Chapter 3 National income and expenditure

Martin Weale

How much of economic output is available as income for the country?

Who receives this income?

Is the UK borrowing from or lending to the rest of the world?

How much of income do we save?

Who is lending to whom?

3.1 Introduction

Gross domestic product (GDP) is a summary measure of the output produced by the economy. As we have seen in Chapter 2, it can be produced both in money terms and as a measure of the volume of output. But policy-makers are likely to be interested in a range of question that GDP cannot answer. How much is the nation’s income? How much of that income is saved? Are we borrowing from abroad? Or are there material imbalances in the domestic economy? For example, is the public sector running up large debts borrowing from households? Or from the rest of the world? Are businesses financing their investment out of the profits that they generate, or are they having to raise external funds in order to invest?

An income/expenditure account for the country as a whole allows us to understand the link between GDP and national income, while accounts for the different sectors in the economy, such as households, corporations, central and local government, allow us to answer the more detailed questions about the performance of the different sectors. Comprehensive accounts allow us to see all the sources of income for each sector, making it possible to compute that sector’s disposable income, and to understand where that income comes from. They also allow us to see whether that income is used for consumption or saving, with saving being used either for investment in capital goods or to lend to other sectors. A key feature of the sector and financial accounts, which distinguishes national accounts from other economic statistics, is that total income equals total outgoings, in other words, the accounts balance.

The national accounts also distinguish between incomes arising in the production process and expenditure on produced or imported goods and services on the one hand, and transfer payments on the other hand. Transfer payments arise as a result of property rights: people, businesses and governments that have savings generally earn interest on those savings, while those who have borrowed pay interest. Businesses that have issued shares pay dividends to the people who own those shares. The private sector pays taxes to the government, which in turn pays benefits to households.

In a comprehensive accounting system, we should be able to account fully not only for the income and expenditure of each sector, but also for receipts and payments of each type of transfer. Total interest paid should equal total interest received. But we will not be able to account fully for transfer payments if we look only at the sectors of the domestic economy. Some interest income is paid abroad, and the United Kingdom also receives investment income from the rest of the world. Some benefit payments may even be paid to people who live abroad, for example, old-age pensions may be paid to formerly British residents who have retired abroad.

As a result, a comprehensive system of accounts has to include an account for the rest of the world. That account does not, of course, provide a full representation of the income and outgoings of the rest of the world, but shows those transactions only as they relate to the United Kingdom.

3.2 What do we mean by national income?

Within the economy, GDP has as its counterpart the income originating in the production process. But this is different from the amount of income available for spending – and for some countries, this can be very different:

primary incomes
Primary incomes are incomes that accrue to institutional units as a consequence of their involvement in processes of production or ownership of assets that may be needed for purposes of production.
secondary incomes
The secondary distribution of income account shows how the balance of the primary income of an institutional sector is transformed into its disposable income by the receipt and payment of current transfers excluding social transfers in kind. These redistributive transfers are mainly aimed at correcting social inequalities.
gross disposable income (GDI)
This is the same as gross disposable household income. It is the amount of money that that all of the individuals in the household sector have available for spending or saving after income distribution measures (for example, taxes, social contributions and benefits) have taken effect.
capital consumption
Consumption of fixed capital is the decline, during the course of the accounting period, in the current value of the stock of fixed assets owned and used by a producer as a result of physical deterioration, normal obsolescence or normal accidental damage.

Here, as with gross domestic product, the term “gross” means that income is measured before taking any account of depreciation, which is the capital used up in the productive process. If economic activity is to be sustainable, capital used up must be made good; it is not available to finance consumption on a sustainable basis. Policy-makers may, therefore, also be interested in Net National Disposable Income, where the term “net” indicates that the calculations are performed after making full provision for depreciation, or, as it is also known, capital consumption.

We have set out this brief account of national income without reference to sectoral accounts. But an important feature of the national accounts is that, if we add the disposable income of each domestic sector, we arrive at the total for national disposable income; the calculation works both on a gross and on a net basis.

We now explore in more detail the link between GDP and gross and net national disposable income, and then look at some of the sectoral detail.

3.3 From GDP to income

GDP and gross national income (GNI) reflect the output and income of an economy, but GNI takes into account net income receipts from abroad. As such, it considers the value of all goods and services produced by nationals, whether these residents are based in the country or not. The fact that national output can be clearly related to the incomes that citizens enjoy is a very powerful feature of national accounting.

3.3.1 Different types of income

As a starting point, we can distinguish the main recipients of income as the counterpart to the national output produced:

compensation of employees
Compensation of employees is defined as the total remuneration, in cash or in kind, payable by an enterprise to an employee in return for work done by the latter during the accounting period.
operating surplus
The operating surplus measures the surplus or deficit accruing from production before taking account of any interest, rent or similar charges payable on financial or tangible non-produced assets borrowed or rented by the enterprise, or any interest, rent or similar receipts receivable on financial or tangible non-produced assets owned by the enterprise.
mixed income
Mixed income is the surplus or deficit accruing from production by unincorporated enterprises owned by households; it implicitly contains an element of remuneration for work done by the owner, or other members of the household, that cannot be separately identified from the return to the owner as entrepreneur, but it excludes the operating surplus coming from owner-occupied dwellings.
indirect taxes
Indirect taxes are taxes that supposedly can be passed on, in whole or in part, to other institutional units by increasing the prices of the goods or services sold.

