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Measures of Fiscal Policy in an Islamic Economy

An Islamic economy would use most of the fiscal measures designed for a non-lslamic economy, although, as we shall see, the application and impact of such measures would be different. There are, however, unique fiscal measures, which may be considered an integral part of the Islamic economic policy. Only two measures will be examined here: (a) the tax of Zakah, and (b) the economic dues.

The Tax of Zakah

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We have already mentioned that Zakah is one of the cornerstones of nomic conditions of the Muslim society. It is, nevertheless, a form of tax. Hence it must be considered a fiscal measure. Yet it cannot be considered a fiscal tool that the authorities can use to achieve economic objectives in the same manner as they can use other taxes. This is so for three reasons:

  1. The tax of Zakah is a religious tax. It must be collected by Muslim authorities at all times whatever the economic situation may be.
  2. Although no form or ratio of the tax of Zakah has been prescribed by the Holy Quran, the Prophet (peace be upon him) prescribed certain ratios on different types of incomes and assets. According to religious views, these ratios are fixed and unchangeable. It follows that the rates of the tax of Zakah cannot be changed (increased or decreased) to achieve economic objectives. In other words it cannot be used as a fiscal tool.
  3. Not only are the ratios fixed but the purposes for which the proceeds of the tax can be used are quite explicit. These objectives are stated in the Holy Quran in Chapter 9, verse 60. The proceeds shall be allocated to: (1) the poor, (2) the needy, (3) the officials over them, (4) those whose hearts are made to incline (to truth), (5) the (ransoming of) captives, (6) those in debt, (7) those in the way of God, and (8) the wayfarer. With regard to those whose hearts are made to incline, the law has ceased to operate since the time of the Prophet (peace be upon him) because he bestowed Zakah upon them as a gratuity to prevent their molesting Muslims and also to secure their occasional assistance. But when the faith gained strength, the custom of bestowing this gratuity was abandoned.

There is for each kind of wealth, a minimum exemption called Nisab. In the case of silver it is approximately 21 ounces; in the case of gold 3 ounces. For other forms of wealth, the Nisab is udged by the value in silver. Zakah is not due from the necessaries of life such as dwelling houses, articles of clothing or household furniture. According to contemporary religious views, Zakah is imposed at a levy of 2.5 per cent (or 1 /40th protion) on assets which are capable of growing (including cash in hand, idle deposits with banks, silver, gold and other jewellery) and on net earnings from transactions and at a levy of 10 per cent on net returns from investment (i.e. after allowing for depreciation).

The preceding paragraphs imply that Muslim authorities cannot manipulate the tax of Zakah or its proceeds in response to changing economic conditions. However, despite the fact that Zakah is not a tool of discretionary fiscal policy, its existence has an extremely strong impact on the major economic variables in an Islamic economy. We shall examine its impact on the consumption function and the investment function.

Effect of Zakah on Consumption

The Mathematical Appendix shows that Zakah would have two effects on total consumer expenditure in an Islamic economy. Firstly, because of the tax of Zakah, both the average and the marginal propensities to consume would be higher in an Islamic economy than in a non-lslamic economy which does not have a similar fiscal measure. Secondly, because of the tax of Zakah, the investment gap at each level of income would be smaller in an Islamic economy which does not have a similar fiscal measure.

Zakah and Progressive Taxation

Keynes advocated progressive taxation as one of the important measures for alleviating unemployment, because it takes a relatively larger part of the incomes of the wealthy than it does of the poor, thereby providing some relief from the inadequate demand for consumption manifested in capitalist economies.

Progressive taxation is not, however, a panacea for unemployment. There are distinct limitations on the extent to which progressive taxes can be used to promote high levels of economic activity. The whole tax system must be progressive for effective results. Also, an inevitable limitation on the extent to which progressive taxation can be used arises from the fact that not all the money which is taxed away from the rich can be given directly to the poor, although to some extent this is done in the form of pensions, relief payments etc. The government which collects taxes for purposes of redistribution must either subsidise private citizens or expand the scope of its activities in order to provide social services for lower-income groups. Services such as education, medical care and public recreational facilities are illustrations. Although services of this type are of great social significance, they do not enable the low-income groups to increase the money income out of which they must feed, clothe and house themselves. Subsidies for housing, or low-cost government housing, are, of course, possible but tend to be strongly opposed by private interest groups. A further limitation to redistributing income by means of progressive taxation is the danger that high tates on large incomes may discourage private investment, upon which the private enterprise economy primarily depends for filling the gap between income and consumption at high levels of employment. If progressive taxation increases the community’s propensity to consume at the expense of weakening the inducement to invest, the losses in employment from the latter may more than cancel the gains from the former.

These limitations clearly show the superiority of the Islamic economic democracy and equality. They also show the superiority of the tax of Zakah, introduced over 1400 years ago, to the measures of progressive taxation introduced by Keynes. First, Zakah has a wider base than progressive taxation; it is imposed not only on incomes but also on idle assets. Secondly, the proceeds of Zakah go mainly and directly to the poor and needy and hence act immediately to raise the propensity to consume. Thirdly, the tax of Zakah falls heavily on assets which are capable of growing and would, therefore, have a stimulating, rather than a discouraging, effect, (as with taxation), on investment.

Fourthly, Zakah is a religious tax which must be collected at all times irrespective of the economic circumstances. Fifthly, the rates of Zakah are fixed and cannot be changed. Sixthly, the purposes, for which the proceeds of Zakah are used, can only be those stated in the Holy Quran.

Effect of Zakah on Investment

Because of Zakah, the demand for investment at a given expected rate of profit will always be higher in an Islamic economy than in a non-lslamic free-market economy. This is proven in the Mathematical Appendix. The relationship between the demand for investment in Islamic economies and the tax of Zakah is shown in Figure 2. It can be seen from Figure 2 that investment in Islamic economies can take An increase in the rate of dues to U2 will lead to reduction in the quantity of money demanded at Y1 to M2D, a further increase in the rate of dues to, say, U3 will lead to a further reduction in the quantity of money demanded to M3D.

Equilibrium between the money supply and the demand for money can be achieved in Islamic economies (where interest does not exist) through the manipulation of the rate of dues on idle cash. This is illustrated in Figure 4. In this Figure, the horizontal axis measures the quantity of money (supplied and demanded) while the vertical axis measures the rate of dues on idle cash. The curve representing the money supply is vertical, indicating that money supply is determined by the state and is independent of the dues. The demand for money is shown to vary inversely with the rate of dues on idle cash. At a rate of dues of U1 equilibrium will be reached at point Er If, at the present level of income there is a greater tendency to hold cash (say M2D) for, say, opportunity purposes, at the existing rate of the dues on idle assets, the state will raise the dues to a level high enough to discourage this greater tendency to hold idle cash. In Figure 3 the new level of dues on idle cash is given by U2. At this level, only will be demanded and thus equilibrium will be restored. The important point is that the state will not restore equilibrium by expanding the money supply to a level equal to M2D but by raising the rate of dues on idle cash. This will ensure that the money supply will not expand in an inflationary way simply in reaction to an increased demand for hoards which may later be disbursed without a corresponding increase in the flow of goods and services.

It is also important to mention here that the dues on idle cash are taxes and can therefore be imposed by the Muslim authorities irrespective of the actual rate of inflation.


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