6. Economics Notes 24

Elaborate Notes

National Income: Concepts and Measurement

Introduction to National Income National Income is the aggregate money value of all final goods and services produced by the normal residents of a country during a financial year. It serves as a comprehensive measure of the economic activity and health of a nation. The concept of national income accounting was systematically developed in the 20th century, with notable contributions from economists like Simon Kuznets (who was awarded the Nobel Memorial Prize in Economic Sciences in 1971 for his empirically founded interpretation of economic growth). In India, early rudimentary estimates were provided by Dadabhai Naoroji in his work “Poverty and Un-British Rule in India” (published 1901, estimates for 1867-68) and the first scientific estimates were made by Dr. V.K.R.V. Rao for the period 1931-32. Modern national income accounting adheres to the internationally accepted framework of the System of National Accounts (SNA), last updated in 2008 by the United Nations.

Core Components of National Income National Income is fundamentally the sum of all productive incomes. This income must be generated from participation in the production process.

Factor Payments: These are payments made to the factors of production in return for their services. They are the constituent parts of national income.
- Rent: Income earned from the ownership of land and property.
- Wages/Compensation of Employees (CE): Remuneration to labour for physical or mental services. This includes wages and salaries in cash, in kind (e.g., rent-free accommodation), and employers’ contribution to social security schemes like provident funds.
- Interest: Payment for the use of capital.
- Profit: The residual income of entrepreneurs after paying all other factors. It is part of the Operating Surplus (OS).
Operating Surplus (OS): This represents the income earned by enterprises from property and entrepreneurship. It is the sum of rent, royalty, interest, and profit.
Mixed Income of Self-Employed (MI): This is a specific category relevant to economies with a large unorganized sector, like India. It refers to the income of self-employed individuals (e.g., farmers, doctors, small shopkeepers) where the income from labour, capital, land, and entrepreneurship is not separable.
Formula (Income Method): National Income is often calculated as the sum of these factor incomes. NI = Compensation to Employees (CE) + Operating Surplus (OS) + Mixed Income (MI)

Distinction from Transfer Payments

Transfer Payments: These are unilateral payments for which no corresponding good or service is produced in the current period. They are a redistribution of income, not a generation of new income. Therefore, they are excluded from national income calculations.
- Examples: Old-age pensions, unemployment allowances, scholarships, gifts, and remittances from abroad.
Pension for Retired Employees: This is considered a deferred wage. It is paid in recognition of productive services rendered by the employee in the past. Hence, it is a factor payment and is included in the national income. This contrasts with social security pensions (like old-age pensions) given to individuals who may not have been part of the formal workforce, which are treated as transfer payments.

Key Aggregates and Adjustments

Depreciation (Consumption of Fixed Capital) Depreciation refers to the expected wear and tear or obsolescence of a country’s stock of fixed capital (e.g., machinery, buildings) during the production process. Accounting for depreciation is crucial for understanding the sustainable level of production.

Gross vs. Net:
- Gross: Includes the value of depreciation. It represents the total production without accounting for the capital consumed.
- Net: Excludes the value of depreciation. It reflects the actual addition to the economy’s wealth.
- Formula: Net Value = Gross Value - Depreciation
- A high rate of depreciation may indicate aging infrastructure and the need for fresh investment to maintain productive capacity.

Factor Cost (FC) vs. Market Price (MP) This distinction arises due to the intervention of the government in the market through indirect taxes and subsidies.

Factor Cost (FC): This is the actual cost incurred by a producer on the factors of production. It is the price of the commodity from the producer’s perspective. It includes subsidies (as they reduce the producer’s cost) and excludes indirect taxes (as they are not payments to any factor of production).
- Note: Production subsidies, such as those given to farmers for fertilizers or to manufacturing units in Special Economic Zones, are not transfer payments. They are considered an input into the production process, reducing the effective factor cost.
Market Price (MP): This is the price that a consumer actually pays for a product in the market. It includes the impact of government policies.
- Formula: Market Price = Factor Cost + Indirect Taxes - Subsidies
Net Indirect Taxes (NIT): This is the net effect of taxes and subsidies on the price of a product.
- Formula: Net Indirect Taxes (NIT) = Indirect Taxes - Subsidies
- Therefore, Market Price = Factor Cost + Net Indirect Taxes
- If subsidies exceed indirect taxes, NIT will be negative, and the Market Price will be lower than the Factor Cost. This can happen in the case of essential goods like food grains distributed through the Public Distribution System (PDS).

