National Income- 1 by Jatin Verma

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National Income- 1 By Jatin Verma

Topics to be Covered

➢ Idea of National Income ➢ What is National Income? ➢ Gross Domestic Product (GDP) ➢ Types of GDP ➢ Understanding circular flow of income ➢ Source of GDP Calculation ➢ Changing Patterns ➢ GDP Calculations ➢ Measures of inflation ➢ Consumer Price Index (CPI) ➢ Wholesale Price Index (WPI)s ➢ GDP Deflator ➢ National Domestic Product(NDP) ➢ Gross National Product (GNP) ➢ Net National Product (NNP) ➢ Personal income and personal disposable income ➢ Base year and related concepts ➢ Ministry of Corporate Affairs (MCA)- 21 ➢ Current Scenario

Idea of National Income • Income is probably the most frequently used term in economics, used by experts and lay men. Income level is the most commonly used tool to determine the well-being and happiness of nations and their citizens. • Basically, when the idea of ‘human development’ came into being in the early 1990s, the concept of the ‘human development index’ ultimately was heavily dependent on the level of ‘income’ of an individual in a country. • Education and life expectancy can only be enhanced once the required amount of ‘investment’ (expenditure on them) could be mobilized. Thus, somehow, income came to be established as the ‘focal point’ of ‘development/human development’. • As income of a single person can be measured, it can be measured for a nation and the whole world.

National Income • What generates the economic wealth of a nation? What makes countries rich or poor? First you should know how income is generated in an economy? • There was a time when possession of natural resources was considered the most important factor for being a rich country. • But the resource had to be transformed through a production process.

• The point is how these resources are used in generating a flow of production and how income and wealth are generated from that process.

How does this flow of production arise?

• People combine their energies with natural and manmade environment within a certain social and technological structure to do production. • From the smallest items like pins to the largest ones like aeroplanes or any saleable service like that of the doctor –the goods and services produced are to be sold to the consumers. • The consumer may be an individual or a firm. • The good or service purchased by consumer might be for final use or for use in further production. • A farmer producing cotton sells it to a spinning mill where the raw cotton undergoes transformation to yarn; the yarn is, in turn, sold to a textile mill where, through the productive process, it is transformed into cloth; the cloth is, in turn, transformed through another productive process into an article of clothing which is then ready to be sold to the consumers for final use. • Such an item that is meant for final use and will not pass through any more stages of production or transformations is called a final good.

For example: • The tea leaves purchased by the consumer are used to make drinkable tea, which is consumed. • But cooking at home is not an economic activity, even though the product involved undergoes transformation. Home cooked food is not sold to the market. So Tea leaves are the final product here. • However, if the same tea brewing was done in a restaurant where the cooked product would be sold to customers, then the same items, such as tea leaves, would not be called final goods. They will be called intermediate goods.

• Goods like food and clothing, and services like recreation that are consumed when purchased by their ultimate consumers are called consumption goods or consumer goods. (This also includes services which are consumed) • Goods which are used in the production process - tools, implements and machines. They are also final goods yet they are not final goods to be ultimately consumed. These are capital goods. They gradually undergo wear and tear, and thus are repaired or gradually replaced over time. • Since each of these commodities is produced for sale, the sum total of the monetary value of these diverse commodities gives us a measure of final output. • The value of the final goods already includes the value of the intermediate goods that have entered into their production as inputs. Counting them separately will lead to the error of double counting. • That part of our final output that comprises of capital goods constitutes gross investment of an economy. • The money spent on regular wear and tear should be deducted from the value of gross investment. This is called depreciation. This does not add any new investment. It is for maintenance only.

Understanding circular flow of income

• The circular flow of income or circular flow is a model of the economy in which the major exchanges are represented as flows of money, goods and services, etc. between economic agents. • Income is money (or some equivalent value) that an individual or business receives in exchange for providing a good or service or through investing capital. • For individuals, income is most often received in the form of wages or salary. • There are four ways to calculate the income of a nation, which are the subject matter of the ‘national income accounting’ • Let us suppose a simple economy – without a government, external trade or any savings. • This economy consists of only two entities - Households and firms • The households receive their payments from the firms for productive activities they perform for the firms. • There may fundamentally be four kinds of contributions that can be made during the production of goods and services (a) contribution made by human labour, for wage is paid (b) contribution made by capital, for which interest is paid (c) contribution made by entrepreneurship, for which profit is paid

