Saturday, April 27, 2013

More On National Accounting

Perhaps I wasn't clear enough when I explained this in the previous post, so I'll make another attempt.

Some readers seems confused by how I related Net Domestic Income (NDI) to GDP (Gross Domestic Product). But Net Domestic Income is really the same as Net Domestic Product (NDP), and similarly GDP is really the same as Gross Domestic Income (GDI), the only difference being that GDP and NDP come from different data sources than GDI and NDI. In principle GDP should always be equal to GDI, and NDP should always be equal to NDI, but because of data collection problems there is almost always some discrepancy though usually only a small one. Note that because given perfect data collection it would always be the case that GDP=GDI and NDP=NDI, the difference between GDP and NDP should always be equal to the difference between GDI and NDI. The difference between both is that the two Gross numbers include capital depreciation (or "consumption of fixed capital" as the BEA calls it) while the two Net numbers exclude it.

But why does this mean that upwardly revising GDP by calling corporate expenditures for intellectual property "capital investment" instead of "input cost" won't mean that America is richer despite the larger GDP? That is because when companies buy stuff that are considered input, these purchases are excluded from the value added that the national accounts estimates that the company has added. For example when a super market purchases food and other goods from its suppliers or when it purchases ads to get people to the store, the value the store adds is the difference between their sales revenues and the cost of these purchases. By contrast, when the super market buys some other things, things that are considered to be more long lasting, like cash registers, that is not subtracted from the perceived value added they contribute to GDP, as it is classified an investment. That cash registers and other investments usually eventually lose their value is disregarded entirely in the GDP number, and is instead classified as "consumption of fixed capital".

The implication of this is that without really affecting real world cash flows or long-term profits, a re-classification of a specific type of corporate purchase as "investment" rather than "input" can raise firms perceived value added, and because GDP is the aggregate of all corporations (and governments) value added, this will also raise GDP/GDI (though as we shall see, without raising NDP/NDI).

For example, assume that someone at the BEA, has gotten the idea that the ads the super market purchases shouldn't be considered input but investment (because he thinks it creates great good will, or whatever) this would mean that these purchases would no longer be subtracted when calculating companies value added, and therefore also not subtracted when calculating GDP, and since less is subtracted, GDP will suddenly become higher.

But does this re-classification really mean that the companies adds more value? Of course not, they have the same revenue as they would have had with the old classification and they still have the same expenditures. The difference in corporate accounting is that the same profit (at least in the long term) is derived by subtracting a larger sum of depreciation from a larger gross profit, and in national accunting that the same NDP/NDI (at least in the long term) is derived by subtracting a larger sum of "consumption of fixed capital" from a larger GDP/GDI

This should illustrate why the net numbers are better. In real life, no investors care how big profits for a company will be before depreciation, they care about what it will be after depreciation, they care about long term cash flows. For the same reason, we shouldn't care what corporations aggregate gross profits (their contribution to GDP/GDI) is, we should care about what aggregate net profits (their contribution to NDP/NDI) is.

Note that this irrational focus on GDP/GDI instead of NDP/NDI creates misleading perceptions in other areas as well. For example, when the burden of taxation and government spending is discussed, tax revenues and government spending is set in relation to GDP. But because GDP overestimates how big aggregate income really is, this means that the burden of taxation and government spending is underestimated


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