Calculating GDP With the Income Approach

What Is the Income Approach?

The income approach to measuring a country's gross domestic product (GDP) is based on the accounting principle that all expenditures in an economy should equal the total income generated by the production of all that economy's goods and services. The income approach also assumes that there are four major factors of production in an economy and that all revenues must go to one of these sources.

Therefore, by adding together all of the sources of income, a quick estimate can be made of the total production value of economic activity over a period. You must then make adjustments for taxes, depreciation, and foreign-factor payments. Learn how this method works.

Ways to Calculate GDP

GDP is the gross domestic product of a country. This is a measurement of the total monetary value of all goods and services produced within a country over a set timeframe. GDP is usually measured over the course of a year, though it can be calculated over any timeframe.

$\begin{aligned}&\text{GDP}=\text{Total National Income}\\&\qquad\quad+\text{Sales Taxes}+\text{Depreciation}\\&\qquad\quad+\text{Net Foreign Factor Income}\\&\textbf{where:}\\&\text{Total National Income}=\text{Sum of all}\\&\quad\text{wages, rent, interest, and profits}\\&\text{Sales Taxes}=\text{Consumer taxes}\\&\quad\text{imposed by the government}\\&\quad\text{on the sales of goods and}\\&\quad\text{services}\\&\text{Depreciation}=\text{Cost allocated to a}\\&\quad\text{tangible asset over its useful life}\\&\text{Net Foreign Factor Income}\!=\!\text{Difference}\\&\quad\text{between the total income that a}\\&\quad\text{country's citizens and companies}\\&\quad\text{generate in foreign countries,}\\&\quad\text{versus the total income foreign}\\&\quad\text{citizens and companies generate}\\&\quad\text{in the domestic country}\end{aligned}$​GDP=Total National Income+Sales Taxes+Depreciation+Net Foreign Factor Incomewhere:Total National Income=Sum of allwages, rent, interest, and profitsSales Taxes=Consumer taxesimposed by the governmenton the sales of goods andservicesDepreciation=Cost allocated to atangible asset over its useful lifeNet Foreign Factor Income=Differencebetween the total income that acountry’s citizens and companiesgenerate in foreign countries,versus the total income foreigncitizens and companies generatein the domestic country​

There are generally two ways to calculate GDP: the expenditures approach and the income approach. Each of these approaches looks to best approximate the monetary value of all final goods and services produced in an economy over a set period.

The major distinction between each approach is its starting point. The expenditures approach begins with the money spent on goods and services. Conversely, the income approach starts with the income earned from the production of goods and services.

Formula for Income Approach

It’s possible to express the income approach formula to GDP as follows:

$\begin{aligned} &\text{TNI} = \text{Sales Taxes} + \text{Depreciation} + \text{NFFI} \\ &\textbf{where:} \\ &\text{TNI} = \text{Total national income} \\ &\text{NFFI} = \text{Net foreign factor income} \\ \end{aligned}$​TNI=Sales Taxes+Depreciation+NFFIwhere:TNI=Total national incomeNFFI=Net foreign factor income​

Total national income is equal to the sum of all wages plus rents plus interest and profits.

Why GDP Is Important

Some economists illustrate the importance of GDP by comparing its ability to provide a high-level picture of an economy to that of a satellite in space that can survey the weather across an entire continent. GDP provides information that policymakers and central banks can use to judge whether the economy is contracting or expanding, whether it needs a boost or restraint, and if a threat such as a recession or inflation looms on the horizon.

The national income and product accounts (NIPA), which form the basis for measuring GDP, allow policymakers, economists, and businesses to analyze the impact of economic variables on both the overall economy and specific sectors of the economy. These variables can include:

• Fiscal and monetary policy
• Economic shocks, such as a spike in oil price
• Tax and spending plans

Along with better-informed policies and institutions, the skillful use of national accounts by policymakers has contributed to a significant reduction in the severity of business cycles since the end of World War II.

Economic Cycle and GDP

GDP does fluctuate because of business cycles. When the economy is booming and GDP is rising, inflationary pressures build up rapidly as labor and productive capacity near full utilization. This leads central bank authorities to commence a cycle of tighter monetary policy to cool down the overheating economy and quell inflation.

As interest rates rise, companies cut back, the economy slows down, and companies cut costs. To break the cycle, the central bank must loosen monetary policy to stimulate economic growth and employment until the economy is strong again.

The Bottom Line

Gross domestic product, or GDP, is a measurement of the total value of all the goods and services produced within a country within a specific period of time, usually a year. It provides a broad pocture of a country's economic health and is used by policymakers and economists to assess the impact of monetary policy, global trends, and other economic changes. GDP can be calculated using one of two approaches.

The income approach to calculating GDP states that all expenditures should equal the total income generated by all goods and services within the economy. The expenditures approach, on the other hand, adds up consumer spending, investment, government expenditure, and net exports. The expenditures method is more widely used, although both methods should produce the same result.