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Comments on Risk-Bearing & Profit-Sharing in an Islamic Framework

Interest rate plays a crucial role in a capitalist economy. It influences resource allocation to various activities and inter-temporal distribution of income in consumption and savings. Interest rate changes are effective means of pursuing monetary policy, which may have a significant impact on general economic activity. On the other hand, Islamic economy does not allow interest and as such there has to be an alternative system to guide the managers and the consumers in making the right decisions regarding investment and savings. The question of what would replace interest rates in an Islamic economy has been of considerable interest to those working on Islamic economics. However, unfortunately the search for an alternative mechanism has always been in the context of a capitalistic economy as if without interest the capitalistic system will become very Islamic. It may be noted that interest is the cornerstone of the capitalistic system and the system will not work without interest. Moreover, while interest is not unjust in a capitalistic economy, there are a number of sources of exploitation in the system. On the other hand, Islamic system does not allow interest because it is considered a source of exploitation. Therefore, in view of these considerations, the author reaches the right conclusion that abolition of riba necessarily implies a rejection of the capitalistic system as a whole. Many other authors, notably Naqvi, have also reached the same conclusion. It is obvious then that instead of Islamising the capitalistic system by amending the capitalistic system here and there to suit the needs of an Islamic economy, we should try to evolve the Islamic system as a whole.

A number of authors, such as Siddiqi, assert that profit-sharing is a better, even perfect, substitute for the rate'of interest, but they never substantiate their argument. Moreover, how the system of profit- sharing will work is left out of discussion. Also left unanswered are a number of questions, such as the role of profits as an allocator of resources, efficiency of the production factors under a system of profit- sharing, and as a means of achieving equal distribution of income. While this paper raises these questions unfortunately it does not contain a satisfactory discussion to answer them. Instead, the author has concentrated on various systems of flexible wage rates currently being operated in some of the developed capitalist economies.


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The author has argued that the basic purpose of the Islamic economic system is social justice. He further argues that the major factor giving rise to income inequalities is the inability of labourers to take part in risky business, which in turn is due to the fact that labourers are unable to get credit against human capital. He suggests that since the labourers are unable to get credit, they should be made partners in the firms where they have been employed. He goes on to suggest that flexible wage systems imply that capitalists are sharing their profits with labourer because the employees have decided to share the risk. And it is here that the author has confused the whole issue. In the flexible wage systems the employees are paid in addition to the fixed wages, not because labourers participate in the risky business, but because it leads to an increase in productivity. Consequently, both capitalists and labourers are better off, and precisely because it increases the GNP, the flexible wage system is given preference to the fixed-wage system. Obviously, then, the arguments for flexible wages are not arguments for improvement in income distribution via participation in risks which the author believes to follow with the adoption of flexible wage system.

We may consider the suggestion of flexible-wage system made in the paper from two points of views. Firstly, if the flexible-wage system is better than the fixed-wage system, we should make the switch-over whether or not we adopt the Islamic system. Secondly, we have to analyse the author’s argument that flexible-wage system be'treated as workers’ participation in risk.

If flexible wages are preferable to fixed wages, and if while moving towards an Islamic system, we decide to adopt flexible-wage system, then it is a straight-forward matter. However, such a preference is not due to the Islamic system as such, and a country should adopt the flexible-wage system irrespective of any switch-over to Islamic economy.

If we interpret the flexible-wage system as workers’ participation in risk, we have to consider the following three issues:

  1. The alteration needed in the existing social institutions when the risk-bearing function is shared by employees,
  2. The issue of participation of workers in the income risk of the enterprise in which the workers are employed, and
  3. The issue of productive efficiency under various schemes of risk allocation.

However, before we start altering our institutions, let us analyse what an employee’s risk-bearing under flexible-wage system implies. Flexible wages interpreted in this way imply that the employees gamble with a part of their income. If the expected value of the gamble is positive, then the ‘dice is loaded’ and it is not clear why capitalists should accept the game. On the other hand, if it is a ‘fair’ game, i.e. the expected value of a gamble is zero, it is again not clear why the labourers who are generally risk-averters, should gamble a part of their wages. The author has suggested that with the emphasis on equitable distribution of wealth and income in the Islamic economic system, there will be more chances of capitalists willing to share their profits with the workers. Of course, this assumes that capitalists in an Islamic economy will be more humane, which is not a plausible assumption to make especially if one keeps in mind that instinct of the capitalists.

Defining profits as return only to risk and not to the invested capital implies a knowledge of the exact amount of rental to capital prior to profit distribution between capitalist and workers. However, in the absence of interest in an Islamic economy, we shall be unable to compute rental to capital and, therefore, the return to risk.

