National Income Accounting

How do we know whether a country's economy is growing or shrinking? We measure the total value of everything it produces. National income accounting is the system for doing this, giving us figures like GDP that are quoted constantly in the news. Understanding what these numbers mean, how they are found, and their limits is essential to macroeconomics.

The most important measure is Gross Domestic Product (GDP), defined as the total money value of all final goods and services produced within a country in a year.

A related measure is Gross National Product (GNP). It equals GDP plus the net income earned by the country's residents from abroad. That includes money sent home by citizens working overseas, minus income foreigners earn here. "Final" goods are counted to avoid double-counting the inputs that go into them.

A large GDP does not mean a rich population. In the early 2000s, India's aggregate GDP was among the largest in the developing world, yet among China, India, Indonesia and Sri Lanka, India had the lowest GDP per capita. Nor does the economy expand smoothly. India's GDP did not quadruple over any ten-year stretch, and both GDP growth and per capita income growth fluctuated from year to year rather than rising steadily. One structural shift after the liberalisation reforms of 1991 is clear: the public sector's percentage share of GDP declined as private activity expanded.

National income can be calculated in three ways, which all give the same total because one person's spending is another's income:

• the product (value-added) method: adding up the value added at each stage of production,
• the income method: adding up all incomes earned (wages, rent, interest, profit), and
• the expenditure method: adding up all spending (by households, firms, government and net exports).

That all three agree is a useful check on the figures.

GDP is a gross measure at market prices. Two adjustments turn it into national income proper.

• Depreciation: machines and buildings wear out during production. Subtracting this wear and tear from a gross measure gives the net measure. GDP minus depreciation is Net Domestic Product (NDP), and GNP minus depreciation is Net National Product (NNP).
• Market price vs factor cost: a market price includes indirect taxes and is lowered by subsidies, so it differs from what producers actually receive. Subtracting indirect taxes and adding subsidies converts a market-price figure into one at factor cost, the income actually earned by the factors of production.

Putting both adjustments together gives the formal definition. National Income is NNP at factor cost: GNP at market prices, minus depreciation, minus indirect taxes, plus subsidies.

The net exports term in the expenditure method applies only to an open economy, one that trades with the rest of the world. A closed economy neither exports nor imports. It has no transactions with other countries, so net exports drop out of the calculation.

The same accounting works at the state level. A state's output is its Net State Domestic Product (NSDP), and dividing by population gives per capita NSDP, the state counterpart of per capita national income. Among the major industrial states around the turn of the century, the descending order of per capita NSDP was Maharashtra first, then Gujarat, then Karnataka, then Tamil Nadu.

A key distinction is between nominal and real GDP:

• Nominal GDP is measured at current prices, so it can rise simply because prices rose.
• Real GDP is measured at constant prices. This strips out inflation and shows the true change in output.

Even real GDP is not the final word on growth. Total output can rise while population rises faster, leaving each person worse off. Dividing by population corrects for this, so per capita real income is the most appropriate single measure of economic growth in living standards.

India's record illustrates the nominal-real gap. Nominal GDP at market prices rises steadily every year, because inflation keeps pushing prices up. The real GDP growth rate, by contrast, fluctuates from year to year rather than rising steadily.

Constant-price estimates need a reference point. The Central Statistical Organisation (CSO), the official agency that computes India's national income figures, values output at the prices of a chosen base year and periodically shifts that base to keep comparisons current. The new GDP series the CSO released in February 1999 shifted the base year to 1993–94.

Comparing GDP across countries at market exchange rates can mislead, because the same money buys far more in some countries than in others. Purchasing Power Parity (PPP) exchange rates correct for this by comparing the price of the same basket of goods and services across countries. Measured in PPP terms, India is the third largest economy in the world, even though it ranks much lower at market exchange rates.

National income is powerful but has limits. GDP says nothing about how income is distributed. A country can grow while inequality worsens. It ignores non-market work like household labour. It also counts activities that harm welfare and the environment. So GDP measures the size of the economy, not the well-being of its people. This is why measures like the HDI (Human Development Index) are also used. The HDI weighs health and education alongside income.

Output grows when an economy builds productive capacity. Capital formation is the creation of new physical capital through investment, such as machines, factories and infrastructure. It is the direct driver of economic growth: more capital lets workers produce more. Physical capital comes in two kinds:

• Fixed capital: assets used in production for many years, such as a farmer's plough, a computer or a machine.
• Working capital: inputs used up in production, such as the yarn a weaver uses or the petrol in a delivery van.