3.3.2 Depreciation

net domestic product (NDP)
GDP minus depreciation of a country’s capital goods

The previous chapter mentioned the difference between gross domestic product (GDP) and net domestic product (NDP). NDP is lower than GDP by the estimated extent of capital consumption – the depreciation that occurs to the capital used to produce output.

Depreciation can be thought of as representing capital used up in the production process, and, if production is to be sustainable, the income associated with it has to be devoted to maintaining the capital stock. An analysis of incomes, therefore, has to give attention to measures net of depreciation, as well as gross of depreciation.

capital consumption
Consumption of fixed capital is the decline, during the course of the accounting period, in the current value of the stock of fixed assets owned and used by a producer as a result of physical deterioration, normal obsolescence or normal accidental damage.

Figure 3.1 shows the decomposition of UK GDP into the categories of income described above for 2016. In this year, capital consumption was £240.3 billion, which is the difference between the gross (£1,969.5 billion) and net (£1,729.2 billion) figures.

Components of income Gross Net
Compensation of employees 963.4 963.4
Operating surplus 641.3 418.8
Mixed income 124.9 107.1
Taxes on production 255.5 255.5
Subsidies –15.6 –15.6
TOTAL 1,969.5 1,729.2

Figure 3.1 The income counterparts of GDP for 2016 (£bn)

Office for National Statistics – UK National Accounts, The Blue Book 2018, table 1.7.2.

In the first column, GDP is broken down into various income categories. These are therefore gross incomes before depreciation is taken into account. In the second column, capital consumption has already been removed from the figures to compute net domestic product. The income categories shown are correspondingly net of depreciation. Taking the operating surplus as a clear example, this is shown as £641.3 billion before providing for depreciation, but £418.8 billion after providing for the depreciation on the capital the sector employed.

Figure 3.1 conveys some useful information about how productive activity generates income, and for whom. But there are further factors that have to be taken into account to establish the total incomes that various sectors of society enjoy.

3.3.3 Primary incomes

There are incomes that accrue because of a sector’s involvement in the processes of production or ownership of assets that may be needed for production. For example, the largest component for households is compensation of employees, which includes wages and salaries, where the household receives income for the labour it provided. Another such factor is the income and outlays associated with property rights. These are claims by an entity that entitle it to some of the income accruing to another entity. For example, a bank lends money and charges interest on it, while shareholders receive dividends paid out of company profits.

primary incomes
Primary incomes are incomes that accrue to institutional units as a consequence of their involvement in processes of production or ownership of assets that may be needed for purposes of production.

Conversely, anyone who has debts usually has an obligation to pay interest to their creditors. Incomes that arise from production or, additionally, as a result of property rights, are referred to in the System of National Accounts as primary incomes. In the domestic economy, flows of primary income largely net out, because payments of dividends by companies are offset by receipts of dividends by households.

There are also international transactions arising from UK investment abroad and foreign investment in the UK, and there are also flows of labour income because some UK residents work abroad, and some foreign nationals work in the UK. As a result of these transactions, UK GNI, evaluated after taking account of the redistribution of primary incomes, differs from UK GDP.

A deficit on the UK balance of goods and services (imports less exports) is a surplus for the rest of the world (ROW). The surplus corresponding to this production therefore gives rise to income for the ROW, in exactly the same way that production in the UK gives rise to income in the UK. In addition, for the UK residents working abroad, the income they earn is shown as compensation of employees arising in the rest of the world.

Taking account of these various points, Figure 3.2 sets out the calculation of the UK’s gross national income (GNI) and its net national income (NNI) for 2016.

Figure 3.2 UK GDP and GNI 2016 (£bn)

UK GDP and GNI 2016 (£bn)

Office for National Statistics – UK National Accounts, The Blue Book: 2018, tables 1.7.2 and 1.7.3.
Note:

  1. net national product = GDP – consumption of fixed capital
  2. net national income = net national product + primary income received from the rest of the world – primary income paid to the rest of the world

Figure 3.2a Output and income of the UK economy

Gross domestic product and gross national income (2016)

Components of income and expenditure (£bn)
Gross domestic product 1,969.5
Capital consumption −240.3
Net national income 1,729.2
Primary income from ROW 133.9
Primary income paid to ROW −182.1
Net national income 1,680.0
Capital consumption 240.3
Gross national income 1,920.1

Figure 3.2b The data

We calculate gross domestic product and gross national income from the components shown here.

Figure 3.2 shows that the amounts of primary income both paid and received by the UK are substantial. On balance, however, payments exceed receipts, and net primary income thus depresses UK GNI, relative to GDP.

It follows that if we start with GNI, and we know property income received and paid, we can use that to calculate GDP. Figure 3.3 shows how income was allocated in 2016, taking into account these effects from interactions with the rest of the world. Note that net property income, in this case, is negative, and so subtracting it means that GDP is greater than GNI.

