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National Income: Theory and Measurements

National Income: Theory and Measurements

Sam Choon Yin (2003)[i]

 

Introduction

National Income Accounting started in the Seventeenth Century by Sir William Petty (1623 – 1687) in England and Pierre le Pesant Sieur de Bouisguillebert  (1646 – 1714) in France. But it was not until the late 1920s and early 1930s where interests on international comparison of countries’ wealth began to develop. It was 1939 when the first international comparison of national income among 26 countries was undertaken. Unfortunately the degree of comparability of the national income statistics was rather low as each of the countries still adopted different methods of estimating their wealth. The first international comparison of national wealth using a common methodology was eventually made in 1944 involving only 3 countries; United States, Canada and Britain. The interest on developing a common methodology for estimating counties’ wealth was enhanced after World War 2 for policy making and decision making purposes.

The first System of National Accounts (SNA) to describe the common methodology was established in 1947. It served as a guide to governments around the world to make use of the same ‘standard’ methodology in calculating their national income statistics. The latest SNA report was published in 1993, giving details of the methods in calculating the social accounts by sectors and industries as well as the new satellite accounts. However, despite rapid developments and advancements of techniques to tabulate national income, the indicator does not provide a complete picture and measurement of peoples’ standards of living. As a result, other social indices like the Human Development Index and the Physical Quality Life Index were developed to supplement the national income statistics. In this essay we introduce certain important concepts of national income accounting and the various methods of calculating national income.

 

Basic Concepts and Definitions

Gross Domestic Product (GDP) measures the amount of goods and services produced within the boundary of the domestic economy in a given period of time (usually in one calendar year). This simple yet strong definition of GDP says that only goods produced this year are supposed to be included into this year’s national income statistics. Second hand goods like second hand cars are considered as ‘transfer’ of property (or change of ownership) from one person (the seller) to another person (the buyer). This transfer does not contribute to the output of the economy. Hence, the transactions should not be included in national accounts. Only the period when the goods were first produced considered their values and thus contributing to the country’s national income. However, it should be noted that services associated with the transfer should be included since income can be generated via the services. For instance, a consultant firm that helps to close the deal between the buyer and seller earns profit. The profit represents a part of the income earned by individuals in the economy. It creates further demand for goods and services leading to larger national income in years to come through the multiplier effect. If the good is produced in year t, then the value should be included in the calculation of the national product for year t. If the same good is re-sold in the next year (t+1), it cannot be included in the calculation of national product for the year (t+1) because the value of the good has already been incorporated in the national product for year t. The transactions in year (t+1) are merely transfers from the seller of the good (say a second hand car which will appear as a debit item in the durable goods account and credit in the financial account) to the buyer (fall in the cash holdings but rise in the holdings of durable goods). The net effect comes out to be zero, no net contribution to the output of the economy.

            Similarly, financial transactions such as shares, options and futures are not included in the national income accounting. Gains in theses transactions are basically derived from price fluctuations in the market. Government controls in the international financial market like the interest rates and exchange rates can lead to deviations from the interest parity conditions, creating money making opportunities to individuals in the market. These gains derived from speculative behavior of the financiers do not reflect any capital gains. They therefore do not contribute directly to larger amount of goods and services available to the economy in that year.[ii]

            To determine the types of goods that should be included in the National Accounts, a basic rule has been developed. The rule states that goods that are transacted in the market are economic output and should be included. To give an example, goods that are sold by retailers are transacted in the market and hence contributed to the national income of the economy. However, this definition is sometimes relaxed especially in the less developed countries where many of the goods produced in the counties do not pass through the market. It could possibly be due to the remoteness of villages which poses difficulties for statistical officers to obtain statistics on transactions actually carried out in the market. An example is the food produced by farmers in villages.

The rule can be stated in another manner. One can say that that national income accounting should include goods that cross the production boundary.  Final goods that are produced by the ‘productive sectors’ like manufacturing, construction, commerce, transport, communication, finance and businesses are transacted in the market or sold to the consumers in exchange for payments either in monetary or non-monetary terms.[iii] Transactions can be two-way in the productive sector. Final goods and services produced by the productive sector may ‘cross-over’ to the household sector in exchange for payments. It can be represented as 'consumption’ from the buyers’ point of view. This flow represents a flow into the productive sector. Part of the payment received by the productive sectors will flow back into the household (unproductive) sector in the form of wages, interest payments, rent and profit, which in gross value should be equal to the payments the productive sector received.

