The vast majority of domestic production is undertaken by factors of production owned by domestic citizens (national income is about 80 percent of gross domestic product). However, key differences do exist. The six main differences between gross domestic product and national income are (1) capital consumption adjustment, (2) indirect business taxes, (3) business transfer payments, (4) net foreign factor income, (5) government subsidies less surplus of government enterprises, and (6) statistical discrepancy.
The following equation captures the relation between national income (NI) and gross domestic product (GDP):
|NI||=||GDP||- Capital Consumption Adjustment - Indirect Business Taxes |
- Business Transfer Payments + Net Foreign Factor Income
+ Government Subsidies less Current Surplus of Government Enterprises
- Statistical Discrepancy
Capital Consumption AdjustmentThe capital consumption adjustment (or allowance) is a portion of the revenue received by the business sector from the sale of production that is set aside to replace depreciated capital. The capital consumption adjustment is revenue received by the business sector but NOT earned by the domestic factors of production. This capital consumption adjustment, by the way, is also what separates gross domestic product and net domestic product.
Indirect Business TaxesIndirect business taxes is the official term used in the National Income and Product Accounts for sales taxes. These are termed INDIRECT taxes because the business sector has the DIRECT responsibility of paying these taxes to the government sector, but the business sector really acts as the "collection agency" for the government, collecting the taxes from the household sector. The taxes are paid INDIRECTLY by the household sector.
In general, sales taxes drive a wedge between the price buyers pay for production (demand price) and the price sellers receive for production (supply price). The demand price IS the market value of production measured by gross domestic product. The supply price is the opportunity cost of the resources used in production, which is factor payments and income earned by the factors (that is, national income). To the extent that sales taxes increase the demand price above the supply price, gross domestic product is greater than national income.
For example, suppose Maurice Finklestein decides to buy a Wacky Willy Stuffed Amigo from the local MegaMart Discount Warehouse Super Center that carries a "shelf price" of $10. However, Maurice needs more than $10 to complete this purchase. The reason, of course, is that the local sales tax is 5 percent. Any purchase made at the MegaMart Discount Warehouse Super Center includes the "shelf price" plus 5 percent. His total expense is thus $10.50.
This means that Maurice must obtain at least $10.50 worth of satisfaction from his Stuffed Amigo. If he receives less than $10.50, then he would not by this Stuffed Amigo. He would spend his $10.50 on a good that DID provide $10.50 worth of satisfaction. This is the essence of what gross domestic product seeks to measure. And from the expenditure approach to measuring GDP, this $10.50 would be included in its entirety.
Now consider the income approach to measuring GDP. The income generated from the production of this Amigo is not $10.50, but only $10. The opportunity cost of using the four factors of production to supply this Stuffed Amigo is $10. To see why, all that is needed is to ask the question: "What is the minimum price MegaMart Discount Warehouse Super Center would except for this Stuffed Amigo WITHOUT SALES TAXES?" The answer, of course, is $10. This $10 covers production cost, which is another way of saying that the factors of production (labor, capital, land, and entrepreneurship) need a total of $10 in income to produce and supply this Stuffed Amigo.
As such, the $10.50 revenue received by the MegaMart Discount Warehouse Super Center is divided in two ways. The first $10 is used to pay the factors of production, which is then included in national income. The remaining $0.50 is used to pay sales taxes.
In the same way, gross domestic product includes the total revenue generated in production, which is then divided among national income and indirect business taxes.
Business Transfer PaymentsBusiness transfer payments are subsidies, or gifts, made from the business sector to the household sector. While a portion of business transfer payments are, in fact, outright gifts to the household sector (such as student scholarships), a substantial portion results when unpaid debts are "written off." In effect, when the business sector "writes off" an unpaid debt, the are giving the household sector "free" goods.
Suppose, for example, that Lisa Quirkenstone purchases a bunch of goods from the MegaMart Discount Warehouse Super Center using her MegaMart Discount Warehouse Super Center installment credit card, a common practice in the retail industry.
In principle, Lisa would pay this debt off over time. However, what would happen if she turned out to be something of a deadbeat, who becomes unemployed and unable to pay off this debt? Try as they may, MegaMart Discount Warehouse Super Center, is unable to collect payment. After several years, they simply write off her debt as uncollectable.
In essence, they have given Lisa the goods that she supposedly "purchased." She receives the goods, but MegaMart NEVER receives payment. This ends up being nothing more than a gift, just as if they had bought Lisa a bunch of birthday presents.
Business transfer payments enter the National Income and Product Accounts much like the capital consumption adjustment. They are part of gross domestic product, but never make it to national income. Business transfer payments are included in the value of the final goods produced (after all, Lisa receives value from the goods that she "bought" MegaMart Discount Warehouse Super Center), but they are not included as factor payments (nor national income). Business transfer payments can be thought of as an extra cost tacked onto the price of goods, over and above factor payments, that compensates for bad debts incurred by the household sector.
Net Foreign Factor IncomeNet foreign factor income is the difference between factor payments received from the foreign sector by domestic citizens and factor payments made to foreign citizens for domestic production. This is, by the way, the key difference between gross DOMESTIC product and gross NATIONAL product. Net foreign factor income actually represents a two-part adjustment between gross domestic product and national income.
A portion of the revenue received from producing DOMESTIC output is actually paid to foreign citizens. As such, factor payments made to foreign citizens for domestic production, much like the capital consumption adjustment and indirect business taxes, are revenue generated from gross DOMESTIC product that is not part of NATIONAL income received by domestic citizens.
However, in a classic example of turn-about is fair play, a portion of the income earned by domestic citizens is the result of production that is part of gross domestic product for OTHER nations. These are factor payments received from the foreign sector by domestic citizens. They are added to factor payments generated by domestic production to obtain national income.
Government Subsidies Less Surplus of Government EnterprisesGovernment subsidies are transfer payments from the government sector to the business sector. As transfer payments, government subsidies are NOT payments for current production. In essence they are government gifts to the business sector. These are then added to the pool of revenue that the business sector uses for factor payments (and thus national income). Because the business sector does NOT receive this revenue as the result of producing goods, it is part of national income but not part of gross domestic product.
In the National Income and Product Accounts, government subsidies are adjusted by the current surplus of government enterprises. Government enterprises are productive activities that essentially operate like private sector businesses. One example is a city that sells electricity directly to consumers. This city-owned electric "company" operates like a privately owned electric company, with one primary difference--the "profit" received.
Because the term "profit" is reserved for use by private businesses, any revenue received by government enterprises over cost is termed government surplus. This surplus is generated from producing valuable output, and is part of gross domestic product.
From a national income perspective, the surplus of government enterprises is important because, unlike private business profit, it is NOT officially earned by any factors of production. Rather than being paid out as national income to any productive factors, this surplus is returned to government treasuries.
Statistical DiscrepancyThe last official difference between gross domestic product and national income is the statistical discrepancy. This is the official "fudge factor" that ensures gross domestic product measured from the expenditure side is equal to gross domestic product measured from the income side.
Even though the two approaches to measuring gross domestic product SHOULD yield identical results, in reality this seldom happens. The economy is extremely complex and measurements are not perfect. This statistical discrepancy is thus used to ensure perfect equality.
While the statistical discrepancy is officially added to national income to when calculating gross domestic product, this value could be either negative or positive. The value of the statistical discrepancy is whatever it needs to be to equate the income and expenditure approaches to measuring gross domestic product.
NATIONAL INCOME AND GROSS DOMESTIC PRODUCT, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2018. [Accessed: March 18, 2018].