10 Major Problems in Measuring National Income

The following points will highlight the six major Problems in Measuring or calculating National Income. The Problems are: 1. Exclusion of Real Transactions 2. The Value of Leisure 3. Cost of Environmental Damage 4. The Underground Economy 5. Transfer Payments and Capital Gains 6. Valuation of Inventories 7. Self-Consumption 8. Lack of Official Records 9. Imputed Income 10. Valuation of Government Service.

Measuring of National Income Problem # 1. Exclusion of Real Transactions:

In measuring national income from the output side only those items which are purchased and sold through the market are included.

However, all direct sales of various goods and services are excluded.

In other words, GDP includes the money value of those items which are sold through the market at current prices.

In developing countries like India a major portion of output is not sold through the market. Yet these are produced by using economic resources and satisfaction is derived from consuming various non-marketed goods and services. Examples are barter transactions and various free services rendered at personal levels.

Many useful services are produced by members of households for the benefit of themselves or their families. Husbands and wives perform useful services for themselves and their families when they prepare meals, make household repairs, and handle their own financial affairs.

The value of these services is not included in GDP because they do not represent services purchased through market transactions. The value of the work people do at home for themselves and their families has been estimated to be about one-third of India’s GDP. If this estimate is correct, GDP significantly undervalues the total output of the nation by excluding non-market household production.

Perhaps you can see this more clearly if you imagine each husband paying his wife for her services and each wife paying her husband for his services. These services would now become market services and would be included in GDP. Similarly, if more people remain single and hire housekeepers to do work that spouses would normally do without monetary compensation, GDP will increase!

Some non-market transactions, however, are included in GDP. For example, homeowners who live in their own homes enjoy the housing services their homes provide. In the National Income and Product Accounts, these owner-occupiers are viewed as being in the business of renting their homes to themselves. An estimate of the value of housing services enjoyed in this way is included in GDP.

In addition, GDP accounts impute the value of farm products consumed on farms and food, clothing, and lodging furnished to employees. The imputed market values of these goods and services are also included in GDP. Of course, the goods and services made available by governments, such as national defence, are not sold in markets.

However, their value is reflected in GDP because government purchases of labour and products are a component of GDP.

Similarly, many workers in rural areas, engaged mainly in the agricultural sector, get their wages in kind — in terms of food and accommodation. But any wages and salaries paid in kind is not included in national income. The reason is that it is not possible to find out the market value of such factor payments accurately.

For the same reason, income from illegal activities which are not reported to tax authorities are excluded. Examples of such incomes are incomes from smuggling, un-authorised gambling, black marketing and other illegal and immoral activities. So expenditure on the purchase of a smuggled camera is not final expenditure and is thus not a part of national income.

Transactions in second-hand goods are also excluded for avoiding double (multiple) counting but expenditure on repair of an old good such as TV set or car is part of final expenditure and is, therefore, included in national income. For all these reasons the official estimate of GDP does not give us the correct GDP figure.

Measuring of National Income Problem # 2. The Value of Leisure:

All of us place some value on our time. We sell some of our time to employers for labour income; however, we retain much of it for our own use of leisure. Some of this leisure is used to render household services that escape inclusion in GDP. The satisfaction we get from recreational activities and other uses of our leisure time are also not included in GDP.

Measuring of National Income Problem # 3. Cost of Environmental Damage:

The people of a country may be able to enjoy more and better goods and services each year, but they must also put up with more congestion, dirty air, polluted water and other environmental costs that decrease the quality of their lives. Costs are associated with pollution and other aspects of industrial activity that damage the environ­ment.

The costs of environmental damage are not subtracted from the market value of final products when GDP is calculated. Some economists, therefore, believe that GDP overestimates the value of output by failing to take into account environmental costs of production.

Measuring of National Income Problem # 4. The Underground Economy:

India has a vast underground economy. This economy consists of transactions that are never reported to tax and other government authorities. It includes transactions involving illegal goods and services, such as trading in harmful drugs, gambling, smuggling and prostitution. These illegal goods and services are final products that are not included in GDP.

The transactions of the underground economy also include activities by people who do not comply with tax laws, immigration laws, or government regulations and who do not report their income to tax authorities. The underground (unofficial) economy is also called parallel economy.

Measuring of National Income Problem # 5. Transfer Payments and Capital Gains:

All domestic transfer payments (personal, private and government) are excluded from national income of a country. For example, if an individual receives a cash gift from his father who is also a resident of India, it will not be a part of India’s national income. The same argument is valid if a student receives Tata Foundation Scholarship for higher studies. This is an example of business transfer payments.

Another example of transfer is the subsidy received by producers of milk from the government. Still another is retirement pension. A surprise omission from national income accounts is interest on government bonds. It is an example of government transfer. It is excluded from national income because the government pays interest on bonds not from profits of public sector enterprises but by imposing tax on people.

So there is transfer of income from taxpayers to bondholders. But there is no net increase in society’s output of goods and services in the process. And it may be a happy coincidence if the same individual is both a taxpayer and a bondholder at the same time. So net interest paid by government (interest paid to individuals less interest received from state governments from loans and advances) is not a par: of national income.