            Another important national income concept is the Gross National Product (GNP) which is GDP plus net property income from abroad. Net property income from abroad measures the difference between profits and dividends and interests on assets held overseas by domestic residents and profits, dividends and interests on assets held in the domestic economy by overseas residents.[iv] A positive (negative) net property income from abroad means that the receipts of interest, dividends and interests on assets from abroad by local residents is greater (smaller) than the profits, dividends and interests on assets paid abroad. Hence, GNP is considered as an ‘income’ estimate of a country’s wealth rather than a ‘product’ estimate, which prompts the United Nations to rename GNP as Gross National Income (GNI). It does not really matter which is used. Both figures should be similar at least in theory. Both GDP and GNP are extensively used to describe the country’s economic performance although some distinctions on the usage exist. GDP is generally preferred as a short-term measure of economic performance. In the short run, the general interest is to know the amount of resources available in the domestic economy, those that can be retrieved relatively easier. Moreover, GDP serves as a better tool to analyze domestic economic conditions like employment and unemployment. However, for long run analysis, GNP may be relatively more appropriate as an indicator. It takes into consideration the amount of resources owned by the domestic residents, regardless of the geographical location of the resources. In Singapore, investment by local residents in other countries has increased over time. Since 1989 (except 1993), GNP at current market price in Singapore has exceeded GDP at current market price, partly due to the ‘second wing’ policy introduced by the government to encourage local businessman to invest abroad. In terms of Foreign Direct Investment (FDI), outward investment had outweighed inward investment since 1981 (except 1981 and 1988).

            Net National Product (NNP) is the other national income concept that one ought to know. NNP measures the net value of total output, after corrected for capital depreciation. Part of the gross investment does not add to the country’s total product. They include those that are meant to replace worn-off machines and equipment. They should be excluded from the national income figures. In short, NNP measures how much the economy is producing after allowing gradual using up of capital stock (to maintain capital intact). Why do we need to estimate NNP? At times of war, it is useful to look at the NNP. Including the replacement investment as part of the total product may overstate the country’s national income during the war years as this form of investment (which could be large at times of war) is meant to replace the machines and equipment destroyed during the war. They do not contribute to the total product/output of the economy.

Measuring depreciation is not an easy task. Computing capital depreciation is purely subjective and full of loopholes. In practice, depreciation is usually treated as an imputed transaction. The firms in their bookkeeping records compute it internally. As a result, NNP is seldom used as a measure of economic performance.

            The next national income concept concerns distinguishing between GNP at market price and GNP at factor cost. The former measures the price of the goods and services sold in the market which include indirect taxes like excise tax or sales tax while the latter measures the amount received by factors of production that produce the good. I will illustrate the difference through an example. Consider an economy with a national product of $100. The figure can be decomposed into the income received by factors of production in the form of wage, interest received, rent and profits. Suppose now that the government imposes an indirect tax of 3 percent on the goods and services produced. The final value of the goods and services increases to $103. The national income valued at market price is therefore $103, but the factors of production still receive $100. The government collects the difference of $3 via the market. GDP at market price in this case is $103, the value of the goods and services actually paid in the market (crosses the production boundary) while GNP at factor cost is $100. The latter excludes indirect taxes received by the government. GNP at factor cost reflects the actual amount the factors of production received for the production of the final goods and services in the form of wage, interest, profits and rent. In the calculation of the disposable income, it is more appropriate to use GDP/GNP at factor cost rather than at market price.

            National income can be presented either at current prices or at constant prices. In the former case, both the output and price levels are allowed to change. Therefore, changes in the nominal GDP/GNP may be due to changes in the price level and/or the output level. On the other hand, GDP/GNP measured at constant prices allows only the output level to change. The prices remain fixed at the base year. This kind of national income is known as real income (or real GDP/GNP). There are various price indices one can use to deflate the national income figures such as the GDP deflator, Consumer Price Index and Producer Price Index. The general formula used to deflate the current national income figures is the same for all the indexes. Consider the following example. Suppose that the base year (say 1990) price index is 100 and the price index for the year 1991 is 103.5. Also assume that the current (nominal) GDP for 1991 is $130. To calculate the real GDP for the year 1991 at 1990 price level, we simply multiply the current GDP with the ratio of the price indexes for the base year to the current year, i.e. [$130. (100/103.5) = $125.60].  Because of the higher price level in 1991, the current/nominal GDP is relatively higher than the real GDP (recall that the GDP can be derived by multiplying the final sales figure with the market price level). With constant prices, only the physical output is allowed to vary. The real GDP shows a smaller figure reflecting the actual output changes. It is important to note that the real GDP series is very sensitive to the base year chosen. In practice, the base year is chosen because the year reflects stability in the country with minimal internal as well as external imbalances. In certain countries, the base year may be an averaged of the price levels for a period of few years so that on average any internal or external imbalances are even out.

 

Measuring the National Income

Basic Economics textbooks list three methods in measuring national income. They are the income approach, output approach and expenditure approach. Singapore reports her national output using all three methods. Whichever method used, the computed national income figures for a country for a specified period should be equal. However, in most cases, different national income figures are usually derived using different approaches. The difference is known in the literature as statistical discrepancy. The statistical discrepancy in Singapore has since reduced in size. For instance in 1986, it accounted for 1.9 percent of the GNP ($729.5 million) while in the last three years, the ratio has fallen to 0.009 percent in 1994, 0.0006 percent in 1995 and 0.0007 percent in 1996.

