What is Disposable Income? Why is It Important
How much money do you really have to spend? What about your employees? To figure out your available spending money, you need to find your disposable personal income. What is disposable personal income?
What Is Disposable Income?
Disposable income, also known as disposable personal income (DPI), is the amount of money that an individual or household has to spend or save after income taxes have been deducted. At the macro level, disposable personal income is closely monitored as one of the key economic indicators used to gauge the overall state of the economy.
How Does Disposable Income Work?
Disposable income can be calculated for a household or for a nation and has important economic significance. Not only is it one of the major determinants of consumer spending, but it is also one of the five determinants of demand. How much disposable income a person or a population of people has can help economists determine how much money they might spend on goods and services or save.
U.S. personal income is the income received by, or on behalf of, all U.S. residents from all sources, both domestic and global. (However, it does not include realized or unrealized capital gains or losses from investments.) U.S. PCE are the value of the goods and services purchased by, or on the behalf of, U.S. residents and are tracked as an important measure of the economy’s strength.
The COVID-19 pandemic of 2020 and 2021 had a major negative effect on DPI and PCE, but these figures began to rise in late 2021. The BEA estimates that U.S. personal income increased by $93.4 billion in October 2021 from the month prior, and that DPI increased by $214.3 billion.
Formula and Calculation of Disposable Income
One could argue there are many slight variations to disposable income; in general, the formula to calculate disposable income is:
Disposable Income = Total Income – Taxes – Mandatory Deductions
Total income represents the entirety of gross wages that an individual or collective society earns. This may be netted against returned wages or sales or other implicit reductions related to the course of earning that direct income. For example, products returned from a customer would reduce a sole proprietor’s total income.
Taxes and mandatory deductions are often government-sanctioned impositions that an individual cannot be excused from. These impositions may include income tax, other payroll taxes, applicable taxes to one’s specific geographical region, and compulsory contributions such as Society Security.
Uses for Disposable Income
Discretionary income is equal to disposable income minus all payments for necessities, including a mortgage or rent payment, health insurance, food, and transportation. This portion of disposable income can be spent at will. Discretionary income is the first to shrink after a job loss or pay reduction. Businesses that sell discretionary goods, like jewelry or vacation packages tend to suffer the most during recessions. Their sales are watched closely by economists for signs of both recession and recovery.
Personal Savings Rate
The personal savings rate is the percentage of disposable income that goes into savings for retirement or other goals.1 For several months in 2005 and 2006, the average personal savings rate dipped into negative territory for the first time since 1933.2 This means that Americans spent all of their disposable income every month and still had to tap into savings or debt to make up the difference.
Marginal propensity to consume is the percentage of each additional dollar of disposable income that is spent immediately, while marginal propensity to save is the percentage that is saved.
Importance of Disposable Income
Disposable income is not only important to individuals but holds massive value to society as a whole. Highlights of why disposable income is important includes:
Financial Flexibility: Having disposable income gives people the freedom to decide how to spend their money. Greater flexibility is possible when managing personal money, taking care of current requirements, and making long-term plans.
Higher Level of Living: A higher level of living is influenced by disposable money. It makes it possible for people to enjoy higher quality goods and services, leisure pursuits, hobbies, and participation in social and cultural events.
Economic Growth: Consumer spending, a major contributor to macroeconomic growth, is driven in large part by disposable income. When people have extra money, they are more inclined to spend it on products and services, which boosts economic activity and opens up job chances.
Savings and Investments: People with disposable income can put money away for the future. It makes it possible for people to achieve long-term financial objectives such as saving for emergencies, purchasing investments, paying into retirement plans, and more. In addition, investing disposable income allows companies to receive capital for further economic growth.
Tax Revenue: If a person has no disposable income, this means all of their wages have been captured for taxes or they do not make any money. This model may be demotivational in a capitalistic society and not sustainable in the long run.
Disposable vs. discretionary income
Disposable income is the amount of money an individual has after taxes. On the other hand, discretionary income is how much an individual has after paying for taxes and necessities, such as rent, utilities, health insurance, and food. An individual can use discretionary income for non-essential items, such as a new television or vacation.
You can use disposable income to calculate discretionary income. Subtract essential spending from disposable income to find your discretionary income.
Disposable Income vs. Gross Income
Gross income means total income, or what someone makes before anything, including taxes, is deducted. Since disposable income represents income after taxes, an individual’s disposable income is always smaller than their gross income (or the same if they are exempt from taxes due to their income level).
How Is Disposable Income Used in Macroeconomics?
Changes in average disposable income are closely monitored by both the Federal Reserve and the Bureau of Economic Analysis. Falling average disposable income can point toward economic decline and even recession, while rising average disposable income may be reflective of a healthy economy. When people make more money, they spend and invest more money, which helps to grow GDP and acts as a boon to companies and their stocks.
Companies in so-called “discretionary” industries (like jewelry, entertainment, and travel) also watch disposable income closely. As mentioned above, higher disposable income means higher discretionary income, and discretionary income is what consumers spend on non-essential products and services.
The more income someone has left over after their basic necessities are paid for, the more they are likely to spend on things like collectibles, sporting equipment, massages, and other non-necessary expenditures. When average disposable income falls, businesses that sell discretionary goods and services tend to see their profits (and as a result, their share prices) shrink.
Thus, we can say that Disposable Income is the one that an individual earns and gets after payment of all the personal tax liability and other deductions and such income is used as spending or saving. The spending done on the necessities will be termed as discretionary income whereas Real Disposable Income is the one when income after payment of taxes is added with the benefits obtained by the person in the economic system. In this article, we have covered what is disposable income and personal income formula, its example and importance along with the formula of real disposable income which will help you in Economics.