Comprehensive Notes on National Income, Taxes, and Business Cycles

National Income

National income is the total market value of final goods and services produced in a country during one year. It includes agricultural, industrial, mineral, and trade products, as well as services from doctors, professors, and lawyers.

Definitions of National Income by Economists

• Prof. Marshall: National income is the quantity of goods and services produced by a country's individuals using its resources and capital.

• Prof. Pigou: National income is the part of a nation's material wealth that can be measured in monetary terms.

• Prof. Paul A. Samuelson: National income is the money measure of the overall annual flow of goods and services in an economy.

• Prof. Ackley, Gardener: National income is the sum of all individual incomes earned from productive services.

• Prof. Fisher: National income is the quantity of goods and services consumed during a year.

• Commerce Department of the United States of America: National income is the total net national income that factors of production receive as rewards for producing goods and services within a specific time.

Various Concepts of National Income

1. Gross National Product (G.N.P)

2. Net National Product (N.N.P)

3. Gross Domestic Product (G.D.P)

4. National Income (N.I)

5. Personal Income (P.I)

6. Disposable Personal Income (D.P.I)

Gross National Product (G.N.P)

Gross National Product (G.N.P) is the total market value of all final goods and services produced by a country during one year.

G.N.P includes:

• Agricultural goods (e.g., wheat, cotton, sugar cane, rice, maize, vegetables, fruits).

• Industrial goods (e.g., cloth, machinery, furniture, fans).

• Mineral goods (e.g., iron, coal, petroleum, gas).

• All kinds of services (private or government institutions, doctors, lawyers, professors).

• Money earned by people working in foreign countries.

• Expenditure on the repair of machines and buildings.

Net National Product (N.N.P)

Net National Product (N.N.P) is derived by subtracting depreciation allowance or replacement cost of machines from Gross National Product (G.N.P).

$Net\ National\ Product = Gross\ National\ Product - Depreciation\ Allowance$

Depreciation Allowance: Expenditures made on the repair of machines that break down due to wear and tear.

Example: If a cloth manufacturing machine costs five lac rupees and becomes useless after five years, the producer should save one lac rupees every year as a depreciation allowance to purchase a new machine after five years.

Gross Domestic Product (G.D.P)

Gross Domestic Product (G.D.P) is the total market value of all final goods and services produced within a country during one year.

$G.D.P = G.N.P - F.I.$ where FI is foreign income

The difference between G.N.P and G.D.P is that the money sent to Pakistan by Pakistanis working abroad is part of Pakistan's G.N.P but not its G.D.P, as it is not earned in Pakistan. Conversely, the profit of a Toyota car factory in Lahore built by Japan is included in Pakistan's G.D.P because it is earned in Pakistan, but not in Japan's G.N.P.

National Income (N.I)

National Income (N.I) is obtained by subtracting indirect taxes from N.N.P and adding subsidies.

$National\ Income = Net\ National\ Product - Indirect\ Taxes + Subsidies$

Indirect Tax: A tax whose burden is shifted to another person (e.g., sales tax, excise duty).

Subsidy: Government provides some goods to the public at a lower price than the market price. The part of the price paid by the government is called subsidy (e.g. flour sold at utility stores).

Personal Income (P.I)

Personal Income (P.I) is the income an individual earns in a year. It includes transfer payments and direct taxes but excludes undistributed corporate profit, corporate profit tax, and contributions for social welfare funds.

$Personal\ Income = National\ income + Transfer\ payments + Direct\ taxes - Corporate\ profit\ tax - Undistributed\ corporate\ profit - Contributions\ for\ welfare\ fund$

Transfer payments are amounts of money received without labor (e.g., donations, alms, pension, relief fund, scholarship, gifts).

Disposable Personal Income (D.P.I)

Disposable Personal Income (D.P.I) is the income remaining with a person after paying direct taxes. The person is free to spend it as per their own wish.

$Disposable\ personal\ income = Personal\ income - Direct\ taxes$

People spend some part of it as consumption and save the remaining.