The size of the discrepancy can provide us with information on the relatively efficiency of the methods of collecting data. Also, statistical discrepancy can be used to measure the magnitude of a country’s hidden economy. Various definitions of hidden economy exist in the literature. Generally, the hidden economy is that part of the GDP which is under-reported and/or unreported in official statistics. The size of the hidden economy can be measured via the statistical discrepancy derived from national income and national expenditure. They are obtained using the income and expenditure approaches respectively. The idea is intuitively simple of understand. Unreported and/or underreported income earned will show up as expenditure, usually in the form of cash. For instance, a person may have earned $150 but reported only $100 in his income (which will be included in the national income accounting under the income approach). This means that $50 is not reported. His/her spending should amount to $150. The excess $50 shown in the expenditure accounts, and not in the income accounts is equal to the size of the hidden economy. What about those countries which do not generate national income statistics based on the income approach? Can they measure the hidden economy using statistical discrepancy derived from national output and national expenditure statistics?

            The answer is yes although unreported income is not shown in the discrepancy figures. Income earned by the individuals is not known. However, the discrepancies derived from national output and national expenditure can be used to measure the hidden economy. More specifically, they measure unreported and /or underreported goods and services produced in the country via the productive sectors. Recall that by definition, the national income figures measured using the three approaches should yield the same results that is national income calculated using the following expression:

 

Output Approach (T) = Income Approach (I) = Expenditure Approach (E)

 

Since E – I = H, where H is the size of the hidden economy, and T = I, then

 

E = T + H

H = E - T               (1)

 

Goods and services that are produced in productive sectors, which crosses the production boundary but are not reported to the tax authority, will show up as expenditure in the expenditure accounts.

In the next few paragraphs, I will discuss in greater details the three methods of measuring national income.

 

The Output Method

The output method measures the value added at the industry level. Basically, the measurements tell us how the industries perform over time or in a particular year.  They can measure structural changes in the country. The methodology involves estimating the value added or intermediate output of goods. Take for example a car industry. Suppose that the cost of producing a car is $50,000. Assume that to make the car the manufacturer requires $500 worth of steel, which the manufacturer buys from the steel industry. Steel in this case represents the ‘intermediate product’, which is used only at some point in time during the production of other good (the car, in this case) rather than in the form of a final consumption good. The value of the car quoted earlier at $50,000 has already incorporated the cost of the steel. Including the $500 worth of steel into the calculation of national income will actually lead to double counting. The same goes to other intermediate products like pig iron (say cost $300) and rubber ($500). See Table 1.

 

Table 1

Intermediate Products (An Example of a Car Industry)

Pig Iron  

$300

Rubber   

$500

Steel                           

$500

Other Components

$48,700

Final Output

$50,000

 

Therefore, in the calculation of national income, one can either 1) add up the value of all the intermediate products ($300 + $500+ $500 + $48,700) or 2) simply taking the final value of the car ($50,000). Quite clearly, the second option is much simpler as compared to the first option at least for the following two reasons. First, it can be tedious and time consuming for the statistical officers to sum up all the different intermediate products for different industries. Second, the cost involved in keeping large accounts of each intermediate product that the industries used can be substantial.[v]

            To summarize, the output approach in measuring the national income involves the following three stages; 1) estimate the gross output in various sectors, 2) determine the intermediate output and 3) estimate the reduction in the value of assets from wear or tear (more commonly known as depreciation). GDP/GNP can be obtained from either (1) directly or by summing all the different intermediate products in (2) while National Income Product (NNP) is obtained by deducting (3) from (1) and/or (2).

            Due to the large number of sectors in the country, it is appropriate to categorize the sectors into different industries. The task to standardize the various sectors was undertaken by two international group; Statistical Commission of the Economic and Social Council of the United Nation (1948) and the National Income Unit of the Organization for European Economic Co-operation (1952). The United Nation’s classification was commonly referred to as the International Standard Industrial Classification (ISIC) which consists of 10 divisions, classified according to their activities. Further sub-divisions were possible to delineate market breath. In Singapore, the latest Singapore Industrial Classification (SSIC) report was published in 1996 (replaced the 1990 version). The SSIC is adapted from the ISIC Revision 3 (1990), which has a total of 18 tabulated categories called ‘sections’ denoted by single alphabet.[vi] The main sections are further classified to 55 2-digit divisions, 155 3-digit groups, 317 4-digit classes and 1,024 5-digit items. To give an example, the Financial Intermediation Section (Code J) is further classified into the following;

 

Classification Name

Title

Code

Section

Financial Intermediation

J

Division

Financial Intermediation Except Insurance and Pension Funding

65

Group

Monetary Intermediation

651

Class

Public Financial Institutions

6511

Item

Monetary Authority

6511

Adapted from SSIC, 1996, p.5.

