Free Free Lunch by David Smith Page A

what about the profit the company makes? What about the tax you pay? Profit is easy enough. That is either reinvested, in which case it generates income for the suppliers of capital equipment. Or it is distributed to shareholders in the form of dividends, which means income for them. Tax is a little trickier. On the face of it, it simply represents the income of government. In practice, the way to think about tax is in terms of the income it generates as the government converts tax into public spending, thus providing income for doctors, nurses, teachers and civil servants, as well as payments to state pensioners and people on welfare benefits. These last are known as ‘transfer payments’ because they are simply transfer money between taxpayers and beneficiaries.
    It really does all add up. GDP is not only the value of everything produced (the value added) in the economy, but also the sum of incomes received. It is also, and I have left what I regard as the most useful until last, the sum of spending.
    The most useful equation in economics
     
    So how does spending fit in? Again, the important thing to avoid in measuring the economy is double counting. What we are therefore concerned with is ‘final’ demand. When you or I buy a car, we have probably read the brochure beforehand detailing all the features and accessories it comes equipped with. What we are concerned with, however, is the entire product. Few people would buy a car and then remove the radio to sell it, or the spare wheel. Similarly, the purchase of all these components by the manufacturer does not feature in GDP. Such purchases are known as ‘intermediate demand’. The car could not be made without them but they are subsumed in final demand.
    Does that mean that spending by consumers is all that matters? After all, if we are talking about final demand, it would seem natural that most of that comes from you and me when we shop. Consumer spending, or household consumption as it is now known by the official statisticians in Britain, does indeed account for the lion’s share of GDP, but not all of it. In the year 2000, for example, UK consumer spending totalled £595 billion (that’s £595,000 million). That in itself is quite an interesting figure, being the equivalent of £10,000 for every man, woman and child in the country. GDP, however, was higher than this, at £943 billion. So consumer spending accounted for most of it, 63 percent, a typical figure. I have used the UK as an example but this is typical of most advanced economies. Consumers drive our economies. After the 11 September 2001 terrorist attacks on America the key question for economists was whether consumers would lose their nerve. Incidentally, you often hear economists and pundits gravely opining that whether the economy slows or not depends on the consumer. I have done it myself. As you can see, there is nothing terribly profound about this. As a matter of simple arithmetic it mainly does depend on the consumer and the rate of growth of consumer spending depends mainly on the rate of growth of income (this is known as the ‘consumption function’). But where does the rest of the spending that makes up GDP come from?
    The next most important category, in Britain at least, is spending by government. Again, this is quite typical. The national accounts showed that for the year 2000 the government spent £175 billion. This is a big number but it is also a little puzzling. As a proportion of GDP it is a little under 19 percent but, as many people will know, both public expenditure and tax in Britain are usually thought of as being roughly 40 percent of GDP. If spending were really only 19 percent of GDP, taxes could be much lower. What has happened to the missing 20 percent or so? The answer, mainly, is that for GDP purposes it is necessary to exclude transfer payments, such as state pensions and benefits, which account for a lot of government spending but which, in economic terms, is money