Discretionary income is the amount of an individual’s income that is spent, invested or saved after paying taxes and paying for personal necessities, such as food, shelter and clothing. Discretionary income includes money spent on luxury items, vacations and non-essential goods and services. Since discretionary income is the first to decline due to job loss or cut wages, companies selling discretionary goods tend to suffer the most during economic downturns and recessions.
Break 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 it. Some people use credit cards to buy discretionary goods, but increasing personal debt is not the same as having discretionary income.
Discretionary 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 is equal to gross income less taxes. In other words, disposable income is a person’s net salary used to cover essential and non-essential expenses.
Discretionary income is what remains of disposable income after the employee has paid rent / mortgage, transportation, food, utilities, insurance and other essential costs. For most consumers, discretionary income is depleted first during a drop in wages. For example, if a person earns $ 4,000 a month after taxes and has $ 2,000 in essential expenses, they have $ 2,000 in monthly discretionary income. If his paycheck is reduced to $ 3,000 per month, he can still meet his essential expenses, but he only has $ 1,000 left in discretionary income.
Discretionary income and economics
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), the marginal propensity to save (MPS) and the leverage ratios of consumers.
In 2005, in the midst of a debt-fueled economic bubble, the personal savings rate in the United States became negative for four consecutive months. After paying the necessary expenses on disposable income, the average consumer spent all of their discretionary income and then some of it, using credit cards and other debt instruments to make additional discretionary purchases beyond what ‘he could afford.
The overall discretionary income levels of an economy fluctuate over time, usually depending on the activity of the economic cycle. When economic output is strong, measured by gross domestic product (GDP) or some other gross measure, discretionary income levels also tend to be high. If inflation occurs in the price of necessities of life, discretionary income decreases, assuming wages and taxes remain relatively constant.