Discretionary income is the amount of an individual's income that is left for spending, investing, or saving after paying taxes and paying for personal necessities, such as food, shelter, and clothing. Discretionary income includes money spent on luxury items, vacations, and nonessential goods and services. Because discretionary income is the first to shrink amid a job loss or pay reduction, businesses that sell discretionary goods tend to suffer the most during economic downturns and recessions.
Breaking down Discretionary Income
Discretionary spending is an important part of a healthy economy. People only spend money on things like travel, movies, and consumer electronics if they have the funds to do so. Some people use credit cards to purchase discretionary goods, but increasing personal debt is not the same as having discretionary income.
Discretionary Income vs. Disposable Income
Discretionary income and disposable income are terms often used interchangeably, but they refer to different types of income. Discretionary income is derived from disposable income, which equals gross income minus taxes. Disposable income, in other words, is a person's take-home pay used to meet both essential and nonessential expenses.
Discretionary income is what is left over from disposable income after the income-earner pays for rent/mortgage, transportation, food, utilities, insurance, and other essential costs. For most consumers, discretionary income gets depleted first when a pay cut happens. For example, if a person makes $4,000 per month after taxes and has $2,000 in essential costs, he has $2,000 in monthly discretionary income. If his paycheck gets cut to $3,000 per month, he can still meet his essential costs but only has $1,000 left over in discretionary income.
Discretionary Income and the Economy
Discretionary income is an important marker of economic health. Economists use it, along with disposable income, to derive other important economic ratios, such as the marginal propensity to consume (MPC), marginal propensity to save (MPS) and consumer leverage ratios.
In 2005, in the midst of a debt-fueled economic bubble, the U.S. personal savings rate went negative for four consecutive months. After paying for necessary expenses out of disposable income, the average consumer spent all his discretionary income and then some, using credit cards and other debt instruments to make additional discretionary purchases beyond what he could afford.
Aggregate discretionary income levels for an economy fluctuate over time, typically in line with business cycle activity. When economic output is strong, as measured by the gross domestic product (GDP) or another gross measure, discretionary income levels tend to be high as well. If inflation occurs in the price of life's necessities, then discretionary income falls, assuming that wages and taxes remain relatively constant.