Figure 3.3 Allocation of primary income in 2016 (£bn)

Allocation of primary income in 2016 (£bn)

Office for National Statistics – UK National Accounts, The Blue Book: 2018, tables 1.7.2 and 1.7.3.

Figure 3.3a Flows of income in the UK economy (2016)

Gross domestic product and gross national income

Components of primary income (£bn)
Gross national income 1,920.12
Property income received from ROW − Property income paid ROW 49.38
Equal gross domestic product 1969.5
Compensation of employees 963.4
Operating surplus 641.3
Mixed income 124.9
Taxes on production and imports 255.5
Subsidies −15.6
Total gross national income 1969.5

Figure 3.3b The data

We calculate primary income from the components shown here.

3.3.4 Gross disposable income (GDI)

gross disposable income (GDI)
This is the same as gross disposable household income. It is the amount of money that that all of the individuals in the household sector have available for spending or saving after income distribution measures (for example, taxes, social contributions and benefits) have taken effect.
secondary income flows
The secondary distribution of income account of the national accounts shows how the balance of the primary income of an institutional sector and the total economy’s national income are allocated by redistributive transactions.

A further set of adjustments takes us from gross national income to gross disposable income (GDI). Large domestic flows – called secondary income flows – take place as a result of direct taxation and payment of benefits. Taking account of these flows leads us to the concept of disposable income.

At a domestic level, these secondary income flows largely net out, because receipts of taxes by the government largely match payments of taxes by households, although households may have tax liabilities to foreign governments arising from income earned abroad. But the definition of secondary income flow also includes items like the UK’s contribution to international organisations and flows of aid to developing countries. It also includes voluntary transfers paid by households to those in other countries, either as intermediated through charities or as direct gifts. Figure 3.4 indicates the effect of these, which is that they reduce the UK’s gross disposable income below its gross national income.

Current transfers (£bn)
UK gross national income 1,920.1
Less payments abroad, plus those received from abroad:  
Current taxes –0.6
Social contributions 0.0
Social security benefits –2.8
Other current transfers –19.1
Equals UK gross disposable income 1,897.6

Figure 3.4 Secondary distribution of income in 2016 (£bn)

Secondary distribution of income in 2016 (£bn)

Office for National Statistics – UK National Accounts, The Blue Book: 2018, table 1.7.4

3.3.5 GNI and GDI: A summary

The first modern national accounts (Meade and Stone 1941) showed all transactions on a net basis, for the obvious reason that it is net output or income rather than gross output or income which indicates the resources available to meet consumption needs or increase the capital stock. But since then, the growing prominence of GDP as a key aggregate with national accounts led towards accounts which show the derivation of gross income.

Let’s summarise what we’ve covered in the previous sections:

3.4 Sectoral allocation of GDI

Section 3.3 showed how it was possible, starting from GDP, to derive a measure for UK gross disposable income. Essentially, this gives us a bridge between national output and the income that citizens of the UK can collectively enjoy. Now we will examine the sectors of the economy to which that income accrues.

3.4.1 Sectoral definition

If you would like to investigate the definitions of the sectors, the international standards are set out in the System of National Accounts:

United Nations Statistics Division (2008), System of National Accounts.

In reality, there is an inevitable blurring at the edges between different economic sectors. But the broad features are clear and, in order to make progress, international conventions such as the System of National Accounts have embodied rules to allow the sectors to be defined.

The breakdown shown in the national accounts has tended to become more detailed over time. The basic idea is to look at economic agents that are either important on their own, such as government, or at groups of economic decision makers whose behaviour might be assumed to be reasonably homogeneous:

non-profit institutions serving households
Non-profit institutions serving households, abbreviated as NPISH, make up an institutional sector in the context of national accounts consisting of non-profit institutions which are not mainly financed and controlled by government and which provide goods or services to households for free or at prices that are not economically significant. Examples include churches and religious societies, sports and other clubs, trade unions and political parties.

ONS Resource

The Blue Book presents a full set of economic accounts, which record and describe economic activity in the UK and are used to support the formulation and monitoring of economic and social policies.

The Blue Book identifies three types of financial corporations: monetary financial institutions, insurance corporations and pension funds, and the remaining financial corporations.

Understanding the financial balances of the UK economy is important for policy considerations. For example:

household saving ratio
The saving ratio estimates the amount of money households and NPISH have available to save (known as gross saving) as a percentage of their total disposable income (known as total available resources).

Figure 3.5 shows the sectoral decomposition of gross disposable income; as before, it would also be possible to construct it on a net rather than a gross basis.

Figure 3.5 The sectoral allocation of gross disposable income 2016 (£bn)

The sectoral allocation of gross disposable income 2016 (£bn)

Office for National Statistics – UK National Accounts, The Blue Book: 2018, table 1.7.4.

Figure 3.5a Households

About two-thirds of the nation’s GDI accrues to households. Household disposable income, when adjusted for the effects of inflation and the number of households, is seen as an indicator of material living standards.

About two-thirds of the nation’s GDI accrues to households. Household disposable income, when adjusted for the effects of inflation and the number of households, is seen as an indicator of material living standards.

