Why is depreciation added to the GDP with the income approach?

Question

In my economics textbook, it states that when calculating GDP using the income approach, depreciation should be added. Specifically, GDP = Employee Compensation + Taxes less subsidies on businesses + Net operating surplus on businesses + Depreciation.

The example it provides is that if some people are running a fruit stand, their capital will endure some wear and tear. As a result,"some of their income is implicitly a compensation for this wear and tear", which is depreciation.

I am confused about how adding depreciation fits into the idea of the income approach. How does the capital stock depreciating fit into the incomes of households? It seems like depreciation has nothing to do with the income of the fruit stand, for example.

Answer 1

In national income and products accounting (NIPA), the word gross (usually*) means including depreciation, while net means excluding depreciation. We have:

• Gross domestic product (GDP) = Employee compensation + Taxes less subsidies on businesses + Gross operating surplus on businesses
• Net operating surplus on businesses = Gross operating surplus on businesses - Depreciation

And hence:

• Gross domestic product (GDP) = Employee compensation + Taxes less subsidies on businesses + Net operating surplus on businesses + Depreciation

You are exactly correct when you wonder why we include depreciation in National Income. Conceptually, what we are more interested in is Net domestic product (NDP), which excludes depreciation:

• Net domestic product (NDP) = GDP - Depreciation = Employee compensation + Taxes less subsidies on businesses + Net operating surplus on businesses

However, depreciation is difficult to estimate. And so often, we simply look at GDP. This is why GDP is the more frequently quoted, even though conceptually we'd prefer to use NDP.

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Example. In 2018, a country had 100 workers (labor) using 100 tractors (capital) to produce agricultural products. We find that in 2018, the country produced \$1M worth of agricultural products and paid out \$800,000 to the 100 workers.

Hence, in our NIPA accounts, we have:

• Employee compensation = \$800,000.
• So, Gross operating surplus on businesses = Total income - Employee compensation = \$1M - \$800,000 = \$200,000.

This \$200,000 goes to the owners of capital, i.e. the 100 tractors. The key is to understand that "gross operating surplus" is the residual (the leftover term) after any compensation paid out to employees and any taxes (less subsidies) paid. (For simplicity we assume there are no taxes/subsidies.)

And now we have:

• GDP = Employee compensation + Gross operating surplus on businesses = \$800,000 + \$200,000 = \$1M.

We now have to estimate depreciation (i.e. wear and tear on the tractors), which in the real world is difficult, but in our made-up example here we'll just say is \$50,000. Then:

• Net operating surplus = Gross operating surplus - Depreciation = \$200,000 - \$50,000 = \$150,000.
• NDP = Employee compensation + Net operating surplus = GDP - Depreciation = \$950,000.

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*Confusingly, there is also another sense in which the words gross and net are used in NIPA (and also more commonly in daily life) — example: Net lending = Lending - Borrowing. See 2.72 in the UN System of National Accounts (2008).

Answer 2

When calculating GDP using the expenditure approach, depreciation is not added because it is not considered a part of the total spending on goods and services in an economy. The expenditure approach measures GDP by adding up the total spending on goods and services by households, businesses, and the government. Depreciation is not included in this measure because it is not a purchase of a good or service, but rather a way of accounting for the reduction in value of a capital good over time.

In contrast, the income approach to calculating GDP includes depreciation because it represents the income earned from the use of capital goods. This approach measures GDP by adding up the total income earned by households, businesses, and the government from the production of goods and services. By including depreciation in this measure, the income approach takes into account the value of the capital goods used in the production of goods and services and provides a more accurate measure of an economy's total output.