$Disposable\ personal\ income = Consumption + Saving$ and $Disposable\ personal\ income = Consumption + Investment$

Measurement of National Income

Three methods are used to measure national income:

1. Product method or output method.

2. Income method.

3. Expenditure method.

Product Method

Also called the method of measuring national income at market prices. It accounts for all agricultural, industrial, mineral, and commercial goods and services produced during a year.

To measure national income using the product method, the following precautions are necessary:

• Avoid Double Counting:

  • Calculate the market value of final goods and services (e.g., bread, cloth, chair, table).

  • Calculate the market value of primary goods and the value added at each stage of production.

  • Example of Value Added Method:

    • Stage 1 (Wheat): Market value at every stage = 1.00 rupee, Value added = 1.00 rupee

    • Stage 2 (Flour): Market value at every stage = 1.20 rupees, Value added = 0.20 rupee

    • Stage 3 (Baked bread): Market value at every stage = 1.60 rupees, Value added = 0.40 rupee

    • Stage 4 (Profit of producer): Market value at every stage = 2.00 rupees, Value added = 0.40 rupee

  • Shape of good at various stages:

    • 1st: Wheat

    • 2nd: Flour

    • 3rd: Baked bread

    • 4th: Profit of Producer

• Subtract Indirect Taxes: Sales tax and excise duty should be subtracted from the total market value.

• Free Services: The market value of commodities produced as a hobby and services performed personally should not be counted.

• Subsidies: Subsidies should be counted while measuring national income.

Income Method

Annual monetary rewards of all factors of production are added up.

$National\ income = Rent\ of\ land + Wages\ of\ labour + Interest\ of\ capital + Profit\ of\ entrepreneurs$

The following rewards are included in national income:

1. All wages, salaries, and other monetary rewards received by employees of government, autonomous and private institutions, and domestic servants.

2. Incomes of farmers, traders, lawyers, doctors, and laborers working on daily wages.

3. All kinds of interest on bonds, securities, and loans.

4. Rent of lands, rent of buildings, and royalty.

5. Corporate profit distributed among shareholders.

6. Undistributed corporate profit and corporate profit tax paid to the government.

Precautions:

• Incomes from smuggling, black marketing, hoarding, bootlegging, bribery, racketeering, and other unfair means are not included.

• Transfer payments (Zakat, alms, donations, scholarships, pensions, gifts) are not included.

Expenditure Method

Add the expenditure made on the purchase of goods and services in a country during one year.

The following expenditures are added to get national income:

1. Private consumption expenditures.

2. Public consumption expenditures.

3. Private investment expenditures.

4. Public investment expenditures.

5. Exports minus imports.

Precautions:

• Depreciation cost should be subtracted from the expenditures.

• Indirect taxes added to prices should be subtracted.

• Subsidies should be included.

• Expenditure on the purchase of a good should be included only once.

Circular Flow of National Income

In a capitalistic system, the economy is divided into two sectors: households (consumption sector) and firms (production sector). Households offer their services to firms and produce goods and services for them. Firms give them rewards for their services. Households purchase goods and services from firms and pay their obtained rewards to firms as the prices of these goods and services. National income moves from firms to households and from households to firms.

Diagram description:

Households (factors of production: Land, Labor, Capital, and Organization) provide their services to firms, and various kinds of goods and services are produced. Firms pay rewards to households for their services, and households spend these rewards on the purchase of goods and services of their need. National income keeps circulating from firms to households and from households to firms.

This circular flow explains that total rewards of factors of production are equal to the total monetary value of goods and services.

Importance of the Study of National Income

1. Study of Economic Conditions:
   National income reflects the economic conditions of a country. Per capita income (National income / Population) indicates the living standard of people.
   Example: Per capita income of America is 26980 dollars, of England 18700, and of Pakistan 736 dollars.

2. Study of Economic Growth:
   Statistical figures of national income are calculated every year to examine the growth rate of the economy.

3. Analysis of Economic Problems:
   The study of national income helps to get details about all sectors of the economy and their problems.

