What is real disposable income?

Disposable income refers to the amount of money an individual or household has available for spending and saving after taxes and other mandatory deductions have been taken out of their total income. It represents the income that can be used at their discretion, hence the term "disposable."

Disposable income takes into account the income received from various sources, such as salaries, wages, bonuses, pensions, and investment returns. However, it excludes any taxes, social security contributions, and other compulsory deductions.

Stages in calculating disposable income:

Original income before government intervention

+ Cash benefits (e.g. state pension)

- Direct taxes and local taxes (e.g. council tax)

= Disposable income

Real disposable income refers to the amount of money an individual or household has available to spend or save after accounting for taxes and adjusting for inflation. It is a key measure of the purchasing power and economic well-being of individuals or households.

The term "real" in real disposable income indicates that it has been adjusted for inflation, meaning it reflects the purchasing power of income in terms of the goods and services it can buy. Inflation erodes the value of money over time, so adjusting for it provides a more accurate picture of changes in actual income.

The formula to calculate real disposable income is as follows:

Real Disposable Income = Nominal Disposable Income x (100/Price Index)

1. Nominal (Money) Disposable Income: This is the total income received by an individual or household before taxes and other deductions. It includes wages, salaries, rental income, interest income, government transfers, and other sources of income.
2. Price Index: The price index used in the formula represents the inflation rate or the overall change in the price level of goods and services in the economy over a specific period. It could be a consumer price index (CPI) or any other relevant price index.

By deflating nominal disposable income by the price index, we can calculate the purchasing power of the income after adjusting for inflation. The resulting real disposable income figure indicates the true increase or decrease in the individual's or household's ability to buy goods and services.

Real disposable income is a crucial metric for assessing the standard of living, economic well-being, and financial health of households over time. It allows economists and policymakers to understand the impact of inflation on people's purchasing power and to analyse changes in their real income levels, which, in turn, can influence consumer spending, savings behaviour, and overall economic trends.