Mechanism of Fiscal Policy

In trying to achieve the desired economic objectives, an Islamic economy may use its fiscal tools differently as compared to non-lslamic economies. In this section we shall examine the mix of fiscal tools available in an Islamic economy to achieve full employment, to curb inflation and to mobilize savings in order to accelerate economic growth. We shall also consider the issue of the “balanced-budget multiplier” and of public debt policy. In so doing, we shall concentrate on new dimensions and leave aside those aspects which are discussed in macroeconomics textbooks.

Use of Fiscal Policy in an Islamic Economy to Cure Unemployment

It is possible that, in an Islamic economy the aggregate demand curve intersects the aggregate supply curve at a point which corresponds to a level of employment less than that of full employment. This would occur if investment were not sufficient to close the gap between national income and consumption expenditure. In other words, the highest expected rate of profit may be inadequate to induce businessmen to undertake sufficient new investment. Pessimistic business expectations result in a shortfall of investment for securing full employment. But because the only alternative available to savers is to hold idle assets, including the holding of cash, the Islamic authorities can easily stimulate aggregate demand by raising the rate of dues on idle assets This would have two effects:

  1. It would stimulate private investment because the alternative to investment is likely to be more costly. Thus more investment would be forthcoming at the present level of business expectations. In other words, if the rate of dues on idle assets were higher than the expected rate of loss on investment, more investment would be forthcoming.
  2. A significant portion of the increase in the revenue from the dues could be passed over, in the form of transfer payments, to the poor and needy whose marginal propensity to consume is usually relatively high. This would stimulate consumption expenditure and contribute towards closing the gap between income and consumption. Moreover, the stimulation of consumption expenditure would push the expected rate of profit upward and this would stimulate private investment even further.

Hence, the rise >n the rate of dues on idle assets would result in an increase in aggregate demand until full employment is achieved.

The use of dues on idle assets in Islamic economies to solve problems of unemployment during severe depressions is more effective than the use of expansionary fiscal policy in non-lslamic free-market economies.

In the latter economies, the increase in government expenditure to solve the problem, could, depending on how it has been financed, results in an increase in the price level which would cause the real money supply to decrease. The decrease in money supply will cause the rate of interest to rise and this will cause investment to fall. The net expansionary effect of the increase in government spending will, therefore, be reduced. Clearly, such an adverse effect on investment does not occur when the rate of dues is used as an economic measure to achieve full employment in Islamic economies.

During periods of moderate recessions, the above analysis would still hold, i.e. the Islamic authorities would stimulate aggregate demand by raising the rate of dues on idle assets. This would still be more effective than the use of fiscal policy in non-lslamic free-market economies in which, in periods of moderate recession, an expansionary fiscal policy will be, for the most part, offset by rising interest rates so that the resultant increase in aggregate demand will be modest. The reason for this is that a significant divergence from the normal rate of interest does not occur during these periods and the demand-for money curves would be almost vertical in this interest range. In addition, there exists a sizable lag between recognizing the need for economic stimulus and the chosen policy having its effect. This means that the increase in aggregate demand resulting from the fiscal policy may not come into force until the economy is well into the expansionary phase of the cycle. This ill-timing of the stimulus would produce excess aggregate demand and inflation. Instead of producing economic stability the policy results in greater instability. This would not be the case with raising the rate of dues on idle assets since such a rise would have an immediate impact on the economy. Savers would feel immediately the burden of the tax if they continued to hold idle assets and the poor and needy will get more income most of which is likely to be spent quickly.

This does not mean that in Islamic economies government expenditure will not be used for stimulating demand. History tells us that public spending in Islamic economies of the medieval period was extremely important. Thus Ibn Khaldun ‘insisted on the role of the State in the economy before Keynes”. He explained that the government performs a function on the demand side of the market. If the government stops spending, ‘‘business slumps and commercial profits decline because of the shortage of capital”.

There is, of course, no need to repeat here what is written in most macroeconomic textbooks on the use of government expenditure in stimulating aggregate demand.

Use of Fiscal Policy in an Islamic Economy to Curb Inflation

In non-lslamic free-market economies, demand-pull inflation can originate in the real sector or in the monetary sector while cost-push inflation results from imperfections in either the labour market or the product market.