Domestic vs. National Concepts

The distinction between ‘Domestic’ and ‘National’ income hinges on the concept of the Normal Resident.

Domestic Income (or Product): Refers to the total value of final goods and services produced within the geographical or domestic territory of a country, regardless of who produces it (residents or non-residents).
National Income (or Product): Refers to the total value of final goods and services produced by the normal residents of a country, regardless of where they produce it (within the domestic territory or in the rest of the world).

Concept of Normal Resident A normal resident (an individual or an institution) is one who ordinarily resides in the country for a period of one year or more and whose center of economic interest (i.e., earning, spending, and accumulation) also lies in that country.

Key Points:
- It includes both citizens and non-citizens (foreigners) who meet the two conditions.
- International Organizations: Bodies like the World Bank, WHO, or IMF are not considered residents of the country in which they are located. They are treated as residents of an ‘international territory’.
- Staff of International Organizations: However, the staff (e.g., an American working at the WHO office in India for over a year) are treated as normal residents of the country where they work.
- Embassies: Foreign embassies are considered part of the domestic territory of their home country. However, local employees (e.g., Indians working in the U.S. Embassy in New Delhi) are treated as normal residents of their own country (India).
- Cross-border Workers: Individuals who live near an international border and cross it daily to work are treated as residents of the country where they live, not where they work.

Net Factor Income From Abroad (NFIA) NFIA is the bridge between Domestic and National income. It is the difference between the factor income earned by a country’s normal residents from the rest of the world and the factor income paid to the non-residents working in the country’s domestic territory.

Formula: National Product = Domestic Product + NFIA
NFIA = Factor income earned from abroad - Factor income paid to abroad
Components of NFIA:
1. Net Compensation of Employees: Difference between income of residents working abroad temporarily and income of non-residents working within the domestic territory.
2. Net Income from Property and Entrepreneurship: Includes net rent, interest, and profits earned from abroad.
3. Net Retained Earnings: Difference between the retained earnings of resident companies abroad and the retained earnings of foreign companies within the domestic territory.
In a closed economy, which has no economic transactions with the rest of the world, NFIA is zero, and thus GDP equals GNP.
For India, NFIA has historically been negative, implying that payments to foreign factors of production operating in India are greater than receipts by Indian factors operating abroad.

Nominal vs. Real GDP

Nominal GDP: The value of goods and services produced in a year, measured at the prices of that same year (current prices). It can increase due to either an increase in production or an increase in prices (inflation).
Real GDP: The value of goods and services produced in a year, measured at the prices of a fixed base year (constant prices). It only increases if the actual volume of production increases, thus providing a true measure of economic growth by removing the distorting effect of inflation.
GDP Deflator: This is a measure of the overall price level in the economy.
- Formula: GDP Deflator = (Nominal GDP / Real GDP) x 100
Base Effect: This statistical phenomenon occurs when interpreting percentage growth rates. When the growth of a period is calculated against a low-base period from the past, the resulting growth rate can appear artificially high. For instance, India’s GDP growth in Q1 2021-22 looked exceptionally high because it was being compared to Q1 2020-21, a period of severe national lockdown and economic contraction.

Methods of National Income Calculation

The National Statistical Office (NSO), under the Ministry of Statistics and Programme Implementation (MoSPI), is responsible for compiling National Accounts Statistics in India. The NSO was formed in 2019 by merging the National Sample Survey Office (NSSO) and the Central Statistics Office (CSO). It calculates GDP on a quarterly and annual basis. There are three primary methods, which should ideally yield the same result.

