Different Levels of Income and Expenditure - Case Study Example

Different levels of income and expenditure Table of Contents Introduction 4 Main body 4 Income from salaries 4 Income from house property 5 Income from business or profession 7 Income from capital gains 7 Income from other sources 7 Household Consumption Expenditure 8 Private Investment Expenditure 9 Conclusion 10 References 12 Introduction The word income does not have any specific definition. However, section 2(24) of Income Tax Act 1961 includes the following under income: dividend, profits and gains, value of perquisite or profit in lieu of salary, value of benefit or perquisite obtained from company by director or obtained by any representative assessee, sum chargeable to tax as business income, allowance granted to assessee to meet his personal expenses at the place of his office or at a place where he ordinarily resides, any capital gains chargeable to tax, any winning from lotteries, crossword puzzles. As per the Income Tax Act, 1961, the taxability of income of a person depends on the chargeability of the following heads of income: Income from salaries (sections 15 to 17). Income from house property (sections 22 to 27). Profits and gains of business or profession (sections 28 to 44D). Capital gains (sections 45 to 55A). Income from other sources (sections 56 to 59). So far as the heads of expenditure of an individual is concerned, the aggregate expenditure of a UK individual can be categorised into the following broad heads: Household Consumption Expenditure and Private Investment Expenditure. Main body Income from salaries Salary as per section 17(1) includes wages or salary, annuity, pension, gratuity, fees and commission, perquisites, profit in lieu of or in addition to wages or salary, advance of salary, any payment received by an employee in respect of the period of leave not availed by him, taxable portion of annual accretion, taxable portion of transferred balance, contribution made by Central Government in prevoius year. The basis of taxation on income from salary is on due basis. So salary due to an employee is taxable irrespective of whether he actually receives it or not. There are certain allowances given to employee which are taxable like dearness allowance, dearness pay, additional dearness allowance,tiffin allowance, fixed medical allowance, servant allowance, deputation allowance, other allowances like marriage allowance, telephone allowance, city compensatory allowance, family allowance etc. In addition to wages and salary, perquisites under section 17(2) are provided to employees by employer which includes certain benefits or amenities provided either voluntarily or under service contract. The perquisites for income tax purpose are tax free perquisites, taxable perquisites, perquisites taxable under specified cases. Example:     Amt in GBP Basic pay    40000 Dearness allowance    3000 Leave salary    5400 Professional tax paid by employer    5400 Perquisite for house:      15% of salary (40000+3000+5400)  7260   Furniture rent  1000   Less: rent recovered by employer  3000 5260 Less: professional tax    1000 Gross total income    53660 Less: tax deduction under section 80C      Contribution to statutory provident fund   4000 Taxable income    49660 Income from house property The measure of charging income tax under this head is the annual value of property which is the inherent capacity of a building to yield income. Annual value has been defined as per Section 23(1) of Income tax act as (a) the sum for which the property is expected to be let from year to year, (b) where the property or part of property is let and annual rent received or receivable by the owner is in excess of sum as in clause (a), such amount received or receivable, (c) property or any part of property being let and was vacant for the whole or part of previous year, owing to such vacancy, the actual rent received or receivable by owner is less than sum as per clause (a), such amount received or receivable. Example: X owned two house properties, one for running business and other was let out at 3000 GBP per month. The second property was used as residence by X. Municipal taxes for two properties were 7200 GBP per annum. The business and let out premises were insured against loss by fire and insurance premium was 900 GBP. Computation of income from house property First property (let out portion)   GBP Gross annual value 3000*12   36000 Less: municipal taxes     3600 Net annual value     32400 Less: Deduction under section 24 (30% of NAV)   9720         Income from first property let out portion   22680 Income from first property used for business   nil Income from second property self occupied   nil total income from house property     22680 Income from business or profession Sections 28 to 44D deal with computing income under this head. The term “business” defined in section 2(13) of Income Tax Act includes any trade, commerce or manufacture or any concern in nature of trade, commerce or manufacture. The term “profession” defined under section 2(36) of the Act includes any vocation. Income