4. Framing Economic Policies:
   National income statistics are taken into account when making the budget of a country and other economic policies.

5. Economic Planning:
   National income statistics hold a primary place in effective economic planning to raise per capita income and living standards.

6. Estimation of Inflation and Depression:
   National income statistics help to estimate the extent of inflation and depression in the country.

7. Importance for Entrepreneurs:
   The study of national income tells the entrepreneurs to avail the chances of investment in economic sectors.

8. Foreign Loans:
   A lending country considers the paying capacity of the borrowing country, which is estimated by its national income.

9. To Remove Regional Disparity:
   Study of national income enables knowing the economic conditions of various regions, helping the government in effective planning for the development of backward areas.

10. Study of Sources of Employment:
    National income statistics help to know the sources of income in the country and professions of the people living in the country.

11. To Estimate Consumption and Investment:
    It indicates the part of national income being spent on goods and services and the part being saved for investment.

12. Importance in Foreign Trade:
    Foreign exchange attained by exports is a part of national income.

13. Comparative Study of Economic Systems:
    The analysis of national income of various countries under various economic systems provides an opportunity to compare the economic systems.

14. Importance for Politicians:
    Politicians study national income while framing their manifestoes to solve the economic problems of the public.

15. Modern Economists and National Income:
    Modern economists believe that a full employment level can be maintained only in the presence of equilibrium level of national income.

Kinds of Taxes

1. Direct Tax

2. Indirect Tax

3. Proportional Tax

4. Progressive Tax

5. Regressive Tax

6. Value Added Tax (VAT)

Direct Tax

Direct tax is paid from the pocket of the person on whom it is levied and cannot be shifted to anyone else (e.g., income tax, property tax, wealth tax, inheritance tax).

Indirect Tax

Indirect tax is not paid from the pocket of the person on whom it is levied, and the burden is shifted to another person (e.g., sales tax, excise duty, custom duty).

Proportional Tax

A tax in which the rate of tax remains the same on every level of income.

Example:

• Upto 100000 rupees: 5%

• Upto 200000 rupees: 5%

• Upto 300000 rupees: 5%

• Upto 400000 rupees: 5%

• Upto more than 400000 rupees: 5%

Progressive Tax

A tax in which the rate of tax increases with the increase of level of incomes. In Pakistan, income tax is a progressive tax.

Example:

• Upto first fifty thousand rupees: 5 percent

• From fifty thousand and one rupee to one lac rupees: 10 percent

• From one lac and one rupee to two lac rupees: 20 percent

• From two lac and one rupee to three lac rupees: 30 percent

• More than three lac rupees: 40 percent

Regressive Tax

Regressive tax is opposite to progressive tax. The rate of tax decreases with the increase in income and vice versa.

Example:

• Upto first one lac rupees: 40 percent

• From one lac and one rupee to two lac rupees: 30 percent

• From two lac and one rupee to three lac rupees: 20 percent

• From three lac and one rupee to four lac rupees: 10 percent

• From four lac and one rupee to five lac rupees: 5 percent

Value Added Tax (VAT)

A tax imposed on every stage of production of a good. The tax is imposed on the value added at every production stage.

Business Cycle/Trade Cycle

In a capitalistic system, economic activities fluctuate between brisk and sluggish periods. These economic ups and downs are called business cycles or trade cycles.

Definitions:

• Prof. Keynes: A trade cycle is composed of periods of good trade characterized by rising prices and low unemployment, alternating with periods of bad trade characterized by falling prices and high unemployment.

• Prof. Hanson: Trade cycle is fluctuation in employment, production, and prices.

• Prof. Haberler: Business cycles are prosperity and adversity; good trade and bad trade.

• Prof. W.C. Mitchell: Trade cycles are fluctuations in the aggregate economic activity.

A typical trade cycle starts from depression, enters into revival, then converts itself into boom, and finally turns into recession.