Figure 3.5b Central government

This is an incomplete picture. Central governments use their income largely to the benefit of households.

This is an incomplete picture. Central governments use their income largely to the benefit of households.

Figure 3.5c Local government

As with central governments, this is an incomplete picture for local governments. Local governments also use their income largely to the benefit of households.

As with central governments, this is an incomplete picture for local governments. Local governments also use their income largely to the benefit of households.

Figure 3.5d Non-financial corporations

Even the income of non-financial companies can be seen as benefiting households in the long term, if not in the short term.

Even the income of non-financial companies can be seen as benefiting households in the long term, if not in the short term.

Figure 3.5e Financial corporations

The same is true for financial corporations. Nevertheless, a focus on household income provides an understanding of the way in which income is redistributed between the different sectors of the economy.

The same is true for financial corporations. Nevertheless, a focus on household income provides an understanding of the way in which income is redistributed between the different sectors of the economy.

Figure 3.5f Non-profit institutions serving households

As the name implies, non-profit institutions serving households also contribute to household living standards.

As the name implies, non-profit institutions serving households also contribute to household living standards.

Components of gross disposable income £bn Percentage of total GDI
Non-financial corporations 164.27 8.7%
Financial corporations 33.46 1.8%
Central government 244.94 12.9%
Local government 122.43 6.5%
Households 1,268.45 66.8%
NPISH 64.07 3.4%
Total 1,897.62  

Figure 3.5g The data

We calculate gross disposable income from the components shown here.

3.4.2 Adjustments to disposable income

The term “disposable income” conjures up the idea of an income over whose expenditure the recipient has discretion. It is questionable how far that is true of the national accounting concept. One issue concerns the provision of resources to households in kind by the government and non-profit institutions serving households, for example, in the United Kingdom, households have free access to education for their children. This provision by the government increases their command over resources – the money that people do not need to spend to educate their children can be spent on other things. On the other hand, they cannot choose not to send their children to school and spend the money instead on something else. (It is true, though, that those who use free public education of their children avoid the costs of private education.) A concept of disposable income that ignores the fact that services are provided to households free at the point of use is missing something, but equally it is not clear that, if the value of these services is included in a definition of income, it is fully disposable. Data showing adjusted income calculated on this second basis are provided in Table 1.7.5 of the Blue Book.

3.4.3 Pensions

A separate issue arises with pensions and pension contributions, which fall into the category of social contributions. Pension receipts by households are similarly treated as receipts of social benefits. This is a reasonable way of handling unfunded pension schemes like the state old age pension. National insurance contributions are similar to taxes, and state pensions are just another form of government spending. It is far less clear that it is appropriate for contributions to private sector pensions. With the definitions set out above, these contributions, which are paid to financial institutions, are counted as a component of their disposable income. But they are in fact resources over which the financial institutions have only very limited discretion, as they are held in trust for the members of the pension schemes.

How it’s done The treatment of pensions

In the European System of Accounts, transactions between households and pension schemes are treated like taxes and benefits. Contributions depress household disposable income, while receipts of pensions increase it. There are in fact four types of pension contribution identified on the national accounts:

  1. Employers make visible contributions: These are a part of employment compensation accruing to households in primary income, but are deducted to reach household disposable income.
  2. Contributions are imputed to employers: These imputed contributions represent the increase in employer liabilities associated with future pension entitlements which are not covered by actual contributions. Like actual contributions, they are a part of household primary income which is then deducted to reach disposable income.
  3. Households make pension contributions themselves: These are a straightforward deduction from household primary income.
  4. Investment income earned by pension schemes: This is described as a social contribution supplement. It is treated as a component of households’ primary income that is used as a pension contribution. In keeping with other pension contributions, it is then deducted from household primary income to arrive at household gross disposable income.

Offsetting these inflows into pension funds, we have to deduct the cost of running them. This is shown as a deduction from inflows, rather than a use of funds. The amount that accrues to pension funds can then be used in one of two ways: either it is used to pay current pensions, or it accrues as saving by the pension fund.

With the definition of GDI, this balance would be treated as the disposable income of financial institutions. But it is not money that can be used by financial institutions in any way that they like, since it is needed to pay future pensions. The balancing item, known as the pension fund adjustment, is therefore added back to the income of households and deducted from the disposable income of financial corporations, before computing the saving of the two sectors. This adjustment applies only to funded pension schemes. As noted earlier, the same issues do not arise with unfunded pension schemes.

If this seems rather involved, that is because, in many countries, funded pensions do not exist. The accounting framework is appropriate to a situation in which pensions are a form of social security benefit, but the adjustment is needed when that is not the case.

Households’ transactions with pension funds in 2016 are summarised in Figure 3.6.

Households’ transactions with pension funds £bn
Employers’ actual contributions 55.6
Employers’ imputed contributions 12.1
Households’ actual contributions 11.2
Social contribution supplements 75.3
Less service charges –20
Total resources 134.3
Benefits paid 81
Pension adjustment 53.3
Total uses 134.3

Figure 3.6 The pensions adjustment 2016 (£bn)

The pensions adjustment 2016 (£bn)

Office for National Statistics – UK National Accounts, The Blue Book: 2018, tables 1.7.4 and 1.7.6.

