PRINCIPLES OF ECONOMICS BDM 121

CONTENTS

NO TITLE PAGES
1 Introduction 2-3
2 Question 4-9
3 Conclusion 10
4 References 11

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INTRODUCTION

National income accounting is a bookkeeping system that a government uses to measure the
level of the country's economic activity in a given time period. Accounting records of this
nature include data regarding total revenues earned by domestic corporations, wages paid to
foreign and domestic workers, and the amount spent on sales and income taxes
by corporations and individuals residing in the country.

Although national income accounting is not an exact science, it provides useful insight into
how well an economy is functioning, and where monies are being generated and spent. When
combined with information regarding the associated population, data regarding per capital
income and growth can be examined over a period of time.

Some of the metrics calculated by using national income accounting include gross domestic
product (GDP), gross national product (GNP) and gross national income (GNI). The GDP is
widely used for economic analysis on the domestic level and represents the total market value
of the goods and service produced within a specific nation over a selected period of time.

Use in Economic Analysis

The information collected through national income accounting can be used for a variety of
purposes, such as assessing the current standard of living or the distribution of income within
a population. Additionally, national income accounting provides a method for comparing
activities within different sectors in an economy, as well as changes within those sectors over
time. A thorough analysis can assist in determining overall economic stability within a nation.

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For example, the United States uses information regarding the current GDP in the formation
of various policies. During the financial crisis of 2008, the GDP began to suffer as increased
market volatility and shifting supply and demand affected consumer spending and
employment levels. As a result, President Barack Obama, after taking office in
2009, instituted an economic stimulus package in response.

As an example, the basic accounting identity for GDP, sometimes known as the national
income identity, is computed using the following formula :

GDP = consumption + investment + government spending + (exports − imports).

National Income Accounting and Economic Policy

The quantitative information associated with national income accounting can be used to
determine the effect of various economic policies. Considered an aggregate of the economic
activity within a nation, national income accounting provides economists and statisticians
with detailed information that can be used to track the health of an economy and to forecast
future growth and development.

The data can provide guidance regarding inflation policy and can be especially useful in the
transitioning economies of developing nations, as well as statistics regarding production
levels as related to shifting labor forces. These data are also used by central banks to set and
adjust monetary policy and affect the risk-free rate of interest that they set. Governments also
look at figures such as GDP growth and unemployment to set fiscal policy in terms of tax
rates and infrastructure spending.

Inaccuracies in National Income Accounting

The accuracy of analysis relating to national income accounting is only as accurate as the data
collected. Failure to provide the data in a timely fashion can render it useless in regard  to
policy analysis and creation.

Additionally, certain data points are not examined, such as the impact of the underground
economy and illegal production. This means the activities are not reflected in the analysis
even if their effect on the economy is strong. As a result, certain national accounts such as
GDP or the CPI index of inflation have been criticized on the grounds that they do not
accurately capture the real economic condition of the economy.

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QUESTIONS

Elaborate ten (10) difficulties in calculating National Income

National income accounting, a set of principles and methods used to measure the income and
production of a country. There are basically two ways of measuring national economic
activity: as the money value of the total production of goods and services during a given
period (usually a year) or as the total of incomes derived from economic activity after
allowance has been made for capital consumption.

The most commonly used indicator of national output is the gross national product (GNP),
which is a measure of the total market value of currently produced finished goods and the
value of services rendered. Because national output includes goods and services that are
highly diverse in nature and some that are not in fact placed on the market, the determination
of market value is difficult and somewhat imprecise. Nonetheless the use of a common basis
of valuation makes it possible to obtain a total that fairly represents the level of output of a
country. The rule that only currently produced goods and services should be counted ensures
that only production occurring in the course of a given year is included and that any
transaction in which money changes hands but no good or service does so in return (so-called
transfer payments, e.g., unemployment or social-security payments, gifts) is excluded. The
rule that only finished or final goods must be counted is necessary to avoid double or triple
counting of raw materials, intermediate products, and final products. For example, the value
of automobiles already includes the value of the steel, glass, rubber, and other components
that have been used to make them.

The following points highlights the major Problems in Measuring or calculating National
Income :

1. Exclusion of Real Transactions 6. Valuation of Inventories

2. The Value of Leisure 7. Self-Consumption

3. Cost of Environmental Damage 8. Lack of Official Records

4. The Underground Economy 9. Imputed Income

5. Transfer Payments and Capital Gains 10. Valuation of Government Service.

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1. Exclusion of Real Transactions

In measuring national income from the output side only those items which are purchased
and sold through the market are included. However, all direct sales of various goods and
services are excluded. In other words, GDP includes the money value of those items
which are sold through the market at current prices.

In developing countries like India a major portion of output is not sold through
the market. Yet these are produced by using economic resources and satisfaction
is derived from consuming various non-marketed goods and services. Examples
are barter transactions and various free services rendered at personal levels.

Many useful services are produced by members of households for the benefit of
themselves or their families. Husbands and wives perform useful services for
themselves and their families when they prepare meals, make household repairs,
and handle their own financial affairs.

The value of these services is not included in GDP because they do not represent
services purchased through market transactions. 

2. The Value of Leisure:

All of us place some value on our time. We sell some of our time to employers for
labour income; however, we retain much of it for our own use of leisure. Some of
this leisure is used to render household services that escape inclusion in GDP. The
satisfaction we get from recreational activities and other uses of our leisure time
are also not included in GDP.

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3. Cost of Environmental Damage

The people of a country may be able to enjoy more and better goods and services each
year, but they must also put up with more congestion, dirty air, polluted water and other
environmental costs that decrease the quality of their lives. Costs are associated with
pollution and other aspects of industrial activity that damage the environment.

