Being slightly nerdy and having a background in accountancy and an amateur interest in some of the current economic controversies, the topic of value added statements and national income accounting interests me. Hence this post. I hope those with an interest in accounting and bookkeeping for national income will find this interesting and useful.
What is value added?
Value added is a measure of wealth creation. At an individual firm level, value added is measured as sales revenue minus the cost of all goods and services purchased from outside the firm. At an individual firm level, a value added statement provides a useful and interesting alternative to a traditional income statement.
Value added is used in accounting for national income because a nation’s value added is the same as a nation’s GDP. Value added statements can assist in evaluating government spending projects.
The government proposes to spend £100 m on a much needed public housing programme. It will borrow funds from wealthy private sector savers to finance the project.
Of the additional GDP created by the project, 10% will be paid to government by way of taxation and 10% will be saved by the private sector. The remaining 80% of additional GDP will be spent on wages and salaries. The recipients of wages and salaries will spend their entire incomes on consumption. This consumption expenditure will be spent 3 parts on imported goods and 5 parts on domestically produced goods and services.
The multiplier effect
The spending in shops, restaurants, cinemas, and on other consumables by workers becomes the income of those supplying the goods and services to the workers. These suppliers will then pay their labour force, who in turn will then spend their wages on consumable goods and services in shops, restaurants etc. However, at each turn of the cycle, the value of transactions will shrink by 50% because the 10% saving rate, the 10% tax rate, and the 30% import rate removes 50% of income received from circulation by the time wages are next paid. This process will continue until all the additional demand generated by the £100 m initial government injection has disappeared. This will occur when the additional GDP has reached £200m. It stops at this point because the multiplier value used in the illustration is 2*. Had the multiplier value been 1.5 then the process would stop when the additional GDP (value added) reached £150 m (1.5 x £100m)
The following statement reports the additional GDP once all transactions have completed.
Some final points
The statement is in two parts. The top part shows how value has been created. The lower part shows how the value has been distributed among the stakeholders. In the above example, providers of finance capital have not been shown as stakeholders. This is a deliberate omission, made to aid exposition
The above example is a simple one. For example, we have assumed that all wages have been spent on consumption. In reality, this is unlikely to be the case because workers may save, just as the firms have done in this example.
Secondly, we are not showing how much of the value added has been distributed to finance creditors and shareholders as interest and dividends respectively. Their share of valued added has been subsumed under savings instead of itemising their respective share of value added .To keep the illustration simple, all consumption expenditure has been assumed to derive from wages and salaries. In reality, dividends and interest payments will impact consumption expenditure.
Another simplification is that all consumption expenditure has been paid for out of income. This is nowadays an unrealistic assumption since it is common for workers to borrow to fund their consumption expenditure. A simplifying assumption has been made in the illustration that workers do not spend more than they have earned.
More elaborate value added statement to incorporate more complex and realistic scenarios are relatively easy to prepare.
The coding shown on the value added statement illustration denotes the item corresponding to the expenditure method of measuring national income, eg G = Government expenditure, C = Consumption, M = Imports and Y = National Income, T = Taxation and S = Savings.
* A multiplier value is calculated as the reciprocal of the sum of leakages. In the illustration, the leakages were tax = 10% + saving = 10% + imports = 30% = 50%. The reciprocal of 50% = 2, which is the value of the multiplier used in the illustration