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
- 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.
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.
*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).