(d) contribution made by fixed natural resources (called ‘land’), for which rent is paid. • In this simplified economy, there is only one way in which the households spend their incomes – by spending their entire income on the goods and services produced by the domestic firms. • We have assumed that the households do not save, they do not pay taxes to the government – since there is no government, and neither do they buy imported goods since there is no external trade in this simple economy. • In other words, factors of production use their incomes to buy the goods and services they produced. • The aggregate consumption by the households of the economy is equal to the aggregate expenditure on goods and services produced by the firms in the economy. • The entire income of the economy, therefore, comes back to the producers in the form of sales revenue. • Hence year after year, we can imagine the aggregate income of the economy going through the two sectors, firms and households, in a circular way. • This is represented in the given fig in next slide. • Since the value of expenditure must be equal to the value of goods and services, we can equivalently measure the aggregate income by “calculating the aggregate value of goods and services produced by the firms”. • When the aggregate revenue received by the firms is paid out to the factors of production it takes the form of aggregate income.

• In Fig. the uppermost arrow, going from the households to the firms, represents the spending households do to buy goods and services produced by the firms. • The second arrow going from firms to households stands for the goods and services which are flowing from the firms to the households. • This flow is what the households are getting from the firms, for which they are making the expenditures. • In short, the two arrows on the top represent the goods and services market – the arrow above represents the flow of payments for goods and services, the arrow below represents the flow of goods and services. • A flow is a quantity which is measured with reference to a period of time. Thus GDP is the flow of goods and services over a period of time. • The two arrows at the bottom of the diagram similarly represent the factors of production market. • The lowermost arrow going from the households to the firms symbolizes the services that the households are rendering to the firms. • Using these services the firms are manufacturing the output. • The arrow above this, going from firms to households, represents the payments made by the firms to the households for the services provided by the latter. • We can measure the uppermost flow (at point A) by measuring the aggregate value of spending that the firms receive for the final goods and services which they produce. • This method will be called the expenditure method. • If we measure the flow at B by measuring the aggregate value of final goods and services produced by all the firms, it will be called product method. • At C, measuring the sum total of all factor payments will be called income method. • Observe that the aggregate spending of the economy must be equal to the aggregate income earned by the factors of production (the flows are equal at A and C). • No matter how complicated an economic system may be, the annual production of goods and services estimated through each of the three methods is the same. • We now discuss the detailed steps of these calculations. • There are four ways to calculate the income of a nation which are the subject matter of the ‘National Income Accounting’.

Net National Gross Product National (NNP) Net Product Domestic (GNP) Gross Product Domestic (NDP) Product (GDP)

Gross Domestic Product (GDP) • Gross Domestic Product (GDP) is the value of the all final goods and services produced within the boundary of a nation during one year period. • For India, the calendar year is from 1st April to 31st March. • For the calculation, it is necessary to understand the terms used in the concept, ‘gross’, means ‘total’ which means same thing in Economics and Commerce. • ‘Domestic’ means all economic activities done within the boundary of a nation/ country and by its own capital; • ‘Product’ is used to define ‘Goods and Services’ together; and ‘Final’ means the stage of a product after which there is no known chance of value addition in it.

Sources of GDP calculation • In India, GDP is calculated by the Central Statistics Office (CSO). • CSO functions under the Ministry of Statistics and Program Implementation. • Previously, the GDP was estimated based on Index of Industrial Production (IIP) data from the Annual Survey of Industries (ASI). • The Annual Survey of Industries (ASI) is the principal source of Industrial Statistics in India. The data includes evaluation of the Principal characteristics of factories, employees, capital, net and gross value, benefits and funds etc. over a period of time on an annual basis. • Now, since the launch of new GDP series in 2015, the corporate affairs ministry’s MCA 21 database and 2011-12 as a base year, is being used for calculation of GDP . It is a wide- ranging compilation of balance sheet data of lakhs of firms.

• MCA-21 database was used on the recommendations of Rangarajan Commission, which reviewed the Indian Statistical System in 2001.

