Personal disposable income refers to after-tax income received by the household sector. It represents aggregate money available for households to save or spend on goods and services.
Personal disposable income formula and its calculation
Please note, personal disposable income is a macroeconomic term. It represents, in aggregate, the remaining money after households pay taxes. Mathematically, we can calculate it using the following equation:
Personal disposable income = Personal income – Personal tax
For instance, the household sector has an annual income of Rp120,000,000 and pays a tax of Rp30,000,000. Therefore, personal disposable income is Rp90,000,000 (Rp30,000,000 – Rp120,000.000).
How households spend their disposable income
Economists divide household spending into two categories: consumption and savings. Any extra income received, they will spend on both. When the proportion of the additional is spent on goods and services, we call it a marginal propensity to consume (MPC). And, when the portion of the extra is saved, it is marginal propensity to save (MPS). MPC plus MPS would always equal to 1.
Marginal propensity to consume (MPC)
Many factors affect MPC. It will be higher when consumers are confident about their future income. During economic expansion, production activities increase, creating more jobs, and leading to better income prospects. As seeing an improved future income, households eager to spend more money on goods and services.
MPC also varies between different income-level groups. High-income households likely spend less on goods and services (low MPC). It contrasts with low-income households. With existing income, high-income households have been able to buy the most valuable items they want. Hence, when receiving extra income, they are more likely to save it.
Marginal propensity to save (MPS)
Besides income, MPS depends on the net worth of the household, i.e., the wealth minus household liabilities.
Household wealth takes two forms, i.e., financial assets such as stocks and bonds and real assets such as property and land.
If the value of those assets increases, households tend to save less as they are reaching wealth accumulation goals. Now, when receiving extra income, they will spend it on goods and services.
How disposable income relates to economic policy
Household consumption determines aggregate demand. In many countries, it accounts for a significant portion of gross domestic product (GDP). For example, in Indonesia, its share represents more than 50% of GDP. With such a considerable contribution, many economic policies are directed at household consumption, for example, through interest rates or personal taxes.
During economic contraction, aggregate demand weakens. The government then adopts an expansionary fiscal policy, for instance, by lowering the personal tax. A lower tax increases disposable income. And now, households have more money to spend on goods and services. As their consumption increases, aggregate demand rises.
Conversely, during the economic boom, inflationary pressure is high. Governments then opt to raise personal tax rates is to prevent the economy from overheating. Higher tax rates reduce disposable income, discouraging households to spend on goods and services. As a result, aggregate demand decreases, and inflationary pressure eases.
Difference between disposable income and discretionary income
Disposable income is the money left after the household pays taxes. Meanwhile, discretionary income represents the money left after households pay taxes and necessities. Examples of necessities include mortgages, rent, utilities, health insurance, food, and transportation.
Households cannot delay spending on necessities. Hence, some economists prefer discretionary rather than disposable income.
One of the determinants of discretionary income is interest rates. A higher interest rate leads to a decrease in discretionary income as households pay more for their mortgages. Usually, they will spend less on goods and services.