3.5 Saving

The disposable income of the country cannot be used to make transfer payments, because it is defined after any transfer payments have been accounted for. It must, therefore, be either consumed or saved – there is nothing else that can be done with disposable income.

3.5.1 Allocation between consumption and saving

Financial and non-financial corporations cannot undertake any consumption. What might seem to be the analogy of consumption, the goods and services that they buy in that are needed for running their businesses are intermediated inputs, and the costs of these are deducted before GDP is calculated. As such, the whole of corporate income is saved, by definition.

The European System of Accounts does not have a definition of income that includes the increase in the value of pension entitlements of households. They are instead shown as an addition to the resources that are then either consumed or saved.

On the other hand, the two government sectors, the household sector and the non-profit institutions serving households, can allocate their income between consumption and saving. In the Blue Book, the use of income account in table 1.7.6 shows this split. This allocation of resources between consumption and saving can be done using either gross disposable income or adjusted gross disposable income. The social transfers in kind received by households increase income and consumption by equal amounts, since, by their nature, they all have to be consumed. So the saving of the different sectors is unaffected whether it is calculated from gross disposable income or adjusted gross disposable income. Similarly, the total consumption undertaken by the nation does not depend on whether transfers in kind have been reallocated from government and non-profit institutions to households or not. But inevitably after the reallocation, the consumption of households increases and the consumption of the other sectors falls.

Figure 3.7 shows these calculations for each of the sectors in the economy, and also provides the aggregate total for the United Kingdom. Here we distinguish individual consumption, attributable to households that are in principle identifiable from collective consumption such as spending on public order or defence, which cannot be allocated to specific households.

BB2018 UK total Non-financial corporations Financial corporations Central government Local government Households NPISH
Resources              
Gross disposable income 1,898 164.3 33.5 244.9 122.4 1,268.5 64.1
Pensions adjustment 53.436         53.4  
Total resources 1,951.1 164.3 33.5 244.9 122.4 1,321.9 64.1
               
Uses              
Individual consumption 1,533.3     157.5 83.2 1,235.2 57.3
Collective consumption 127.3     87.9 39.4    
Total consumption 1,660.6     245.4 122.6 1,235.2 57.3
Pensions adjustment 53.4         53.4  
Gross saving 237.1 164.3 -20.0 -0.4 -0.2 86.6 6.7
Total uses 1,951.1 164.3 33.5 244.9 122.4 1,321.9 64.1

Figure 3.7 Consumption and saving 2016 (£bn)

Consumption and saving 2016 (£bn)

Office for National Statistics – UK National Accounts, The Blue Book: 2018, tables 1.7.4 and 1.7.6.

net saving
Net saving is net disposable income less final consumption expenditure.

A striking feature of the savings figures is that the net saving of financial corporations in 2016 was negative. Their income measured as resources including receipts of pension contributions, but with payments deducted, and after dividends had been paid, was smaller than the pensions adjustment, suggesting strongly that these companies were able to pay dividends only by borrowing or drawing on reserves.

This, however, may serve to illustrate a separate problem with the definition of income. Many financial institutions derive what they see as their income from trading in securities, and it is perfectly possible that national income accountants see the same transactions as capital gains, which are kept out of the income account. Thus, looking solely at these data, it is not possible to say whether financial corporations were distributing more than their earnings.

3.5.2 The saving ratio

gross saving
Gross saving is gross disposable income less final consumption expenditure.

The saving ratio is calculated by dividing the gross saving of the household and non-profitmaking institutions by the gross disposable income of the two sectors, plus the pension adjustment. In Figure 3.8, this ratio is shown together with a cash measure, calculated as savings excluding the pensions adjustment divided by household gross disposable income.

The two series move largely in step because the pensions adjustment evolves smoothly. But the chart serves to indicate the importance of pension savings in overall household saving. Since people do not have easy access to these, the series excluding the pensions adjustment may serve as a better indicator of whether consumers are becoming over-stretched. In recent years, the UK saving ratio has fallen to levels that are low by historical standards. This has raised concerns around how households might adjust their consumption in response to a shock to the UK economy, where a cut-back in consumer spending might lead to a further slowing.

Figure 3.8 The saving ratio

The households’ saving ratio since 1987

The households’ saving ratio since 1987

It is by no means clear that household and non-profit institutions’ consumption should be seen as being determined solely by their gross disposable income. If companies reduce their dividend payments, then household incomes will fall, but company saving will rise. This increase in company saving may well be reflected in higher share prices, and households may well spend some of these gains. If households do behave like this, then the gross disposable income of the household and company sectors taken together might well be more closely related to consumption than the household measure.

Similarly, if the government is running a budget deficit, households may well assume that this is a signal that taxes will rise. If they aim to smooth out their consumption from one year to the next, then it is perfectly possible that they will increase their saving as a response to a budget deficit. In that situation, we might well find that it is national disposable income rather than household and non-profit institution disposable income which is a proximate influence on consumption.

