Why are "transfer payments" not part of GDP?

Question

It is well-known that transfer payments are not counted in GDP (e.g. wikipedia 1 and wikipedia 2).

For instance, exercise 2.c in Chapter 2 of Jones book's Macroeconomics ask to calculate how much GDP changes if:

During a recession, the government raises unemployment benefits by $100 million.

The official solution says:

No impact. This is a government transfer payment, not a government purchase of a good or service.

But, what if that transfer is spend in goods? Would that not increase C? What if just a portion of the transfer is used to buy goods?

In fact, an article from Business Insider states the following:

While transfer payments are not included in GDP, they are largely put in the hands of those who spend most of the money immediately. Therefore, transfer payments show up in GDP as increased personal consumption.

I am puzzled. Why transfer payments do not increase GDP? I would have thought that it depends on whether that money is spent. Also, is this completely independent on where that money comes from? What if it comes from borrowing abroad, or nationally, or from taxes?

Answer 1

Transfer payments aren't included in GDP to prevent double-counting.

The reason the author's question is troubling you is because the answer externalizes everything that happens after the payment has been made (which is when the money from that payment DOES get factored into GDP, see below). I assume it does this to reinforce that transfer payments aren't counted in GDP, but you are right to question what's going on here.

That \$100 million is transferred from the government to consumers, who will presumably spend a good portion (say, \$98 million) of those funds on goods and services, at which point those funds would be added to GDP. If we had included the transfer funds in GDP, the change reflected would be \$198 million instead of the more accurate \$98 million.

You can also have an example on a much smaller scale:

1. You give your child \$5 to buy a burger; none of that is added to GDP.
2. Your child spends \$4.75 on the burger; \$4.75 is added to GDP.

Answer 2

The question:

How much would GDP change if during a recession the government raises unemployment benefits by $100 million?

can be understood in more than one way. There is the pure accounting question which could be formulated more precisely (albeit in terms of a rather unrealistic scenario) as follows:

Suppose, in a certain period, the economic activities and transactions of two countries in recession A and B are exactly the same, except that in A the government pays $100 million more in unemployment benefits than in B. How much does GDP differ between A and B?

The answer to this question, which is presumably what Jones means, is that GDP is the same in both countries, because transfer payments are not a component of GDP. Why not? Because although they are expenditure by the government and income to the recipients, they are not directly associated with any element of production or output.

Then there is the question about economic effects:

Suppose, during a recession, the government raises unemployment benefits by $100 million. What would be the likely economic effects, and how would GDP change as a result?

The answer to this question will depend on circumstances, and so it is entirely proper here to raise further questions including how the $100 million is funded and how it will be used. It's a reasonable assumption that the propensity to spend of benefit recipients will be high. If the funding were from increased taxation of people on middle and high incomes who have a somewhat lower propensity to spend, then the net effect would be an increase in aggregate demand, perhaps with a multiplier effect, so GDP would probably increase. (I say 'perhaps' and 'probably' because there could be further complications, eg spending on imports.) If the funding were via government borrowing, then there would potentially be direct effects on both demand and interest rates, and it would be quite challenging (and need further information) to identify all the indirect effects including the effect on GDP.

Answer 3

I believe that the author's answer is clear. GDP is the total product produced in a country. By increasing the unemployment benefits, the government does not increase the product.

If you think GDP as the total income of a country, then a transfer payment means that the government pay you back what you have already pay with taxes. In other words, the total government earnings by taxation are 100 million, which they go back to people as an unemployment benefit.

Answer 4

Thank you to everyone for your information on this interesting topic. As stated by many of you, the expenditure, output or income approach is measuring economic activity. Hence, expenditure on goods or services which have been produced represents economic activity. For example, government spending on the construction of new roads. However, when governments make transfer payments, there is no economic activity being produced, so this 'spending' cannot be included directly in AD. As people in the post have well identified, part the transfer payments will form part of Consumption, and there will be an indirect increase on AD. As stated also in the post, we can branch out further, considering the sources of the transfer payments, budget deficits, government bonds, and such areas as crowding out. However, I suggest students to be clear of primary and secondary effects before moving onto the realms of uncertain variables.