 

             In Singapore, the output approach of measuring national income has been reported by the Department of Statistics since 1967 for national income of 1960-1965. The approach draws data from various sources such as; External Trade Statistics, Census of Industrial Production, Income accounts from various statutory boards, Government Financial Statements, Censuses and Surveys of the Commerce and Services Sectors and other surveys carried out by the Department of Statistics.

             An advantage of using the output approach is its ability to report and measure the relative performance of the various sectors an economy. In the case for Singapore, one can note that the main sectors in Singapore are the manufacturing sector and financial and business sector, contributing about one-half of the total GDP in Singapore. Since 1993, financial and business sector had overtaken the manufacturing sector as the most important contributor to GDP. On the other side of the spectrum, the agriculture and quarrying sectors seem to be the least important sectors. This is not surprising since Singapore is a city-state with land area equals to approximately 640 squares kilometer. Singapore does not have much physical land area to build-up its agricultural sector, given that most of its land area is devoted to industrial estates, public housing and business offices and buildings.

 

The Income Approach

In the income approach, the national income is calculated using information on income received by factors of production. The basic idea of this approach is that income generated in the country’s economy in a given year has to be owned by economic agents in the form of wages (or salaries), rent, income and interest. Wages take up the largest component of the income generated. It includes payments received by labor suppliers (employees) as well as entrepreneurs. In 1996, the average monthly earnings in Singapore was S$2,347 as compared to S$2,219 in 1995, where the highest earnings recorded were found in the Financial and Business Services followed by the Community and Personal Services.[vii]

            Rent refers to the income received by economic agents for supplying property resources to the market. The income derived from rental payments is usually obtained from tax returns collected by the Inland Revenue and/or censuses. Rent refers to the inflow of steady income over a period of time, either daily, weekly or monthly depending on the agreement between the supplier and demander of land. The receipts contribute to the suppliers’ daily expenditures. Therefore the concept of rent is not similar to sales which can be a one-time payment type of transaction.  One should also distinguish between rent and consumption expenditure. To understand the distinction, one should be clear which method of calculating national income is being utilized. To illustrate, consider the following example. Suppose that individual A rents out an apartment to B who earns $1,000 per month for $200 per month. The question that we are interested is: how much do A and B contribute to the national income? To answer the question we have to first define the method used to measure the national income. Let us suppose the income approach method is used. Out of the four components of the income approach (wages, income, profit, rent), two of them are present here and they are wage ($1,000) received by B and rent payments ($200) received by individual A. Therefore national income contributed by these two individuals is $1,200 ($1,000 + $200).

Now let us consider the expenditure approach of measuring the national income. Recall that out of the total $1,200 wage received by individual B, $200 is paid-out to A as rent. Does the $200 considered as a form of consumption by individual B? The answer is no since the ‘expenditure’ here is ‘unrecorded’ (unlike expenditure on goods and services in retail outlets). However, the $200 received by A as rent, which is later spent on goods, and services are included in the calculation of national income. The total expenditure in this case is equal to $200 by individual A and $1,000 by individual B. This gives us a total of $1,200. Note that the figure is similar to the national income calculated using the income approach.[viii]

            Interest refers to the price of money services – the price one has to pay to borrow money. The recipients of the interest payments range from individuals to banks and entrepreneurs. Like rent, the interest payments and receipts are recorded by the respective enterprises. The relevant statements must be submitted to the Inland Revenue. Due to the complications involved in determining whether certain interest payments are to include or not in measuring national income, all enterprises involved must first be clear on the methodology used. This is to allow recordings to be made more efficiently to avoid double counting.  First, the enterprises must distinguish between interest payments and profits. Some enterprises may receive interest from other enterprises. These interest receipts can therefore be part of their profits. Profits recorded by the enterprises in the income tax forms should be adjusted for interest receipts to avoid double counting. Similarly, banks’ report in the income tax returns should distinguish clearly between profit before-interest expenses and profit after-interest expenses. If the profits declared by the banks are measured before deducting interest expenses to say households who hold accounts with the banks, then interest received by the households should not be included in the national income accounting. Conversely, if the profits declared by the bank in the income tax forms are based on after-interest expenses, then the Inland Revenue authority should include the interest receipts by the households.

            Profits refer to the difference between the revenue generated from the sale of output and the cost of the factors used in the production. Profits can be decomposed into three components; dividends, corporate income tax and undistributed profits. Dividend is the part of the profit that is distributed to the shareholders. The dividends paid out depend on the performance of the enterprises. The board of directors determines the amount. Corporate income tax flows to the government as government revenue. Undistributed profit is the ‘leftover’ of profits (after deducting the total profit from payments on interest, dividends, transfers and taxes). It can be retained or invested. 