under this head includes profits and gains from business or profession carried out by an assessee during previous year, income derived by a trader or professional from specific services perforemed by it for its members etc. Income from capital gains Income from capital gains is dealt under sections 45 to 55A of Income Tax Act 1961. Section 45 of the Act states any profit or gain arising out of transfer of capital asset is chargeable to income tax under the head capital gains and shall be deemed to be the income of previous year in which the transfer took place. Chargeability of income from capital gains under section 45(1) requires a capital asset, transferability of such capital asset, such transfer been affected in previous year, a gain to be arised from such transfer of capital asset. Example: Mr.A has business loss of 30000 GBP, short term capital gain of 6000 GBP, long term capital gain of 190000 GBP, then his net income will be [(-) 30000+6000+190000 = 166000]. Income from other sources Income chargeable under Income Tax Act, not falling for assessment under any of the above four heads is chargeable to tax as income from other sources. This head is a residuary head of income where income is computed only after deciding whether the particular item of income is assessable under any of the first four heads. Such items of income has been provided under section 56(2) and includes dividends, amount received under Keyman insurance policy including bonus on each policy,winnings from lotteries, income in the form of interest from securities if not chargeable under the head profits and gains of business or profession, income from hiring machinery, hiring of building with machinery etc. Household Consumption Expenditure Household Consumption Expenditure or private consumption is the total amount of expenditure as incurred by households on purchase of goods and services in order to satisfy their wants. It is the most important component of aggregate demand also. According to John Maynard Keynes, the consumption expenditure is mainly dependent on the income of country and the propensity to consume. Propensity to consume or consumption function expresses the functional relationship between the aggregate consumption and the national income. It indicates the various amounts of consumption at varying levels of income.Consumption expenditure increases as income increases but increase in consumption is less than increase in income.This theory is called Keynes’ Psychological Law of Consumption (Sisay, D., 2012) (Christopher D. C., 2001). The propensity to consume will be of two types, namely, Average propensity to consume (APC) and Marginal propensity to consume (MPC) (Carroll, C. D., 2001) (Friedman, 1957). Average propensity to consume is the value of consumption function at particular level of income. It is the ratio of aggregate consumption to national income (Holden, G.R.,1938, p.91). Symbolically, it can be expressed as, APC= C/Y, where, APC is average propensity to consume, C is aggregate consumption, Y is aggregate income. Marginal propensity to consume is the ratio of change in consumption to change in income. It reflects that part of additional income which is not spent on consumption (McEachern, 2011, p.92). It can be symbolically denoted as, MPC= ∆C/∆Y where ∆C denotes the change in consumption and ∆Y denotes the change in income (McEachern, 2012, p.112) (Pettinger, T., 2011). The values of APC and MPC at varying levels of income has been depicted as under: Income ($) Consumption ($) APC (C/Y) MPC (∆C/∆Y) 0 100     100 150 1.5 0.5 200 200 1 0.5 300 250 0.83 0.5 400 300 0.75 0.5 500 350 0.7 0.5 600 400 0.67 0.5 The consumption function or propensity to consume has the following features- Propensity to consume implies the actual amount of consumption expenditure, it does not mean a desire to consume It in not confined to consumption expenditure at particular level of income rather it denotes the entire consumption schedule showing different consumption expenditure at different level of income. Consumption increases as income increases). Propensity to consume of poor is higher to that of rich ones. Consumption can never be zero even if income gets zero. Propensity to consume generally remains constant during short period. After reaching at a particular level of income, consumption lags behind income as people start saving on reaching at higher level of income Private Investment Expenditure Private investment is the total demand for capital goods by private entrepreneurs.Investment refers to that part of income which is used for further production. It is a kind of expenditure that is made on creation of new capital assets like machine, equipment, building, tools, inventories etc. Investment refers to an addition to existing stock of real or physical assets leading to an increase in productive capacity of economy. Investment can be induced and autonomous investment (Harcourt, G.C. et al., 1967). Induced investment is a kind of investment generally made in private sector with an objective to earn profit. An investor is induced by the profit motive to