Economics Online Tutor
The Income Approach to GDP
Calculation
GDP USING THE
IN
COME APPROACH -
QUICK REFERENCE
FORMULA:


COMPENSATION OF EMPLOYEES
(WAGES)

plus

NET INTEREST

plus

RENT

plus

PROFITS (PROPRIETORS'
INCOME PLUS CORPORATE
PROFITS)

equals

NATIONAL INCOME (NI)

plus

INDIRECT BUSINESS TAXES
(SALES TAX PLUS EXCISE TAX)

equals

NET NATIONAL PRODUCT (NNP)

plus

CAPITAL CONSUMPTION
ALLOWANCE (DEPRECIATION)

equals

GROSS NATIONAL PRODUCT
(GNP)

minus

NET FACTOR INCOME FROM
ABROAD (NET FOREIGN FACTOR
INCOME, WHICH IS INCOME
RECEIVED BY CITIZENS OUTSIDE
THE NATION'S BORDERS MINUS
INCOME RECEIVED BY
FOREIGNERS WITHIN THE
NATION'S BORDERS).

equals

GROSS DOMESTIC PRODUCT
(GDP)
========================
The previous section showed how to calculate GDP using the expenditures
approach.  If you recall from the circular flow model, the flow of expenditures
in the economy has a corresponding flow of income.  Since these flows are
equal in equilibrium, Gross Domestic Product, or GDP, can also be computed
from the incomes received by the factors of production.  This method of
computing GDP is called the income approach.

Recall that the
income received by the factors of production is as follows:

Labor earns wages (sometimes called compensation of employees)

Capital earns interest

Land earns rent

Also, firms earn profits, which remain within the circular flow.  Sometimes,
economists consider entrepreneurship to be a separate factor of production
(rather than a special category of labor), and profit would be listed as the
income received by entrepreneurs.  Profit as an income category is in turn
divided into two categories: proprietors' income (sole proprietorships and
partnerships) and corporate profits (corporations).

Total income received by the segments of the economy, then, would be:

Wages + Interest + Rent + Profits

This sum of income received by the segments of the economy do not add up
to GDP, however, and will not match the GDP amount calculated using the
expenditures approach.  Some adjustments need to be made in order to get
from this number to GDP.  However, this number does have a name: National
Income, or NI.  It follows that the formula for national income is:

NI = Wages + Interest + Rent + Proprietors' Income + Corporate Profits

From national income, three more adjustments are needed in order to get to
GDP.


First, you may notice that government receipts are not part of this equation.  
That is because income tax receipts include money that is part of the
incomes of the other segments of the economy.  They are already being
counted elsewhere.  However, some taxes are collected from consumers by
businesses, who have to turn this money over to the government.  These
taxes include state and local sales taxes, and excise taxes.  Together, they
are called indirect business taxes.  In order to balance income and
expenditures, this amount needs to be added to NI.  This yields a number
that is called net national product, or NNP.

NNP = NI + Indirect Business Taxes

This number (NNP) still does not equal GDP.  GDP using the expenditures
approach includes an item called 'gross private domestic investment'.  Not
all of this amount is received as income.  Some of it is used to replace
worn-out equipment, plus the replacement of damaged or accidentally
destroyed equipment.  This replacement value is called capital consumption
allowance.  The routine replacement of worn-out equipment is called
depreciation, and is computed and allocated over the lifetime of the
equipment using an accounting procedure at each individual firm.  Since
depreciation makes up the vast majority of the capital consumption
allowance, often this allowance is simply referred to as depreciation.  In
order to balance income and expenditures, this amount needs to be added
to income.  Adding the capital consumption allowance (or depreciation) to
NNP will yield a number that is called Gross National Product, or GNP.

GNP = NNP + Capital Consumption Allowance (or Depreciation)
Notice the distinction in terms here.  GNP, NNP.  The difference is gross vs net.
 Gross refers to gross investment and net refers to net investment, which is
total investment net of the allowance for depreciation.  You may need this
information for exercises in economics class.  The formula is:

Gross investment minus depreciation equals net investment


Okay, we are almost there, but not quite.  We are looking for GDP, and we now
have GNP.  GNP includes income received by citizens, regardless of whether
the income was earned on production within the country or not.  It excludes
income earned within the country's borders by non-citizens.  GDP is a measure
of production that occurs within a nation's borders, regardless of the
nationality of whoever it is that produces it.  An adjustment needs to be made
to GNP to account for this difference.  This adjustment is called net factor
income from abroad, or net foreign factor income.  It is found by taking income
received by citizens outside the nation's borders, and subtracting income
received by foreigners within the nation's borders.  Subtracting net factor
income from abroad will yield GDP.  Finally!!


GDP = GNP - Net Factor Income from Abroad


This GDP amount, found using the income approach, should be equal to GDP
using the expenditures approach.  Since compilation of figures in the real
world is imperfect, there may be a difference for routine error and rounding.

This explanation of the income approach to calculating GDP is rather lengthy.  
It begins with income received by the factors of production, makes several
adjustments, and ends up with an amount equal to GDP.  Perhaps what you are
looking for is a summary or a formula instead of the lengthy explanation.  For
that reason, I have included a summary in the left-hand column at the top of
this page.  Since you are now looking at the bottom of the page, here it is
again.  This is a summary that simply takes all of the intermediate steps
together (the adjustments) into one formula:


GDP = Wages (compensation of employees) + Interest + Rent +
Profits (proprietors' income plus corporate profits) - Net Factor
Income from Abroad + Capital Consumption Allowance
(depreciation) + Indirect Business Taxes (sales tax plus excise
tax)


Besides GDP, other important measurements of the overall economy are part
of national income accounting.  Some of them are mentioned on this page:
GNP, NNP, and NI.  There are others, and they are listed in the next section.  
Also in the next section is a discussion of per capita measurements, and
nominal and real values.  To continue with this discussion of these
measurements,
click here.
This page, along with additional commentary, was posted on the "Economics
Online Tutor" Facebook page's timeline on August 19, 2012.
Do you find the information on this page
helpful?

The left column of the
home page lists all of
the economics topics covered in this
website. Now, you can receive a FREE
ebook version of the information in this site
under the title

Basic Economics for Students and
Non-Students Alike
By Jerry Wyant

Or if you prefer, you may purchase a
paperback version from Amazon, Barnes &
Noble, Sony, Apple, and other distributors.

This makes a great handbook and
reference. Students: please help to make
sure your classmates and teachers are
aware of this resource!

Click here to order a FREE ebook from
smashwords.com

Click here to purchase a paperback
version from amazon.com