Phases of the Business Cycle

1. Depression or slump

2. Recovery or revival

3. Boom or prosperity

4. Recession or contraction

Depression or Slump

Economic activities are very slow. Production of goods and services is very low. Level of income and employment is the lowest. Demand for goods and services falls to the lowest level, as a result, the general level of prices also falls. Profits of the entrepreneurs are minimized, and firms shut down their business. Deposits of banks decrease, and expansion of loans ceases. Rate of interest falls down. Purchasing power of the people decreases. Prices, consumption, income, employment, wages, and interest rate reach the lowest ebb.

Recovery or Expansion

Demand for goods starts rising, and production units start production to meet this rising demand. Firms replace their existing machines. The level of employment, national income, and consumption start rising up. Entrepreneurs become hopeful and increase their investment. Prices, wages, interest rate, profits, employment, and production start rising gradually.

Boom or Prosperity

Level of incomes rises, owing to which demand for goods and services increases swiftly in the market. Level of employment and living standards rise up. Production, income, and investment increase rapidly. Rate of interest increases. Profits of the entrepreneurs are highest. Demand for labor increases, and wages increase. Prices of goods and costs of production increase. National income, individual incomes, wages, profits, prices, employment, and living standards reach their peak.

Recession

Producers work day and night to produce more goods to maximize their profit. The production of goods becomes much higher than the market demand. They start closing down the production units, and the labor becomes jobless, decreasing the demand for goods. Entrepreneurs decrease the prices to sell their goods as soon as possible. Profits start falling, and there are chances of loss. Investment falls down, and banks demand the payment of their debts.

Main Characteristics of Business Cycle

1. Identical in Duration: Boom or depression in all industries appears almost in the same period.

2. International in Nature: Depression in a country envelops the whole world.

3. Difference in Degree: Depression or boom appears in all industries at the same time, but their intensity differs.

4. Regular Intervals: The phases of trade cycle follow one another by regular intervals (generally in a period of 8 to 12 years).

5. Difference in Ups and Downs: Recovery from depression is very slow, while the phase from boom to recession passes very swiftly.

6. The Features of Boom and Depression: In the period of boom, prices, wages, interest rate, profits, incomes, production, and employment all increase, while in depression, they all decrease.

7. Cause of End: The two extremes of the trade cycle (boom and depression) themselves cause their end.

8. Difference in Trade Cycles: Every trade cycle is different from the other.

9. Difference in the Duration of Trade Cycles: The duration of some trade cycles is from 3 year and 4 months, some from 9 to 10 years, and some from 50 or 60 years.

Theories of Business Cycles

1. Theory of Sun-Spot or Climatic Change

2. Psychological Theory

3. Under Consumption or Over Saving Theory

4. Over Investment Theory

5. Monetary Theory

6. Keynes' Theory of Business Cycle

7. Innovation Theory

8. Modern Theory of Business Cycles or Multiplier and Accelerator Interaction

THEORY OF SUN-SPOT OR CLIMATIC CHANGE

Changes in climate and weather cause trade cycles. Spots that appear on the surface of the sun with intervals decrease agricultural production, negatively affecting industrial production and starting the process of recession.

Criticism:

• This theory does not explain the four phases of the trade cycle.

• Climatic changes alone do not cause trade cycles.

• The economic causes of fluctuations are ignored.

PSYCHOLOGICAL THEORY

Business cycles occur because of the psychological behavior of the businessmen. Their optimism or pessimism about the future business prospects influence the economy.

Criticism:

• Change in psychological condition is not the sole cause of trade cycle.

• This theory does not explain how people fall a prey to optimism or pessimism.

• This theory does does also not explain the occurrence of all the four phases of business cycle.

UNDER CONSUMPTION OR OVER SAVING THEORY

The rich save more money for investment but are not able to buy produced quantity of goods. Thus, aggregate supply increases more than aggregate demand. There is a problem of over-production. This results in decreasing the prices and profits. The investors contract their investment and reduce the quantity of production. In this way the phase of depression starts.

Criticism:

• This theory explains the causes of depression but fails to explain the phase of boom.

