GDP is defined as the market value of all final goods and services produced within an economy over a specific period (usually one year). There are two primary methods to calculate GDP: the income approach and the expenditure approach (see also Gross Domestic Product). According to the income approach, GDP can be computed by finding total national income (TNI) and then adjusting it for sales taxes (T), depreciation (D), and net foreign factor income (F). Thus, we can use the following formula:
GDP = TNI + T + D + F
In the following paragraphs, we will take a closer look at each of those components and learn how to calculate GDP using the income approach step-by-step.
1) Find Total National Income (TNI)
First, we have to find the total national income (TNI). Total national income is the sum of all the income that a country’s residents and businesses have earned over a certain period. This includes all salaries and wages (W), rent (R), interest (i), and profits (P). Note that these components are sometimes listed separately in the GDP formula (i.e. GDP = W + R + i + P + T + D + F). However, for the sake of simplicity, we’ll stick with the formula we’ve introduced above.
Let’s illustrate this step with a simple example. Think of an imaginary country called Smolland. As the name suggests, Smolland is a small country with only 100 inhabitants. Together, they earn a total of USD 2,000,000 in wages and salaries, USD 500,000 in rent, and USD 150’000 in interest payments. In addition to that, there are 10 companies located in Smolland. Let’s assume they make a profit of USD 4,000,000. Plus, they earn an additional USD 500,000 in rent and USD 350’000 in interest. In that case, Smolland’s total national income adds up to USD 7,500,000 (i.e. 2,000,000 + 500,000 + 150,000 + 4,000,000 + 500,000 + 350,000).
2) Adjust for Sales Taxes (T)
Once we have calculated total national income, we have to adjust it for sales taxes (T). Sales taxes describe taxes imposed by the government on the sales of goods and services. These taxes are usually paid by consumers (i.e., end users), but collected by retailers and then passed on to the government. Therefore, they are not included in total national income by default and must be added separately.
Meanwhile, at this point, it’s important to point out that the US is one of only a few developed countries that still use conventional sales taxes. Most other developed countries have adopted value-added taxes (VAT) instead.
Now, going back to our example, let’s say that only two types of goods exist in Smolland: hot dogs and candy bars. A hot dog sells for USD 2.00 while a candy bar costs USD 1.00. Now the government introduces a sales tax of USD 0.10 per hot dog and USD 0.05 per candy bar. That means, if the people of Smolland buy 100,000 hot dogs and 100,000 candy bars, the sales taxes add up to USD 15,000 (i.e., 100,000*0.1 + 100,000*0.05).
If we add this to the total national income from above, the interim result is USD 7,515,000.
3) Adjust for Depreciation (D)
Now that we have the sum of total national income and sales taxes, we have to adjust it for depreciation (D). Depreciation describes the decrease in the value of an asset over time. That means, it explains how much wear and tear reduces the value of a particular good. Because depreciation is not linked to actual cash flow, but still reduces profits (and therefore TNI), it must be added separately.
In the case of Smolland, assume that the 10 firms we mentioned above have a combined capital stock worth USD 10,000,000. Now let’s say the depreciation rate is 10%. That means the country’s depreciation adds up to USD 100,000.
If we add this to the sum of total national income and sales taxes we calculated above, the new interim result is USD 7,615,000.
4) Adjust for Net Foreign Factor Income (F)
Last but not least, we have to add an adjustment for net foreign factor income (F). Net foreign factor income describes the difference between the total income that local citizens (and businesses) generate in foreign countries, versus the total income that foreign citizens (and businesses) generate in the local country. This adjustment is necessary because GDP describes the economic output that is generated within an economy, regardless of whether the employees or employers are local citizens or not.
Please note that net foreign factor income can be positive or negative, depending on the ratio between locals working abroad and foreigners working within the country.
To illustrate this, let’s say 10 Smolland citizens work abroad. They earn USD 500,000 in wages. In the meantime, there are exactly 20 foreign citizens who work in Smolland. Their wages add up to USD 1,000,000. As a result, net foreign factor income is USD -500,000 (i.e. 500,000 – 1,000,000).
Finally, by adding this to the sum of total national income, sales taxes, and depreciation, we can calculate GDP with the income approach. In the case of Smolland, GDP is 7,115,000 (i.e. 7,500,000 + 15,000 + 100,000 – 500,000).
In a Nutshell
GDP is defined as the market value of all final goods and services produced within an economy over a specific period (usually one year). According to the income approach, GDP can be computed as the sum of the total national income (TNI), sales taxes (T), depreciation (D), and net foreign factor income (F). Total national income is the sum of all salaries and wages, rent, interest, and profits. Sales taxes describe taxes imposed by the government on the sales of goods and services. Depreciation describes the decrease in the value of an asset over time. And last but not least, net foreign factor income represents the difference between the total income that local citizens (and businesses) generate in foreign countries, versus the total income that foreign citizens (and businesses) generate in the local country.