The costs of environmental damage are not subtracted from the market value of final
products when GDP is calculated. Some economists, therefore, believe that GDP
overestimates the value of output by failing to take into account environmental costs of
production.

4. The Underground Economy

Economy consists of transactions that are never reported to tax and other government
authorities. It includes transactions involving illegal goods and services, such as trading
in harmful drugs, gambling, smuggling and prostitution. These illegal goods and services
are final products that are not included in GDP.

The transactions of the underground economy also include activities by people who do
not comply with tax laws, immigration laws, or government regulations and who do not
report their income to tax authorities. The underground (unofficial) economy is also
called parallel economy.

5. Transfer Payments and Capital Gains

All domestic transfer payments (personal, private and government) are excluded from
national income of a country. Another example of transfer is the subsidy received by
producers of milk from the government. Still another is retirement pension. A surprise
omission from national income accounts is interest on government bonds. It is an
example of government transfer. It is excluded from national income because the
government pays interest on bonds not from profits of public sector enterprises but by
imposing tax on people.

So there is transfer of income from taxpayers to bondholders. But there is no net increase
in society’s output of goods and services in the process. And it may be a happy
coincidence if the same individual is both a taxpayer and a bondholder at the same time.
So net interest paid by government (interest paid to individuals less interest received
from state governments from loans and advances) is not a par: of national income.

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6. Valuation of Inventories

We have already noted how inventories are to be treated in national income accounts.
However, while estimating national income of a country, one problem has to be faced.
This problem arises due to price level changes, i.e., inflation and deflation which lead to
stock appreciation or depreciation. And the national income accountants have to face
certain problems associated with the valuation of inventories.

Two methods are normally used for inventory valuation :

(i) the market price method

(ii) the factor cost method

According to the market price method, stock appreciation (increase in inventory) is valued at
current market prices of goods held in inventories. It may be noted that market price of every
item stocked includes imputed (notional) profit which may or may not be realised in the same
year. On the other hand, if the factor cost method of valuing inventories is used, imputed
profit is excluded from cost calculation. This is the usual practice.

Changes in the Mix of Inventories

Another problem of inventory valuation. Is associated with changes in the physical

composition of inventories. Inventories are not a homogeneous entity. They consist of
various items. It is quite possible for the total volume of inventories of a firm to remain
constant over an accounting year.

However, there is no guarantee that each individual item existing at the beginning of an
accounting year will also exist at the end of the year.

Since inventories are both flow and stock variables, new items are stocked every year for
future sales and old items stocked earlier are sold in the current period. In other words,
some items disappear from the stock as they are sold and others are added to stock. Thus
inventories involve a dual transaction. So they are always a troublesome item in the
national income accounts of a country.

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7. Self-Consumption

A special problem arises in agriculture which is the most dominant sector in less
developed countries (LDCs) like India. Subsistence farmers who produce food for
themselves and their family members consume a major portion of their own output every
year. Since this portion is not sold through the market, it is excluded from GDP.

The reason is that it is difficult to measure the market value of this output. A lot of
arbitrariness is involved in the process of measuring.

8. Lack of Official Records

Another problem arises due to lack of reliable data. The reason is that many people in
LDCs sell their output through the market no doubt but they do not maintain any official
accounts of their transactions.

For example, most roadside small traders, (retailers) as also many business enterprises in
the unorganised sectors (mainly sole proprietorship organisations or single-owner firms)
and self-employed persons do not keep proper records of their incomes and expenses.

This is why it is difficult to include proprietor’s income (which is essentially a mixed

income) in the national income accounts of a country. However, in theory, such income
is a part of national income. The reason is that it is earned through market transactions.

9. Imputed Income

Imputed income such as income from owner-occupied houses and flats is a part of a
person’s taxable income. Therefore, it is a part of national income. Such income is fixed
on the basis on notional rent. Even if an individual keeps his house vacant he has to pay
tax on notional rent.

In this case, the value of the service rendered by the house has to be imputed. The same
thing is true of unintended inventories. For example, if a firm is not able to sell its entire
output during the current year, the unsold stock will have to be valued at the current
market price and included in national income.

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10. Valuation of Government Service

Finally, government services provided to people free of cost are also to be included.
However, it is very difficult to find the true values of such services, since these are not
sold through the market.

This, in turn, raises the question of how to evaluate the economic contribution, i.e., value
added of the government which is the provider of public goods like national defence, law
and order, etc. for which no market prices exist. In the absence of market prices for many
types of public services, the problem of their valuation must be somewhat arbitrarily
settled by accounting conventions.

It may also be mentioned here that to avoid such arbitrariness, national income
accounting procedure in centrally planned or socialist economies deliberately excludes
value added by the entire ‘service sector’ including the government. This results in an
estimate of material production in the economy excluding services, for which the product
method of accounting is better suited.

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CONCLUSION

Statisticians face a number of difficulties and complications in computing the national

product and income. Although there is a wealth of information available from regular
production returns made by companies, from value-added tax figures, from income and
corporation tax returns, and from other reports relating to incomes or expenditures, they are
all incomplete, subject to errors, and based on different definitions and valuation methods.
Statisticians have developed various techniques for estimating and adjusting so as to improve
the quality of the figures. Much indirect evidence is used to close gaps in data. Margins of
error that accompany published calculations are themselves subject to error. Thus simple
comparisons of, for example, one nation’s reported national product and income with
another’s may be misleading. National accounting remains an inexact science, but
it constitutes an invaluable tool for economic planners and government budget makers.

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REFERENCES

1. www.economicsdiscussion.net

2. www.investopedia.com

3. www.britannica.com

4. Chapter 8 : National Income Accounting

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