Islamic Economy: Three-Sector Model

Modern economies offer two institutions to tackle the allocation and distribution problems, namely the market and the government. Alternatively, the two may be referred to as the private and the public sectors. Private sector is characterised by the forces of demand and supply, price and profit motive. The public sector acts not in defiance of the forces of demand and supply as reflected in the price phenomenon but as a corrective mechanism and as a supplement to it. In this sector profit motive is substituted by social welfare. In the so- called free enterprise economies, private sector is the prime allocative and distributive mechanism whose excesses, lapses and distortions are corrected by the public sector. The socialist economies reverse this role. Public sector is the prime allocative and distributive mechanism while the private sector acts as the minor partner in the process. However, an Islamic economy may be characterized as a three-sector economy. It will comprise of the private sector motivated by profit, the private sector free of any profit motive (the voluntary sector) and the public sector. Alternatively, we may describe the three insti tutions as the market, voluntary economic institutions, and the government. The three-sectoral characterization of the Islamic econo- my derives from the value premise of an Islamic society which involves the voluntary flow of a sizable part of its total resources in such activities as are considered to attain the welfare of Al-Akhira but have significant economic implications for the society.

To avoid confusion, it may be appropriate, at the very outset, to de- fine the third sector. It encompasses all such individual and social activities, which are not by intent or design, undertaken to attain any economic or material benefit for the doer or doers, but generate wide ranging economic repercussions. Thus though some of these operations may appear outwardly similar to the private sector but are essentially different in object and conduct. For instance, the cash disbursement of Sadaqat, creation of Auqaf, organization of education and health services for the poor, contribution (voluntary) to state’s defence needs, construction and maintenance of mosques, provision of shelter and meals to the way-farers and various forms of charitable activities fall within this sector. To this, we may add that part of Zakah, which may be left for assessment and distribution to the individual assessee — we mean Zakah on Amwal-Batinah (as specified, for instance, in recent Pakistan legislation). Empirical and historical evidence suggests that substantial economic and financial resources have passed through this sector in Muslim countries.12 The volume of the economic resources flowing through the third sector will be a function of the state of Taqwa of an Islamic community. It will be, so to say, a barometer of the state of moral health of the Ummah. It will be distinct from the public sector inasmuch as it will be totally free from any element of compulsion. Even in an Islamic society state operation will in effect be compulsive in nature even if overall design may be decisively moral and religious. Moreover, there is nothing wrong if the public sector is actuated by economic benefit and aims at maximization of profit or of eventual social good. But the third sector will lose all, if it aims at economic benefits.

The Allocation Function

The allocation function in an Islamic economy will be performed through each one of these institutions separately as well as jointly with each institution working complementarily to the other. But each sector will operate in its own characteristic way. The market mechanism, however, will not be the only institution in the allocation branch. Its allocative function will be implemented through the price mechanisrrf acting in conjunction with the profit motive. The pattern emerging out of the market mechanism will, however, be modified by the voluntary institutions operating through Sadaqat and non-profit economic activities of the economy. This modification may basically alter certain economic magnitudes and flows.

In the first place the allocation of sizable monetary resources through the voluntary institutions may increase private expenditure in some crucial avenues of productive activity where the market fails to operate. For instance, it is likely to increase private expenditure on the production of goods and services beyond the equilibrium indicated via the equality of marginal revenue and marginal cost. In modern market based economies such a shortfall in production is compensated by supplementary public expenditure. It may also channelize privately-owned savings in such avenues that do not indicate a reasonable rate of return to private investment. As an illustration, we may cite the production of coarse textile fabrics. The profit motive of the private businessman prevents him to expand his supplies to meet the full societal requirements. For such an expansion is likely to exercise a downward pressure on prices, thereby reducing the reasonable rate of marginal return, a calculation not wholly based on objective cost assessments but partly derived from subjective evaluation of what constitutes a reasonable rate and the expected rate of return in alternative investment. The second case may be illustrated through the provision of rent-free schools, development of shrines etc. Thus voluntary institutions may do two specific things. They may make-up the shortage of output of goods and services which the market fails to do, and secondly invest in such avenues as do not attract private capital motivated by profit.