However, the treatment of interest on private (corporate) bonds and debentures is different. It is not transfer income and is thus included in national income. The reason is that a company pays interest on its bonds and/or debentures from its current sales revenue for receiving a useful productive input, viz., financial service.

However, any transfer payment from abroad will be a part of a country’s national income. Thus, if an individual receives $ 20,000 from his father who is a non-resident Indian, it will be part of India’s national income.

Capital gains are also a form of transfer payments and are, therefore, excluded from national income. Let us consider, for instance, the case of an individual who sells shares in the stock exchange and makes a capital gain of Rs. 50,000. This money just gets transferred from the buyer to the sellers of shares. But there is no change in society’s output of goods and services nor is any income generated in the process.

Measuring of National Income Problem # 6. Valuation of Inventories:

We have already noted how inventories are to be treated in national income accounts. However, while estimating national income of a country, one problem has to be faced. This problem arises due to price level changes, i.e., inflation and deflation which lead to stock appreciation or depreciation. And the national income accountants have to face certain problems associated with the valuation of inventories.

Two methods are normally used for inventory valuation, viz., (i) the market price method and (ii) the factor cost method. According to the market price method, stock appreciation (increase in inventory) is valued at current market prices of goods held in inventories. It may be noted that market price of every item stocked includes imputed (notional) profit which may or may not be realised in the same year.

On the other hand, if the factor cost method of valuing inventories is used, imputed profit is excluded from cost calculation. This is the usual practice.

In fact, during inflation, the market value of inventories and reported profits will be higher than they actually are. So they have to be deflated by the price index (or the GDP deflator) to neutralise the effects of inflation. Otherwise, a company will be required to pay extra tax on inflated profits.

And it will not be able to retain a substantial amount of earnings, e.g., it will find it difficult to replace an old machine when it wears out completely. It may be noted that during inflation such reported profits are partly illusory (because they are the result of favourable market conditions and not increased volume of sales).

So if such profits are not deflated appropriately, nominal profits will be higher than-real profits. And, as a result, a company will have to pay more taxes than it is supposed to pay.

Therefore, its undistributed profit will also be less than what it should be. Therefore, it will not be possible to set aside adequate funds for depreciation. Old machines cannot be replaced when they wear out completely.

The economy’s existing stock of capital cannot be maintained. And it will not be possible to produce even the economy’s current level of output, not to speak of increasing the GDP through an act of net investment.

Changes in the Mix of Inventories:

Another problem of inventory valuation. Is associated with changes in the physical composition of inventories. Inventories are not a homogeneous entity. They consist of various items. It is quite possible for the total volume of inventories of a firm to remain constant over an accounting year.

However, there is no guarantee that each individual item existing at the beginning of an accounting year will also exist at the end of the year.

Since inventories are both flow and stock variables, new items are stocked every year for future sales and old items stocked earlier are sold in the current period. In other words, some items disappear from the stock as they are sold and others are added to stock. Thus inventories involve a dual transaction. So they are always a troublesome item in the national income accounts of a country.

Measuring of National Income Problem # 7. Self-Consumption:

A special problem arises in agriculture which is the most dominant sector in less developed countries (LDCs) like India. Subsistence farmers who produce food for themselves and their family members consume a major portion of their own output every year. Since this portion is not sold through the market, it is excluded from GDP.

The reason is that it is difficult to measure the market value of this output. A lot of arbitrariness is involved in the process of measuring it.

Measuring of National Income Problem # 8. Lack of Official Records:

Another problem arises due to lack of reliable data. The reason is that many people in LDCs like India sell their output through the market no doubt but they do not maintain any official accounts of their transactions.

For example, most road­side small traders, (retailers) as also many business enterprises in the unorganised sectors (mainly sole proprietorship organisations or single-owner firms) and self-employed persons do not keep proper records of their incomes and expenses.

This is why it is difficult to include proprietor’s income (which is essentially a mixed income) in the national income accounts of a country. However, in theory, such income is a part of national income. The reason is that it is earned through market transactions.

Measuring of National Income Problem # 9. Imputed Income:

Imputed income such as income from owner-occupied houses and flats is a part of a person’s taxable income. Therefore, it is a part of national income. Such income is fixed on the basis on notional rent. Even if an individual keeps his house vacant he has to pay tax on notional rent.

In this case, the value of the service rendered by the house has to be imputed. The same thing is true of unintended inventories. For example, if a firm is not able to sell its entire output during the current year, the unsold stock will have to be valued at the current market price and included in national income.

Measuring of National Income Problem # 10. Valuation of Government Service:

Finally, government services provided to people free of cost are also to be included. However, it is very difficult to find the true values of such services, since these are not sold through the market. As Prof. Amit Bhaduri comments, the valuation of services of many public goods like a museum or a park becomes highly problematic.

This, in turn, raises the question of how to evaluate the economic contribution, i.e., value added of the government which is the provider of public goods like national defence, law and order, etc. for which no market prices exist. In the absence of market prices for many types of public services, the problem of their valuation must be somewhat arbitrarily settled by accounting conventions.

It may also be mentioned here that to avoid such arbitrariness, national income accounting procedure in centrally planned or socialist econo­mies deliberately excludes value added by the entire ‘service sector’ including the govern­ment. This results in an estimate of material production in the economy excluding services, for which the product method of accounting is better suited.