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# Comments on Fiscal Policy in an Islamic Economy

#### Banking

In his paper on ‘Fiscal Policy in an Islamic Economy’, the author claims that Zakah causes the average and marginal propensities to consume to be higher than any other fiscal measure of a non-lslamic economy, and hence that it helps in closing the gap between income and investment at all levels of income. Without doubt, his basic thesis, that Zakah will interease consumption, is true. However, the other claims are not so clearly valid. Certainly, the proof of some of his propositions is erroneous. It is on this aspect of the paper that I would like to comment.

It is clear that any form of tax on wealth, being a disincentive to saving, must tend to reduce saving and hence increase consumption, Zakah, being such a tax, must tend to increase consumption and reduce savings. However, will the consumption, so achieved, increase investment? The effect is not clear. There could be an increased expenditure on consumer goods which does not contribute to investment, or there could be an investment boom, depending on the rate of inflation, the rate of interest, the level of confidence in investments, etc. A zero interest rate does not, by any means, ensure an increase of investment. (The topic has been dealt with extensively by Prof. Syed Nawab Haider Naqvi in various works.) It is clear that a progressive taxation scheme must lead to more consumption than a constant ratio scheme fixed at the lowest tax level. We see that the conclusions reached in the paper are clearly wrong. Let us now try to understand where the author went wrong.

There are various errors in the paper, some of a more technical kind and other of a more fundamental, logical, kind. Consider, for example, his equation M(4), (we refer to the equations in the paper under discussion by using an M with the equation number).

Z = «Y                                                                         (1)

Here the equation is not entirely meaningful. The problem lies with definition of the Y and Z. Y is taken to be the total income of the community and Z the total Zakah collected. Equation (1) then purports to say that 'Total Zakah is in a constant ratio to total income’.

The statement is true only in a tautological way. One might as validly say that ‘the total amount of Zakah is in a constant ratio to the total number of butterflies', or more generally ‘One constant is in a constant ratio to another constant’. For the statement to be meaningful it must relate variables. Let us look at the assumptions implicit in the derivation of the simple looking Equation (1).

We know that the Zakah, Z, paid by an individual, is given in terms of his wealth, we, by

Z          =          a' (w-n)                                            (2)

where n is Nisab and «' js a number, usually taken to be 2.5 per cent.

Now, if  there are N individuals in the community, 0N of whom pay

Zakah, the total Zakah collected will be obtained by summing Equation (2) over all Zakah-payers to give:

Z          =          a'Wz-<x'0nN                                  (3)

where Wz is the total wealth of the Zakah-payers.

The author clearly wants to assume a linear relationship between the wealth and the income, y, of all individuals. This assumption is invalid, but may be taken as being approximately correct. Since the income can be from sources other than stored wealth, we must take

y          =          oc"w + 7                                     (4)

where <*" is some constant measured in inverse units of time, as income is measured in units of money per unit of time, and y > 0 is salary, wages, etc. Clearly y is unrelated to w.

The error in Equation (1) is now quite clear. It lies in dealing with Z and Y as variables instead of as constants. Consider the ideal situation of an economy in which wealth is fully distributed. There Z = 0 and Y should be greater than in cases where wealth is not as well distributed. Thus, as Z increases, Y should decrease opposite to Equation (1). This point is brought out by Equation (6) which says that the Zakah increases with an increase of income due to wealth of the Zakah-payers but decreases with salary income increases. If there is no wealth beyond Nisab with any individual Zakah will obviously be zero and adequate redistribution of wealth will have been achieved. This point has been arrived at here by the use of mathematics, but it is economically obvious.

Let us now turn to the main proposition of the paper. The author starts with some assumptions which amount to the assumption that the average propensity to consume is greater than the marginal propensity to consume, which is positive thus

0< dc  <c

w      y                                                                      (7)

Dividing Equation (7) through by y we obtain

l dc _ £W <0                                                                  (8)

y y2

Which gives us

4y(f)<0                                                                          (9)

which yield the required conditions. Thus the economic assumptions of the author are just those mentioned above about average and marginal propensities to consume.

