Calculating GDP Using the Income Approach - Online Tutor, Practice Problems & Exam Prep

Gross Domestic Product (GDP) can be calculated using two approaches: the expenditures approach and the income approach. The expenditures approach sums consumption, investment, government purchases, and net exports, while the income approach totals national income components, including compensation of employees, rents, interest, proprietors' income, corporate profits, and taxes on production. Adjustments for net foreign factor income and depreciation are necessary to align both methods, emphasizing that expenditures equal income. Understanding these calculations is crucial for analyzing economic performance and national wealth.

Calculating GDP Using the Income Approach

So the most likely way you're going to run into the GDP calculation is the expenditures approach that we went through in other videos. However, you can also use an income approach to calculate GDP. Let's check that out here. So remember, GDP is the value of final goods and services produced during a year. Right? And when we were talking about GDP before with the consumption, investment, government purchases, net exports. We were talking about the expenditures, everything that was spent during a year. Right? And we had those four main components. However, we can look at the other side of the coin, right? If we look at everything spent during the year, well, every dollar we spend is earned by someone else, right? So we could look at the expenditures or we can look at the income. So the main thing to take away here is that expenditures equal income. Okay? The expenditures are going to equal income. So we can total up expenditures and for the most part, you're probably just going to want to know this on a high level. The main reason these textbooks and some professors like to go through the income approach is because of this idea that expenditures equal income. However, the main focus is going to be on that expenditures approach. Just you'll have this as a reference if your professor wants to go through a little more detail with the income approach. So let's go ahead and go through it. Remember, we're thinking about the income approach, we're thinking about all the income that is earned rather than when we were doing expenditure, it was everything that was spent. Here, it's everything that's earned and they are two sides of the same coin. So let's go ahead and go through the income approach.

The first thing we want to calculate is national income. So it's the income of the nation. So let's go ahead and see what's included there. First, we have the compensation of employees, and naturally, this is going to be the largest part of national income. This is all the income of all the citizens in the country. This is wages and salaries paid by businesses and government to employees. So compensation to employees is going to be part of the national income. Next, we have rents. And this is income received by landlords. So when you pay rent every month, well, they're getting income, right? They're getting income and that's included in our income calculation. And sometimes we talk about net rental income, which is the gross receipts minus depreciation, right? You buy a rental property, it’s not going to last forever. It’s going to depreciate over time and some of that value is going to be lost. So net rental income is those actual depreciation. Next, we have interest. That's another way people earn income, right? You earn interest. So interest is earned on loans by banks, right? If you have to pay interest on a loan and you also earn some interest in your savings account. Now, I know those savings accounts are paying 0.0 whatever interest right now is not so great. You can find some high-yield savings online where you might get a little more, but overall interest is Yes, it's income but it's not such a significant part for our households in our savings account anymore, unfortunately. Alright. So let's go on to the next one. Proprietors income. So proprietors, this is if you have your own business, your own private business by a sole proprietorship or a partnership, right? When I do my private tutoring and I have my private students and they pay me directly, while I'm earning income through that and it's not being paid to me through a corporation or a business or something it's being paid directly to me through my sole proprietorship, well, that would be a proprietor's income there, right? That's money still being earned and it would be included in national income. Next, we have corporate profits. So this is profit earned by corporations, right? Corporations are also earning money in our nation, so their income is also included here. Now, notice that corporate income taxes are included, right? We're going to include these corporate income taxes because they're earned by the government. Even though they’re taken away from the corporation and given to the government, well, there's still earnings of the nation, right? They're earned by the government in that case. Dividends, we talk we know what dividends are. These are profits that are paid out to stockholders. So when the corporation earns profit, pays some of it to the stockholders, well, those stockholders are getting a dividend there And lastly, what they don't distribute, the undistributed profits, we call them retained earnings in accounting. That's the general name is retained earnings because they're retained by the corporation to reinvest in the corporation. But they're all profits, right? The taxes which are going to the government, the dividends going to the stockholders or the undistributed ones being held by the corporation. It's all profit there included in national income. Remember, we're calculating GDP here still. This is all a calculation of GDP and we're adding up all the different sources of income in the nation.

Finally, are the taxes on production and imports. So this is just general taxes that are levied by the government. Well, the government is making income. The government is a body in our economy and they're earning income, so it's included in our national income. Okay? And these taxes, what do we say here? Are included in GDP income because government purchases are in GDP expenditures. Remember, the expenditures approach, the government purchases are included, so naturally the government income is included in the income approach. Okay? So that is how we calculate national income and then we're going to adjust it. There are a few adjustments that we make that get us to final GDP. So let's go through these adjustments first. We take our national income and we adjust it first for net foreign factor income because when we think about GDP, we're thinking about domestic income. However, there is dealings with foreign people that is going to influence this calculation. First, we must remove the income earned by Americans from supplying services abroad, right? Because we're thinking about domestic, gross domestic product. So if they're supplying resources abroad, that's not domestic. That's happening abroad. And then we must add income earned by foreigners. So remove income of Americans abroad and add income of foreigners that is domestic, right? If they're earning income in the United States, well, that should be in gross domestic product because it’s happening here in the US. So that's the first adjustment where we deal with foreigners. We have to deal with the foreign income, our income US citizens overseas, and foreign citizens happening here. Next is consumption of fixed capital. So like we talked about with rental income depreciation, there's going to be some depreciation on our long-term assets and we're going to have to adjust our national income for that depreciation and finally, everyone's favorite, a statistical discrepancy. We've got a little bit of an error here. Let's just call it a discrepancy and move on. Right? Remember that expenditures have to equal income, right? Expenditures equal income in the ideal idea of this, right? We're going to have everything get spent is earned by someone else so whatever we come up with from the expenditures approach should equal the income approach. Alright. Let's take a quick pause here and then on the next page, we're going to take a look at the United States GDP calculation from both approaches.