Public and Quasi-Public Goods

Modern economists usually classify goods into two separate categories, namely, private goods and public/social goods. The latter defined as those economic goods which the entire community consumes, and in whose respect cost and revenue calculations are not possible on account of the indivisibility of benefit derived therefrom. For instance, defence is a public good. Radio and T.V. networks are other examples. It will be more appropriate, however, to define public goods not on the basis of the indivisibility of the benefit derived there from but on the basis of their being non-profit goods, that is to say, goods required by the society whose benefit is not translatable in terms of economic revenues. For example, investment in education, science research, health, certain items of social overheads etc. In all modern economies production of public goods is usually reserved for the state. The state ensures allocation of a part of the community’s resources to the production of public goods, usually through conscription, or borrowing. In an Islamic economy, however, the voluntary institutions will play a significant role in certain areas of public and quasi-p buc goods. Private resources may be passed to the state for some activities, or may be directly expended on their production. For instance, education is one important area where considerable private resources may flow without the scantiest regard for a reasonable rate of return. In this respect it may be pointed out that religious general and scientific or technical education are all treated at par insofar as they jointly improve the quality of a Muslim community and its prowess. That is the reason why all knowledge has been strongly recommended by the Prophet’s tradition as the goal of the Muslims. Next is the provision of health. The care of the diseased, incapacitated, weak and poor is necessary. Thirdly, defence may also claim sizable part of resources channelized through the voluntary institution. We may, therefore, envisage that in an Islamic economy voluntary institutions will provide not an inconsiderable part of the resources required for the production of public and quasi-public goods and services.

Gross National Output and its Composition

The voluntary institutions will exert a direct influence on consumption and national output. The disbursement of accruals from Auqaf, Zakah and Sadaqat to those who do not have financial resources to buy certain goods/services in desired quantities are likely to enter the market and thus raise the money demand. With higher marginal propensity to consume, the receivers of these funds are likely to spend proportionately greater part of their income on consumption. Given excess capacity and unemployed resources, this phenomenon may release forces that increase output of such consumption goods as enter the poor man’s budget. That may result in a different pattern of intersectoral and intrasectoral allocation of resources and alter the composition of society’s output. It is obvious that the resultant change in the composition of output will be in favour of poorman’s goods and services. This will be an indirect allocative impact of the voluntary institutions which will express itself through the market.

Optimum Allocation

An optimum intersectoral and intrasectoral allocation of resources is a desirable objective of every economy. The market mechanism fails to bring about a desirable pattern of intersectoral allocation of community’s resources for the obvious reason that it acts on the basis of profit — the only relevant factor in its behaviour. Its decision as regards the priority of investment in different sectors may not coincide with the optimum required by the sum total of socio-economic benefits or costs. Any deviation from this optimum is corrected by the state both through regulatory techniques and direct participation in the economic process. In the three-sector model we have presented above the distortions emerging out of the market mechanism will be rectified by the voluntary institutions as well as the government. We have already indicated above that an allocation pattern weighted in favour of luxury goods/or comforts will be suitably altered by the activities of the voluntary institutions. Thus within the industrial sector (intrasectoral) itself an altered allocation of resources may be brought about. As between industry, agriculture and services, the allocation emerging out of the market will be similarly modified. We have already discussed above, the way in which social services will attract not an inconsiderable part of resources flowing through voluntary institutions.

Role of the State

It may be safely asserted that a significant part of the role associated with government in correcting distortions of deviations from the socially optimum allocation of resources will be taken over by the voluntary institutions. Even though minimal, the government’s role will not be in any way less important. First, the government may alter the pattern of voluntary institutions’ expenditure through its educative effort. It may provide the necessary information in respect of the needs of the poorer classes, expend a part of the resources handed over to the public sector in accordance with its own assessment of priorities, alter the time and spatial distribution of Zakah and Sadaqat resources, use or cause to be used a part of these resources in directions where the play of market forces has resulted in supply deficiencies. As indicated above the voluntary institutions’ economic behaviour is likely to change the market allocation of resources through its impact on consumption demand. But the government sector’s allocative function will not be limited to indirect or complementary/supplementary measures. Its allocative function will also relate to direct public expenditure in those avenues where neither of the two sectors, jointly or separately, are able to enter, or where supply deficiencies require a larger share of community’s resources than that allocated otherwise. It may also involve the removal of sectoral disparities generated through the economic activities of the two sectors.

Deviations from, or failure to attain, the socially optimum allocation of resources will, therefore, be corrected by the government sector. Although such a failure of the market mechanism may be partly compensated by the voluntary institutions in an Islamic economy, gaps are still likely to remain for the reason that this sector too, by reason of its individualistic approach, will fail to take a total view of society’s economic and social needs. Although proceeding from different value premises, and working under different assumptions, both the market and voluntary institutions may result in socially sub-optimal allocation of resources. An example may help in understanding this situation better. Roads connecting the market with the production point may be translatable in terms of cost/revenue calculation of an entrepreneur. But roads connecting far off villages to the town are most likely to be excluded from the list of profitable investment of the private sector as well as the voluntary institutions evaluation of what is useful for the under-privileged in the society. Similarly industrial projects with long gestation periods are likely to attract much less capital than necessary. Hence, the government sector will be required to step in.

