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CHAPTER 1. THE GROSS DOMESTIC PRODUCT

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Measured GDP: Some Caveats

Have you ever wondered how GDP gures are calculated in practice? Probably not...but let me tell you anyway. In principle, the GDP is calculated either by summing up incomes or expenditures over some specied period of time (e.g., month, quarter, year). This sounds simple in principlebut how is it done in practice? Does the government or some other organization keep a running tab on everybodys income and expenditures at all times? No, this is not how it works. In practice, data is collected from a variety of sources using a variety of methods. For example, government statistical agencies may have access to payroll data or personal and business income tax forms and use this information to construct an estimate of income. As well, these same statistical agencies may perform regular surveys of randomly selected establishments (within a variety of sectors) to gather sales data from which to form an estimate of expenditure. Thus, it is important to keep in mind that available GDP numbers are just estimates (which are often revised over time), whose quality depends in part on the resources that are spent in collecting information, the information that is available, and on the methodology used in constructing estimates. It is not clear that any of these factors remain constant over time or are similar across countries. Another thing to keep in mind is that measuring the value of income and expenditure in the way just described largely limits us to measurements of income and expenditure (and hence, the production of output) that occur in formal markets. For present purposes, one can think of a formal market as a place where: [1] output exchanges for money at an observable price; and [2] the value of what is exchanged is observable by some third party (i.e., the government or some statistical agency). It is likely that most of the marketable output produced in the so-called developed world is exchanged in formal markets, thanks largely to an extensive market system and revenue-hungry governments eager to tax everything they can (in the process keeping records of the value of what is taxed). In many economies, however, a signicant fraction of marketable output is likely exchanged in markets with observable money prices, but where the value of what is exchanged is hidden (and hence, not measurable). The reason for hiding the value of such exchanges is often motivated by a desire to evade taxes or because the exchange itself is legally prohibited (e.g., think of the marijuana industry in British Columbia or the cocaine industry in Colombia). The output produced in the so-called underground economy should, in principle, be counted as part of an economys GDP, but is not owing to the obvious problem of getting individuals to reveal their underground activities. A large fraction of the marketable output produced in the so-called underdeveloped world is likely exchanged in informal markets. The reason for this is

1.A. MEASURED GDP: SOME CAVEATS

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twofold. First, one thing that characterizes underdeveloped economies is lack of formal market structures, particularly in rural areas (where output is largely consumed by the household, or perhaps bartered in small and informal transactions). The lack of local market prices thus requires statistical agencies to impute market value, which are calculations that require resources that may not be available. Second, many rural regions in the underdeveloped world operate largely in the absence of any (federal) government intervention (taxation). Since tax information constitutes an important source of data for estimating income, the lack of any federal-level record-keeping system outside of urban areas may severely hinder the collection of any relevant data. These measurement problems should especially be kept in mind when attempting to make crosscountry comparisons of GDP (especially across developed and less-developed economies). Finally, a word needs to be said about an asymmetry that exists in the measurement of private versus public sector activity. Consider the following example. The private sector consists of a household sector and a business sector. The household sector generates labor income and the business sector generates capital income. Members of the household sector are employed in either the business sector or the government sector. Let WP denote wage income from those employed in the business sector and WG denote wage income from those employed in the government sector. The household sector also pays taxes T, so that total after-tax household earnings are given by: WP + WG T. The business sector produces and sells output (at market prices), which generates revenue YP . Capital income is therefore given by: YP WP . Adding up the two equations above yields us the after-tax income of the private sector: YP + WG T. The government sector produces output YG . Measuring the value of YG , however, is problematic since most of what a government produces is not sold at market prices (it is largely given away). Nevertheless, one could impute a value for YG . Having done so, government sector income is given by: YG + T WG . If we add up private-sector and government-sector income (the previous two equations), we arrive at a gure for total income; i.e., Y = YP + YG . The key question here is how to impute a value for YG ? The way this is done in practice is to assume: YG = WG .

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CHAPTER 1. THE GROSS DOMESTIC PRODUCT

In other words, it is assumed that the value of what is produced by government employees is equal to what the government pays for their services. To see the potential problem of this method of imputation, consider an extreme case in which government employees produce nothing of value so that in truth YG = 0 and Y = YP . In this case, the government wage bill WG in fact represents a transfer of income from one part of the population to another; i.e., it does not represent the (market) value of newly produced goods and services. In this case, imputing the value YG = WG overstates the value of governmentproduced output and will therefore overstate an economys GDP.