Let me discuss more extensively about the undistributed profit. Several issues need to be clarified when estimating this component. First, enterprises have to take into account all foreign exchange dealings such as currency conversions using the appropriate exchange rates. Tax regulations in the foreign countries (withholding tax rates) and tax allowances must be carefully taken into consideration. It is possible for these enterprises to ‘cheat’ the government by underreporting the income to avoid tax payments.  Profits can be minimized through the adoption of accounting techniques or transfer pricing.[ix] If the extent of underreporting the enterprises’ income is large, then the national income estimated using the income approach may seriously under-estimate the true performance of the country’s economy. The converse can be true. It is possible (and increasingly common) for managers to inflate the companies’ profits. The purpose is to put more money into their pockets, enhancing their reputation and employability. Managers who do so can effectively ruin the companies’ reputation leading to failures in their businesses. External costs on the society like loss of jobs and shareholders’ wealth are thus created.

Secondly, in reporting the income statements by the enterprises, allowances received/offered by the government authority can be added up while profits accrued to the foreigners should be extracted. Thirdly, the enterprises should value the cost of the inventories at replacement costs, which reflect the current value of the inventories, rather than at the historical ‘average’ costs.  Measuring the inventories at current value allows comparison of national income estimates with other components since the latter is usually measured at current prices.

 

Expenditure Approach

            The expenditure approach is also known as the final product approach. As the name implies, the approach attempts to measure the total final product spent by households, firms and governments both domestically and abroad. Since the expenditure approach measures the ‘sales’ at which the various parties pay, the GDP/GNP measured is at market price. However market price values do not usually reflect the true national income of the country’s economy since transfers like taxes and subsidies can distort prices of goods. These transfers do not contribute to the production level of the economy. Therefore to convert GDP/GNP at market price to GDP/GNP at factor price, the former has to deduct indirect taxes less subsidies from the final sales value of each product group. In the System of National Accounts, the expenditures are usually classified according to the types of final products spent.

            Private consumption of goods and services can be classified to;

 

1)         consumer durable (except land and building)’

2)         non durable goods like food and

3)         value on the services provided by the government and private enterprises (like hotels, catering and restaurants).

 

However, one should note that not all household expenditures are included in national income computation. For example, expenditures of foreigners on local goods must be deducted while expenditures by local in other countries have to be included. Due to the difficulty involved in obtaining the relevant information, the distinctions can be ignored if we assume that the expenditures by foreigners in the home country is more or less equal to the expenditures by locals in the foreign countries. Inflows of gifts and remittances that do not contribute to the growth of national output must be excluded.

            Expenditures on goods and services by private consumers are usually classified into groups to ease allocation, measurement and interpretation. Based on the latest Consumer Price Index statistical handbook from the Department of Statistics (1995), the expenditures are classified into the following groups.

 

A)        Food

1) Non-cooked food          2) Cooked food

B)        Clothing

C)        Housing

D)        Transport and Communication

E)         Education

F)         Health

G)         Miscellaneous

 

            The second component in the expenditure approach of measuring national income is domestic capital formation (the first component discussed above is household consumption). Domestic capital formation is made up of domestic ‘private’ capital formation and domestic ‘public’ capital formation. In Singapore, the private sector had always been the main contributor to the level of capital formation. In 1960 for instance, the private sector accounted for 64.9 percent of the total gross domestic capital formation in Singapore. The percentage was raised to 75.3 percent in 1980 and 80.2 percent in 1995, peaking at 81.1 percent in 1970. Gross fixed capital formation in Singapore can be further divided into construction and works (which is made up of residential buildings, non-residential buildings and other construction and works), transport equipment and machinery equipment. In the private sector, transport and machinery equipment dominated. For instance, transport equipment peaked at 31.9 percent of the total fixed capital formation by the private sector in 1980 before declining to about 20.0 percent thereafter until 1995. Machinery equipment on the other hand were more superior since 1970, accounted for 46.8 percent of the total fixed capital formation by the private sector to 39.4 percent in 1980 and 41.7 percent in 1995, peaking at 53.7 percent in 1990. The expansion of the electronics perhaps explained the high performance of the machinery equipment component in the earlier years while the dominance of the component in the 1990s may be due to the structural transformation of Singapore into high-technology industries.

In the case of the public sector, residential buildings dominated since 1960 until today. In 1960 for instance, residential buildings accounted for 33.4 percent of the total fixed capital formation of the public sector. The percentage stayed well-above the 35.0 percent mark all through the 1970s and 1980s, peaking at 56.5 percent in 1983 before declining to 27.1 percent and 36.1 percent in 1990 and 1995 respectively.

            The third component of the expenditure approach is government expenditure, which comprises expenditures on books for national libraries and stationary for the various government departments and statutory boards etc. Note that in the Yearbook of Statistics of Singapore, government expenditure is classified as Government Consumption Expenditure. Total government expenditure in Singapore is made up of three components namely; government consumption expenditure, government fixed capital investment and government transfers. Detailed data can be obtained from the government’s budget.

