6.1. Economic well-being should be measured in terms of a household's capacity to consume, its capacity to accumulate wealth and the value of the wealth held by the household. This paper has attempted to describe the first two of these in terms of the dynamics of its three separate accounts: current, capital and other changes in stocks. However, if the term 'economic well-being' is to represent the total command over economic resources held by a household, all three elements have to be brought together to derive a single index of command over economic resources.
6.2. The capacity to consume and the capacity to accumulate wealth have been described in the flows models for the three accounts. The value of the wealth itself is, however, a stock measure. The difficulty arises in combining a flows model with a measure of the value of the stock to the household during the reference period.
6.3. The formulation of a composite measure of economic well-being will therefore be considered in two steps: first the simple flows model that ignores the value of the stock, and second, building on this, a composite stocks/flows measure that deals with the value of the stock itself.
Flows measure of economic well-being
6.4. The accounts in the flows model can be brought together in a number of different ways to measure a household's command over goods and services. In particular, the option is available of approaching the measure of economic well-being from the viewpoint of the household's receipts or from the viewpoint of the household's disbursements.
This formula is, however, rather clumsy in that it includes saving twice - i.e. saving is a component of disposable income and is also included in the calculation of 'transactional change in net worth'.
6.7. An alternative approach is to measure economic well-being from the disbursements position, using the relationship between disposable income and consumption described in paragraph 4.12.
This consumption measure states that:
Stocks and flows measure of economic well-being
6.5. In approaching the measure of economic well-being from the receipts side of the accounts, emphasis is placed on the household's capacity to consume rather than on its actual consumption. To some extent, the choice will be determined by the availability of data and, in the Australian context at present, this will more often mean a receipts based measure.
6.6. Economic well-being, using the receipts approach of the flows model, can be formally described as follows:
6.8. The formulation of the measures of economic well-being above takes into account only the change in net worth over the period but ignores the absolute value of household net worth at any point in time.
6.9. The value of the stocks of assets and liabilities is of great importance in any consideration of a household's economic well-being. A high level of net worth can contribute a number of advantages. It gives security against a rainy day. The consumption patterns of the household and the level of saving that takes place are also affected by the value of the stock. For example, if a household has a high level of assets then it may be more comfortable consuming all, or more than all, of its income. The household with a low level of assets or with a high level of liabilities may feel more constrained in its consumption. Stocks of assets may also provide for the security of future income through their capacity to generate a flow of income via interest, rent and dividends.
6.10. It is important, therefore that any comprehensive measure of economic well-being takes into account the absolute value of household net worth as well as the value of changes to stocks of net worth over the period. The question arises, therefore, as to how the value of these stocks can be incorporated into what has so far been a flow model of economic well-being. The value of the stocks cannot be added directly to a flow value.
6.11. The solution adopted is to create a combined stock/flow model by converting the stocks to a notional annuity for the household. The notional wealth annuity in this context can be defined as the transformation of the value of household net worth into a right to be paid a (notional) fixed annual sum of money for a defined lifetime.
Notional wealth annuities
6.12. The question then arises as to whether all wealth should be annuitised or whether the annuitisation should be limited to fairly liquid assets. Arguments can be made, for example, that the value of the owner-occupied dwelling should be excluded on the grounds that it is not available for annuitising while the owner is still living there. A similar argument is often put forward against annuitising the value of consumer durables such as the family car.
6.13. However, a strong argument for including all assets in annuitised income is that the nature of wealth holdings is age-related. The exclusion of non-financial assets, and owner-occupied dwellings in particular, would seriously under-estimate the full income potential of the aged.
6.14. Given these considerations, the annuitisation of both non-financial and financial assets held by households is recommended in the ICW framework.
6.15. Annuitisation of wealth requires that a number of other value judgements and assumptions also be made in relation to, e.g. the period over which the wealth should be annuitised (life of householder or spouse?) and the interest rates to be used. These issues will be addressed in future work by the ABS on the annuitisation of household wealth.
ICW stock/flow model
6.16. In incorporating the notional annuity with the flows measures set out in Flows measure of economic well-being above, the choice can again be made between the income approach or the consumption approach.
(Note that the notional wealth annuity will include both a component comprising the running down of the stock of wealth and a component reflecting the likely interest earned on that stock over the owner's lifetime. It is therefore necessary, when defining the notional annuity, to deduct the value of all property income actually received during the reference period, the value of imputed rent from owner-occupied dwellings, and the value of services provided to the household by consumer durables.)
6.18. The consumption approach to economic well-being that incorporates the notional wealth annuity gives the following measure:
6.19. Given that the wealth annuity is only a notional flow, then the measure of economic well-being is also a notional measure. That is, economic well-being is measured not entirely as the level of well-being enjoyed by the household during the reference period but as the level of well-being available to the household if it chose to use all of the economic resources available to it.
Permanent income and lifetime earnings
6.17. The income approach gives the following as an improved measure of economic well-being in a stock/flow model:
6.20. The income/wealth measure described above still has some shortcomings as a measure of economic well-being. In particular, it ignores the value of human capital. In so doing, it annuitises the accumulated economic wealth (held predominantly by the middle-aged and older section of the population) while ignoring the future wealth that will be accumulated by the young.
6.21. This omission is particularly important given that the consumption and saving patterns of the young may well be influenced by considerations of permanent income. For example, young people may feel free to consume and go into debt in the expectation that higher salaries later in life will assist in paying for this life-style.
6.22. Despite these considerations, however, this paper does not propose the use of a permanent income measure at this stage. This stance is taken for a number of reasons.
6.23. First, data on life-time income is virtually non-existent for Australian households at present. Very few panel surveys have been run and even these panel surveys do not provide a picture of lifetime income.
6.24. Second, while simulation techniques for deriving permanent income are being developed, they are heavily dependent on assumptions about earnings, consumption, changing household composition and other life choices. Further research needs to be carried out in this field.
6.25. However, the ABS recognises the usefulness of cross-section life cycle data for analysis of distribution of income and income inequality and this approach has been used in ABS analyses such as the Fiscal Incidence Study.
6.26. A further necessary refinement to the measure of economic well-being is to take into consideration the differing needs for economic resources for different households. These needs, and the economic well-being of the households, will differ according to the size and socio-demographic characteristics of the household. For example, to achieve the same standard of living, a person living alone is assumed to require less income than a married couple without children who in turn would require less income than a married couple with, say, five children. In addition, a person working outside the home may incur greater costs with respect to, say, clothes and transport than a person who is not in the labour force.
6.27. In order to take these variations into account, equivalence scales should be applied to income data used to measure economic well-being. Equivalence scales are used to adjust household income to account for the effects that differences in size, composition, labour force participation and other characteristics have on a household's standard of living.
6.28. A number of different equivalence scales have been used in Australia for the analysis of cash income and none of these scales is perfect. The most commonly used equivalence scales are those derived for the Henderson Inquiry into Poverty in the 1970s. There is an extensive array of literature on the strengths and short-comings of these and other commonly used scales. Another option is to adopt a more widely recognised, and internationally used, set of equivalence scales.
6.29. Most equivalence scales have been developed for use with cash income and these are often applied to broader measures of income which include non-cash income. This may not be conceptually correct in all cases. As with consumption expenditure, the equivalence scales should take into account the differing effects of the non-expenditure consumption on the household's standard of living. It is likely that several equivalence scales, used in conjunction with different forms of non-cash consumption and non-cash income, will be required, along with sensitivity tests to show the effects of choosing different sets of scales.
6.30. At this stage the ABS does not recommend a particular set of equivalence scales for use in analysis of cash income and this issue will be addressed in a separate study.