make investment. It is related to changes in national income. It is income elastic as the investment will go up as national income will go up. As per J.M.Keynes, induced investment is determined by the marginal efficiency of capital (expected rate of return on new investment) and rate of interest (John J. H., 2008). On the other hand, autonomous investment is independent of national income. It is income inelastic as at all levels of national income, the volume of autonomous investment remains the same. Autonomous investment is influenced by discovery of new resources, increase in population, public utility works and discovery of new technology. It is not influenced by expected probitability and this investment is made generally in public sector. In the context of investment, ex-ante investment denotes the intended or planned inverstment. Similarly, ex-post investment denotes the actual investment made in an economy at a particular time period. It is also called realised investment (Chiswick, Barry R. 1974). It is the sum of planned and unplanned investment. Investment demand function states the relationship between rate of interest and investment demand. Investment demand and rate of interest are inversely related. The higher the interest rate, the lower will be the investment demand level and vice versa. As investment increases, the marginal efficiency of investment falls. As per Keynes, change in income is a multiple of change in investment which is called investment multiplier or multiplier. K= ∆Y/∆I where K is multiplier, ∆Y is change in income and ∆I is change in investment. The size of multiplier is determined by the size of MPC. The higher the value of MPC, the greater will be the size of multiplier and a greater cumulative decline in income (Richardson, C. et al., 2013). Multiplier and marginal propensity to consume can be symbolically expressed as, K=1/1-MPC= 1/MPS [Since, MPC+MPS=1]. Conclusion The above discussion has elaborated different income and expenditure of the individual by classifying it into broad heads. Apart from the income earned by individual and expenditure incurred, the balance which lefts is called savings which is also dependent on income as when income increases, savings also increases and vice versa which is further explained by savings function. The household consumption expenditure and private consumption expenditure of individual form part of aggregate demand of economy which has also two other components, government expenditure and net export. The consumption function capturing the relation between consumption and income forms the core building block in keynesian economics. Consumption function has the following two key parameters:The intercept term indicating autonomous consumption and the slope indicating induced consumption which is the marginal propensity to consume. Thus, by consumption function, the fundamental psychological law is captured explaining that consumption expenditure by households is dependent on income and only the portion of additional income is utilized for consumption. References Carroll, C. D., 2001. A Theory Of The Consumption Function, With And Without Liquidity Constraints. Journal of Economic Perspectives. Available from http://www.nber.org/papers/w8387. [Accessed on March 4,2013]. Chiswick, Barry R. 1974: Income Inequality: Regional Analyses within a Human Capital Framework. Available from http://www.nber.org/chapters/c3675.pdf. [Accessed on March 4,2013]. Christopher D. C., 2001. Codes for A Theory of the Consumption Function, With and Without Liquidity Constraints. Quantitative Macroeconomics & Real Business Cycles. Available from http://www.nber.org/papers/w8387. [Accessed on March 4,2013]. Friedman, 1957. A Theory of the Consumption Function. National Bureau of Economic Research. [online]. Available from http://ideas.repec.org/h/nbr/nberch/4403.html [Accessed on March 4, 2013]. Harcourt, G.C. et al., 1967. Economic Activity. Cambridge: Cambridge University Press.  pp. 112-139 Holden, G.R.,1938. Mr.Keynes’ Consumption Function and The Time-Preference Postulate. Vol.52, No.2. Oxford: Oxford University Press. http://www.economicshelp.org/blog/2812/economics/consumption-function-definition/. [Accessed on March 4,2013]. John J. H., 2008. The Investment Function: Determinants Of Demand For Investment Goods. Rensselae. Available from: http://www.economics.rpi.edu/workingpapers/rpi0806.pdf. [Accessed on March 4,2013]. McEachern, W.A., 2011. Macroeconomics: A Contemporary Approach. 9 edition.United States: South-Western College Pub. McEachern, W.A., 2012. Economics: A Contemporary Introduction. 10 edition. United States: South-Western College Pub. Pettinger, T., 2011. Consumption Function Definition. Economics help. Available from Richardson, C. et al., 2013. Investment Functions and the Profitability Gap. Society of Heterodox Economists. Available from: http://www.asb.unsw.edu.au. [Accessed on March 4,2013]. Sisay, D., 2012. Financial wealth and the consumption function. Danmarks Statistik Modelgruppen. Available from www.dst.dk/ext/adam/DSI260312. [Accessed on March 4, 2013]. Read More