The Income Approach to GDP

Gross Domestic Product, or GDP, is a common indicator of a country’s economic health and activity. There is no one definition for GDP, and rather economists use various approaches, or equations, to calculate GDP.

There are three primary methods:

the production approach.

the expenditure (spending) approach.

the income approach.

In other articles we’ve explored the expenditure (spending) approach, and here we’ll break down the income approach. The income approach attempts to calculate GDP, or economic activity, by summing income, so how much everyone earns. Hence, while other approaches judge via direct output (goods, etc), the income approach focuses instead on what people and companies earn, which theoretically reflects output.

The Income Approach Explained

In pursuing cumulative income, or the total national income that constitutes GDP via the income approach, we can consider the following formula:

GDP = Compensation of employees + Gross operating surplus + Gross mixed income + Taxes − Subsidies

This looks intimidating, so let’s break it down, and then explore an easy layered method to calculate GDP via income without a formula:

1. Compensation of Employees: This includes wages, salaries, and other employee benefits.
2. Gross Operating Surplus: the profits of companies.
3. Gross Mixed Income: the income of unincorporated businesses (sole proprietorships).
4. Taxes: earned income (both from individuals and corporations) sent to the government. Taxes boost GDP. This primarily refers to indirect business taxes like VAT.
5. Subsidies: subsidies on production and imports, which reduce GDP.

Let’s consider a hypothetical country’s economy with the following data:

• Compensation of Employees: $500 billion
• Gross Operating Surplus: $300 billion
• Gross Mixed Income: $150 billion
• Taxes: $200 billion
• Subsidies: $50 billion

Using the formula, GDP via the income approach can be calculated as follows:

1. Add up incomes:

Compensation of Employees ($500 billion) + Gross Operating Surplus ($300 billion) + Gross Mixed Income ($150 billion) = $950 billion

2. Adjust for taxes and subsidies:

Taxes ($200 billion) − Subsidies ($50 billion) = $150 billion

3. Sum incomes and taxes/subsidies:

Income Total ($950 billion) + Tax Adjustment ($150 billion) = $1,100 billion

So, the GDP of this country through the income approach is $1,100 billion ($1.1 trillion).

Let’s now explore a layered, non-formulaic approach to calculating an equivalent which includes all the variables in the formula:

First, start with National Income. National income is the total amount of money earned by residents of a country. It includes income from wages, profits, rent, and interest, and is equivelant to the sum of Compensation of Employees, Gross Operating Surplus, and Gross Mixed Income from the formula. Consider this hypothetical graph, which details how we can understand GDP through national income, or the combination of wages, profits, interest, and rents:

Hypothetical descriptor of wages, profits, interest, and rent as constituting GDP.

Then, add Indirect Business Taxes and Depreciation. These are taxes businesses pay that don’t directly tax consumer earnings (think sales tax). Depreciation, meanwhile, accounts for the loss in value of equipment over time—think of a car that decreases in resale value each year as it ages, its miles increase, and newer, better cars come out.

Finally, add Net Foreign Factor Income. We have to adjust the national income to account for income earned abroad, as well as foreign income earned domestically (individals and corporations). So, we’ll add income from foreign sources and subtract payments made to foreign workers and investors.

You should be able to see how our layered approach and formula are attacking the same core factors—national income, for example, including compensation of employees, profits, and gross mixed income.

That’s it! We’ve explored how income can be used to calculate economic activity in the form of GDP. Let me know if you have questions in the comments.

To learn more, consider reading about the Economic Fluctuations Model, the Gains from Expanded Trade Model, and the Spending Allocation Model. Else, consider the other articles in my Economic List below.