GDP Calculation • It is calculated in three ways which are as follows-

Expenditure Method

Income Method

Production Method

• Expenditure Method: • It is also calculated by adding national private consumption, gross investment, government spending and trade balance (exports-minus-imports). • The use of the exports-minus-imports factor removes expenditures on imports not produced in the nation, and adds expenditures of goods and service produced which are exported, but not sold within the country.

• C (consumption) is normally the largest GDP component in the economy, consisting of private (household final consumption expenditure) in the economy. • I (investment) includes, for instance, business investment in equipment, but does not include exchanges of existing assets. • G (government spending) is the sum of government expenditures on final goods and services. It includes salaries of public servants, purchase of weapons for the military, and any investment expenditure by a government.

• X (exports) represents gross exports. GDP captures the amount a country produces, including goods and services produced for other nations’ consumption, therefore exports are added. • M (imports) represents gross imports.

Changing pattern of consumption • The data from NSSO Household Consumption survey also shows the increase in the share of non-food expenditure in total consumption over time. • Share of food in total consumption has gone down. • Overall, the share of non-food expenditure has increased with the expenditure share increasing for education, medical, conveyance and durable goods. • This shows that the shift towards discretionary spending has been increasing while with the spending on necessities has been gradually decreasing.

Current trends in Government spending [G] i.e. Government Final Consumption Expenditure (GFCE) • Government Final Consumption Expenditure (GFCE) at Current Prices is estimated at ₹24.34 lakh crore in 2019-20 as against ₹21.35 lakh crore in 2018-19. • At Constant (2011-12) Prices, the GFCE is estimated at ₹16.65 lakh crore in 2019-20 as against ₹15.06 lakh crore in 2018-19. • In terms of GDP, the rates of GFCE at current and constant (2011-12) prices during 2019-20 are estimated at 11.9 per cent and 11.3 per cent, respectively, as against the corresponding rates of 11.2 per cent and 10.7 per cent, respectively in 2018-19. • GFCE is calculated using growth of revenue expenditure net of interest payments and subsidies. • GFCE comprises government’s (revenue) expenditure on compensation of employees, net purchase of goods and services and consumption of fixed capital. • The third major component of demand is investment. ✓ Investment (Gross Capital Formation) accounts for nearly 32 percent of GDP, within which fixed investment (Gross fixed capital formation) accounts

for about 29 per cent of GDP. ✓ The other two components of investment are change in stocks and valuables, each having a share of around 1 percent in GDP. ✓ Fixed investment mainly refers to the value of new machinery and equipment and the value of new construction activity of dwellings and other structures.

Current trends in Net Exports ( Exports - Import [X - M] • The fourth component of demand is net exports. • As India is a net importer, net exports are always negative. However, the growth contribution of net exports is positive in many years.

GDP Calculation Example Solution: By using the data in Table 1 we can calculate the GDP using the expenditures approach. As you can see, the table contains more data than is necessary so you have to look for the parts which make up the expenditures approach to calculating GDP. The necessary data is highlighted within the table. Remember: GDP = C + G + I + (X - M) In this case the C is represented by Household Consumption which is $304. The G refers to Government Spending which is $156. I is gross private investment and is $124. (X - M) is the net exports and in the table is shown to be $18.

Therefore: GDP = $304 + $156 + $124 + $18; GDP = $602

• Income Method: It takes into account the income generated from the basic factors of production which are: Land, Labor, Capital and Organization. • Only those incomes that are come from the production of goods and services are included in the calculation of GDP by the income approach. We exclude: • Transfer payments e.g. the state pension; income support for families on low incomes; the Jobseekers’ Allowance for the unemployed and other welfare assistance such housing benefit and incapacity benefits

• As we can see in the table, growth of real per capita PFCE is slightly higher than that of per capita GDP or per capita net national income (NNI). ✓ Definition: Gross fixed capital formation is essentially net investment. It is a component of the Expenditure method of calculating GDP. ✓ Gross fixed capital formation measures the net increase in fixed capital.

✓ Gross fixed capital formation includes spending on land improvements (fences, ditches, drains, and so on); plant, machinery, and equipment purchases; the construction of roads, railways, private residential dwellings, and commercial and industrial buildings.

Production Method or GVA Method for calculating GDP: • It focuses on finding the total output of a nation by directly finding the total value of all goods and services a nation produces. • Because of the complication of the multiple stages in the production of a good or service, only the final value of a good or service is included in the total output. • This avoids an issue referred to as double counting, where the total value of a good is included several times in national output, by counting it repeatedly in several stages of production.