As said earlier, the main issue which needs very careful analysis and thorough research is profit-sharing and risk-bearing in the Islamic economy. Naturally, when interest is forbidden, and profit-sharing is the only alternative, every household which saves and wants to invest will have to necessarily take some risk. Similarly, every entrepreneur will have to share with his.financier productivity gains. This introduces an element of risk throughout the economic system and could possibly distort incentives for the entrepreneurs. In an Islamic system, would an option be available to a household to protect its savings against inflation without bearing any risk? Would a producer or a group of workers be able to raise capital without sharing the gains made through a more intensive utilization of the resources? These questions have been only partly answered in the literature and they need further research and discussion. Indexing of money in banks with the rate of inflation is one way of protecting the savings of a household. Should the blue-print of an Islamic economy not include this option?

As regards investment, Professor Naqvi has suggested that capital goods should be auctioned. This is a suggestion worth considering, because that way, the scarcity price of capital will be reflected in the producer’s decision. Another proposal could be to pattern the Islamic economy upon the Yugoslavian economy wherein capital is owned by the state and workers’ union can rent capital from the state. The profits are then distributed amongst the workers. However, rental to state will be similar to interest rate, but then the recipient will be the state not the individual. Whether Shari'ah would allow such an economic system or not will have to be assessed very carefully.

Dr. A. R. Kemal

 

A sound and true Islamic economic system, by definition, has to be based on the principles of Islam, as Deen. Islam, the last Deen of the Creator, brings principles which cover all aspects of man’s universe. And hence the complexity and almost impossibility of the task of the rule-definers in the new fields of socio-economic life. An Islamic economic system will be the expression and in several domains the materialization of divine principles of Islam in the daily economic life. Muslim economists have a gigantic task not only to avoid contradictions but to structure the Islamic economic framework according to and in complete harmony with these principles.

Islam, being a divine system, independent and different from others, cannot be reached and realised simply by correcting other systems, capitalism, socialism etc. This is why the question put forward by

S.Aftab Ali, whether “capitalism minus riba equals an Islamic economic system?” cannot get an affirmative answer. Certainly both systems are man-implemented and aim at human societies. But Islamic principles are Divinely defined and the aims are entirely different. From this point of view the problem of comparison between Islam and capitalism becomes irrelevant. One basic aim, in capitalism, is profit maximisation. This can even be considered the essential characteristic of that system. Capitalism is essentially an economic system based not solely on the institution of riba but on the conception of absolute “maximisation of profit” at all costs (a tout prix). This conception is alien to Islam and even contradictory to it. In Islam “profit” has to be legitimate and must be obtained according to the rules of Shari'ah. Whereas in capitalism, profit searching legitimates all actions and in its original form the system is "ethical free”.

But in the framework of “social policy”, and especially since the second half of 19th century, some anti-social aspects of capitalism began to be corrected. This happened under the pressures of the efforts of religious movements, trade unions, socialist parties, benevolent societies and writers. In order to realise social justice the State has to take action to ensure social equality and more recently a welfare society. Measures to reduce poverty, hazards of work, uncertainty, social disturbances, radical movements and political revolutions require a considerable reduction in the number of working hours per person per week, the recognition of the right to coalition for workers, the protection of women and children against some practices of work, the fixation of minimum wages, prohibition of arbitrary dismissal, extension of social security system and acceptance of free collective bargaining for the definition of working conditions. At the same time, these practices are aimed at the “humanization” and the “democratization” of the capitalistic system. The standard of living of citizens in capitalistic countries has advanced remarkably since the last century. This progress is partly due to economic development and higher real incomes for the population as a whole and partly due to the social policies, some important aspects of which have already been mentioned above.

In the capitalistic countries now a number of new measures have been implemented and new institutions set up aimed at humanization and democratization of capitalism. Workers participation in decision making in a firm as well as several mechanics of co-determination and profit-sharing schemes are also recent practices adopted for the same purpose. As it has been rightly pointed out by Syed Aftab Ali, these are “a step in the direction of industrial democracy”. These new measures, particularly that of risk-bearing and profit-sharing by workers, aiming at the welfare of the labour and the democratization of industrial relations, although mainly considered positive elements brought into a new social policy, failed to change the very basic nature of the capitalistic system which is based on its own institutions and conceptions, such as profit-maximization, riba, the principle of free competition-market economy, private ownership of goods of productions, class relations, money and credits mechanism, banking and financial systems etc.

Risk-bearing and profit-sharing schemes can be welcomed in the field of industrial relations. If we look at the matter from Islamic economic point of view, it can bring material advantages to the workers, strengthen democracy and increase productive efficiency of the firms. But certainly introducing and developing a profit-sharing mechanism in the capitalistic system, is not going to change the nature of this system into an Islamic one. Islamic economic system is independent of others and is not a corrected form of some systems. It has its own principles and framework, derived from the Divine text and tradition of the Prophet (peace be upon him).