Comparison of U.S. GDP Calculation

Alright. So here we have a calculation of the GDP for the United States in 2009 based on the expenditures approach on the left and the income approach on the right. Notice that at the bottom, we reach the same final number, 14,256, and that was the GDP during that year. Now, this is in billions. We're talking about in billions, so we're going to add a whole bunch of zeros after that. We're talking about nine zeros after all of these numbers, but let's go ahead and go through each one. Notice on the left, we're going through our expenditures approach. We start with consumption which is the biggest part of expenditures, is consumption. Then we add investment, gross government purchases, c+i+g + net exports. And notice for the United States, it's negative. Right? And why is it negative? Because imports exceed exports. We are running a trade deficit, so we're going to have a negative number there, and remember net exports is just exports minus imports. So if those imports are bigger, we're going to have a negative number there. Okay? So we have a trade deficit because we import more stuff than we export. So we just add those four numbers and we get to our gross domestic product.

There we go. 14,256. Let me get out of the way here. Let's look at the income approach on the right. So the first thing we want to do is calculate national income like we talked about on the previous page. We're going to add up all the compensation. So remember, compensation of employees, that's the biggest portion here. Notice how it's the biggest one. And then we add everything else. We've got the rents, the interest, proprietor income, corporate profit, and taxes on production and imports. That gets us to total national income and then we make our adjustments. We've got our foreign factor income, our consumption of fixed capital, our depreciation there, and finally, our statistical discrepancy. Hey, we made a we got to make these things equal out. So let's go ahead and use 209. Let's plug that in there so that everything works and looks pretty here. 1,400,256 equals 1,400,256. The main equals 1,400,256. The main takeaway, remember, expenditures equal income.

Okay, that's the idea here, that expenditures are going to equal income. Now, like I said at the beginning of the video, you're not going to have to spend too much time on the income approach. Generally, you're going to focus on the expenditure approach and focus on this consumption plus investment plus government purchase plus net export throughout this course. Okay? Now, some teachers like to go through this and compare the two, but that's because the main takeaway here is that those expenditures equal income. Cool? Alright. Let's go ahead and move on to the next topic.

Here’s what students ask on this topic:

What is the income approach to calculating GDP?

The income approach to calculating GDP sums up all the incomes earned in the production of goods and services within a country during a specific period. This includes compensation of employees (wages and salaries), rents, interest, proprietors' income, corporate profits, and taxes on production and imports. Adjustments are made for net foreign factor income and depreciation to ensure the final GDP figure aligns with the expenditures approach. The key idea is that total expenditures in an economy should equal total income, reflecting the value of final goods and services produced.

How do you calculate national income in the income approach?

To calculate national income using the income approach, you sum the following components: compensation of employees (wages and salaries), rents (income received by landlords), interest (earned on loans and savings), proprietors' income (income from sole proprietorships and partnerships), corporate profits (including corporate income taxes, dividends, and retained earnings), and taxes on production and imports. This total gives you the national income, which is then adjusted for net foreign factor income and depreciation to arrive at the GDP.

What adjustments are made to national income to calculate GDP using the income approach?

To calculate GDP from national income using the income approach, two main adjustments are made: net foreign factor income and depreciation. Net foreign factor income involves subtracting income earned by Americans abroad and adding income earned by foreigners domestically. Depreciation, also known as consumption of fixed capital, accounts for the wear and tear on long-term assets. Additionally, a statistical discrepancy may be included to ensure that the income approach aligns with the expenditures approach, reflecting the principle that total expenditures equal total income.

Why do expenditures equal income in GDP calculations?

Expenditures equal income in GDP calculations because every dollar spent in an economy is earned by someone else. When consumers, businesses, and the government spend money on goods and services, this spending becomes income for workers, landlords, businesses, and the government. This relationship ensures that the total value of expenditures on final goods and services (expenditures approach) matches the total income earned from producing those goods and services (income approach), thereby providing a consistent measure of GDP.

What are the main components of national income in the income approach?

The main components of national income in the income approach are: compensation of employees (wages and salaries), rents (income received by landlords), interest (earned on loans and savings), proprietors' income (income from sole proprietorships and partnerships), corporate profits (including corporate income taxes, dividends, and retained earnings), and taxes on production and imports. These components collectively represent the total income earned within a nation from the production of goods and services.