What is... | April 4, 2011

What is disposable income?

How does this measure of take-home pay differ from available income? Disposable income is an example of a concept that is highly relevant – particularly in the current economic climate – but which may not be widely understood.

Rather than something that is thrown away, disposable income is the amount of money left after an individual pays direct taxes and government charges. It is one of those economics terms that conceals more than they explain.

Disposable income is take-home pay
Disposable income – also commonly known as take-home pay – is a useful measure because it can tell economists how much households have to spend on goods and services. In turn, this potential spending can generate wealth and jobs. However, there is pressure on post-tax income at home from the costs of food, heating and other essentials. In many places, the prices of these necessities have risen sharply in recent months. So while disposable income for some families might grow, it doesn’t always follow that they have more to spend on life’s little luxuries. Inflation in the prices of basic goods and services can squeeze disposable income.

Discretionary income is “spare cash”
Perhaps a more useful concept is discretionary income, which the FT’s Lexicon defines as “income that you can spend on things that are not completely necessary for living”. In the United Kingdom, the Bank of England sponsored survey of the financial position of British households uses a similar measure. It terms it “available income”, or “income left over after paying tax…housing costs, loan payments and utility bills”.

A squeeze on disposable income can have big economic consequences
The crisis in the Middle East has put up oil prices, which feed through to petrol (gasoline) and heating costs. Rising prices of crops have added to people’s food bills. While this may seem obvious – after all, everyone can see the bill when they fill up their car or go to the supermarket checkout – it is also a worry for economists. If people have less money to spend they will become less confident about their future livelihood, which may encourage them to cut spending further. According to market researchers Nielsen, rising food and utility costs contributed to a fall in confidence in half of 52 countries it surveyed.

Poor you
While everyone other than the super-rich are affected by falls in discretionary income, the pain is felt most by poorer people for whom essential items take up a higher share of their income. Research by the Federal Reserve Bank of Cleveland found that while the richest fifth of US households spent 7.9% of disposable income on food and energy, this rose to a “whopping” 44.1% for the poorest fifth.

(Don’t) spend, spend, spend
While many households will have already responded to falls in discretionary income by cutting spending, they still have options to mitigate the impacts. There is evidence that consumers are altering their behaviour to spend more “wisely”. There is evidence drivers cut their car usage because of higher fuel prices. In an eZonomics poll more consumers said they would prefer to see food package sizes shrink than pay a higher price for the original size. Adventurous investors willing to risk some of their remaining spare cash can invest in food commodities as this article explains.

Phil Thornton
Phil Thornton

Lead consultant at Clariti Economics