Income Method: A Simplified Explanation

National income is the accumulated value of total goods and services produced by a country within a financial year. It is the net outcome of all economic activities that takes place in a country and valued in terms of money. National income is measured using three methods, income method, expenditure method and product method.

The overall money earned by all citizens and businesses in a country over a given period is referred to as national income or gross national income. National income can alternatively be defined as the total value of all products and services produced during a certain period. It is thus the result of all economic activity that takes place in a country over the duration of a year. The figure includes the country's gross domestic product (GDP) as well as income from international entities. It is valued in monetary terms. It is also useful in understanding the country's progress. Wages, rent, interest, and profit received by elements of production such as capital, land, labour, and entrepreneurship in a country are included.

National income can be calculated in a variety of ways. The value-added method, the income method, and the expenditure method are the three most prevalent Methodologies. The income approach concentrates on the income received from production variables such as land and labour. Let's take a closer look at the Income Method.

Income Method Definition

Income method calculates national income based on the flow of factor revenues. There are four factors associated with every production activity; these are land, labor, capital, and entrepreneurship. Laborers receive their wages, the land gets rent, capital accrues interest, and entrepreneurship gets profit, each earning through the individual means.

Apart from that, self-employed individuals like doctors, CAs, advocates, etc. employ their own capital and labor. Thus, their income is regarded as mixed income.

Therefore, in the income method, the national income is measured in terms of these factor payments. Thus, it is also known as the ‘factor payment method.’

To arrive at national income using this method, you must sum up all the individual income that occurred in a country within a specific period. It includes wages and salaries, rent of land, interest gained on capital and income of self-employed individuals. This method conclusively indicates the distribution of national income among every income group of a country. 

Income Method Formula

National Income (NNPFC) = Net Domestic Product at Factor Cost (NDPFC) + Net Factor 

Income from Abroad

Here NDPFC = Compensation of Employees + Operating Surplus + Mixed-Income

Here Operating Surplus = Rent + Interest + Profit

Steps of Income Method Formula

1. Identification and Classification of Production Units

The first step in calculating national income by income method is to identify and segregate the units of production. They are classified into three categories, primary, secondary, and tertiary. 

2. Classify and Estimate the Factor Income

The next step of the income method of national income is to classify factor payments in different categories like wages, rent, interest, profit, and mixed income. Otherwise, they can be classified into compensation to employees, operating surplus, and mixed income.

After classifying, estimate the number of such payments made by enterprises.

3. Calculating Domestic Income

Summing up all factor incomes of every sector will present the domestic income figure (NDPFC). 

NDPFC = Compensation of Employees + Operating Surplus + Mixed-Income

4. Estimate NFIA to arrive at National Income

The last step to reach the final National Income figure is to estimate Net Factor Income from Abroad (NFIA) with NDPFC.

National Income (NNPFC) = Net Domestic Product at Factor Cost (NDPFC) + Net Factor Income from Abroad (NFIA)

Components of Factor Income

Factor income is an essential part of the income method. Summing up all the factor incomes within a country for a period resulted in Domestic Income or NDPFC. There are three components of factor income compensation to employees, operating surplus, and mixed income.

Compensation to Employees (COE)

Compensation to employees refers to the remuneration paid by an employer to his/her employees for their productive services. It includes all monetary and non-monetary benefits that employees receive, directly or indirectly. Moreover, COE comprises of 3 elements, these are –

• Wages in Cash

It consists of every monetary benefit, such as wages, bonuses, commissions, dearness allowance, etc. However, business expenditures incurred by employees or any reimbursements will not be calculated under COE. Such expense is reconsidered as intermediate consumption of an enterprise.

• Wages in Kind

This includes every non-monetary benefit that employees receive from their employers, like home, car, medical and educational facilities. The imputed value of such benefits should be included in national income.

However, facilities which are necessary for work and employees have no discretion in it should not be included here. For instance, uniforms that employees use, or vehicles used for business purposes, etc. Such facilities are considered as intermediate consumption.

• Employer’s Contribution to Social Security Schemes

It includes the contribution employers make in social security plans such as employees provident fund, gratuity, pension plans, etc.

Operating Surplus

Operating surplus is also divided into 3 categories, these are –

• Rent

Rent arises from the ownership of properties. Income under this head comprises both actual rent and imputed rent. Actual rent is calculated on properties to let out on rent. Whereas imputed rent is rent on self-occupied properties—such rent calculated according to the market value of the property.

• Interest

It refers to the interest amount received for loaning funds to a manufacturing unit. This interest comprises both actual and imputed interest. Additionally, it also includes interest paid on loans taken for production units.

However, it does not include interest paid by the government against public debt as well as interest on consumer loans. Moreover, interest paid by one company to another is also not included as it is already accounted for in the company books as profit.

• Profit

An entrepreneur earns profits for his/her contribution to the company. It is a residual income, which the entrepreneur earns after paying other factors of production. 

Mixed-Income

Self-employed individuals and unincorporated businesses generate this form of income. The mixed income arises when elements of factor incomes cannot be separated from each other. For example, a doctor running his/her clinic.

Precautions

The following measures must be taken to calculate national income correctly using the income method:

• Only factor revenues received from rendering productive services are considered. All forms of transfer income, such as old-age pensions, unemployment benefits, and so on, are excluded.

• Second-hand products are excluded since they are not part of the current year's production, but commission paid on second-hand goods is included because it is compensation for providing productive services. Similarly, the proceeds from the selling of stocks and bonds are excluded.

• Direct taxes are to be mentioned, such as income tax paid by employees from their salaries and corporate tax paid by a joint-stock firm from its profits. Wealth and gift taxes, on the other hand, are not included because they are paid from previous savings and wealth. Indirect taxes, such as sales tax and excise duties, which tend to raise market prices, are also excluded.

• Smuggling, black-marketing, and other unlawful operations, as well as windfall income (e.g., from lotteries), are not included.

• Imputed rent for owner-occupied houses and the value of production for self-consumption is included, but not the value of self-consumed services such as those provided by housewives.

Treatments of Different Items in National Income

Following Items are Excluded While Calculating National Income:

• Transfer Income and payments like Scholarships, Pensions etc.

• Sale and purchase of financial assets.

• Non-market trades, such as kitchen gardening, etc.

• Compulsory Transfer Payments like capital gain tax, interest tax, etc.

• Second-hand commodities, such as the sale or purchase of an old house, etc.

• Windfall gains like lotteries, gambling, etc.

• Interest on the national debt, as well as interest paid by households to commercial banks.

• A capital loss like the destruction of a building by flood or earthquake etc.

• Capital gains like Profits from a rise in the value of land, buildings, or stocks, etc.

• Intermediate consumption expenditure like vegetables purchased by a dairy shop, the purchase of raw material by a firm, etc

The Below Items are Included While Calculating National Income:

• Owners of production units supply services such as imputed rent of the owner's inhabited residence and interest on own capital, etc.

• Employer contributions to a provident fund and bonus etc.

• Wages obtained by Indian employees working overseas, profit earned by an Indian organization through its foreign branches, etc.

• Brokerage/Commission on sale/purchase of second- hand goods.

• Capital Formation includes things like a company buying machinery, building a flyover, and building bridges, etc.

• Payment of bus fare by households, payment of phone bills, examination fees for students, etc.

• Government-provided services such as dispensary, education and government expenditure on street lighting.

• Interest on the loan paid by commercial banks.

Income method is an important chapter of economics. Apart from this, students can also navigate to other chapters available in Vedantu’s website to learn the details of 10+2 economics. Vedantu’s app is also available for use in smartphones and similar devices.