These issues have been widely researched by economists. While there is perhaps no overall consensus, it seems to be the case that consumption is more influenced by current income than it would be if people saw through the corporate and government veils described above. At the same time, an approach to understanding consumption that assumes that the ratio shown in Figure 3.8 is constant is unlikely to perform well.

3.5.3 Sectoral net lending

The income and expenditure of the different sectors of the economy imply a path for each sector’s net lending to, or borrowing from, the others. These sum to zero in theory, as there must be a pound lent for each pound borrowed. In recent times, the domestic sectors of the economy – households, businesses and government – have each had to borrow or run down their savings to finance their spending and investment (see Figure 3.9). This has reflected the low level of saving in the UK economy. By historical standards, it is not typical for each of households, businesses and the government to be net borrowers – for instance, households have typically saved more than they invest, which helps to finance the deficits of the businesses and government. As such, the rest of the world has been a net lender to the UK, as national investment is larger than national saving, so must be financed by net borrowing from overseas.

Figure 3.9 UK households, corporations and government all appear as net borrowers in recent years

UK households, corporations and government all appear as net borrowers in recent years

UK, net lending/borrowing

Bank of England – ‘A millennium of macroeconomic data’
Notes:

  1. Households include non-profit institutions serving households
  2. Corporations comprise financial and non-financial corporations
  3. Government comprises central and local government
  4. Households, corporations and government comprise the UK economy

3.5.3 The capital accounts

capital accounts
The capital account records acquisitions less disposals of non-financial assets by resident units and measures the change in net worth due to saving (final balancing item in the current accounts) and capital transfers.

Figure 3.7 shows that the income of each sector is either consumed or saved. The capital accounts show what is done with this saving. As we have observed, despite the fact that net pension contributions are regarded as a part of the income of financial corporations, saving is defined after adjusting for the increase in pension liabilities to which those contributions give rise.

The capital accounts show that savings are used. The underlying accounting is very simple:

\[\begin{align} &\text{Gross saving} \\ &+ \text{gross receipts of capital grants and taxes} \\ &- \text{gross payments of capital grants and taxes} \\ &= \text{gross capital formation plus net lending} \end{align}\]

We expand on this in Figure 3.10 below, which is a simplified version of Table 1.7.7 of the Blue Book.

  UK total Non–financial corporations Financial corporations Central government Local government Households NPISH Rest of world Total
Gross saving 237.0 164.2 –20.0 –0.4 –0.2 86.6 6.7    
Capital taxes, transfers and grants received 36.4 4.4 0.1 6.0 13.0 2.4 10.4    
Total resources 273.4 168.6 –19.9 5.6 12.8 89.0 17.1    
Capital taxes, transfers and grants paid 38.0 1.5 0.2 25.2 2.7 8.1 0.3    
Capital consumption 240.3 130.3 8.2 18.3 11.4 62.3 9.9    
Changes in inventories 8.6 8.3 0.0 –0.3 0.0 0.5 0.0    
Net acquisitions of valuables –0.2 –0.2 –0.3 0.1   0.5 –0.2    
Net capital formation 91.0 57.8 2.6 –17.2 –9.1 –62.9 –9.9    
Net acquisition of non–produced assets 0.2 3.6 0.0 –0.9 –2.3 –0.4 0.2 –0.2 0
Net lending –104.5 –32.7 –30.5 –19.6 10.2 81.0 16.9 104.3 0
Total uses 273.4 168.6 –19.9 5.6 12.8 89.0 17.1    

Figure 3.10 The summary capital account 2016 (£bn)

The summary capital account 2016 (£bn)

Office for National Statistics – UK National Accounts, The Blue Book: 2018, table 1.7.7. Totals may not sum due to rounding.

We start with each sector’s gross saving. There are some minor transactions involving the rest of the world, such as capital grants paid abroad or received from the rest of the world. But the only material contributions to the total come from gross saving and net lending.

For each sector, as noted above, the flow of savings is enhanced by receipts of capital taxes, grants and transfers received by each sector. These are the capital account equivalent of the taxes, benefits and transfers shown in Figure 3.4.

Inheritance tax and capital gains tax are the two big capital taxes, while the government pays investment grants to other sectors in the economy, and some other capital transfers also take place.

Six uses of these transfers can be identified:

  1. Payments of capital taxes, grants and transfers: As with transfers in the current account, the total received must equal the total paid, and Figure 3.10 shows that that is the case.
  2. Capital consumption: As we have noted throughout, it is a matter of choice where this is shown; it would have been possible to have deducted it at a much earlier stage. Following the same steps would then lead to net income and net saving.
  3. Capital consumption + net capital formation = gross capital formation: It would be possible to show gross capital formation as a single item in the table rather than breaking it down like this.
  4. Inventories: As well as investment goods whose purchase is financed by capital consumption payments or net capital formation, there are three other types of investment good that each sector can buy. Much the most important of these is inventories (stocks), and, not surprisingly, most of the change in inventories is due to the non-financial corporations.
  5. Valuables: Assets such as paintings are treated as capital assets and net purchases of these are shown.
  6. Non-produced assets: By their very nature, the total supply of these must be zero once transactions with the rest of the world are taken into account.

