Calculating GDP With the Income Approach

The income approach measures a country’s gross domestic product (GDP) based on the accounting principle that all expenditures should equal the total income generated by producing the economy’s goods and services.

The income approach assumes that there are four major factors of production in an economy and that all revenues must go to one of these sources. Add together all of the sources of income over a period and make adjustments for taxes, depreciation, and foreign-factor payments.

Measuring GDP

GDP measures the total monetary value of all goods and services produced within a country over a set timeframe. GDP is usually measured over a year, but can be calculated over any period. There are various ways to calculate GDP, each distinguished by its starting point:

• Income approach: Starts with the income earned from producing goods and services.
• Production approach: Sums the “value-added” at each production stage, defined as total sales less the value of the inputs into the production process. 
• Expenditures approach: Begins with the money spent on goods and services.

Income Approach Formula

$begin{aligned}&text{GDP}=text{Total National Income}\&qquadquad+text{Sales Taxes}+text{Depreciation}\&qquadquad+text{Net Foreign Factor Income}\&textbf{where:}\&text{Total National Income}=text{Sum of all}\&quadtext{wages, rent, interest, and profits}\&text{Sales Taxes}=text{Consumer taxes}\&quadtext{imposed by the government}\&quadtext{on the sales of goods and}\&quadtext{services}\&text{Depreciation}=text{Cost allocated to a}\&quadtext{tangible asset over its useful life}\&text{Net Foreign Factor Income}!=!text{Difference}\&quadtext{between the total income that a}\&quadtext{country’s citizens and companies}\&quadtext{generate in foreign countries,}\&quadtext{versus the total income foreign}\&quadtext{citizens and companies generate}\&quadtext{in the domestic country}end{aligned}$​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​

Alternate Calculation

Total national income is equal to the sum of all wages plus rents plus interest, and profits. It’s possible to express the income approach formula for 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​

Why GDP Is Important

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) form the basis for measuring GDP, allowing 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 prices
• Tax and spending plans

Economic Cycle and GDP

When the economy is booming, GDP rises, and inflationary pressures can build up rapidly as labor and productive capacity near full utilization. This leads a central bank to initiate a tighter monetary policy to cool down the overheating economy and quell inflation.

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

The Bottom Line

Gross domestic product (GDP) provides a broad picture 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. The income approach to calculating GDP states that all expenditures should equal the total income generated by all goods and services within the economy.