1. Income Method (or Distribution Method) This method sums up all factor incomes received by residents of a country.

Formula: NDP at FC = Compensation of Employees (CE) + Operating Surplus (OS) + Mixed Income (MI)
Precautions/Exclusions:
- Transfer Incomes: Excluded as they do not correspond to any productive activity.
- Windfall Gains: Income from lotteries or capital gains are excluded as they do not arise from production.
- Sale of Second-hand Goods: Excluded, as their value was already counted in the year of original production. However, any commission or brokerage earned on the sale is a new service and is included.
- Sale of Financial Assets (Shares, Bonds): Excluded, as these are mere transfers of ownership and do not represent the creation of new goods or services.

2. Output Method (or Value Added Method) This method measures the contribution of each producing enterprise in the domestic territory. It calculates the Gross Value Added (GVA) at each stage of production and sums them up. This avoids the problem of double-counting.

Gross Value Added (GVA) = Value of Output - Value of Intermediate Consumption
Example: A farmer produces wheat worth ₹500 (intermediate consumption is zero). A miller buys the wheat for ₹500 and turns it into flour worth ₹1000. A baker buys the flour for ₹1000 and bakes bread worth ₹2000.
- Value Added by Farmer = ₹500 - 0 = ₹500
- Value Added by Miller = ₹1000 - ₹500 = ₹500
- Value Added by Baker = ₹2000 - ₹1000 = ₹1000
- Total GVA (GDP) = ₹500 + ₹500 + ₹1000 = ₹2000, which is equal to the market value of the final good (bread).
GDP at MP = Sum of GVA at Basic Prices + Net Product Taxes

The Eight Aggregates of National Income

Gross Domestic Product at Market Price (GDP at MP): Gross market value of all final goods and services produced within the domestic territory.
Net Domestic Product at Market Price (NDP at MP): NDP at MP = GDP at MP - Depreciation.
Gross Domestic Product at Factor Cost (GDP at FC): GDP at FC = GDP at MP - Net Indirect Taxes.
Net Domestic Product at Factor Cost (NDP at FC): NDP at FC = NDP at MP - Net Indirect Taxes. It is also known as Domestic Income.
Gross National Product at Market Price (GNP at MP): GNP at MP = GDP at MP + NFIA.
Net National Product at Market Price (NNP at MP): NNP at MP = GNP at MP - Depreciation.
Gross National Product at Factor Cost (GNP at FC): GNP at FC = GNP at MP - Net Indirect Taxes.
Net National Product at Factor Cost (NNP at FC): NNP at FC = NNP at MP - Net Indirect Taxes. This is the purest form of income and is officially termed National Income.
- NNP at FC = GDP at MP - Depreciation - Net Indirect Taxes + NFIA

Prelims Pointers

National Income: The sum of factor incomes (rent, wages, interest, profit) earned by normal residents of a country in a financial year.
Transfer Payments: Not included in National Income. Examples: old-age pensions, remittances, unemployment allowance, gifts.
Pension to Retired Employees: Included in National Income as it is a deferred wage.
Factor Cost (FC): Producer’s price. FC = Market Price - Net Indirect Taxes.
Market Price (MP): Consumer’s price. MP = Factor Cost + Indirect Taxes - Subsidies.
Net Indirect Taxes (NIT): Indirect Taxes - Subsidies.
Depreciation: Also known as Consumption of Fixed Capital.
Net Value: Gross Value - Depreciation.
Normal Resident: A person or institution residing in a country for one year or more with their center of economic interest in that country.
Domestic Income: Income generated within the domestic territory of a country.
National Income: Income generated by the normal residents of a country.
NFIA (Net Factor Income From Abroad): Factor Income from Abroad - Factor Income to Abroad.
Relationship: National Product = Domestic Product + NFIA.
Nominal GDP: Calculated at current year prices.
Real GDP: Calculated at constant (base year) prices. India’s current base year is 2011-12.
GDP Deflator: (Nominal GDP / Real GDP) x 100. It is a measure of inflation.
National Statistical Office (NSO): The body that calculates National Income in India. It is under the Ministry of Statistics and Programme Implementation (MoSPI).
NSO Formation: Created in 2019 by merging the Central Statistics Office (CSO) and the National Sample Survey Office (NSSO).
Official ‘National Income’: Refers to Net National Product at Factor Cost (NNP at FC).
Domestic Income: Refers to Net Domestic Product at Factor Cost (NDP at FC).
Exclusions from NI (Income Method): Windfall gains, sale of second-hand goods, sale of shares/bonds, transfer payments.
Inclusions in NI (Income Method): Commission on the sale of second-hand goods, imputed rent of owner-occupied houses, value of production for self-consumption.