            Government obtains its revenue mainly through taxes, fines imposed, and returns from investment. The funds are spent on, among other things, education, defense, and infrastructure development. Government expenditures can be used to stabilize the economy during recessions and booms and enhance the status of poorer people. It has been generally agreed among economists that incurring budget deficit is acceptable during recessions to expand the country’s economy. Government expenditures raise the country’s equilibrium national income through the multiplier effect.

            Net exports represent the final component of the national income determination. Goods produced in the home country can be exported to other countries. Exports can be in the form of goods and services. The former, like cars and computers, are tangible items. The latter, like tourist spending and consultation fees, are generally intangible and cannot be stored. Revenue receipts from exports are spent on imports, which like exports, can be in the form of goods and services. The actual receipts and payouts in foreign transactions are responsive to changes in exchange rates movements. To eliminate exchange rate risk, traders can engage in the derivative market, using financial instruments like forwards, futures, swaps and options. It is often perceived that importing is bad. This is not true. Importing of goods and services is useful if doing so can contribute to and assist further production thus potentially raising the national output. This is the case in Singapore. Goods produced in Singapore have high import content. This is not surprising given that Singapore is a city-state with very limited natural resources to support its production. Maintaining strong Singapore currency appears to be the development strategy adopted by the country’s regulating agencies to minimize import prices, which in turn raises the country’s export competitiveness against other countries. The general point to note is that trade (imports plus exports) should not be treated as a zero-sum gain although governments in transitional countries need to pace and sequence their liberalization process properly to suit their respective circumstances and environment.

 

Problems with using national income

As we know, the Gross Domestic (National) Product is the most frequently used indicator of a country’s economic performance. However, it faces several problems as a measure of society’s welfare. I will discuss some of these problems.

            Problems related to the use of GDP as a measure of performance (either to compare performances over time or between countries) are addressed in most (if not all) Economics textbooks.  The basic argument against the use of GDP is that, it fails to justify improvements in the welfare of the individuals despite an increase in the level of per capital GDP. The economic welfare of the individuals, as they argued, involves more parameters, and not merely income per capita of the country. Education attainment, health care provision, crime rates, infant mortality rate, life expectancy are some of the social indicators proposed to supplement national income statistics. These indicators should be used to supplement the national income indicator, rather than replacing it.

            As we have seen earlier, the calculation of GDP does not take into account of goods that are not transacted. For example, a carpenter who builds bookcases for sales in the market contributes to the economy’s GDP while the bookcases built for their own uses are not accounted in the economy’s GDP. Likewise, food served by restaurants to their customers is considered as transacted goods. They are added to the calculation of national income in the economy. On the other hand, home-cooked food which may taste as good (if not better) is not included as part of the national income. It is clear from the examples that the more self-help activities conducted, the larger is the under-estimation of the country’s national income, ceteris paribus. An increase in the number of housewives relative to the number of working mothers would have potentially detrimental effect on the levels of national income of the country involved. This is a serious problem if one is interested to make comparison of GDP between countries.

            It is generally perceived that higher income leads to happiness and improvements in general welfare of individuals. This may not be true. This is due to the various components of items included in the calculation of national income that do not have direct effect on economic welfare of individuals. Consider the country’s expenditures on defence. The expenditures are part of the government expenditure component. They can be regarded as a form of injection to the country’s circular flow of income. However, the economic well doing of the individuals is not likely to increase proportionately. In fact, individuals there may be living in fear as the increment in expenditure may give them an impression that the country is going to engage in a war with other countries. Similarly, expenditures by the government on environmental protections equipment may not imply that the individuals are better off. The expenditures are redundant and avoidable if individuals are more protective on the environment in which they live in.

            GDP figures were believed to tell inaccurately about the sustainability of the country’s economy. Impressive growth in GDP does not imply that the same level of GDP would be sustained in the long run. If, for instance, the growth came at the expense of environmental degradation, then future scenario would turn bleak in view of the declining sources of growth

            Countries like to compare their national income levels today with that of say, 30 years ago. Let’s take a hypothetical example. Country A for example, may report that its national income had increased to $10,000 today from $5,000 thirty years ago, and therefore claims that its economy had experienced an impressive growth of 100 per cent. Is there anything wrong with the statement? Yes. First, comparing absolute amounts does not reflect the conditions today and those that it experienced thirty years ago. The price factor is not accounted for.  As we know, national income could grow either as a result of increments in output, prices or both. To examine the true increment in output attributed solely to the increment in the output level, one has to remove the price effect. Price indexes have to be computed. The eventual national income figure should be quoted as real GDP instead of nominal GDP. Real GDP, therefore, refers to the value of output measured in constant price. The general rate of inflation is deducted to record the real command over resources. As was mentioned earlier, real GDP can easily be computed by dividing the nominal level of national income by the price index (usually the consumer price index or the GDP price deflator).         