How much growth a given investment delivers depends on the capital-output ratio, the amount of capital needed to produce one unit of output. A high capital-output ratio means capital is being used inefficiently, so even an economy with high savings and high capital formation can record low growth. This is the standard explanation for India's slow growth in earlier decades despite a high savings rate.

A related term is capital gains: the rise in the value of an asset already owned, such as property whose price appreciates or a painting that grows more valuable as it becomes popular. Higher sales revenue from a product is ordinary operating income, not a capital gain.

Market economies do not grow in a straight line. Output, income and employment move in waves called the business cycle, which has four phases:

• Boom: business activity at a high level, with income, output and employment rising.
• Recession: a gradual fall in income, output and employment, with business activity in low gear. Technically, a recession is two consecutive quarters of negative GDP growth.
• Depression: the deepest phase, with a drastic fall in income and output and unprecedented unemployment.
• Recovery: a steady rise in prices, income, output and employment as activity revives.

Two news terms are easily confused with these phases. A slowdown is only a fall in the growth rate: the economy still grows, just more slowly, so GDP does not fall. A meltdown refers to a sharp fall in stock prices, not in output.

Taxes do more than fund the government. They are the main tool for changing how income is distributed. The best route to redistribution combines progressive taxation, which taxes the rich at higher rates, with progressive public expenditure, which directs spending toward the poor. Together they move income from higher to lower income groups.

When the government supplies a commodity free to the public, its cost does not vanish. The opportunity cost is transferred from the consumers of the product to the tax-paying public, who fund the expenditure.

The tax-to-GDP ratio measures tax collections as a share of national output. A falling ratio usually signals slowing economic growth, since a weaker economy shrinks the tax base. It says nothing direct about how equitably income is distributed.

The Union Budget divides government money into a revenue budget and a capital budget. The dividing test is simple. Capital receipts either create a liability for the government or reduce its assets: borrowings create a liability, and disinvestment, the sale of government shareholding in public enterprises, reduces assets. Interest received on loans the government has given is a revenue receipt, because it neither borrows nor sells anything. The capital budget covers capital receipts, including loans received from foreign governments, and capital expenditure: spending that acquires assets like roads, buildings and machinery, plus loans and advances granted to States and Union Territories.

Until 2017 expenditure was also classified as Plan and Non-Plan. Non-Plan expenditure covered the government's recurring, committed payments:

• Defence expenditure: the running cost of the armed forces.
• Interest payments: servicing past borrowings.
• Salaries, pensions and subsidies: obligatory current payments.
• Maintenance expenditure: upkeep of infrastructure created in previous plans.

Disinvestment proceeds are routed to the National Investment Fund, which sits outside the Consolidated Fund of India. Professional Asset Management Companies manage it, and a fixed share of its annual income finances select social sector schemes. Budgets are also used as incentives: the Union Budget of 2000 gave new industrial units in the North-Eastern Region a ten-year tax holiday to promote industrialisation there.

A budget deficit appears when spending outruns receipts, and economists slice it three ways:

• Revenue deficit: revenue expenditure minus revenue receipts.
• Fiscal deficit: the government's total borrowing requirement in a year, equal to total expenditure minus all receipts other than borrowings.
• Primary deficit: fiscal deficit minus interest payments, showing the deficit created by current policy rather than past debt.

A worked example fixes the formulas. If revenue expenditure is 80,000 crore and revenue receipts are 60,000 crore, the revenue deficit is 20,000 crore. If borrowings are 10,000 crore, the fiscal deficit is 10,000 crore. Subtracting interest payments of 6,000 crore gives a primary deficit of 4,000 crore. The fiscal deficit is always larger than the old budgetary deficit, because it adds market borrowings and other liabilities, including borrowing from the Reserve Bank of India.

Reducing a persistent deficit requires cutting spending or raising receipts: reducing revenue expenditure, rationalising subsidies, downsizing the bureaucracy, privatisation and disinvestment of public sector shares all qualify. Launching new welfare schemes or cutting import duties worsens the deficit. In India, deficit financing, spending beyond revenue by borrowing or creating money, has traditionally been used to raise resources for economic development. The opposite lever is a fiscal stimulus: deliberate government action to boost economic activity in a downturn, chiefly by cutting tax rates and increasing government spending. Abolishing subsidies is contractionary and is not stimulus.

The Constitution calls the budget the Annual Financial Statement, provided for under Article 112 (the provision requiring a yearly statement of estimated receipts and expenditure). The Finance Minister lays it before both Houses on behalf of the President, and no demand for a grant can be made except on the recommendation of the President. The budget is prepared by the Budget Division of the Department of Economic Affairs in the Ministry of Finance. The same ministry publishes the Economic Survey, the annual review of the economy presented just before the budget.