Example: Production Method • Suppose there are just 2 producers in an economy. First one is a farmer and the 2nd one is a hotel owner. Farmer produces vegetables worth Rs. 200 in a year without using any input except human labor. • Farmer sells vegetables worth Rs. 100 to the hotel owner. Hotel owner use this vegetable to prepare food dishes worth Rs. 400 in a year. • Now while calculating the national income for the mentioned economy, if we directly add the production value of both producers, we will get a figure of Rs. 600 (400(hotel’s produce) + 200(Farmer’s produce)). • But by using the Value added method for calculating national income we will get a total figure of Rs. 500. While using this method we will deduct the value of vegetables purchased by hotel owner from farmer i.e. 400 - 100 = 300. Therefore, the net contribution made by the bakers is, Rs 400 – Rs 100 = Rs 300 • Hence, aggregate value of goods produced by this simple economy is Rs. 500.

Current Situation of GVA

Types of GDP

Nominal GDP: • It is the market value of goods and services produced in an economy, unadjusted for inflation. • The calculation of production of final goods and services at the current prices is called Nominal GDP. • Nominal GDP can change from time to time because of two reasons: • Changes in the physical volume of output or • Changes in the prices at which output is valued. • We want to use GDP to look at changes in the physical volume of output and compare how much we grow year after year. • Since, Nominal GDP can also change due to changes in the prices at which output is valued it is necessary to "deflate" the value recorded for Nominal GDP (GDP with inflation) into "real" so that we can make comparisons across years.

Real GDP: • The calculation of Production of final goods and services valued at the base year prices which are referred to as constant prices is called Real GDP. • (Base year is the year taken as a reference year to which the prices prevailing in the current year are compared, i.e, a year free from fluctuations in prices, which is usually assigned an arbitrary value of 100.) • Real GDP can change only because of changes in the physical volume of output. • As a result, real GDP is considered a better measure of economic growth than nominal GDP. • Final goods and services is important here, counting intermediate goods would lead to the double counting and increases the value of the output. • Takeaways: We need to deduct for inflation and also need to avoid Double accounting.

Highlights

Actual GDP : • The real-time measurement of all outputs at any interval or any given time. It demonstrates the existing state of business of the economy.

Potential GDP: • The ideal economic condition with 100% employment across all sectors, steady currency, and stable product prices.

Measures of inflation- the Consumer Price Index (CPI), the wholesale price index and the GDP Deflator

• Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. • There are other ways to measure change of prices in an economy which are known as the Consumer Price Index (CPI) & the wholesale price index (WPI). • A consumer price index (CPI) measures changes over time in the general level of prices of goods and services that households acquire for the purpose of consumption. • However, since CPI is based only a basket of select goods and is calculated on prices included in it, it does not capture inflation

across the economy as a whole. • Many commodities have two sets of prices. One is the retail price which the consumer actually pays. The other is the wholesale price, the price at which goods are traded in bulk. • Goods which are traded in bulk (such as raw materials or semi-finished goods) are not purchased by ordinary consumers. • Like CPI, the index for wholesale prices is called Wholesale Price Index (WPI). In countries like USA it is referred to as Producer Price Index (PPI). • The wholesale price index basket has no representation of the services sector and all the constituents are only goods whose prices are captured at the wholesale/producer level. • The GDP deflator is a weighted average of Consumer Prices Index (CPI) and the Wholesale Price Index (WPI).

GDP Deflator • It is calculated by dividing Nominal GDP by Real GDP and then multiplying by 100.

• As discussed above the, GDP deflator can also be called implicit price deflator is a measure of the level of prices of all new, domestically produced, final goods and services in an economy.

What does that mean? • It means, the GDP deflator is a measure of price inflation/deflation with respect to a specific base year. • GDP Deflator in India increased to 138.80 points in 2020 from 134.80 points in 2019. India GDP Deflator - data, historical chart, and calendar of releases - was last updated on March of 2020 from its official source.

