What’s it: Disposable income is the money you have left after paying taxes. You can use it for savings or 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.
From OECD data, the United States ranks first in the country with the highest disposable income per capita in 2018 with $53,123. There are Luxembourg ($47,139) and Switzerland ($41,561) in second and third place.
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.
You can then use the remaining money for whatever you need. You can use it to buy products to meet your needs and desires. You can 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.
The difference between disposable income and discretionary income
Disposable income only considers taxes a deduction because it is a mandatory expense for you as a citizen. However, you may also have other fixed expenses that cannot be deferred, such as a mortgage, utilities, and other basic necessities. They represent the cost of living, which if you don’t pay, you will be fined or impact the quality of your health or life.
We call the money left after paying these fixed expenses as discretionary income. It represents the money left after you have met all of your everyday needs. 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 disposable income 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 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 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
From the formula, you can see, two main factors influence disposable income: taxes and nominal income. It increases when:
- Personal tax rate cut
- Nominal income increases
When the government lowers the tax rate, households have more money to spend on goods and services. It is usually when the government runs an expansionary fiscal policy. The tax cut aims to stimulate economic growth during a recession.
Meanwhile, many factors affect the nominal income, depending on the types of income. But, generally speaking, it happens during a prosperous economy. Strong economic growth brings more income to households.
During this period, the salary and employment outlook improves. Business profits are also growing, allowing the company to pay more dividends. Higher profits also push up their share prices, allowing households to earn more income from capital gains.