Disposable Income (Definition) | Discretionary vs Disposable Income

What is Disposable Income?

Disposable income also known as DPI (Disposable Personal Income) is an important mechanism used to measure household incomes and it includes all sorts of income such as wages and salaries, retirement income, investment gains, etc that is, in other words, it is the amount of money that is left with a person after paying off all the direct taxes or the net income left with an individual after paying off his direct taxes.

Formula for Disposable Income

DPI (Disposable Personal Income) = Gross Annual Income – (Payable Taxes + Other Deductions)

Explanation

From a macroeconomic perspective, economists consider DPI to better understand the health of an economy. Higher levels of income result in increased levels of this income, adding to the spending ability of consumers and promoting the tendency to save and invest in better and more sophisticated avenues for the longer term. This also reflects the state of an economy and if individuals and households are borrowing or saving more on a collective level. It is widely used for calculating several metrics including discretionary income, marginal propensity to save (MPS), marginal propensity to consume (MPC) and personal savings rates.

How Discretionary Income Differs from Disposable Income?

Discretionary income is another useful measure that differs from disposable income in it takes away income taxes as well as all the necessary expenses from gross income to arrive at the portion of income available to a household for spending with a certain amount of discretion. They can choose to spend it on investment vehicles, buy household equipment or articles of personal use or save the amount for future use. Examples of non-discretionary expenses could include rent, food and clothing expenses, transportation, insurance premiums, and any outstanding bills. Disposable income, on the other hand, can be described as the take-home pay which is going to be used for making any and all expenses, including both discretionary and non-discretionary in nature.

Discretionary income can be calculated thus:

Discretionary Income = DPI (Disposable Personal Income) – Essential expenses (including rent, outstanding bills, insurance premiums, food, transport, clothing, etc.)

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Discretionary income is the actual portion of household income which can be utilized with a view to secure financial future through savings and investments or can be used for acquiring goods or availing services of one’s choice.

Example

Let us assume that a household has a total annual gross income of $54,000 and after taking away income tax and other deductions a total of $40,000 are left, then that would be the disposable personal income for the household for that year.

Taking ahead the same example for disposable income, suppose non-discretionary expenses like rent, food, and clothing, etc amount up to $31,000, then we would deduct it from the disposable personal income of $40,000 to derive the figure of $9,000 which would represent the actual discretionary income for that household which they can choose to spend as they wish.

One example of how disposable Personal income and discretionary income would be affected by economic changes on a broader scale would be how changes in interest rates would potentially affect any mortgage repayments and thus influence the discretionary incomes of households. For instance, if interest rates went up, discretionary income would be proportionately reduced by taking away a bigger chunk for mortgage repayments and if interest rates go down, it would add to the discretionary income available to a household.
Another example of disposable income is that of income tax rates in a country that directly impacts the levels of this income available to households. If income tax rates are increased, it would lower the disposable personal incomes and if they should go down, these incomes would witness a commensurate rise.

Related Metrics

#1 Personal Savings Rates can be described as the percentage of income that goes into savings for use at retirement or other purposes.
#2 Marginal Propensity to Consume (MPC) can be described as the percentage of every extra dollar spent out of disposable personal income. It depends on rising or lowering levels of discretionary income which serves as an important indicator for economists to gauge the levels of spending and increasing or waning interest of individuals in spending a greater amount of what they can choose to save or spend.
#3 Marginal Propensity to Save (MPS) can be described as the percentage of each additional dollar that is saved out of disposable income. It also depends on changes in levels of discretionary income available to an individual or household, which in turn depends on the level of disposable income as well. This is another economic indicator often used for a study of the increasing or declining propensity to save in individuals in a specific economic environment.

MPS and MPC and personal savings rates might also be influenced by changes specific to individuals or households in terms of their discretionary income. For instance, if mortgage repayments are over for a household, it would reduce the non-discretionary expenses and add to the discretionary income available to that household, thus increasing the chances of a marginal rise in the propensity to consume and save along with personal savings rates. However, as these economic indicators are used on a larger scale as a part of macroeconomic analysis, collective changes have greater significance.

Disposable Personal Income and Wage Garnishment

Disposable Personal income is also used as a starting point to calculate wage garnishment in the US. Apart from income tax, health insurance premiums and involuntary retirement plan contributions are also deducted from gross income by the government for calculating this income for wage garnishment. This wage garnishment is often used for paying back taxes or for child support purposes.

Conclusion

Disposal Income is the income resources available for expenditures, saving and investment purposes after all the payable income taxes have been accounted for in a household. Disposable Personal Income income can be broken up in its components to be understood better and for a detailed analysis of personal income and expenditure.

Disposable income or DPI is no doubt an important economic measure for studying how well an economy is doing on the whole and whether households or individuals are earning enough to meet their non-discretionary expenses with relative ease. This is what frees them for thinking more about improving their quality of life and financial security by spending more on higher-quality goods and services as well as saving for future use. Other measures related to this income, especially discretionary income, play an important role in understanding the finer points about the household economy better, which in turn reflects the overall state of the economy as well.