Last time, we looked at the production value in Ireland’s national accounts. Between market and non-market output this is estimated to have been €790 billion in 2021. This represents a lot of activity but, just like turnover, there is also a lot of double counting in production value. The classic textbook example is the loaf of bread where the aggregate production value is the sum of the output of the farmer who grows the wheat, the miller who makes the flour, the baker who makes the bread and the retailer who sells it. Adding up aggregate value of their production does not give us the income of those involved as each stage includes the production value of the stages that preceded it.
To better reflect the value that is produced at each stage we must subtract the costs of current goods and services purchased for use in production. For the farmer this is the seeds, for the miller it is the wheat, for the baker it is the flour for the retailer it is the actual loaf of bread. We have already subtracted the cost to the retailer of buying the loaf of bread with the deduction for goods and services sold in same condition as purchased. But for the other stages of production goods, and services are purchased and are transformed or used in the production process. These purchase of these goods and services is referred to as intermediate consumption. Subtracting intermediate consumption from production value gives the value added at each stage of production.
We might like to include some government services as intermediate consumption. Policing, the legal system, roads and other government services contribute to firms’ ability to produce output. However, we have no way of dividing such collective services into the amount used by households and the amounts used by firms. Thus, it is assumed that all government services are final services consumed by households. This leads to an underestimate of intermediate consumption.
In 2021, the intermediate consumption in the Irish economy was estimated to be €390 billion. Gross value added in the Irish economy is estimated to have been around €400 billion. Thus, the €1 trillion of turnover resulted in gross incomes (for persons or businesses yet to be determined) of around 40 percent of that amount.
Taxes and Subsidies on Products
Almost every transaction we enter involves taxes of some form of another, or at least they should. The buying or selling of goods and services is no different. It can be argued that this is part of the value of a transaction – it must be if the final user, such as the consumer pays it – but it goes to neither the worker nor the business owner; it goes to the government. In 2021, taxes on products came to €26.5 billion. On the consumption side this includes VAT (€16.5 billion), Excise Duty (€6 billion) and EU Customs Duty (€0.5 billion), while for capital transactions Stamp Duty (€1.5 billion) is included. As these are included in the expenditure of final users they are added to GDP.
On the other hand, the amount of product subsidies paid by government is subtracted from GDP. In Ireland, these include subsidies for public transport, health insurance and third-level education. A total of €1.5 billion of such subsidies were paid in 2021.
In several places above emphasis was placed on the need to avoid double counting. However, it appears we are doing just this with the inclusion of taxes on products in GDP, at least from the perspective of production. These taxes are collected by government and go, in part, to fund the production of the non-market output such as government provision of health and education services. So, given that we have already included the production of such services in GDP is it double counting to also include in GDP taxes that are used to fund them?
In a sense, it is. Consider a hypothetical situation where the government abolished VAT and Excise Duty but required households to pay directly for health services used. Let’s just assume that nothing else changes. The production of non-market output will fall by €22 billion but this will be offset by a €22 billion rise in market output. However, there will be a €22 billion reduction in the amount of product taxes added to GDP. In aggregate terms, production is still the same but nominal GDP is lower. And, in the simple case of no other changes, all that has happened is that the method of paying for what is produced has changed – there has been an institutional change. Of course, GDP in volume (or real GDP) is unaffected as the tax and price changes will be picked up by the deflators.
Irrespective of where the economic incidence lies, taxes on products are certainly included in the market price of output and form part of the expenditure of final users. Also, if there was some way of excluding VAT from consumption expenditure, then there would be no direct way of determining the household savings rate and related measures.
Of course, it could also be argued that the subtraction from GVA of subsidies on products to get GDP leads to an undercounting. Again, the reason for doing so is the desire for an equivalence between the output and expenditure approaches to GDP. So, it is not so much that the inclusion of taxes and subsidies on products leads to a double counting in or undercounting of GDP; it is more a desire to maintain the equivalence between the different approaches to measuring GDP. Here we have seen it in terms of the output approach, but it also arises with the income approach when taxes and subsidies on production affect the factor income earned from production.
Could taxes and subsidies on products be excluded from GDP? Yes. However, that would lead to a gap between the output and expenditure approaches to measuring GDP. There is an attractiveness in having a theoretical equivalence between the different approaches to measuring GDP. However, a wedge caused by taxes means that in practice they will not be equivalent. Thus, one can view the tax adjustments being our effort at making them equivalent.
The system of national accounts is based on production and output. Consumption plays a role but only the consumption of output that is counted in production is included. As noted, this is derived on turnover and intermediate consumption.
The contribution of the Encyclopaedia Britannica to value added was the company’s turnover from the sales of its volumes minus its intermediate consumption to produce them. This would have declined as users switched to online options, such as Encarta and latterly Wikipedia, and in 2013 the company announced it was ceasing the production of printed volumes. This ended the contribution of printed encyclopedias to GDP. What contribution does Wikipedia make to GDP? Very little actually.
Wikipedia does not have a turnover in the sense of charging for the services it provides. Wikipedia is a non-profit entity. For the user-value produced, Wikipedia has a relatively modest wage bill. These costs are covered by donations. The production focus for GDP means there is an emphasis on costs rather than benefits. It is likely that Wikipedia provides much greater benefits than Britannica, if only because of the number of people who can access it, but makes a smaller contribution to GDP. If Wikipedia was to collapse, GDP would be largely unaffected, but the significant value users get from the service would disappear. GDP is a measure of production based on prices not consumer surplus based on benefits.
Similar outcomes can be seen for other digital technologies such as search engines. Users derive huge benefit from search engines, but because they are provided for free they make little direct contribution to GDP. Users perform billions of searches on Google each day but the value of this service consumption is not included in GDP. For GDP, Google is mainly an advertising company. In national accounts, Google’s turnover is the mainly the amount it collects in advertising revenue. This is a significant amount but will be well below the value users get from using the services that Google provide.
This suggests that, similar to government services, the value of certain private services may be undercounted in GDP. While true this is not necessarily a reason to discard GDP. GDP has limitations because of what it is: a measure of output that can contribute to national wealth. GDP is a flow that can lead to changes in national wealth, and there are other things that can change national wealth.
The output included in GDP should give rise to something that can be included on a national balance sheet. If Wikipedia and Google give their main products away for free, then that means there is no direct way they can give rise to something that can be included on a national balance sheet. In one sense, this means that GDP undercounts the value of these services. It does. But in the sense that GDP was created for, it more accurately reflects the value of the output produced that gives value that can be added to national wealth – though not necessarily of the country in which the output is produced.
Anyway, after those few digressions, we can now see how production value is translated into value added and subsequently into GDP.
The Output Approach to GDP
Using the output approach gives us Gross Value Added (that will go to persons and businesses) and adding the government net take from taxes and subsidies on products to GVA gives us Gross Domestic Product (GDP).
|equals||Gross Valued Added at basic prices||400,000|
|plus||Taxes on products||26,500|
|less||Subsidies on products||(1,500)|
|equals||Gross Domestic Product||425,000|
This is an important measure of an economy and taking the components of the phrase in reverse we have:
- Product: the value added of the output produced (including taxes)
- Domestic: activity that that takes place within a country’s borders
- Gross: before depreciation or the cost of replacing capital used
Irish GDP in 2021 was around €425 billion. With a population of 5.1 million this is just over €85,000 for every man, woman and child in the country. With an average of around 2.4 million in employment during the year, it is about €180,000 per worker. GDP is one of many Irish macroeconomic indicators that is distorted by the presence of MNCs here. Our next journey will be the steps to go from GDP to national income.