In the light of this basic observation one can discuss several aspects of the profit-sharing scheme. The risk is divided by the shareholders of joint-stock corporations and measurement of their liability is at the level of their invested capital. This invested capital and the profit it brings are measurable in money unit circulating in the market. To transform the factor labour into a “social over-head” poses the problem of measurement from the very beginning in this framework of profit- sharing. This problem seems also unsolvable in four profit-sharing schemes which have been analysed in S. Aftab Ali’s valuable paper. An answer to this problem, though, can be provided in a purely theoretical framework but theoretization may lead to unrealistic models specially in the domain of social, economic and financial policies. Some well- established schemes of profit-sharing and co-determination, different type of workers’ participation, such as “mitbestimmung” in Federal Germany, implemented in the Western industrialised countries can be examined closely in order to conceive more operational proposals specially for Islamic countries which are almost entirely developing economies. In these Islamic countries, the sources for investment in education, including technical and vocational education, are limited and as a consequence of its human capital cannot gain increased significance in the economy in a short span of time.

In a profit-sharing system, these participating workers are having the status similar to the shareholders of a joint-stock company except that they are employed in the firm. In the presentation of S. A. Ali, the workers are shown to foregb part of their wages. Against their labour employed in the firm, workers can and must get a secure income for their living. The only source of income for the workers is, by definition, the wages of their labour, and this has to be guaranteed. If the workers are not wage-earners, the profit-sharing system conceived until now changes radically and they become pure shareholders working in the firms.

A more pure living example of workers having the shares of the firm and being joint owner of the enterprise, regardless whether they are working in it or not, is best given by Turkish Workers’ Companies (T.W.Cs). These Companies are founded by Turkish workers’working in Western European countries. And have developed from the experimental stage to a real factor of industrialization and of job creation in the under-developed regions of Turkey. At present these Companies have completed about 100 industrial projects in Turkey and are involved in some 60 more. These projects have opened up employment opportunities for 20,000 people. The number of T.W.Cs are nearing 150 and of the workers who are members (shareholders) of these companies are nearing 155,000.

T.W.Cs are based on the.self-help initiatives of Turkish workers who live abroad, mostly in Federal Germany, and who invest their savings in the form of shares in order to establish a company in Turkey. As a rule, T.W.Cs are formed by small numbers of founder-members abroad in the form of a Turkish stock company and are registered in Turkey. In the original stage, they are strongly dependent on individuals, i.e. they are linked to the existence and motivation of local leaders. Several of these local leaders are Imams and other religious men. T.W.Cs exclude, in their statutes majorisation by large-scale investors (banks, government etc). As a rule, legal entities or individuals must not hold more than 10 per cent of the original capital. The shares are issued in the name of the holder and are transferable only after a certain time period. The majority of the T.W.Cs favour shareholders in the distribution of jobs.

T.W.Cs are encouraged by the government through a series of special rules and regulations. Turkish State Industry and Labour Investment Bank has given the objective of supporting workers investment and help them to use their savings efficiently. The example of workers’ savings going directly to investment project instead of depositing it, against riba, in the banks is given by T.W.C. Here the workers are bearing the risk and sharing the profit. Certainly in that model they are not wage-earners, provided they are not working in the firm. If they do they have both status at the same time: wage-earners and shareholders. This example given by a Muslim country, can be studied closely by others.

One lesson is clear from T.W.C. as long as a worker buys the share of his own company and becomes a real shareholder the system is workable. The system can also work if the credits received by the workers are used in buying the share of the company. But the idea of borrowing against human capital seems very abstract. Muslims, whether workers or not, can be attracted by ethical considerations and can prefer to invest their savings into investment projects, bearing the risk and sharing the profit, rather than to deposit the same into banks against the riba. The motivation of a Muslim is different from home economics of capitalistic systems.

The thoughtful and valuable paper of Dr. S. Aftab Ali raises other important issues for economists, Muslims and non-Muslims alike.

Dr. Nevzat Yalcintas

 

General Comments. The three general comments are:

In general, the paper is a good summary of works by Dreze, Franke and others on the theory of Labour-Management pertaining to allocation of risks and productive efficiency under different wage systems. But unfortunately the paper’s contribution in furthering our understanding of Islamic economics is very little or marginal in the sense that the paper has not examined any of its objectives or hypothesis in the light of Islamic economic values as reflected in Shari'ah. This is evidently clear not only from a few passing remarks about Islam but also from the references used. Excepting only one article on “Money and Banking in an Islamic Framework” which is not really relevant for the purpose of the article, no books on Islam, not to speak of Islamic economics, are consulted as mentioned in the references. The fact is that in a scientific research in Islam what is needed is to put forward a hypothesis or hypotheses which can be confirmed or rejected or replaced. Consequently, we can adopt or adapt or reject some of the existing socio-economic institutions regardless of any economic system. Considered from this viewpoint the paper has not advanced our knowledge base in Islamic economics.