• This theory does not take into account regular intervals and international trade activities.

OVER INVESTMENT THEORY

Business cycles occur owing to over investment. Commercial banks and other financial institutions offer loans at low interest rates; investment increases, and production activities increase, resulting in the phase of boom. When demand for loans rises, the banks increase the rate of interest. Investment contracts, and the demand for capital goods decreases, creating unemployment.

Criticism:

• This theory does not explain what are the causes of expansion and contraction in investment.

• The basic cause of depression is not the abundance of consumer goods but the decrease in their demand.

MONETARY THEORY

Trade cycles occur because of expansion and contraction in legal money and credit money. Banks provide them loans by the creation of credit. Commercial banks have enough money, so they start lending money on low rate of interest. Hence, the economy proceeds towards revival or expansion.

Criticism:

• Trade cycles are universal in nature and not a national phenomenon.

• Hawtrey gives excessive importance to money ignoring the importance of capital goods that cause fluctuations in economic activities.

KEYNES' THEORY OF BUSINESS CYCLE

The major causes of trade cycle are the changes in investment that appear because of the change in the marginal efficiency of capital. Rate of interest and marginal efficiency of capital both determine the level of investment. Marginal efficiency of capital means the expected rate of profit by investment.

Criticism: This theory explains only the phase of recession and fails to explain the phase of prosperity.

INNOVATION THEORY

Technical innovations bring about trade cycles. Innovations deal with searching for new markets, adopting new techniques of production, and discovering new resources. When some entrepreneurs introduce new products in the market by adopting new innovations, demand for their goods increases, and they make excessive profits.

Criticism:

• This theory fails to explain the causes which help in maintaining the effects of trade cycles for an equal period.

• Social factors bring about innovations, and it is difficult to explain the role of social factors in bringing about trade cycles.

MODERN THEORY OF BUSINESS CYCLES OR MULTIPLIER AND ACCELERATOR INTERACTION

Trade cycles are explained by the interaction of the multiplier and accelerator.

• Multiplier: With the increase in investment, the income increases many times and with the decrease in investment, income decreases many times.

• Accelerator: Investment increases many times with the increase in income, and investment decreases many times with the decrease in income.

Changes occur in national income and employment under the influence of the multiplier and accelerator, which are named as trade cycles.

REMEDIAL MEASURES TO CHECK TRADE CYCLES

1. Prohibitive Measures

2. Curative Measures

Prohibitive Measures

The measures are taken to control a trade cycle before its actual occurrence. Effort are made to control it as soon as the specific cause appears.

Curative Measures

Trade cycle can be controlled by taking curative measures, If trade cycle cannot be controlled by prohibitive measures and trade cycle appears one way or the other.

• Monetary Policy

• Fiscal Policy

• International Measures

Monetary Measures

The measures that the central bank takes to control the supply of money. The central bank increases the bank rate; sells government securities in the open market, increases the ratio of the cash reserves of commercial banks, and takes some other qualitative measures.

Conversely, if there is an economic depression in the country as the government decrease bank rate, buys government securities from the market, and decreases the ratio of the cash reserves of commercial banks

Fiscal Measures

Government policy of income and expenditure.

1. Rise and Fall in Taxes: Government should levy new taxes and increase the rate of existing taxes on the contrary, government should reduce the rate of taxes and should totally banish some of the taxes

2. Rise and Fall in Expenditures: Private investors also take part in investment. Government should cut down its expenditures. It should stop the under construction projects of social welfare.

3. Preparation of Budget: Government should make a deficit budget and during boom, the govt. should make surplus budget and surplus amount should be saved for period of depression.

International Measures

The trade cycle appearing in one country influences the whole world. Required steps are:

1. International Production Control: There should be an international control on the production of agricultural and other Industrial goods in every country, so that over-production cease to exist.

2. International Investment Control: The advanced countries should be bound to invest their capital in backward countries so that these countries may economically become stable and prosperous.

Deficit Financing

If the government expenditures are more than its income, it meets its expenditures by printing new currency notes.