Entries for the rest of the world are shown only for net acquisition of non-produced assets and for net lending. This reflects the fact that for these two categories, by definition the entry for the UK must exactly offset that for the rest of the world, that is, the total must be zero.

The entry for the net lending of the rest of the world implies that the United Kingdom as a whole borrowed £104.3 billion from the rest of the world in 2016. The government sector and the non-financial and financial corporations were substantial borrowers, while the household sector was a substantial acquirer of financial assets. But it was unable to meet all the borrowing of the corporate and government sectors, so the balance had to be financed from abroad – that is, the UK runs a current account deficit.

Net lending in the economy as whole, including the rest of the world insofar as it interacts with the United Kingdom, adds to zero; it is impossible to be a lender unless there is a borrower as a counterpart. That is, for every pound that is borrowed, a pound must be lent.

The table also allows us to assess the performance of the government sector against the so-called golden rule – that it should finance current expenditure out of current revenues, and only borrow to invest. Adding central and local government together, we can see that gross saving amounts to negative £0.6 billion. But, in addition capital consumption came to £29.7 billion, so that, relative to the golden rule, government current consumption exceeded government revenue by £30.3 billion.

Perhaps the most striking observation from these data is that net capital formation is small relative to capital consumption and gross saving, not only for the United Kingdom as a whole, but also for all the sectors. Indeed, for the country as a whole, gross saving is less than capital consumption, and net borrowing from the rest of the world is larger than the sum of changes in inventories and net acquisitions of valuable, capital formation and non-produced assets. Equivalently, then, this table allows us to see that the country as a whole must have been borrowing from abroad, not only to finance additions to the capital stock, but also to cover consumption expenditures. That borrowing is equal to the GDI of the rest of the world arising from transactions connected with the UK, adjusted for capital taxes, transfers and grants, and transactions in non-produced assets.

3.6 Measurement using financial assets

In Figure 3.10, we arrived at a figure for the net lending of each sector. Once the rest of the world is taken into account, net lending has to add up to zero. But in Figure 3.10, net lending is derived as a balancing item. The financial accounts are the counterpart to the capital accounts – that is, borrowing and lending has to be financed by the net acquisition of financial assets and liabilities by each sector.

3.6.1 The financial accounts

There is the obvious question of whether we can measure net lending directly, by collecting data on financial transactions. Another question is whether this gives the same answer as Figure 3.10. Table 1.7.8 of the Blue Book shows data on financial transactions and identifies a statistical discrepancy that represents the gap between net lending in Figure 3.10 and net lending as computed from financial transactions. A summary version of Table 1.7.8 is presented in Figure 3.11.

A substantial amount of detail is provided, with financial instruments collected into eight broad categories, as shown in Figure 3.11, which are then subdivided. Thus the broad category of debt securities – tradeable claims such as government bonds – is broken down into short-term and long-term securities. These are further subdivided to show transactions in debt issued by central government, local government, monetary financial institutions or other UK residents, and debt issued by the rest of the world. For short-term securities, those issued by monetary financial institutions are distinguished from those issued by other UK residents. Similarly, seven categories of equity-like investment are identified. It should be noted that these data are on an unconsolidated basis. That means that a bank that issues its own debt securities, but also buys some corporate bonds, will be shown both as acquiring financial assets and as issuing liabilities, even though both items are shown in the same category of the table.

Some authors (e.g. Stone, Champernowne and Meade, 19421) have suggested that the data in the various tables should be adjusted to remove the discrepancies, with the adjustments reflecting the judgements about the reliability of each data point. A fuller exposition of this approach is given by Sefton and Weale (1995).2

Figure 3.11 shows, not surprisingly, that the total value of the acquisition of each instrument as a financial asset must equal the total value acquired as a liability. If financial assets and liabilities are fully accounted for, then net lending/borrowing from the financial account should sum to zero, as, apart from a rounding error, it does just as net lending/borrowing does in Figure 3.10. Nevertheless, there is a material gap between the two estimates of net lending/borrowing, shown in the penultimate row of the table. Historically the distinction has been made between net financial transactions, shown as net lending in Figure 3.10, and identified net acquisition of financial assets computed from the financial account. The implication was that the financial account data were incomplete and therefore of worse quality than the data derived from spending and saving. But, after a considerable amount of work on improving the financial accounts, the presentation of the series is more neutral nowadays.