Given its concept of social welfare, and given its value premise the Islamic economy will decide the mix of its resource allocation between the three sectors. Where and if, the actual and optimum intersectoral allocation of resources do not coincide, the government will strive to correct the intersectoral imbalance of resource allocation through the devices indicated above as well as taxes. Contemporary discussions of optimal intersectoral allocation of resources, may be traced back to Hansen and Galbraith.13 Hansen contends that public sector should be used to promote the educational and cultural development of Americans, the “submerged tenth”. He believes that economics in a mature society should emphasize social priorities rather than goal of maximum national output. Galbraith asserts that due to traditional bias against public sector spending and what he calls a "dependence effect" there has been an under-allocation of resources to the public sector. This discussion, however, does not indicate a theoretical principle which may guide an optimal allocation of resources, except that of relevance of social objectives. The attempt made by some economists to work out a precise formula of resource allocation through the indifference curve technique is at best arbitrary. The production potential of the society, as determined by its resources and technology is brought into a relevant relationship to society’s preference for public and private goods, as made effective by the state of income, wealth and political choice and shown through an indifference map. But that is an effort which proves conclusively that no criterion based on “value free” marginal analysis of a universally valid optimum intersectoral allocation of resources is possible. The Islamic economy will determine the optimal allocation of resources between three sectors with reference to its social norms and value premises. Its guiding principle will be the maximization of aggregate social welfare which has both a material as well as spiritual dimension.

An optimum allocation of resources in an Islamic economy may be defined as the one that establishes an equilibrium between the moral and economic imperatives of the society, given its income, and the state of technology. As indicated above moral imperatives will be primarily taken care of through the voluntary institutions, while the institution of market will reflect its economic imperatives. The public sector will not only supplement the economic activities of the two but will also act in a way calculated to ensure a better performance by both. In addition to this aspect of the government’s economic activities, the allocation function of the public sector will also involve direct public expenditure to help the economy reach the equilibrium indicated above.

The Distribution Branch and Islamic Economy

Although in an Islamic economy the distribution function will be performed through the activities of the voluntary sector aided and sup plemented by government operations but for purposes of the present analysis, let us assume that most part of Zakah resources — the chief distributive device — are imbursed through the state. Thus distribution function may be initiated through any facet of the government budget ranging from expenditure policies to various forms of government revenue-gathering activities.

The main objective of distribution function may be achieved through either an exhaustive public expenditure programme or a scheme of negative taxes and/or transfer payments or other secular taxes on income and wealth. Since Zakah proceeds are envisaged as the principal redistribution mechanism in an Islamic economy and since it is traditionally a form of transfer payment let us start with it.

Zakah as Negative Tax

The transfer of funds between individuals through Zakah disbursements or other taxes may redistribute real income amongst the members of the society via the redistribution of purchasing power. Zakah payment may be conceived of in terms of what is described as a “negative tax”. Under the concept an individual is considered to be capable of making a positive tax contribution to the government if his personal income exceeds poverty level but is considered eligible to receive the negative transfer of funds from the government if his personal income is below a designated poverty level of income. Under Ztffoj/7/transfer payment the government may similarly designate a poverty line based on current living standards and make payment to those individuals whose income falls below the poverty line so designated. But the calculation of such eligibility will be more complex ip an Islamic scheme of things. Any poverty line designated with reference to current standards of living will have to be adjusted in the light of Zakah Nisab. Nisab allows for a dynamic interpretation in terms of cost of living index and reasonably defined current standards of living. But sometimes there is a loose link between current incomes which fall short of needs and one’s saving in terms of gold/ jewellery, which exceed Zakah Nisab. Hence, the disbursement of transfer payments, will have to take into account both of these aspects of the situation.

A 100 per cent payment of transfer funds to bring individuals above the poverty line may have to be revised for its likely disincentive effect on work effort. Thus a trade-off may necessarily arise between the goal of alleviation of poverty and protection of work efforts. In case 100 per cent transfer /Zakah payment conceived as negative income-tax to bring individual above the designated poverty line involved an expenditure in excess of Zakah proceeds, a trade-off may inevitably arise between the goal of mitigation of poverty, preservation of labour incentive and loss of revenue. In that situation a 40 per cent or 50 per cent payment may be considered as sufficient.

