What Is Disposable Income, and Why Is It Important?

What Is Disposable Income?

Disposable income is the amount of money that an individual or household has to spend or save after federal, state, and local taxes and other mandatory charges are deducted. Economists closely monitor disposable personal income as a key indicator of the strength of the economy. Also known as disposable personal income or net income, It includes both necessary spending on essentials like food and rent and discretionary spending on leisure and luxury items.

Formula and Calculation of Disposable Income

There are several ways to calculate disposable income but the main formula used is:

Disposable Income = Total Income - Taxes - Mandatory Deductions

Total income is the entirety of gross wages that an individual earns. This is sometimes adjusted to reflect factors that alter that total. For example, products returned by a customer would reduce a sole proprietor's total income.

Taxes are eliminated from disposable income because they are mandatory. An individual may down-size to save money or splurge on a fancier car but there's no wiggle room in taxes.

Understanding Disposable Income

Disposable income is the amount of money that a person or family has left after paying their taxes. It is the portion of income that can be spent on necessities, such as food and rent. People can also use disposable income to pay for discretionary items, leisure activities, and investments.

This type of income plays a critical factor in the economy. It drives how much consumers spend, how much companies earn, and how much people save and invest. By extension, it drives consumer demand for goods, manufacturing levels, distribution, and the overall well-being of the economy.

Different statistical measures and economic indicators are derived from the number for disposable income. It is the starting point for calculating measurements such as discretionary income, personal savings rates, marginal propensity to consume (MPC), and marginal propensity to save (MPS).

Special Considerations

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 paid.

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.

How to Use Disposable Income

Unlike taxes, disposable income is relatively flexible and highly individualized. It includes both essential and non-essential spending. We've listed some of the key spending categories that people can and often use with their 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 ends meet.

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. Its essential qualities include:

• Financial Flexibility: Having disposable income gives people the freedom to decide how to spend their money. It is key to taking care of current requirements as well as making long-term plans.
• Higher Level of Living: More disposable income means a higher level of living. 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 encourages job creation.
• Savings and Investments: People with disposable income can put money away for the future. It makes it possible for people to achieve long-term goals such as college tuition and retirement. Investing feeds economic growth by providing capital to companies.
• Tax Revenue: A person who has no disposable income probably has little or no taxable income. Tax revenues are the primary source of government spending.
  

Interpreting Disposable Income

The Bureau of Economic Analysis (BEA) tracks the month-to-month changes in disposable personal income. The agency reported that disposable income increased by $89.9 billion, or 0.5%, in February 2024 compared to the previous month. A decrease in this month-over-month measurement would mean that households have less residual income compared to the prior month.

The Federal Reserve is also interested in disposable income, as household savings and spending influence monetary and fiscal policy, The Federal Reserve Bank of St. Louis reported aggregate real disposable personal income of over $16.95 trillion as of January 2024. It was substantially higher (about $20.42 trillion) in March 2021 when the Federal Reserve raised interest rates to cool inflation.

Certain industries like agriculture have good reasons to watch the numbers on disposable income. The U.S. Department of Agriculture measures the percent of disposable income an average individual spends on food. That helps farmers plan future harvests.

The Bottom Line

Disposable income is money that remains to be used after all taxes are paid. All products and services including rent or mortgage payments, food, and utilities come out of disposable income. What is left over for wants (as opposed to needs) is known as discretionary income.

In a society as a whole, when disposable income increases, people spend or save more, leading to a growth in overall consumption. Consumer spending is one of the most important measures of demand, in turn driving business expansion and the creation of jobs.