Mains Insights

GDP as a Measure of Economic Welfare: Significance and Limitations

Significance:
- Indicator of Economic Health: GDP growth is the most widely used metric to assess the performance and health of an economy. Positive growth indicates expansion, while negative growth (recession) signals contraction.
- Policy Formulation: Governments use GDP data for fiscal and monetary policy decisions. Nominal GDP is crucial for setting fiscal deficit targets (as a percentage of GDP), while real GDP growth is a key target for monetary policy and developmental planning.
- International Comparisons: GDP and Per Capita GDP are used to compare the economic performance and living standards of different countries, influencing investment decisions and international aid.
Limitations:
- Excludes Non-Monetized Activities: GDP does not account for the vast informal economy and non-market transactions, such as the services of a homemaker or barter exchanges, which are significant in developing countries like India.
- Ignores Distribution and Inequality: GDP is an aggregate measure and does not reveal the distribution of income. High GDP growth can coexist with rising inequality, where the benefits are concentrated in the hands of a few. Economists like Thomas Piketty in his work “Capital in the Twenty-First Century” (2013) have highlighted this growing divergence.
- Neglects Welfare and Quality of Life: GDP does not capture crucial aspects of welfare like health, education, leisure, and political freedom. Amartya Sen’s ‘Capability Approach’ argues for focusing on human well-being and freedoms rather than just economic output. The Human Development Index (HDI) is an attempt to address this gap.
- Environmental Externalities: The calculation of GDP often ignores the negative environmental impact of production, such as pollution and resource depletion. This led to the advocacy for concepts like ‘Green GDP’, which would subtract the cost of environmental degradation from the national income.

Debates on National Income Calculation in India

Methodological Shift of 2015: India revised its National Accounts Statistics in 2015, shifting the base year from 2004-05 to 2011-12 and adopting new methodologies.
- Headline Growth Rate: The headline GDP growth rate is now measured in terms of GDP at Market Prices (MP), replacing the earlier practice of using GDP at Factor Cost (FC). This aligns India with international best practices under SNA 2008.
- Data Sources: The new series incorporates data from the MCA-21 database of the Ministry of Corporate Affairs, providing a wider coverage of the corporate sector.
- Controversies: The new series was criticized by some economists for its methodology and for showing higher growth rates during certain periods than other economic indicators (like credit growth, industrial production) seemed to suggest. The debate highlights the challenges of accurately capturing economic activity in a complex and diverse economy.

Implications of Key Concepts for Policy

Real vs. Nominal GDP in Policy: The divergence between nominal and real GDP growth (the GDP deflator) is a critical indicator for policymakers. High nominal growth driven by inflation rather than real output can create a misleading picture of economic prosperity. Fiscal policy targets nominal GDP, while monetary policy often targets inflation, which influences real GDP.
The Base Effect Trap: Policymakers and the public must be cautious of the ‘base effect’ when interpreting growth figures, especially during recovery phases after a crisis (like the COVID-19 pandemic). A high growth percentage off a contracted base may not signify a robust, sustainable recovery. Sound policy should be based on a longer-term trend analysis rather than short-term, base-effect-driven figures.
NFIA and External Sector Management: India’s consistently negative NFIA is a reflection of its relationship with the global economy. It indicates high returns on foreign investment within India and relatively lower factor income for Indians from abroad. While remittances (a transfer payment, not part of NFIA) are a major source of forex, the negative NFIA underscores the need for policies that promote Indian investments abroad and enhance the competitiveness of Indian human capital in the global market.

GS Notes