The author now makes the assumption that

C = a + gyb                                                                 (10)

where a > 0 and 0< b < 1, g >0. No attention is paid to the units in which quantities are measured. Clearly C is taken to be measured in units of money per unit time, a (in the same units) is just the minimal (subsistance) consumption. Now, since y is measured in the same units but is raised to some fractional power, g must be measured in units such that gyb is measured in units of money per unit time. When the author now postulates that with Zakah Equation (10) is replaced by

C = a + g (0-«)yb +g (1—/3+«)y5                              (11)

we see that there are serious problems. Let us look at the problems individually in some detail.

The first problem we are faced with is that Equation (11) makes no sense because g has to be measured such that gyb has the same units as gy^, which is not possible except when b = 5. Thus if Equation (11) holds in dollars it will not hold in cents. What is more is, if it holds in 1978, it will not hold in 1980 (due to inflation). Thus Equation (11) would have to be rewritten, to be meaningful as

C = a+g [(y/y1 )b (0-«) + (y/y2)5 (1-MI                       (12)

where y1 and y2 are some constant (specified) incomes and g is measured in units of money per unit time. There is a serious problem, now, of specifying y1 and y2, but at least the equation may be taken to be meaningful. This problem is dealt with by the author by taking b and 5 to be estimated statistically for some units, and changing with change of units. This method does not work as b may be less than 5 in some units and not in others.

Another problem is the meaning to be given to b and 5. There is no question of claiming that, there are marginal propensities to consume for Zofc<7/?-payers and non-Zo/?o/7-payers. That was only true if b - 6 = 1, as can be seen easily. Let us ignore the problem of why b and 6 should be supposed to be unequal when the dependence on income of the individual is already taken into account in the consumption function. Anyhow, now is the total consumption function being supposed to have the same (non-linear) functional form as that of the individual consumption functions. In fact, summing up Equation (12) [or Equation (11) for that matter] will not yield.

c = a+g [(0+«) (y/yn )b +g (i-0 + oc) (y/y2)61                  (13)

as b and 6 are not supposed to be unity.

The result obtained nevertheless contains some true part. Let us see where this comes from. The functional form taken in Equation (11) clearly increases C above its value given by Equation (10), for all values of income, the difference increasing for larger values of income. Thus all values of consumption and their derivatives must be greater in the form given in Equation (11) than that given in Equation (10). This fact is due to our having started off by saying that the introduction of Zakah brings in a higher propensity to consume (6 > b). Having assumed this fact to start with, it is certainly not surprising that we find it in the conclusion. Since this assumption was valid economically the result is true in spite of the erroneous analysis in so far as the assumption itself is true - but no further.

The author now makes a logical error. Having shown that the MPC and APC with Zakah are greater than those without any tax (which he has in fact assumed) he goes on to say that the MPC and APC with Zakah are greater with any tax on wealth or otherwise. This is simply not true. Any wealth tax must have the same effect. Worse still, the author’s analysis purports to show that a constant ratio income tax leads to an increase in MPC and APC. This is surely nonsense.

In the next section there are more simple (technical) errors. Thus, when the author writes

rn = r(1-e) + e                                                           (14)

he forgets about the units in which the quantities are being measured, e is just a number between 0 and 1 while r is measured in units of inverse time. Taking the equation to be meaningful nevertheless, the requirement that rn > 0 means that

r (1-e) + e > 0

or         e > r(e—1)                                                   (15)

which is just the positivity of e as e < 1. The author’s requirement that

r(e—1) > e         ;.                                                    (16)

is wrong as 0 < e < 1, because he requires that a negative quantity should be greater than a positive one.* Clearly the subsequent discussion is equally absured.

Let us now consider what can be reasonably said about Zakah. Historically, it is one of the earliest forms of wealth tax, and is the progenitor of all modern taxes on wealth. The purpose of Zakah is to provide social welfare. Notice that the modern idea of social welfare as a desirable goal also originates in Islam. However, when Zakah was originally introduced the economy was nearly static and very simple.