CPI and GDP Deflator

Net Domestic Product (NDP)

• Net Domestic Product (NDP) is the GDP calculated after adjusting the weight of the value of ‘depreciation’. • Every asset (except human beings) go for depreciation in the process of their uses, which means they ‘wear and tear’. This depreciation needs to be adjusted to know about the real value of the total assets • For example, a residential house in India has a rate of 1 per cent per annum depreciation, an electric fan has 10 per cent per annum, etc.,

• NDP of an economy has to be always lower than its GDP for the same year. However, NDP is not used in comparative economics, i.e., to compare the economies of the world. • It is because of different rates of depreciation which is set by the different economies of the world. • Recently, the Union government increased the depreciation on new vehicles for buyers to 30% from the existing 15%. It did so to increase the sale of cars which is going down.

What are the uses of NDP ?

• To show the achievements of the economy in the area of research and development. R&D tries cutting the levels of depreciation. • To understand the loss due to depreciation to the economy.

• Also used to understand and analyze the sectoral situation of depreciation in industry and trade in comparative periods

Gross National Product (GNP) • Gross National Product (GNP) is the GDP of a country added with its ‘income from abroad’. Here, the trans-boundary economic activities of an economy is also taken into account. • A big difference between a country's GNP and GDP means integration into the global economy. • GDP includes the contribution made by non-resident producers - who work in the domestic territory of other countries - by way of wages, rent, interest and profits. • For example, the income of all people working in Indian IT companies abroad is the factor income earned abroad.

Items included in the category ‘Income from Abroad’ are: • Private Remittances: the net outcome of the money which inflows and outflows on account of the ‘private transfers’ by Indian nationals working outside of India (to India) and the foreign nationals working in India (to their home countries). • Interest on External Loans: the net outcome on the front of the interest payments, i.e., balance of inflow (on the money lent out by the economy) and outflow (on the money borrowed by the economy) of external interests. • External Grants: the net outcome of the external grants i.e., the balance of such grants which flow to and from India. Nowadays, India sends much more grant compared to the receipts. • Net factor income from abroad is the difference between the income received from abroad for rendering factor services and the income paid for the factor services rendered by non- residents in the domestic territory of a country.

For Example: • If Tom Cruise works in Indian movies his income will be deducted. If Priyanka Chopra works in Holywood her income will be added. • GNP is, thus, the sum of GDP and net factor income from abroad.

Net national product (NNP) • It can be derived by subtracting depreciation allowance from GNP. • It can also be found out by adding the Net factor income from abroad to the NDP.

• There is need to understand the following costs and prices in an economy which are as follows- • FACTOR COST: It is the total cost of all factors of production consumed or used in producing a good or service. • BASIC PRICE: It is the amount receivable by the producer from the purchaser minus any tax payable, plus any subsidy receivable, on the goods/services produced. • MARKET PRICE: Market price is the price at which a product is sold in the market. It includes the cost of production in the form of wages, rent, interest, input prices, profit etc. It also includes the taxes imposed by the government. • Market price = Factor price + indirect taxes - Subsidies • Basic Price = Factor Cost + Production taxes – Production Subsidy • Market Price = Basic Price + Production taxes – Production Subsidy • GVA at basic prices=GVA at factor cost + Production taxes - Production subsidies • GDP at market prices = GVA at basic prices + Product taxes- Product subsidies • GDP at factor cost (FC)= GDP at market prices MINUS indirect taxes PLUS subsidies. • GDP (FC) = GDP(MP) – indirect taxes + subsidies.

Note: • Production taxes or production subsidies are paid with respect to production. • They are independent of the volume of actual production. • E.g. production taxes are land revenues, stamps and registration fees and tax on profession.

NNP at factor cost or National income • NNP at factor cost is the volume of commodities and services produced during an accounting year, counted without duplication. • It can also be defined as the net value added at factor cost (by the residents) in an economy during an accounting year. • In terms of income earned by the factors of production, NNP at factor cost or national income is defined as the sum of domestic factor incomes and NFIA. • If NNP figure is available at market prices indirect taxes must be subtracted and subsidies added to get NNP at factor cost or national income.

Personal income and personal disposable income

• Personal income is the sum of all incomes actually received by individuals during a given year. • In order to estimate it, from national income the sum total of social security contributions, corporate income-taxes are subtracted and personal payments (which is income received but not currently earned) is added. • After the deduction of personal taxes from personal income of the individuals, we get personal disposable income which is equal to consumption plus saving.

