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Fiscal Policy in an Islamic Economy

Macroeconomic literature is reasonably rich with discussions on fiscal policy (i.e. government tax, expenditure and debt policies) in both developed and developing free-market economies. The aim of this paper is to show that fiscal policy in Islamic economies [i.e. economies which would be strictly ruled by Islamic laws derived from the teachings of the Holy Quran, the traditions of the Holy Prophet, Muhammad (peace be upon him), and the practices of early Muslims] would differ in its role, objectives, measures and mechanism from that in non-lslamic economies.

Fiscal policy would play a much more important role in an Islamic economy than in a non-lslamic free-market economy for the following reasons.

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1. The role of monetary policy will be relatively much more limited in an Islamic economy than in a non-lslamic free-market economy for at least two reasons:

  1. The rate of interest does not play any role in an Islamic economy. Muslims are forbidden to receive any interest on any type of loan (personal or otherwise). Thus in an Islamic economy a variation of interest rates as an important tool of monetary policy does not exist.
  2. Islam does not permit gambling4. This applies not only to races, games of cards and other conventional gambling activities but also to many types of speculation and certain forward transactions which take place in non-lslamic economies5. This has two implications: (i) Open market operations would not be very effective in an Islamic economy. Stock exchange would definitely not play as great a role in these economies as in non-lslamic free-market economies where speculation is an integral part of economic life, (ii) There would be no speculative demand for money in the Keynesian sense. However, the possibility of holding cash to wait for more profitable opportunity is allowed. This opportunity demand for money would be subject to both Zakah and dues on idle cash. The absence of “Keynesian speculative demand” for money and the non-existence of interest imply that the bond market will not play an important role in Islamic economies.

2. Irrespective of the economic conditions in an Islamic economy, a strictly Muslim government must ensure that the tax of Zakah (a religious tax) is collected from every Muslim whose wealth exceeds a specific minimum value and that the proceeds are used for the purposes specified in Chapter (or Surah) 9, verse 60 of the Holy Quran6. This built-in fiscal policy device is unique to Islamic economies7. However, as we shall see later the tax of Zakah even though it has important repercussions on the major economic variables, can not be used in Islamic economies as a discretionary fiscal tool in the same way as other taxes. Economic dues other than Zakah are the crux of fiscal policy in Islamic economies.

3. There are substantial differences between Islamic and non- Islamic economies in respect of the role and management of public debt. Since all loans in Islam are interest-free, much government spending is financed either from the proceeds of taxes and dues or (in case of productive projects) on a profit-sharing basis. Hence, the size of the public debt is much smaller in Islamic economies than in non-lslamic economies. In a national war, Islam conscripts not only labour, but also capital.


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