            The use of consumer price index, however, has its own problem. The items used in the computation would have differed over the years, where some goods (items) may have been assigned more weights than others. For instance, the increasing used of hand phones and pagers in recent years certainly increases the need to assign more weights to these items than say 15 years ago. To tackle this problem, the index used has to be revised frequently (recommended five years once) to take into account recent trends and tastes of consumers, so that more appropriate weights can be applied to the items. As pointed out by Hogendorn (1992), the poorer a country and the less developed its statistical services, the less frequently one may expect for the indexes to be revised.[x]

            Besides taking into account price changes over time, it is also appropriate for economies to take into account changes in the population. An economy that enjoys two per cent growth in its national income may not see an overall growth in the national income level per capita if the population grew by more than 2 per cent in the same period. This is so as the higher income level now has to be shared with more people in the country. A more appropriate measure therefore is the computation of real income per capita to assess GDP performances over time.

            To see which economy is financially better off, one usually has to compare national income levels between one country and another. Country A for example, could be said to be relatively more advance if its national income is higher than Country B.  Can this sort of comparison be made internationally? Generally, the answer is yes but there are several problems.

            First, price effects have to be removed from nominal GDP to reflect the true output growth of the economy. This should be done for all countries if comparisons are to be made. Second, the countries’ population growths have to be considered. An economy with high level of national income, in absolute term, need not be relatively more well off if the pie has to be shared with a larger number of individuals.  Third, the comparison is only meaningful if the monetary values are reflected/converted into the same unit of measurement.  In practice, the national income of the economies is usually converted into US dollars. This was done via the official exchange rates that are available daily. For instance, assume that he exchange rate of Singapore against the US dollar is S$1.65 = USD1 and Singapore’s real GDP is assumed to be S$118 billion, then the equivalent Singapore’s real GDP in US currency should work out to be USD 72 billion. While the unit of measurement has been converted to the same currency, therefore facilitating comparison, the figures computed still does not reflect the true national income of the economy, in this case Singapore.

The reason being that the exchange rates captures only the purchasing power of the internationally traded goods. The prices of the non-traded goods are not reflected in the exchange rates. Why would this pose a problem? The use of exchange rates would not pose a problem if the prices of the non-traded goods between countries were similar (statistically) to the countries’ prices of the traded goods. Unfortunately, the prices of the non-traded goods are usually much lesser than the prices of similar non-traded goods. The reason being that, labor costs in the less developed countries are relatively cheaper as compared to those in more developed nations. As a result, a dollar of US currency would be able to purchase more units of non-traded goods in say India than the officially quoted exchange rates. Another cause of distortion in the officially quoted exchange rates is that, in some countries, the government deliberately controls the movement of the exchange rates either by means of exchange controls or simply putting a cap on the movement of exchange rates. The moves therefore distort the demand and supply of the currencies.

To tackle the problem, Irving Kravis, Alan Heston and Robert Summers from the World Bank (in the project called the International Comparison Project) attempted to compute a weighted average world price for each of the commodities (approximately 150 of them). Base on this, they computed the purchasing power parity foreign exchange rate. Basically, the series would be looked upon as the international dollar, which could be used to purchase commodities of all the countries without significant arbitrage profit making opportunities.

            In the calculation of national income, output produced by households is usually excluded. The word ‘usually’ is used here because in certain countries, household services are included by means of imputed values. In some other countries however, household services are excluded from the computation of national income. The implication is that the recorded national income tends to understate the true value. There are several reasons for excluding household services. First, the household services are non-transacted in the market. It is therefore, difficult to account for the types of services provided, the values that should be assigned to the services and the time spent by the individuals in providing the services. Second, there is a problem in defining household production for the services. More than one member of the family can undertake the services. Also, more than one activity could be undertaken. The lack of records to keep track on the output produced and time devoted to the production of the services generates additional hindrance to the inclusion of household services in national income computation.

There are further complications for the inclusion of household services. While imputed values can be assigned to household services, they too can be under-estimated. Work done at home carries an embodiment of love, care and a desire to promote the highest quality housework. These values, unfortunately, are difficult to quantify.

            Even, if the countries decide to include household production in the calculation of their national income, it would be difficult to make comparisons between countries. This is because of the difference in the nature of services provided by different households, depending on the culture and availability of technology. The latter for instance lightens the workload to household services. As a result, it is more appropriate to make comparison of household services over time rather than across countries.

            Despite the above problems involved in the computation of household services, social scientists have attempted to measure household production for social accounting purposes. Several factors have led to the increased in the interest of including household production in national income accounting. Some of these factors include advances in economic theory, improvements in the methodology of calculation, public interests in measures of quality of life, increasing number of female labor force participation which reduces the validity of using national income (without taking into of household production) as a comparison measurement between countries, new technologies introduced in household production and new discoveries for the use of empirical estimates on household production.  The imputed values can be found due to the availability of close equivalents of household services, which are not exchanged for money. Values for household services like cleaning, taking care of children, cooking for instance, can be compared with prices provided by similar services like launderettes, day-care centers and home cooked meal caterers.