It follows then that the title of the paper is somewhat misleading. In my view the appropriate title of the paper should be Riskbearing and Profit-sharing in Market Economy. In the paper there is hardly any discussion of analytical nature with reference to principles of Islamic economic behaviour governing the whole range of labour- capital relationship, wages etc.

Lastly, in the paper we find several instances of a shift of assumption and or contradictory assertions or assumptions. For instance, while the author maintains that Islamic prohibition of riba implies rejection of the entire capitalist system he comes out rather strongly that the various types of profit-sharing schemes can co-exist with the highly developed financial institutions named on interest as found in the USA, Canada, UK and especially, West Germany. Does this imply that the profit-sharing schemes under an Islamic framework can also work within the existing capitalistic system? Does it imply that Islamic economic system can adopt or adapt some of the socioeconomic institutions and practices of the capitalistic system, for that matter, socialistic system? These are questions which need clear answers.

Let us now turn to specific comments on the paper.

Specific Comments. The eight specific comments are as follows:

 

  1. While the potential scope of optimal risk allocation should be extended, resulting from investment in human capital, it may not lead to an automatic increase in labourer’s share of income as maintained by the author. Investment in human capital may not necessarily lead to increase in incomes unless it is accompanied by necessary social and institutional reform. This is documented on the basis of income differential between the black and white graduates in the USA. The stress on institutional all reform is all the more important where societies are stratified.
  2. The paper discusses the obstacles in borrowing against human capital on a large scale from the existing commercial banking operation based on interest, as the paper uses the “incompatibility of interest” of workers, banks and firms. The desire of the worker for limited liability comes into conflict with “the interest” of the bank to obtaining the safeguard of possible “unlimited liability”. The paper is completely silent as to how to turn this “incompatibility of interest” into “compatibility of interest” under Islamic framework? The question arises as to how to institutionalise the workers’ participation in the income risks in an Islamic state? The paper has not touched this issue from the Islamic angle.
  3. The author has further maintained that the existing commercial banks have not used the human capital of workers as a basis for their credit worthiness in a significant way and that without resorting to legal means, bank cannot secure reimbursement from the defaulting debtors. It is not, however, clear what makes the author to assume that the existing commercial banks may not have to resort to the same level means against the defaulting workers when loans against human capital are used to buy their shares facing the prospects of loss or actual loss. The paper has not spelled out or indicated the type of institutional reform needed to achieve the Islamic goal of “integration” where the interest of the workers, banks and firms can reconcile.
  4. The author’s contention that any profit-sharing scheme implies worker’s foregoing a part of their wages has a doubtful validity in the light of Shari'ah. If uncertainty with regard to a part of wages is accepted as a strategy for worker’s participation, an institutional arrangement, free of exploitation by capital owners need to be evolved.
  5. The author’s suggestion of “collective profit-sharing” lacks analytical rigour in the sense that the danger of possible growth of worker’s monopoly power with its attendant evils needs to be examined closely. The paper is silent as to how this monopoly of human capital cannot emerge under an Islamic framework.
  6. It is implicit in the analysis that under profit-sharing schemes the firm is expected to pursue profit-maximising goal. It is not, however, clear from the paper whether this objective will remain valid in Islamic scheme of affairs.
  7. The paper came out very clearly in favour of adjustable wage system. The analysis based on the assumption of a Pareto Optimum criterion which can hardly be accepted in Islamic framework. By far the greatest deterrent to using the Pareto criterion lies in tackling the problem of income distribution. If giving a means taking from B, then a narrow interpretation of Pareto criterion rules out such a transfer. As such the Pareto criterion for judging efficiency can not be widened into the yardstick of welfare and happiness of workers unless the prevailing distribution of income (land and wealth) is acceptable to the community. The author’s proposed risk allocation and diversification cannot ignore the existing level of income distribution a point which seems to have been ignored in the paper. The equitable risk allocation calls for a framework of equitable income distribution.
  8. Lastly, the author’s recommendation for “pure incentive system as the most preferable wage system” appears to have a relative validity only in the case of firms producing “private goods” where it is easy to put a “price tag”. What about the sectors or industries dealing with production of ‘social goods’? What is the remedy when labour shortage takes place in the case of firms or industries showing the prospects of lesser profits. These questions need to be tackled in the paper.

In conclusion, it should be pointed out that if the paper will make a contribution to Islamic Economics then it should be revised in the light of the above comments. As it stands, the paper is essentially a good summary of the most recent works on labour-management in the context of market economy as the author himself acknowledged this without any claim to originality. The paper has, however, raised a number of issues and questions which can be related to Islamic economic values, thereby serving as a basis for an in-depth study.

Dr. M. A. Mannan

 

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