Exhaustive Public Expenditure and Redistribution Function

Modern governments have the option to redistribute real incomes either through transfer payments or direct availability of certain important quasi-public goods to the poor. A mix of both the approaches, however, is a realistic policy goal. There are some pertinent questions that arise in this respect when we proceed to analyse the approach of an Islamic state to its distributive function. As we have seen above Zakah disbursements in the form of transfer payments/or negative income-tax have traditionally been considered valid. But the formulation of an exhaustive public expenditure programme intended to make available to the poor certain important public or quasi-public goods financed out of Zakah revenues is received with mixed feelings by Muslim scholars. At any rate, two forms of public expenditure programmes for the poor are universally approved. These are education and health programmes. Educational programmes not only improve the ideological and cultural receptivity of the poor but enhance their income-earning capacity as well. Empirical studies have conclusively proved a positive functional relationship between human resource development and aggregate economic performance of a nation/com- munity/group of people. The tendency of the market to under supply education stems from its nature of being a quasi-public good, that is to say, a good whose benefits defy easy quantification or pricing. But increase in the supply of education to the poor has a redistributional role as well. If free of charge, it confers direct financial benefit on the recepient and ensures future financial returns in terms of increased earnings. In this regard technical education is of greater importance. It benefits the poor more by increasing their skill and income earning capacity.

An Islamic state’s distribution function may, therefore, be performed through an expenditure programme of education, medicaid, medicare facilities. These items belong to allocation as well as distribution branch of fiscal economics. But direct provision of a number of private goods, such as textiles, shoes, medicinal drugs, etc., free of cost or at cheap rates to the poor, and financed out of Zakah funds are also permissible from the Shari'ah point of view.

Stabilization Function and Islamic Fiscal Policy

If we assume that Islamic economies are expected to belong to that part of the present world which is characterized as underdeveloped, many of the destabilization problems, such as the deflationary or inflationary gaps of the intensities experienced by advanced economies will not be relevant. Still some such problems as monetary inflation, temporary recession may be experienced depending upon the financial organization of the Islamic economy.

If the Islamic economies opt for a fractional reserve monetary system, where banks have the power and ability to create bank money, excess credit situations may occur. The substitution of interest by mudarabah or profit-sharing and consequent restructuring of the capital market, are expected to establish a direct link between bank money and productive investment. But the urge of the banker to seek more and more avenues of investment will still be there, with the significant difference that he will be directly exposed to losses, if the investment is not profitable in the strictly economic (not financial) sense. It is sometimes argued that such a direct involvement is most likely to dissuade the banker from excess credit creation since marginal investment may be highly risky. But the fact that bank portfolio may be quite wide ranging and that losses in some investments may be absorbed partly by the cushion provided for this purpose, and the specific provision in terms of reserves may insulate the shareholders from shock of losses, may still encourage the banker to create excess credit. Any amount of credit that does not correspond to the real resources elsewhere in the economy may generate inflationary pressure. To this urge we may add differing interpretations of what is an economically profitable investment. The banker, intent upon maximizing the earnings of his shareholders, may include not only productive investments in his list of sound investment projects but quite an impressive schedule of commercial transactions as well, which do not add an iota to GNP. In the absence of speculative transactions involving bonds and stocks, wide fluctuations in market conditions are not feasible. Hence such investments will continue to be attractive. Thus bankers in an Islamic state may also be prone to excess credit creation. Financing of public expenditure through the printing press, or bank borrowing (free of interest) may accentuate the inflationary gap.

Zakah collection and its disbursement may act as effective stabilizing agents against such a situation. Zakah levies even though not directly connected with current income will, in effect, constitute a charge on it. With fixed rates, Zakah levies will, therefore, constitute an inbuilt fiscal stabilizer. Zakah disbursements, however, may work as discretionary fiscal stabilizers as well, with the government managing it as it does the transfer payments, or exhaustive government expenditure programme.

It may, however, be pointed out that because of the Zakah rate and base being given, it may not be adequate to the needs of the situation in some periods. In that situations, other taxes, whose rate may be varied, and transfer expenditure, which are not financed out of Zakah may be Used to that effect.

A comprehensive set of fiscal measures appropriate to an Islamic economy may be designed to remedy such a situation. The elimination of modern varieties of purely financial papers and speculative trading in them, will exercise a restraining influence on excess money supply. In addition, the state may devise discriminatory penal taxes on some investments and business that exert relatively higher destabilizing effect on the economy. Moreover, it may decrease/increase public expenditure depending upon the needs of situation.


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