Discretionary income refers to the amount of income an individual or family possesses after they cover their personal expenses and taxes. Critical personal expenses include shelter, food, clothing, transportation, and medicines. The money which remains is available for savings, investing, or consumption spending. This means that a discretionary form of income would include such items as goods and services which were not necessary, restaurant meals out, vacations, and luxury items.
It is a fact of life that this discretionary income decreases first when there are problems that lead to payroll reductions or losses of jobs. This is why those companies which sell discretionary types of good will be the ones which experience the greatest amount of pain in the periodic recessions, depressions, and economic downturns.
When an economy is healthy and growing, then discretionary income represents a significant and critical part of it. Individuals and families are only able to spend their money for items such as electronics, vacations, and movies when they have the surplus resources to do it. When consumers employ their credit card resources to buy these discretionary items or goods, this does not represent income which is discretionary. Instead it is merely growing their personal debt levels.
While many people tend to use disposable income and discretionary income as if they were interchangeable, they are in fact not the same. They represent different kinds of income. Discretionary forms of income come from disposable income. Income that is disposable equates to gross income, less taxes. This means that it is effectively the pay people take home after taxes which they can utilize for non-essential as well as essential costs.
Discretionary income is instead the amount of income that remains from the original disposable income once the bill payer has covered mortgage or rent, food, transportation, insurance, utilities, and other unavoidable costs of living. Looking at an example helps to make this clearer.
If individuals earn $5,000 each month (after taxes are taken out) in take home pay, they may have $2,500 in critical costs. This would leave them with $2,500 for the month in discretionary income. Should their checks become reduced to $4,000 per month, these earners would still have the ability to cover their essential expenses. Their extra income would be reduced to $1,500 as income that was discretionary.
The amount of such income which is discretionary remains one of the crucial measurements of an economy’s health. Economists and analysts employ it and the related concept disposable income to come up with other critical economic ratios. Among these are the MPS Marginal Propensity to Save, MPC Marginal Propensity to Consume, and consumer leverage ratios.
Consider the following example. In the year 2005, the personal savings rate of the United States turned negative and stayed this way for a full four months in a row. Once the consumers had covered all required expenses from their disposable income, they then spent the remainder of all their discretionary income and more. They utilized their credit cards, personal lines of credit, and home equity loans and home equity lines of credit to fund other discretionary purchases which they honestly simply could not afford.
This was a dire warning about the upcoming economic problems which began to materialize the following year of 2006 as the subprime mortgage crisis unfolded. By 2007, the Great Recession and Global Financial Crisis had both begun in earnest. Though they technically ended officially in 2009, in many countries of the Western world including the United States, the income and prosperity levels have still never returned to those pre-crash levels even a full decade later. Most of the problems which surfaced were predictable by watching the ways that discretionary income was being used and abused. Negative savings rates which the consumers pursued in order to continue funding their discretionary lifestyles spelled financial doom eventually.