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What’s it: Disposable income is the money you have left after paying taxes. You can use it for savings or to buy goods and services.
Disposable income is essential to describe household purchasing power. When it increases, we expect households to increase spending. Increased spending stimulates businesses to increase production and recruit workers. As a result, the economy is growing, the unemployment rate is falling, and the outlook for household income is improving.
OECD data shows that the United States had the highest disposable income per capita in 2018, with $53,123. Luxembourg ($47,139) and Switzerland ($41,561) were second and third.
Calculate disposable income
Disposable income consists of your various income after deducting taxes. Income can come from salaries, capital gains, stock dividends, bond coupons, and government transfer payments. You will not spend your income because you have to pay taxes.
The remaining money can then be used for whatever you need. You can use it to buy products that meet your needs and desires, save it, and allocate it to various financial instruments such as stocks and mutual funds.
Mathematically, the disposable income formula is as follows:
- Disposable income = Total income – Personal taxes
As a simple example, assume your income is $100. The government collects an income tax of around 20%.
Applying the formula above, your disposable income is $80 = $100 – (20% x $100). It is available for you to shop or tube.
Disposable vs. Discretionary Income
Disposable income only considers taxes a deduction because they are a mandatory expense for citizens. However, you may also have other fixed expenses that cannot be deferred, such as a mortgage, utilities, and other basic necessities. These represent the cost of living, and if you don’t pay them, you will be fined or have your health or life impacted. We call the money left after paying these fixed expenses discretionary income. It represents the money left after you have met all of your everyday needs, and you can use it to meet other secondary needs.
In a mathematical equation, we can write a discretionary income formula as follows:
- Discretionary income = Total income – Personal taxes – Fixed expenses = Disposable income – Fixed expenses
As a note, we only put 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 disposable income matters
Disposable income is the primary indicator of household purchasing power and consumption. The changes affect the demand for goods and services and economic activity in various countries. Household expenditures comprise a significant share of gross domestic product (GDP). In fact, in some countries, it contributes more than 50% of GDP.
Economists use disposable income to identify trends in household saving and consumption. When it rises, we expect the demand for goods and services to also increase. 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.
Typically, economists also observe trends in the Consumer Price Index (CPI), a measure of the increase in the price of products purchased by consumers. If the CPI inflation trend is also low, households’ purchasing power for goods and services will be stronger. Thus, it will amplify its impact on aggregate demand and economic growth.
How significant is household consumption’s impact 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 effect of consumption on the economy. For example, suppose country A has an MPC of 0.75 and Country B has an MPC of 0.50. Suppose disposable income in both countries increases by an equal percentage. In that case, the impact will be more significant for Country A than for Country B.
Economists call this effect a fiscal multiplier. They formulate it as follows:
- Multiplier = 1 / [1-MPC (1-t)]
Where t is the tax rate.
A decrease in taxes increases disposable income. It magnifies the effect of household consumption on the economy. Say, the tax rate in both countries falls to 17%. Using the 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 the increase in aggregate output
Country B = 1 / [1-0.50 (1-0.17)] = 1.71 times the increase in aggregate output
Factors Affecting Disposable Income
The formula for disposable income (Disposable Income = Total Income – Personal Taxes) highlights the two main factors influencing how much money households have left to spend:
Taxes
Personal income taxes are a direct deduction from your total income. When the government lowers tax rates, households keep a larger portion of their earnings. This translates to an increase in disposable income.
Typically, governments implement tax cuts as part of an expansionary fiscal policy aimed at stimulating economic growth during a recession. By putting more money in people’s pockets, the government encourages spending, which boosts demand for goods and services and can help pull the economy out of a slump. On the other hand, tax increases have the opposite effect, reducing disposable income and potentially dampening economic activity.
Nominal income
This refers to the total income earned before adjusting for inflation. During a prosperous economy, several factors contribute to an increase in nominal income for households:
- Improved job market: Strong economic growth often leads to a rise in salaries and wages. Businesses may expand their operations, hire more workers, and compete for talent, driving up overall compensation. This translates to higher income for households, boosting their disposable income and spending power.
- Increased dividends: As companies experience higher profits during economic booms, they may distribute more money to shareholders through dividends. This additional income source increases disposable income for investors, who can then use those dividends for spending or reinvestment.
- Capital gains: When stock prices rise in a growing economy, investors who sell their shares can earn capital gains. This additional income adds to their disposable income. However, it’s important to note that capital gains are typically only realized when stocks are sold, and the stock market can be volatile.
Beyond the formula: additional considerations
It’s important to remember that nominal income doesn’t consider inflation. While nominal income might rise during economic prosperity, it’s crucial to factor in inflation to understand the true purchasing power of disposable income.
Inflation erodes the value of money over time, meaning that a dollar today won’t buy the same amount of goods and services as it will tomorrow. Therefore, even if nominal income increases, inflation can eat into disposable income if it rises faster. Economists track inflation using the Consumer Price Index (CPI), which measures the average change in prices over time.
Other factors can also influence disposable income, such as:
- Government transfer payments: Social Security benefits, unemployment benefits, and other government programs can provide a source of income for households, particularly during economic downturns. These transfers can help support disposable income levels.
- Interest rates: Interest rates paid on savings accounts and bonds can be a source of income for some households. However, low interest rates can reduce this income stream and potentially impact disposable income.