Net acquisition of financial assets (£bn) UK Total Non-Financial Corporations Financial Corporations Central government Local government Households NPISH Rest of the world
Monetary gold and special drawing rights −1.4 0.0 0.0 −1.4 0.0 0.0 0.0 0.0
Currency and deposits 407.2 42.3 277.1 1.8 −1.0 85.1 1.8 21.1
Debt securities −77.5 2.0 −87.6 6.5 −2.1 2.3 1.3 91.1
Loans 185.6 13.5 163.2 13.3 4.7 −9.1 0.0 14.1
Equity and investment fund shares −57.9 36.7 −33.1 −2.2 −2.1 −54.7 −2.5 27.6
Insurance, pensions and standardisdes guarentee schemes 78.6 0.1 12.1 0.0 0.0 66.4 0.0 1.1
Financial derivatives and employee stock options 23.5 −0.5 20.7 0.9 0.0 3.0 −0.6 0.0
Other accounts receivable 26.1 6.5 4.4 13.8 0.3 −0.7 1.8 0.0
Total net acquisition of financial assets 584.1 100.5 356.8 32.7 −0.2 92.4 1.9 155.0
Net acquisition of financial liabilities (£bn) UK Total Non-Financial Corporations Financial Corporations Central government Local government Households NPISH Rest of the world
Monetary gold and special drawing rights 0.0 0.0 0.0 0.0 0.0 0.0 0.0 −1.4
Currency and deposits 313.7 0.0 295.7 18.0 0.0 0.0 0.0 114.6
Debt securities 118.7 28.4 27.9 62.0 0.4 0.0 0.0 −105.1
Loans 137.7 97.9 −35.0 −1.8 2.5 72.8 1.3 62.1
Equity and investment fund shares 12.9 −10.2 23.1 0.0 0.0 0.0 0.0 −43.2
Insurance, pensions and standardisdes guarentee schemes 79.6 9.4 68.6 0.9 0.2 0.0 0.6 0.0
Financial derivatives and employee stock options 1.9 1.7 0.2 0.0 0.0 0.0 0.0 21.6
Other accounts payable 27.2 14.1 2.6 5.0 3.4 1.2 0.8 −1.1
Total net acquisition of financial liabilities 691.7 141.2 383.1 84.1 6.5 73.9 2.8 47.4
Summary (£bn) UK Total Non-Financial Corporations Financial Corporations Central government Local government Households NPISH Rest of the world
Net lending(+) / borrowing(−) from the financial account −107.6 −40.7 −26.3 −51.4 −6.7 18.5 −0.9 107.6
Statistical discrepancy between financial and non-financial accounts 3.1 8.0 −4.2 0.1 0.0 −4.6 3.8 −3.1
Net lending(+) / net borrowing(−) from non-financial accounts −104.5 −32.7 −30.5 −51.3 −6.8 13.9 3.0 104.5

Figure 3.11 Financial transactions 2016 (£bn)

Financial transactions 2016 (£bn)

Office for National Statistics – UK National Accounts, The Blue Book: 2018, table 1.7.8. Totals may not sum due to rounding.

3.6.2 Capital accumulation and the balance sheet

Figure 3.10 shows the accumulation of three types of produced capital – inventories, valuables and (fixed) capital, while Figure 3.11 shows the accumulation of the different types of financial assets. The stocks of these, at the start and the end of the year in question, are shown at current prices in the national balance sheets. The balance sheet value of a stock of assets can change either because the asset is accumulated or because the price of the asset changes. Balance sheets normally distinguish the two sources of variation, with the data underlying Figure 3.10 and Figure 3.11 providing the information on accumulation of assets. This will be discussed further in Chapter 10.

3.7 Summary

GDP and GNI reflect the output and income of the economy, but the latter takes into account net income receipts from abroad as well the income generated from domestic activity. As such, it considers the value of all goods and services produced by nationals – whether these residents are based in the country or not. Gross disposable income also takes into account transfer payments between the economy and the rest of the world. The word “gross” means that these measures are all gross of capital consumption, an estimate of the amount of capital used up in the productive process. Net measures can also be evaluated, and net national disposable income per head of population is generally thought to be the most helpful single simple indicator of economic well-being. It reflects, better than any of the other measures, the amount of money available to people to be used to finance consumption or to be saved up for the future.

Income is distributed to households, corporations, government and the rest of the world. The national accounts provide the conceptual framework for understanding how GDP becomes income, and how that income is then distributed. They also show how this income is used, paying for outgoings such as taxes, interest payments and consumption of goods and services. The balance left over is saving, and that may be used to purchase investment goods or financial assets. The amount invested in financial assets is often referred to as the financial balance. The UK’s financial balance with the rest of the world is the surplus on the current account of the balance of payments.

For the recent past we have seen a deficit, not a surplus. The UK current account deficit captures the extent to which it is borrowing from the rest of the world, and indicates that national investment is larger than national saving; the excess of investment over saving must be financed by net borrowing from overseas. In recent times, each of the domestic sectors of the economy – households, businesses and government – have had to borrow or draw down past savings to finance their consumption and investment. This borrowing and lending must be financed by the changes in the level of financial assets and liabilities that are held by each of these sectors, which provide some insight around the extent to which these financial imbalances are sustainable, which is of particular importance to policymakers.

3.8 Further reading

Notes

  1. Stone, JRN, Champernowne, DG, Meade JE (1942), ‘The precision of national income estimates’, Review of Economic Studies Volume IX, pages 111 to 125 

  2. Sefton JA, Weale MR (1995), ‘The Reconciliation of National Income and Expenditure: Balanced Estimates of United Kingdom National Accounts, 1920–1990’, Volume 7 in Studies in National Income and Expenditure of the United Kingdom, Cambridge University Press, Cambridge