Disposable Income

Disposable income does not refer to that portion of an entity’s earnings which can be used without regard to other expenses or responsibilities, as is commonly believed. Instead, the phrase has a particular meaning within the context of financial management: It is the total amount of a person’s earnings, less the amount the person owes in taxes. Disposable income is, in other words, the amount of a person’s income available for paying expenses (e.g., rent, food, utilities) and for so-called discretionary items, that is, purchases that are not strictly necessary to maintain one’s standard of living, but which one may choose to make. There is often confusion in the media and among the public about the difference between disposable and discretionary income, largely because people associate the word "disposal" with throwing something away, assuming that disposable income is the category that can be thrown away on luxury items.

Background

Governments and jurisdictions have varying requirements about what types of taxes and fees must be deducted from earnings in order to calculate a person’s disposable income. For example, health insurance premiums are a category of expense that usually must be deducted from income in order to determine disposable income, but contributions to retirement savings accounts typically are not. The method of calculation of disposable income becomes important because many government programs and financial initiatives are targeted toward persons whose disposable incomes fall within specified ranges, or they offer benefits that are tied to the size of a person’s disposable income. This can be seen in the case of wage garnishments imposed due to nonpayment of child support or other debts; the law places a maximum limit on the percentage of a person’s disposable income that may be subject to garnishment. Thus, to calculate the size of the garnishment, the court will require proof of earnings and of all taxes and fees which must be deducted, and will then apply the percentage to the remaining (disposable) income—often the rate is capped at 25 percent.

Similar calculations are involved for those participating in some of the federal government’s student loan forgiveness plans. These plans were developed in response to a growing problem: students graduating from college with tens of thousands of dollars in student loan debt were either unable to find employment or were unable to find employment at a salary high enough for the students to be able to pay their debts. Student loan forgiveness programs address this issue by limiting the repayment amounts students are required to make, usually to a percentage (10 to 15 percent is common) of the student’s discretionary income. As noted above, this is the amount of disposable income left after one pays one’s bills. The result is that those who are earning less are required to pay back less, while those fortunate enough to have higher paying jobs are required to pay more (not a higher percentage, just more in actual dollars). Since most student loans are backed by the federal government, federal requirements as to what payments are used to calculate disposable and discretionary income are controlling.

Overview

Disposable income is used by economists as a way to try to track how the overall economy is performing, and as a way to determine how people are using their money. By comparing average disposable incomes against the earnings of particular sectors in the economy, it is possible to observe whether people have spent a greater or lesser percentage of their disposable income on a particular category of consumer goods. By using earnings data and tax rates from around the country, economists are able to calculate average disposable income for a given period—a month, a year, a decade—and this makes it possible to estimate what percentage of disposable income the average person is spending, saving, or otherwise investing. This, in turn, provides an indication of how the economy is doing. So, in 2005, when consumer spending actually outpaced disposable income, economists were able to take note of this and express their concern that as a whole, the country was spending more than it was earning. This meant that large numbers of people had not only stopped saving, but also were either spending their savings or going into debt in order to keep spending. Later, it became clear that this trend was related to the housing bubble that ultimately produced the mortgage crisis in 2008, in which people had been using their houses as sources of cash, refinancing multiple times in order to borrow more money against the (inflated) value of their homes.

Disposable income can also be an indicator of good news. When there is an upward trend in disposable income nationwide, it is generally interpreted as a sign of a growing economy, because people are working and earning more money. This often means that people will spend more, which in turn drives additional economic growth. Since this fits with many people’s definition of prosperity, policymakers from every political party tend to focus on the creation of programs that will encourage this kind of scenario. Tax cuts are often proposed as the best way to drive the economy forward, under the theory that reducing taxes gives people a greater amount of disposable income. While tax cuts can incentivize spending by increasing disposable income, this approach also has its critics, who point out that reducing taxes means reducing government revenue. The problem with doing this is that the government’s expenses continue to rise even when its revenue declines. This leads to an ongoing debate about the appropriate size of government, with some advocating a larger role for government, funded by correspondingly larger taxes, and opponents demanding the opposite. While no resolution to this dispute is likely in the foreseeable future, it is clear that disposable income will remain both an important tool for measuring economic performance and a tempting prize for commercial advertisers and tax authorities alike.

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