What it is: Disposable income is the money you have left after paying taxes. You can use it to save or buy goods and services.
Disposable income is important to describe household purchasing power. When it increases, we expect them to increase spending. Increased spending stimulates businesses to increase production and recruit workers. As a result, the economy is growing, the unemployment rate is declining and the outlook for household income is improving.
From OECD data, the United States ranks first as the country with the highest disposable income per capita in 2018 with US$53,123. In the second and third positions, there are Luxembourg (US$47,139) and Switzerland (US$41,561).
Calculating disposable income
Disposable income consists of your various income after deducting it with taxes. Income can be sourced from salaries, capital gains, stock dividends, bond coupons and includes transfer payments from the government. You will not spend income because you have to pay taxes.
You can then use the remaining money for any of your purposes. You can use it to buy products to fulfill your needs and wants. Or, you can save it, allocating it to various financial instruments such as stocks and mutual funds.
Mathematically, the disposable income formula is as follows:
Disposable income = Total income – Personal tax
As a simple example, assume, your income is Rp. 100. The government levies an income tax of around 20%.
Applying the above formula, your disposable income is IDR 80 = IDR 100- (20% x IDR 100). It is available for you to spend or save.
Difference between disposable income and discretionary income
Disposable income only considers taxes as a deduction because it is your mandatory burden as a citizen. However, you may also have other fixed expenses that cannot be deferred, such as mortgages, utilities, and other essentials. They represent the cost of living, which if you don’t pay you will be fined or have an impact on your health or quality of life.
We call the money left over after paying these fixed expenses as discretionary income. It represents the money left over after you have met all your regular needs. You can use it to fulfill other secondary needs.
In a mathematical equation, we can write the discretionary income formula as follows:
Discretionary income = Total income – Personal taxes – Routine expenses = Disposable income – Routine expenses
As a side note, you only include personal taxes as a deduction for income. It excludes other indirect taxes, such as sales tax and value added tax (VAT).
Indeed, an increase in indirect taxes can reduce purchasing power. However, it is difficult for us to trace the effect of indirect taxes on each individual.
Why is disposable income important
Disposable income is a key indicator of household purchasing power and consumption . The changes affect the demand for goods and services and economic activity in various countries. Household spending accounts for a significant share of gross domestic product (GDP). In fact, in some countries, the contribution reaches more than 50% of GDP.
Economists use disposable income to identify trends in household saving and consumption. When disposable income rises, we expect the demand for goods and services to increase as well. That will stimulate the business sector to increase production and recruit more workers. As a result, economic growth (measured in real GDP ) increases and the unemployment rate decreases.
Usually, economists also observe trends in the Consumer Price Index (CPI), a measure of the increase in the prices of goods and services purchased by consumers. If the trend of CPI inflation is also low, the purchasing power of households towards goods and services is stronger. Thus, it will magnify its impact on aggregate demand and economic growth.
How big is the impact of household consumption on economic growth?
It depends on the marginal propensity to consume (MPC).
MPC is the extra disposable income that households spend. The higher the MPC, the greater the influence of consumption on the economy. For example, country A has an MPC of 0.75 and Country B has an MPC of 0.50. If disposable income in both countries increased by the same percentage, the impact would be more significant for Country A than for Country B.
Economists call this effect the fiscal multiplier. They formulated it as follows:
Multiplier = 1 / [1-MPC (1-t)]
Where t is the tax rate.
Tax reductions increase disposable income. It magnifies the effect of household consumption on the economy. Say, the tax rate in both countries drops to 17%. Using the above formula, we can calculate the multiplier effect in the two countries as follows:
- Country A = 1 / [1-0.75 (1-0.17)] = 2.65 times increase in aggregate output
- Country B= 1 / [1-0.50 (1-0.17)] = 1.71 times increase in aggregate output
Factors affecting disposable income
From the formula, you can see, two main factors affect disposable income: tax and nominal income. It increases when:
- Personal tax rate down
- Nominal income increases
When the government lowers tax rates, households have more money to spend on goods and services. That is usually when the government implements an expansionary fiscal policy. Tax cuts aim to stimulate economic growth during a recession.
Meanwhile, many factors affect household nominal income, depending on the type of income. But, in general, it happens as long as the economy is prosperous. Strong economic growth brings more income to households.
During this period, salary and job prospects improved. Business profits also grow, allowing the company to pay more dividends. In addition, rising profits also push up their share prices, making households receive more income from capital gains .