What Is Disposable Income, and Why Is It Important?

What Is Disposable Income?

Disposable income, also known as disposable personal income (DPI), is the amount of money that an individual or household has to spend or save after income taxes have been deducted. At the macro level, disposable personal income is closely monitored as one of the key economic indicators used to gauge the overall state of the economy.

Understanding Disposable Income

Disposable income is the amount of money that people or families have left over after paying their taxes and other mandated costs. These mandated costs often stem from government legislation. It stands for the portion of income that may be freely spent on discretionary items or activities such as saving, investing, or enjoying leisure time as well as living costs that may not necessarily be imposed but still needed to survive.

Disposable income plays a critical factor in today's economy. It drives how much consumers spend, how much companies earn, and how much people save. By extension, it causes or impacts consumer demand for goods, manufacturing, distribution, and the well-being of the economy.

A number of statistical measures and economic indicators derive from disposable income. For example, economists use disposable income as a starting point to calculate metrics such as discretionary income, personal savings rates, marginal propensity to consume (MPC), and marginal propensity to save (MPS).

Formula and Calculation of Disposable Income

One could argue there are many slight variations to disposable income; in general, the formula to calculate disposable income is:

Disposable Income = Total Income - Taxes - Mandatory Deductions

Total income represents the entirety of gross wages that an individual or collective society earns. This may be netted against returned wages or sales or other implicit reductions related to the course of earning that direct income. For example, products returned from a customer would reduce a sole proprietor's total income.

Taxes and mandatory deductions are often government-sanctioned impositions that an individual cannot be excused from. These impositions may include income tax, other payroll taxes, applicable taxes to one's specific geographical region, and compulsory contributions such as Society Security.

Uses for Disposable Income

Discretionary Income

Discretionary income is equal to disposable income minus all payments for necessities, including a mortgage or rent payment, health insurance, food, and transportation. This portion of disposable income can be spent at will. Discretionary income is the first to shrink after a job loss or pay reduction. Businesses that sell discretionary goods, like jewelry or vacation packages tend to suffer the most during recessions. Their sales are watched closely by economists for signs of both recession and recovery.

Personal Savings Rate

The personal savings rate is the percentage of disposable income that goes into savings for retirement or other goals. For several months in 2005 and 2006, the average personal savings rate dipped into negative territory for the first time since 1933. This means that Americans spent all of their disposable income every month and still had to tap into savings or debt to make up the difference.

Marginal Propensity

Marginal propensity to consume is the percentage of each additional dollar of disposable income that is spent immediately, while marginal propensity to save is the percentage that is saved.

Importance of Disposable Income

Disposable income is not only important to individuals but holds massive value to society as a whole. Highlights of why disposable income is important includes:

• Financial Flexibility: Having disposable income gives people the freedom to decide how to spend their money. Greater flexibility is possible when managing personal money, taking care of current requirements, and making long-term plans.
• Higher Level of Living: A higher level of living is influenced by disposable money. It makes it possible for people to enjoy higher quality goods and services, leisure pursuits, hobbies, and participation in social and cultural events.
• Economic Growth: Consumer spending, a major contributor to macroeconomic growth, is driven in large part by disposable income. When people have extra money, they are more inclined to spend it on products and services, which boosts economic activity and opens up job chances.
• Savings and Investments: People with disposable income can put money away for the future. It makes it possible for people to achieve long-term financial objectives such as saving for emergencies, purchasing investments, paying into retirement plans, and more. In addition, investing disposable income allows companies to receive capital for further economic growth.
• Tax Revenue: If a person has no disposable income, this means all of their wages have been captured for taxes or they do not make any money. This model may be demotivational in a capitalistic society and not sustainable in the long run.

Wage Garnishments

The federal government uses a slightly different method to calculate disposable income for wage garnishment purposes. This is the seizure of a portion of a wage earner's paycheck before it is paid every payday until the amount due for back taxes or overdue child support is repaid.

For this purpose, the government uses disposable income as a starting point to determine how much of each paycheck to seize. The amount garnished may not exceed 25% of a person's disposable income or the amount by which a person's weekly income exceeds 30 times the federal minimum wage, whichever is less. The amount paid into a gross income retirement plan also is deducted from disposable income in this calculation.

Real World Examples of Disposable Income

The Bureau of Economic Analysis within the U.S. Department of Commerce tracks month-over-month change of disposable personal income. For example, from February 2023 to March 2023, the government tracked that average disposal household income increased 0.3%. Should this month-over-month measurement decrease, this means households would have less residual income compared to the month prior to satisfy needs.

The Federal Reserve is also interested in disposable income, as household savings and spending influence monetary and fiscal policy. For example, as of March 2023, the Federal Reserve Bank of St. Louis reported aggregate real disposable personal income in excess of $15.6 trillion. This is contrast of $19.2 trillion in March 2021 when the Federal Reserve prioritized economic stimulus in light of the pandemic.

Last, specific industries are particularly interested in disposable income. For example, the United States Department of Agriculture measures what percent of disposable income an individual spends on food. Long-term trend analysis like this allows the industry to plan for future harvests, understand where consumers purchase goods, and allowing for business owners (or in this case, farmers) to adequately plan for the future.

The Bottom Line

Disposable income is what is left over after taxes, and is what households used for consumption of needs and wants. Things like rent, bills, food shopping, gasoline, and so on come out of disposable income. What is left over for savings or wants (vs. needs) is known as discretionary income.

To increase disposable income, one can earn more and/or reduce their tax liability. In aggregate, when disposable income increases, households have more money to either save or spend, which naturally leads to a growth in consumption. Consumer spending is one of the most important determinants of demand; it creates the demand that keeps companies profitable and hiring new workers.