The modern, more complicated economies require more elaborate taxation schemes to ensure social welfare and social justice. For example, a sliding scale scheme may be preferable to the previous fixed ratio. It is not the name of Zakah, or the fixed ratio, that is the essence of Zakah, rather it is the purpose. Any wealth tax whose proceeds go to social wealfare is Zakah.

To sum up, I would like to stress the need to study the difference between a fixed and a sliding scale wealth tax before implementing it. In my opinion the paper under discussion has not done justice to the subject. To take true pride in the great achievement of Islam of introducing Zakah we should not revert to the early form of Zakah but try to find the most efficient way of achieving the goal of Zakah — social welfare. A more comprehensive view of Islamic requirements and goals, as is provided by Naqvi et. a/ is greatly needed to develop a meaningful Islamic economics.

It is a great pleasure to thank Prof. Syed Nawab Haider Naqvi and Dr. A. R. Kemal for many illuminating discussions on the subject, and for some detailed comments which have been incorporated into this discussion.

It is useful to remember what early Muslim scholars did in the domain of scientific research. They started by appraising the state of affairs, discarding theories and postulates which did not conform to Islamic principles. As for the rest of knowledge which did not run counter to Islam, they kept it and added to it. In addition, with the progress of the Islamic community, they developed new branches of scientific knowledge, such as Algebra, as well as deepening and improving the state of existing sciences.

It seems to me that in economics, at the present time, the task lying ahead is to do the same as our former scholars did. Our task as Muslim economists is neither to show that Islam can accept this theory or that idea, nor to show Islamic superiority over wordly theories. Islamic principles and tenets are superior par excellence and this is to be taken for granted. A further step would be to develop new economic theories and policies steming from Islamic principles.

Dr. Metwally’s paper could be looked at from this angle. He divides his paper into four parts, which deal with: the role of the fiscal policy in an Islamic economy; objectives of fiscal policy in an Islamic economy; measures of fiscal policy in an Islamic economy; and mechanism of fiscal policy in an Islamic economy. We shall discuss these parts successively.

Role of the Fiscal Policy in an Islamic Economy

Dr. Metwally considers the role of fiscal policy in an Islamic economy to be more important than in a non-lslamic free-market economy. It is known that the role of fiscal policy in Western market economies is manifold, namely allocation, distribution, and stability. If we add to this the objective of growth and development, it looks to me that the role of fiscal policy in an Islamic economy would be the same.

In this section the author rightly states that gambling is forbidden. But speculative demand for money is not always gambling. Thus speculative demand for money may exist in an Islamic economy. This is due to search for more profitable opportunities even in the absence of a bond market.

A further point stated by Dr. Metwally is that “open market operations would not be very effective in an Islamic economy” I can not see why? Furthermore stock-exchange would play a greater role in Islamic economies because of the extensive use of sharing as a substitute for borrowing. Zakah’s rates although cannot be changed between periods, are different for different assets. This may be so, among other things to stimulate productive activities.

Objectives of Fiscal Policy in an Islamic Economy

My main observation on this section is the confusion between the money “market” and fiscal policy. Since the Islamic economy will be monetized, there will be a scope for monetary policy. The abolition of interest rate does not mean that there are no other variables which govern demand for and supply of money. The rate of dues on idle cash suggested by the author is not sufficient for determining the demand for money. It should be complemented by the rate of return on investment in permissible activities. I feel that the introduction of the rate of return on investment (in assets other than bonds) would keep the post-Keynesian analysis intact. We shall discuss this point later.

Measures of Fiscal Policy in an Islamic Economy

The measures of fiscal policy examined by the author are Zakah and economic dues. Here the role of expenditure, is not discussed. This is done in Section IV. Therefore I would have preferred to label this part as sources of public revenue. The paper then discusses the effect of Zakah on consumption, investment and the demand for money.

As for Zakah on all idle assets, it is applicable to cash and deposits with banks, only if they remain idle for a complete year. This condition is important to mention because there can be some demand for money for speculative purposes, in the Keynesian sense, without being subject to Zakah.

