Consumption and GDP
By Scott Sumner
Robert Barro argues that GDP is mismeasured:
That is, the standard concepts of national income and net product count net investment once when it occurs and include the same present value again when adding up the future returns realized on this investment. Therefore, in the steady state, national income involves precisely double-counting of net investment.
Thus suppose Tesla builds a battery factory that costs $1 billion, which lasts for 20 years. They hire workers and pay another $2 billion in wages over 20 years. The batteries sell for a total of $3.3 billion, a profit margin of 10%. In this example, $4.3 billion is added to GDP over the life of the factory—$1 investment and another $3.3 billion in consumer goods (batteries). But there is actually only $3.3 billion worth of actual “goods” being produced; the $1 billion factory investment is an input.
A commenter at Tyler Cowen’s blog suggests that GDP is not mismeasured, rather it is occasionally misinterpreted:
The algebra is fine as it is, but I take strong issue with the idea that GDP “mismeasures” something. As any decent intro macro course will tells its students, “GDP is not a measure of welfare.” Indeed, the Kuznets quotes that Barro points to are exactly of this nature; we have this high profile GDP number, but it doesn’t do what you want it to do – or at least not ALL the things you want it to.
What Barro does here is construct a new measure – present discounted value of consumption – and shown how it relates to GDP (and GDP’s present discounted value). In addition, he provides a capital income / labor income decomposition for both measures (GDP having such an exact decomposition because of constant returns to scale, Euler’s identity for homogenous functions, and marginal-value input prices). He then says present discounted value of consumption, and its associated decompositions, are “right” while the other the construction GDP is “wrong” and thus gives “misstated” decompositions. Of course, “right/wrong” and “correct/incorrect” begs the question – right about WHAT? Correct for WHAT?
Let’s look at an example:
Real consumption expenditures fell by 2.37% in 1942, and rose by nearly the same percentage in 1970. Yet 1970 was a recession year while 1942 was a boom year. Why is that? In 1942, military spending rose sharply and unemployment was very low despite falling consumption. In 1970, investment spending declined and unemployment rose sharply, despite healthy consumption.
If you are interested in studying labor markets over the business cycle, then real GDP is probably the number you should focus on. Total production impacts the labor market. (In that sense I agree with Tyler’s commenter). If you are interested in most other topics, including living standards, tax incidence, and economic inequality, then consumption is the right variable. Unfortunately, we tend to use GDP (or national income) for all sorts of issues where it doesn’t fit. We inappropriately tax income when we should be taxing consumption. We study income inequality when it is consumption inequality that matters. We compare living standards across countries by looking at GDP/person, not consumption/person.
In the Tesla example, a consumption tax applies to the $3.3 billion in batteries, whereas an income tax applies to the entire $4.3 billion in GDP–double taxing the $1 billion investment.
Is Barro’s paper important? I’m no expert in this area, but the following seems rather important, given the way most people interpret income share data:
That is, the combined 1999 and 2013 revisions in the BEA’s measurement of intellectual property can “explain” a rise in the capital-income share of GDP from 0.33 to 0.40.
Barro is saying that an entirely arbitrary definitional change by federal bureaucrats made the capital-income share seem to rise substantially. This reminds me of an earlier Matt Rognlie paper, which showed how the capital-income ratio is affected by imputed income from houses.
The more we learn about these issues, the clearer it becomes that the real issue is not the share of income earned by capital, rather it is the increasing inequality of labor income. Progressives should advocate a progressive wage tax, where investments are expensed and all “capital income” earned by workers (including CEOs) at their own firm is treated as wage income. This would help to reduce tax avoidance schemes.