Sunday, June 29, 2014

An Inconvenient Context

GDP is a measure of final spending only. Not all spending. For example, GDP excludes things that can be taken as corporate tax deductions. Things like the "cost of goods sold". If you buy stuff in order to sell it, that is not "final" spending.

A carmaker buys tires so that the cars he sells can be driven off the lot. Maybe he buys 4000 tires and sells 1000 cars. The cost of the tires is included in the price of the cars, obviously. Let's say all 1000 cars are included in GDP. So now GDP already includes the cost of the 4000 tires the carmaker bought. So you don't want to add the separate purchase of 4000 tires to GDP, because then GDP would include 8000 tires. That would be double-counting: We know there were only 4000 tires involved. So economists say the purchase of the tires was a preliminary (they say "intermediate"; I say "preliminary") transaction, not a "final" transaction. And they do not add the preliminary purchase to GDP.

In our scenario, the manufacture and sale of those tires did happen. Yes, the value of all that work is included in GDP when the car sales are included in GDP. However, there are many transactions involved in the production and sale of the tires that are not separately added to GDP. That is because GDP is a measure of what we have produced. It is not a measure of the economic activity that was required for production.

GDP is a measure of what we have produced. It is not a measure of the economic activity that was required for production.

If you listen for it, you will often hear people say GDP is the size of our economy. You will hear them say GDP is a measure of all economic activity. The latter claim is most certainly incorrect. GDP is a measure of what we have produced. It is by no means a measure of all the economic activity required by the production process.

GDP is the cream floating on top, in a glass bottle of milk that's not homogenized... if you're old enough or bold enough ever to have seen such a thing.

Source: Udder Farm Milk Cream & Cheese Company
via FlavourCrusader
For the sake of argument, so to speak, I am throwing together data to create a number to use as a context number in place of GDP. I don't want to figure just the cream for context. I want to figure everything in the bottle.

In order to describe where I'm going, let me begin by describing where I start. I start with GDP. GDP is "final" spending. The cream on the top. It includes most or all of consumer spending, most or all of business investment spending, and most or all of government spending. (And, yes, net exports.)

Wikipedia points out that the government component does not include transfer payments, and the business investment component does not include purchases of financial products. The former (I think) are counted in GDP as part of the consumer spending component; the latter (Wikipedia says) are saving, not investment.

But let me put it the way I put it the other day:

Back in the late 1970s when I got my three credits in macro, they said GDP equals consumer spending plus business investment plus government spending plus net exports.

See it? GDP includes business investment, but not all of business spending.

Almost missed that, didn't you, in the flurry of details about transfers and financial products. If you take all of business spending and put it in two piles, the pile of business investment spending would amount to about 18% of the cream floating at the top of the milk bottle. The other pile of business spending, the pile that's not investment, completely fills the bottle below the cream.

Got it now?

I want to take final spending -- GDP, the cream on the top -- and add to it the non-final spending that represents actual economic activity, but is written off as business expenses, filling the milk bottle in the process.

I have to do this by poke-and-hope, as I've never seen it done by someone who might actually know what they're doing. I'm thinking businesses write off their non-final expenses, but they also write off (or at least they depreciate) their final expenses. So I think if I look at total business tax deductions I will get both final and non-final spending all in one number. I can live with that.

But the final part of that number is already included in GDP. If I take GDP and add total business income tax deductions (as an estimate of total business spending) then I will be double-counting final business spending. So I need to start with GDP, subtract out the business investment component, and then add total business tax deductions. And this will give me a number that represents the dollar value of the economic activity that was required for the production of GDP.

In words it sounds complicated, but the arithmetic is simple:

GDP - I + Business Income Tax Deductions

where I is the business investment component of GDP.

In order to figure the numbers for economic activity required for the production of GDP, I need the numbers for GDP. That's simple enough; I can get them from FRED. I need the numbers for business investment. For this I can use Gross Private Domestic Investment, also available from FRED. The third thing I need is the series of numbers for business income tax deductions. For this I can turn to the Historical Statistics for data through 1970.

