NI at Factor Cost – Contributions to Social Insurance – Corporate Income Taxes – Retained Corporate Earnings + Transfer Payments

Disposable Income:

Disposable income is that income which is left with the individuals after paying taxes to the government.  The individuals can spend this amount as they please.  However, they can spend in categorically two ways, i.e., either they can spend on consumption goods, or they can save.  Therefore, the disposable personal income is equal to:

Disposable Income    =          Personal Income – Personal Taxes

or 

Disposable Income    =          Consumption + Saving

Details of National Income Accounts:

It is very important to take a brief tour of major components or particulars of national accounts or product accounts.  In this way, we can thoroughly understand the concept of GDP/GNP:

(a)   GDP Deflator: The problem of changing prices is one of the problems economists have to solve when they use money as their measuring rod.  Clearly, we want a measure of the nation’s output and income that uses an invariant yardstick.  This problem can be solved by using ‘price index’, which is a measure of the average price of a bundle of goods.  The price index is used to remove inflation from GDP or to deflate the GDP, that is why, it is also called ‘GDP deflator’.  The function of GDP deflator is to convert the ‘nominal GDP’ or the ‘GDP at current prices’ to ‘real GDP’.  The formula of real GDP is as follows:

Real GDP       =          Nominal GDP            

                                    GDP Deflator            

or

Q         =          PQ

             P

Nominal GDP or PQ represents the total money value of final goods and services produced in a given year, where the values in terms of the market prices of each year.  Real GDP or Q removes price changes from nominal GDP and calculate GDP in constant prices.  And the GDP deflator or P is defined as the price of GDP.

Example:

A country produces 100,000 litres of coconut oil during the year 2005 at a price of Rs. 25 per litre.  During the year 2006, she produces 110,000 litres of coconut oil at a price of Rs. 27 per litre.  Calculate nominal GDP, GDP deflator and real GDP (using 2005 as base year).

Solution:

Nominal GDP:

Year

Price

P

Quantity

Q

Price × Quantity

PQ

Nominal GDP

2005

25

100,000

2,500,000

2006

27

110,000

2,970,000

Hence, during 2006, the nominal GDP grew by 18.8%.

GDP Deflator:

P1         =          Current year price ÷ Base year price     =          Rs. 25 ÷ Rs. 25 = 1

P2         =          Current year price ÷ Base year price     =          Rs. 27 ÷ Rs. 25 = 1.08

Real GDP:

Year

Nominal GDP

PQ

GDP Deflator

P

Real GDP

(PQ/P)

Q

2005

2,500,000

1

2,500,000

2006

2,970,000

1.08

2,750,000

Hence, during 2006, the real GDP grew by 10%.

(b)   Investment and Capital Formation: Investment consists of the additions to the nation’s capital stock of buildings, equipment, and inventories during a year.  Investment involves sacrifice of current consumption to increase future consumption.  Instead of eating more pizzas now, people build new pizza ovens to make it possible to produce more pizza for future consumption.

To economists, investment means production of durable capital goods.  In common usage, investment often denotes using money to buy shares from stock exchange or to open a saving account in a bank.  In economic terms, purchasing shares or government bonds or opening bank accounts is not an investment.  The real investment is that only when production of physical capital goods takes place.

Investment can be further categorised as:

(i)     Gross investment: Gross investment includes all the machines, factories, and houses built during a year – even though some were bought to replace some old capital goods.  Gross investment is not adjusted for depreciation, which measures the amount of capital that has been used up in a year.

(ii)   Net investment: Gross investment does not adjust the deaths of capital goods; it only takes care of the births of capital.  However, the net investment takes into account the births as well as deaths of capital goods.  In other words, net investment is adjusted for depreciation.  Therefore, the net investment plays a vital role in estimating national income:

Net Investment    =          Gross Investment – Depreciation

(c)    Government Expenditure: Government expenditures include buying goods like from roads to missiles, and paying wages like those of marine colonels and street sweepers.  In fact, it is the third great category of flow of products.  It involves all the expenditures incurred on running the state.  However, it does not mean that GDP includes all the government expenditures including ‘government transfer payments’.  The government transfer payments, which include payments to individuals that are not made in exchange for goods and services supplied, are excluded from GDP measurement.  Such transfers payments include expenditures on pensions, old-age benefits, unemployment allowances, veterans’ benefits, and disability payments.  One peculiar government transfer payment is ‘interest on national debts’.  This is a return on debt incurred to pay for past wars or government programmes and is not a payment for current government goods and services.  Therefore, the interests are excluded from GDP calculations.

(d)   Net Exports: ‘Net exports’ is the difference between exports and imports of goods and services.  Pakistan is facing negative net export situation since her birth, except for few years.  The biggest reason is that Pakistan is a developing nation and consistently importing capital goods and final consumption goods from developed countries at much higher prices.  Whereas, we export raw materials and intermediate goods at lower prices, which have less demand due to their poor quality or because of availability of much cheaper substitute goods in the market.

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