• GVA(FC) + Product tax(GST) - Product subsidy (LPG Pahal, MSP etc.) = GDP at market price. • Then the price is adjusted with base year 2011- 2012 • We get official GDP at constant prices.

What is the base year? • At present, the base year for GDP is 2011-12 while it is 2012 for Consumer Price Index. • From January 2015, the Central Statistics Office (CSO) updated base year for GDP calculation to 2011-12, replacing the old series base year of 2004-05, as per the recommendations of the National Statistical Commission.

• The 2011-12 series started using the updated Ministry of Corporate Affairs (MCA-21) data instead of the dated Annual Survey of Industries to estimate corporate gross value added.

Why the Data source was changed? • As per the rationale provided by government MCA-21 data was far superior compared to the data provided by ASI, because: • ASI was underestimating manufacturing growth in the GDP by up to one percentage point as about half the manufacturing companies registered under the Companies Act were not in the ASI list. • As many as 70,000 manufacturing companies registered under the Companies Act have not been captured under the ASI because these establishments aren't registered under the Factories Act. The ASI tracks only the companies listed under the Factories Act. • This change has included segment of organized activities, which was earlier invisible.

Why the base year is Changed? • Ideally, the base year should be changed after every five years to capture the changing economy. • GDP based on 2004-05 did not reflect current economic situation correctly. • The new series is also compliant with the United Nations guidelines in System of National Accounts-2008. • After the base year is changed, the GDP in previous years is revised according to the new base year for a fair comparison. This is called GDP back series. • Back series calculations are always done to link a new series of national accounts with an old series. This gives a better comparison of growth over the years.

Ministry of Corporate Affairs (MCA)-21 • MCA 21 is an e-Governance initiative of Ministry of Company Affairs (MCA). It is envisioned to provide anytime and anywhere services to businesses. • Its application is designed to fully automate all processes related to the proactive enforcement and compliance of the legal requirements under the Companies Act, 1956, New Companies Act, 2013 and Limited Liability Partnership Act, 2008. • The project seeks to put in place across the country a uniform system that will enable: ✓ Businesses to register a company and file statutory documents online ✓ Public to have quick and easy access to the records they want ✓ Professionals to offer efficient services to their clients ✓ Financial institutions to easily register and verify charges ✓ MCA to ensure proactive & effective compliance with relevant laws and corporate governance ✓ Employees to deliver best of breed services

• Thus, it includes the data of all registered companies and organizations under the mentioned acts.

Controversy around usage of MCA 21 data • A National Sample Survey Office (NSSO) report highlighted deficiencies in the MCA-21 database of Indian companies. ✓ NSSO conducted a technical study between June 2016 and June 2017, in which it examined parts of the MCA 21 database. It found that 37% of the companies listed under data could either not be traced, had shut down or were wrongly classified in terms of what sector they belonged to. ✓ Other major challenge in using MCA-21 data is consistency of the balance-sheet information of companies in the database. ✓ On this issue, Government has clarified that the MCA 21 functions on a real-time basis and companies which become non-functional after entering the database are removed at the time of KYC drive.

Current scenario • Doing this has been complicated this time around because of the change in methodology (which now conforms to the best global practices) – some of the data used under the new methodology is not available for earlier years. The MCA-21 data, for example, is not available beyond 2007-08. • The National Statistical Commission (NSC) constituted a Committee on Real Sector Statistics under the Chairmanship of Dr. Sudipto Mundle in April, 2017 for improvement and modernization of real sector database.

• The Committee submitted its report to the NSC in July, 2018.Chapter V of the report discusses alternative approaches for converting the old GDP series to the new base year 2011-12. • The Mundle committee has listed three approaches to generating the back series: ✓ Use the current methodology using base data wherever available; ✓ A production shift approach; ✓ Project the old series using the base year of 2004-05 forward up to a certain year and then adjusting it to the 2011-12 base by comparing it to the new series.

Current Situation • The report of the Committee on Real Sector Statistics headed by Sudipto Mundle shows that from 2004-05 onwards, growth calculated by the new methodology was higher than that calculated by the old methodology. • The growth in 2006-07 actually touched 10 percent (10.08 percent to be exact) against 9.57 percent when calculated under the old methodology.