After 1970 I can use various editions of the Statistical Abstract. If I find the right table in the Abstract I can pull out numbers for four or five consecutive years. Then I need a later edition of the Abstract so I can grab another batch of numbers. I really want a one- or two-year overlap so I can see that there is continuity in the data. I sure don't want my graphs to show data revisions that I don't know about.

Gathering these numbers is the "inconvenient" thing, in case you were wondering.

Actually, I had this all done in time for the post of 26 June. But at the last minute I noticed a problem. I was using numbers for corporate business instead of all U.S. business. Hey, you know, corporations dominate; so if I only count corps I get the dominant effect.

Yeah, but if I only count corps, I may misinterpret the growth of the corporate economy as the growth of business. I think non-corporate business faded as corporates rose, so that the growth of business spending would be less than the growth of corporate spending, and less than my first series of numbers were showing. But I'm not sure, and I can't be sure until I get a second batch of numbers completed, numbers that include proprietorships and partnerships as well as corporate businesses.

That's what I'm doing now.

Man! That takes hours.

I got numbers for 1959 thru 2008. That's decent.

Okay, here's what I got:

Graph #1: Federal Spending relative to Final Spending (blue)
Federal Spending relative to Final + NonFinal Spending (red)
I'm just gonna leave you with that. I have too much time in this already.


jim said...

I'm not sure where you are going with this but my take on final spending has always been that it is just an excuse to shift the tax burden away from businesses to individual workers.

Supposing a worker quits his job and goes into business (say selling insurance). The magnitude of expenditures on things like driving to work may not change but now some of his expenditures can be counted as tax deductions. So it is possible that there are now the same expenditures on transportation, computer and some portion of living space that are still income to others but no longer counted as part of the national income.

So what do you call gross spending? Do you call it Gross Gross Domestic Product.

The Arthurian said...

Hey Jim. My take is exactly like yours on the tax thing. But I'm not going anywhere near taxation in this bunch of posts. Many people think that GDP is a measure of TOTAL economic activity or TOTAL spending. So if we look at, say, Federal spending relative to GDP, I guess people think Federal spending is 22 or 23 percent of all the spending in our economy. Good heavens, I would oppose that, too! But if total spending is approximately three times GDP, which it is, then Federal spending is somewhere around 8% of the spending that is occurring.

This does not mean that government spending is suddenly less and is therefore okay. It does mean that people have been mistaken in their thinking, and that Federal spending, say, is much less than they thought. So maybe some of their conclusions about excessive government are wrong.

Gross Gross Domestic Product?
Good grief.

I do think, if we want to gauge the size of Federal spending, we ought to compare it to gross spending and not to some small fraction of that.

The Arthurian said...

Jim -- How about Gross Domestic Spending or GDS...

Greg said...

Good post Art.

One thought I have is that, as it is expressed, GDP is technically the PRICE of all we have produced.

You then have people like Rowe and Sumner who come along and claim that all we have to do is keep the prices of everything we produce rising at say 5% a year and our troubles will be over. Recession type troubles that is. More accurately, the MMers say just promise to keep the prices rising as high as they need to to keep employment at full capacity.

Im anxious to see where you take this train of thought.

Ill posit a guess on one thing you say;

" this will give me a number that represents the dollar value of the economic activity that was required for the production of GDP."

Here's my guess;

The dollar value of the economic activity required for production of GDP has risen in proportion to the growth of the financial sector. Financial sector activity is a net cost to everyone else.

In spite of claims that financial sectors are grease for the wheels, I would say they are gum for the wheels in more instances.

jim said...

Hi Art,
OK, call it gross spending. `

My meaning was that the justification of the tax system is the reason for the GDP story that we are told. But the story is a distortion of reality. We're told that consumption is 70% of spending, but if your numbers are correct consumption is like 30% of gross spending.

A retiree is supposed to be able to get by on 60% of the income as a worker. That is an indication that consumption that is not used for production might be as little as 20% of gross spending.