GDP and taxation

Question

I have a question about the calculation of GDP measures. The question is perhaps easiest to understand if we consider calculating calculating GDP using the income approach (see here), but might arise under different approaches.

If I understand matters correctly, the basic idea is to add up everyone's income, where 'income' means 'pre-tax income'. For example, if we are talking about a worker's salary, we are talking about their pre-tax salary. This seems to have strange implications when considering public sector employees, who are both paid by the government but also 'pay back' the government via income taxes. More specifically, it seems to imply that the government can boost GDP by paying public sector employees more while increasing the amount of tax that they pay.

To provide a concrete example, suppose that the government pays someone \$100,000/year and exempts them from income tax. (I understand that governments sometimes do this for certain roles.) Suppose now that they decide to instead pay them \$150,000/year and bill them \$50,000/year in income tax (let's say that this is the impact of removing the tax exemption). Am I right that this will increase GDP by \$50,000?

Answer 1

Yes, your understanding is correct. Under the income approach to calculating GDP, increasing a public sector employee's pre-tax salary from \$100,000 to \$150,000 while imposing \$50,000 in income tax would indeed increase GDP by \$50,000.

The income approach sums up all the incomes earned by factors of production in an economy, which includes wages, rents, interest, and profits. Importantly, these incomes are measured before personal income taxes are deducted. This means that the GDP calculation considers gross incomes rather than net incomes after taxes.

In your example, the employee originally earns a pre-tax salary of \$100,000 with no income tax. This \$100,000 is included in GDP under the compensation of employees. When the government increases the pre-tax salary to \$150,000 and imposes \$50,000 in income tax, the compensation of employees increases to \$150,000 in the GDP calculation. The \$50,000 collected as income tax is not subtracted from this amount in the income approach.

From the expenditure approach perspective, government spending includes expenditures on public sector wages. In the revised scenario, the government's expenditure increases by \$50,000 due to the higher wages paid. Taxes collected from households are not subtracted in this calculation either, so GDP increases by \$50,000 from this perspective as well.

However, it's important to note that while GDP increases, the actual output or productivity hasn't changed—the employee is performing the same job for the same net pay. This example highlights a limitation of GDP as a measure of economic activity, as it can be influenced by accounting changes without reflecting a real change in economic output or welfare.

In conclusion, by increasing the pre-tax salary of a public sector employee and imposing an equivalent amount in income tax, the government's actions lead to a higher GDP calculation, even though there's no change in net income or actual economic output. Therefore, your conclusion that GDP would increase by \$50,000 in this scenario is correct.

Answer 2

You are right. In your example GDP should increase by \$50,000. Why?

GDP is concerned with the total market value of goods and services. If the government increases pay from \$100,000 to \$150,000 for an employee the market value of their labour has increased by \$50,000. The taxation is just considered redistribution of income and not a decrease in income.

From an expenditure perspective, an increase in government spending with a balanced budget policy - i.e. an equal increase in taxation - also results in a 1:1 increase in GDP. In your example, the increase in government spending is the increase in the employees wage, and the increase in tax is the increase in income tax.

This isn't really a desirable thing for governments to do. As the underlying productive capacity of the economy isn't actually increasing, we can think of this increase in GDP as inflationary. More money is circulating around the economy chasing the same amount of resources. If you think about the sequence of exchanges, the government first pays the employee \$100,000 and takes nothing back, then they pay the employee \$150,000 and then takes $50,000. Where did the additional \$50,000 come from intially? The government creates \$50,000 and increases the money supply resulting in inflation.