            There are various methods in the calculation of household services. Two of the commonly used methods are the replacement method and the opportunity cost method.

The replacement cost method looks at the equivalent values that households can obtain if they are to undertake the activities in the market. Alternatively, one could take the value (wage) of a hire person to do all the items in the household, so that a single wage could be assigned to the particular individual. This is a simplified method and more practical in the sense that attaching a single wage to all items is much simpler than assigning different wages. One problem related to the replacement method is that it does not take into account quality differentials of individuals engaged in household production.

            The second method of computing household production is the opportunity cost method. The method attempts to measure the values of household production, based on the idea that people choose to work at home, because the present value of working at home exceeds the present value of the wages that could be obtained form working in the market. Therefore, the wage income that one has to give up when he/she chooses to engage in the household services of similar kind is taken as the estimated value of the household services.

 

Conclusion

            National income measures are often quoted in newspapers and other forms of media. They are observed by governments, international agencies, research institutions and business community. Even students and households are interested to how their country has performed economically. Historical national income figures are usually examined although there are also some individuals interested in predicting future GDPs. This present essay discusses this very often-quoted and important economic measure.

            The essay reminds readers that despite the usefulness, there are problems associated with using national income to measure the country’s economic and social welfare performances. Mostly used as a secondary data, users are generally not aware of the detailed methodology in collecting national income and the magnitude of errors made. But recognizing how the national income is generally measured is useful. This essay illuminates this point. If, after this essay, readers are able to define what national income is, highlighting what it measures, how it is computed and discusses some of its limitations as an economic measure, then my objective of writing this essay is met.

 

 



[i] This article was first written sometime in 1997. This is a revised version completed in October 2003. No efforts were put in to update the numbers. The original ideas remain.

 

[ii] However, it should be noted that in practice, it is difficult to distinguish between pure capital gains and trading profits from the financial transactions. In Singapore, the Department of Statistics (DOS) is currently reviewing the SNA methodology to include earnings of banks coming from treasury operations which the DOS thinks measures the capital gains of the banks and hence should be included in Singapore’s National Accounts.

 

[iii] The values included in the national income accounts comprise the price of the goods times quantity transacted. In the case of monetary payments, the price and quantity figures can be easily obtained. As for the non-monetary payments like goods transacted through barter trade, more detailed information is usually not readily available. In practice, the figure is derived via imputation using the value of almost similar goods transacted in the market.

 

[iv] International capital income consists of 1) profits derived from operation of branch plants and offices abroad and from the ownership of foreign subsidies, 2) dividends on the ownership of foreign stocks, 3) interest on foreign private and government bonds, foreign mortgages, and savings account and royalties from foreign properties and rights. Similarly the reverse takes place for international capital income paid abroad.

 

[v] However, this does not mean that keeping records of the intermediate products has no use at all. The records can in fact be utilised to analyse the input-output linkages between the industries. The benefits and costs illustrated above relate only to the measurement of national income as reported in the countries’ national income statistics.

 

[vi] The 18 sections are 1) Agriculture, Fishing, Forestry and Hunting (A, B), 2) Mining and Quarrying (C), 3) Manufacturing (D), 4) Electricity, Gas and Water (E), 4) Construction (F), 5) Commerce (G, H), 6) Transport, Storage and Communication (I), 7) Financial, Insurance, Real Estate and Business Services (J, K) and 8) Community, Social and Personal Services (L to Q).

 

[vii] The average earnings include bonuses but exclude employers’ contribution to the Central Provident Fund (CPF), which could account for 20 percent on the gross salary. One can easily compute the total gross earnings (inclusive of bonus) as follows. Let E be the average earnings, G is the average gross wage and we is the employers’ contribution rate to CPF. With this, we have

 

E + weG = G  or

G = E/(1-we)

 

Average gross wage without bonus (Gwb) can therefore be written as

 

Gwb = E/(1-we) – B where B is the average bonus.

 

[viii]Not all of the rental values received by property suppliers are recorded in income statements. Hence the computed rental values based on the income statements (received by the Inland Revenue) can be underestimated. In the above example, the national income figure measured using the income approach may be less than $1,200. The difference in the national income figures calculated based on the income approach and the expenditure approach is said to be resulted from hidden activities in the economy. To minimise the problem, some countries have tried to include the imputed rental value into the national income figures (from the income approach). The imputed rent can be estimated from the household expenditure surveys.

 

[ix] Transfer pricing refers to the technique employed by an enterprise to buy (sell) goods from its affiliated units or subsidiaries from another country which have lower (higher) corporate tax rates. By doing so, the enterprise aims to lower its tax payments since firms in a country with higher tax rates can experience a drop in profit levels while affiliated unit(s) in lower tax countries can earn higher profit levels. Transfer pricing is an illegal practise.

 

[x] Hogendorn, Jan (1992) Economic Development. Second Edition. HarperCollins Publishers (United States).