Parliament controls public finance through several established methods: placing the Annual Financial Statement before it, allowing withdrawal from the Consolidated Fund of India only after passing the Appropriation Bill, voting supplementary grants and a vote-on-account, and passing the Finance Bill that gives effect to tax proposals. India has no Parliamentary Budget Office, so a mid-year review by such an office is not among these methods.

Two stop-gap devices differ in scope. A vote-on-account deals only with expenditure, letting any regular government draw funds until the full budget passes. An interim budget covers both receipts and expenditure and is not reserved for caretaker governments alone. If the Lok Sabha rejects the budget, the government is treated as having lost its majority, and the Prime Minister submits the resignation of the Council of Ministers.

The Constitution organises government money into three funds, and each State has the same three:

• Consolidated Fund of India: under Article 266 (the provision creating the fund), all revenues from taxes and other receipts, and all borrowings, are credited here. Not a rupee can be withdrawn without authorisation by Parliament through an Appropriation Act, a requirement set by Article 114 (the provision governing Appropriation Bills).
• Public Account: holds money the government keeps as a banker, such as provident funds and small savings. Disbursements from it do not need a parliamentary vote.
• Contingency Fund: an imprest at the President's disposal for unforeseen expenditure, later recouped from the Consolidated Fund.

The Finance Commission, the constitutional body set up under Article 280 to share revenues between the Centre and the States, recommends the principles governing grants-in-aid to the States out of the Consolidated Fund of India under Article 275. Railway appropriations, when budgeted separately, were subject to the same parliamentary control as all other disbursements.

The government finances its fiscal deficit by borrowing, and the stock of these borrowings is the public debt. Internal debt, owed to lenders within the country, has three main components: market borrowings through dated government securities, treasury bills for short-term needs, and special securities issued to the RBI. Dated securities sold at market-related rates in auctions form the largest component, and a share of household financial savings flows into these government borrowings through banks and funds. The borrowing programme is handled by the Department of Economic Affairs, with the RBI acting as the government's debt manager. The RBI itself was nationalised on 1 January 1949, not in 1950.

Sustained heavy borrowing has costs. It keeps real interest rates high, and a rising fiscal deficit to GDP ratio crowds out private investment. Interest payments became the single largest component of the Union government's non-plan revenue expenditure. External liabilities reported in the budget are valued at current exchange rates, not historical ones.

A broader statistical category is non-financial debt: the debt of all borrowers outside the financial sector. It includes housing loans owed by households, amounts outstanding on credit cards, and government treasury bills.

External debt is what residents of a country owe to foreign lenders. Two common assumptions about India's external debt are wrong: most of it is owed by private entities, not by the government, and it is denominated in several currencies, not only US dollars. In the early 2000s, the modest rise in India's external debt came mainly from an increase in multilateral and bilateral debt, concessional loans from agencies like the World Bank and from partner governments.

Capital flows into developing countries differ in quality. Foreign Direct Investment (FDI) is the most desirable inflow for a host country: it is long term, brings technology and cannot flee overnight. Portfolio investment, commercial loans and external commercial borrowings are volatile or debt-creating, a lesson driven home by the East Asian financial crisis of the 1990s and the Latin American debt experience.

Debt becomes dangerous at two points. A country is in a debt trap when it must borrow afresh just to pay interest on existing loans, a self-feeding spiral. And sovereign debt ultimately rests on trust: government bonds such as US Treasury securities are backed not by hard assets but by the full faith and credit of the government, so a default would leave bondholders unable to enforce their claims.

The Fiscal Responsibility and Budget Management (FRBM) Act, 2003 is the law that binds the Union government to fiscal discipline. It targeted both deficits: elimination of the revenue deficit by 2007–08 and progressive reduction of the fiscal deficit. It barred the Centre from borrowing from the RBI except in specified circumstances, and capped the government guarantees that may be given in a financial year as a percentage of GDP. It set no target for eliminating the primary deficit.

The Act also forces transparency. Along with the budget, the Finance Minister must lay three statements before Parliament: the Medium-Term Fiscal Policy Statement, the Fiscal Policy Strategy Statement and the Macro Economic Framework Statement. This obligation comes from the FRBM Act, not from the Constitution or convention.

The FRBM Review Committee (chaired by N. K. Singh), set up to re-examine these rules, recommended a combined government debt-to-GDP ratio of 60 percent by 2023, split as 40 percent for the Centre and 20 percent for the States. State borrowing has its own constitutional check: under Article 293 (the provision on State borrowing), a State that owes money to the Centre must obtain the Centre's consent before raising a fresh loan.