Four Factors and Five Payments

• Compensation of Employees: The official measure of wages earned by the household sector for supplying labor services. Compensation of employees is far and away the largest of the five factor payments, typically running about 55 percent of gross domestic product. It includes standard wages and salaries paid directly to employees, as well as fringe benefits paid on behalf of employees to third parties.


• Net Interest: The official measure of interest earned by the household sector for supplying capital services. Net interest is usually less than 8 percent of gross domestic product, typically in the 5 to 7 percent range. It is revenue generated from borrowed funds but is considered payment for the productive services of capital.


• Rental Income of Persons: The official measure of rent earned by the household sector for supplying land and related services. Rental income of persons is typically the smallest of the five factor payment categories, usually less than 4 percent of gross domestic product. It includes payments for the use of land, natural resources, and capital goods attached to the land.


• Corporate Profits: The total accounting profits received by corporations, which is the official measure of profit earned by the household sector for supplying entrepreneurship services through corporations. Corporate profits the second largest factor payment category, usually coming it around 15 to 20 percent of gross domestic product.


• Proprietors' Income: The excess of revenue over explicit production cost of owner-operated businesses and includes payments to all factors of production--labor, capital, land, and entrepreneurship. Proprietors' income is usually less than 8 percent of gross domestic product, typically falling in the 6 to 9 percent range.

A Summary Equation

NI

=

Wages + Interest + Rent + Profit + Proprietors' Income

National income usually runs about 80 percent of gross domestic product. Compensation of employees is far and away the largest factor payment, most recently comprising about 70 percent of national income, which also makes it well over half of gross domestic product. This indicates why so many people are so concerned with unemployment. While corporate profits tend to ebb and flow with the corporate health, it is usually the second biggest factor payment, comprising around 20 to 25 percent of national income. Proprietors' income and net interest are the next biggest, at 5 to 10 percent of national income. And the smallest of the five is rental income, which is usually less than 5 percent of national income.

Three Complexities

• Proprietors' Income and Other Factor Payments: The first complexity arises by noting that corporations are not the only form of business organization earning profits. Proprietorships and partnerships also earn profits. However, a major measurement problem surrounds the profits of these two business organization types. More often that not, profit is not separated from other factor payments. For example, Phil Gardener, a zucchini grower, is a proprietor who supplies the labor, capital, and land used for zucchini production. He also supplies the entrepreneurship. However, Phil does not compensate himself separately for his labor, capital, and land. At the end of the year, Phil merely adds up his revenue, deducts his out-of-pocket expenses, and what remain is his "profit." But this "profit" actually includes wage, interest, and rent factor payments as well.

  The folks at the Bureau of Economic Analysis would like to include Phil's wages, interest, rent, and capital in the corresponding items in the National Income and Product Accounts, if they could. But such is nearly impossible. They do not know how much of Phil's "profit" is wages, interest, rent, and profit. So, they simply lump together the profit, or income, of proprietorships and partnerships like Phil's into a separate category called proprietors' income.



• Net Interest and Capital Investment: A second complexity arises with net interest. Even though interest is a payment for borrowed funds, it is considered as a factor payment for capital. How so?

  The answer lies with capital investment and the role of financial markets. Firms generally finance capital investment expenditures with investment borrowing. A given investment project (such as building a new factory) is undertaken if the extra revenue generated by the capital is at least as much as the cost of acquiring and using the capital. In particular, the decision comes down to a comparison between the net revenue (revenue less operating cost) and the interest paid on the loan.

  Suppose for example that a firm borrows $1 million at 10 percent annual interest to build a factory. The interest expense on this loans is thus $100,000 per year. If the firm generates at least $100,000 of net revenue each year from the factory, then this is a profitable investment. This $100,000 net revenue is the productivity of the factory. It is the income generated by this resource.

  Given competitive markets, with numerous lenders and borrowers seeking market balance and a wide range of potential investment projects with varying returns, the aggregate economy tends to reach a point of investment in which the net revenue, or productivity, of the capital is equal to the interest rate charged for investment borrowing. It is for this reason that interest payments are considered the factor payment for capital.



• Capital, Rental Income, and Corporate Profits: A third complexity relates to rental income of persons and corporate profits, which are considered payments to land and entrepreneurship, respectively. In principle, rent is payment for the use of land, including both the space of land and its natural resources. The rental income of persons category in the National Income and Product Accounts DOES include these types of rent payment. However, they also include "rent" paid for the use of apartments, houses, and other structures. This type of "rent" is actually a payment of the use of capital, not land. When Pollyanna Pumpernickel "rents" an apartment, she is NOT just renting the land upon which the apartment is built. She is also renting the structure, and probably some appliances and furniture, too. These are capital goods.

  Using a similar argument, a portion of corporate profits is actually payment for the capital (factories, equipment, etc.) owned by the shareholders of corporations. In principle, profit is payment for the risks of production undertaken by entrepreneurship. Shareholders DO undertake a degree of entrepreneurial risk when they buy shares in the ownership of a corporation. However, a significant portion of their stock ownership is simply capital ownership. They own the factories and they receive compensation for this ownership based on the productivity of the capital. As such, corporate profits reflect factor payments not only for entrepreneurship, but also for capital. In fact, because corporations also own land and natural resources, a portion of corporate profits is also a factor payment for land.

Personal Income

National income and personal income are different because some income is earned but not received (IEBNR) and some income is received but not earned (IRBNE). This observation indicates that income is frequently redistributed within members of the household sector and between household, business, and government sectors. In fact, one of the major functions of government is too redistribute national income among citizens of society. While this income might be redistributed from the rich to the poor, or possibly from the poor to the rich, it is almost ALWAYS redistributed from those who own factors of production to those who do not.

This occurs because the ONLY income that exists during given year is the income EARNED by the factors of production. If there is NO production, then there is NO income. To EARN one must PRODUCE. Any income received without production is a transfer payment. And the only source of income that can be used as a transfer payment is income EARNED by factors of production.

The connection between national income (NI) and personal income (PI), with adjustments for income is earned but not received (IEBNR) and some income is received but not earned (IRBNE), is given with by the following equation.

NI

=

PI + IEBNR - IRBNE

National Income and Production

Two equations indicate the connection between national income (NI) and the two measures of production--gross domestic product (GDP) and net domestic product (NDP). First, gross domestic product.

NI

=

GDP

- Capital Consumption Adjustment - Indirect Business Taxes - Business Transfer Payments + Net Foreign Factor Income + Government Subsidies less Current Surplus of Government Enterprises - Statistical Discrepancy

NI

=

NDP

- Indirect Business Taxes - Business Transfer Payments + Net Foreign Factor Income + Government Subsidies less Current Surplus of Government Enterprises - Statistical Discrepancy