The collection of Zakah is not subject to changing economic conditions. The proceeds of Zakah, however, will vary in boom and recession. On the other hand the domains for spending Zakah embrace all possible activities and these could be reallocated, and has been reallocated at the time of Umar Ibn Abdulaziz, between various uses in conformity with prevailing economic conditions. The author states a different point of view.

As far the effect of Zakah on consumption, I disagree with the author’s statement that “both the average and marginal propensities to consume would be higher in an Islamic economy than in a non-Islamic economy. The pattern of consumption is determined by a host of factors. Islamic values urge people not to be spend-thrift. It is true that Zakah will lead to a more equitable distribution of income and wealth. This does not mean, however, that the overall propensities to consume will be higher. In effect Duesenberry has shown, with the use of Veblen’s demonstration effect, that consumption as a proportion of a given level of income could be higher under inequality than under a more equitable distribution of income. I believe that in an Islamic economy, consumption would be less than that in a non-lslamic economy with the same level of income and size of population. It is not difficult to work-out an example which shows this.

The imposition of Zakah on idle money will not necessarily make any investment opportunity with the rate of profit(r) > 0 acceptable. However, one would be tempted to agree with the author that “the demand for investment at a given expected rate of profit will be always higher in the economies of Islam than in non-lslamic economies (at the same level of income).” (parenthesis are mine).

As far the effect of Zakah on the demand for money, I think that the three motives for the demand for money would exist in an Islamic economy. This matter needs a detailed analysis.

With respect to economic dues, I have a different point of view. My views in this regard are: (a) demand for money for speculative purposes is different from speculation in the general sense. If the latter is not allowed, the former need not be so; and (b) demand for money for transactions and precautionary motives is dependent mainly on income in both Islamic and non-lslamic economies.

The author states that "money supply in an Islamic economic framework will expand at a constant exponential rate equal to some proportion of the rate of growth of national income”. I fail to see why this should be the case.

Mechanism of Fiscal Policy in an Islamic Economy

The mechanism detailed in this section follows the accepted philosophy of stimulating demand during recession and constraining it if there are fears of galloping inflation.

My remarks on this section are:

1. In the discussion on the use of fiscal policy in an Islamic economy to cure unemployment, it would have been better to distinguish between developing and advanced Islamic countries.
2. I think in an Islamic economy, the possibility of experiencing both demand-pull and cost-push inflation does exist. It would have been better to discuss both cases rather than discarding cost-push inflation.
3. The statement that we would expect the marginal revenue of a Muslim entrepreneur to be equal to the product price, and the real wage paid by him to Muslim labourer to be equal to marginal product! assumes that perfect competition exists both on the product and factor markets. This is a far fetched assumption.
4. Translating Baitul-Mal in English to "the Central Islamic Bank’’*, is not accurate. Baitul-Mal is the Ministry of Finance or Treasury. The Central Bank is something different.
5. As for sources of financing government projects, I would add borrowing. Islam forbids interest but does not forbid borrowing when the need for it arises.
6. The possibility of a "roll-over debt” (which bears no interest) might be an additional source of inefficiency in government activities which should not be encouraged.
7. Adding Zakah to government expenditures and comparing it to the "amount of taxes corresponding to the full employment level of income” we might: (i) confuse the issues involved, because how do we add revenues to expenditures, and do we know what is the amount of taxes corresponding to the full employment level of income? An alternative formulation would be:

G = Z + U with U = 0 in full employment G<Z+U U>0in periods of inflation G > Z + U U<0in periods of depression

Sultan Abu Ali

Conclusion

Public finance in Islamic thought is a field distinct from other fields of economics. Muslim scholars have discussed it since the early years of Hijra. Dr. Metwally tried to relate Islamic thinking to current thoughts on public finance. In conclusion, I would have liked, before suggesting the use of “economic dues”, to see an estimate of Zakah proceeds as a percentage of GNP. Then to assess how this could affect the economic life of the society. I- would expect that the proceeds of Zakah if properly collected and spent could more efficiently tackle the various economic conditions which might prevail in a country, than the secular management of public finance.

Source: Fiscal Policy and Resource Allocation in Islam, Ziauddin Ahmed, Munawar Iqbal and M. Fahim Khan. Republished with permission.