In a closed Islamic economy, demand-pull inflation is more likely to take place than cost-push inflation, given the economic postulates of Islam. This, however, does not mean that trade unions can not exist in an Islamic framework. It only implies that in such framework, harmony is brought about through a social contract reached between the employers and the employees in order to avoid social exploitation.

The above implies that, in an Islamic framework, the aggregate supply curve will not shift to the left because of monopoly power on the part of either employers or employees. Hence, the possibility of inflation accompanied by unemployment is not likely to exist in a closed Islamic economy.

Let us assume that the economy is at full employment and that, for some reason, the government decides to increase its expenditure and to raise the necessary finance by an increase in dues on personal income equal to the increase in expenditure. Since we started from a position of full employment, the increase in aggregate demand (due to the fact that not all the dues would have been spent by the tax-payers) cannot result in an increase in real national income but must manifest itself as a rise in money incomes. In other words the same level of output will now be demanded at a higher price level.

There are two curves for inflation in Islamic economies. The first is through an increase in the rates of dues on personal incomes. This will result in a decline in consumption which will cause a shift in aggregate demand towards the equilibrium (full employment) price level. The second method is to make use of the reserves accumulated in Baitul Mai. These reserves are made up of the proceeds of Zakah and dues which were not spent during a particular time period. These reserves can be manipulated in a manner which ensures economic stability. During periods of inflation, the Muslim government could spend less than its reserves from full-employment proceeds. This would result in a high degree of economic stability.

Use of Fiscal Policy in an Islamic Economy to Accelerate Economic Growth

In a developing Islamic economy, accelerated economic growth may become the primary objective of fiscal policy. Since growth is a function of the rate of savings, fiscal policy should aim at achieving the maximum mobilization of savings in these economies.

Also, increased government expenditure may be needed to build the necessary infrastructure and to invest in projects which are not attractive to the private sector.

Since interest is prohibited by Islam, mobilisation of savings in Islamic economies takes place through direct participation of savers in entrepreneurship. Savers themselves may start small enterprises or may combine with partners to organize a bigger concern or subscribe towards the large capital of a joint stock company. Shares rather than bonds will predominate in a financial market with zero interest rate. There is no barrier, under such conditions, to a government’s raising funds for productive public enterprises by issuing shares rather than bonds, and dividends can replace a fixed rate of interest.

The financing of profit-producing government projects is carried out in an Islamic economy through the application of the principle of “partnership”. The government institutions carrying out these projects can obtain the necessary finance directly from the public through the issue of ordinary shares of small denominations. The shareholders will share profits and losses. Their liability, however, will be limited to the values of their share. In this way public investments (railways, hydroelectric works, canals, large iron and steel works, shipyards and similar works) can all be built up without borrowing money at interest.

Non-profit-producing government projects may be financed from one or more of the following sources: (i) the general revenue; (ii) the imposition of a special tax; and (iii) the surplus of government’s profit- producing enterprises.

Of special interest here is finance for military purposes. No-interestbearing war loans are allowed by Islam. In a national war, Islam not only conscripts labour, but also conscripts capital. The Quran says “God hath bought from the believers their lives and their wealth, for theirs (in return) is the Garden (of Paradise): They shall fight in His cause and shall slay and be slain. It is a promise which is binding on Him in the Torah and the Gospel and the Quran. Who fulfilleth his Covenant better than God?”. According to Islamic doctrine both soldiers and capitalists should share the burden of national wars and if the physical brunt of the war is borne by the same generation.

The above suggests that the quantity of public debt outstanding in an Islamic economy would be minimal (not zero) and that such debt would be interest-free. This means that its management would not be as difficult as in non-lslamic economies, for three reasons, (i) The government does not have the problem of servicing the debt, interest being zero, (ii) The debt, even though it would have to be repaid eventually, could be regarded as a “roll-over” debt since its age of maturity can be postponed with no cost to the government, (iii) Because the debt is relatively small, the government does not have to run substantial surplus-budgets at relatively frequent intervals to service it.

This last point suggests that Islamic economies would tend to use balanced-budgets; i.e. the government increases its expenditure and its taxes by equal amounts. This would result in an increase in income equal exactly to the increase in government expenditure. The multiplier in this case is equal to unity.

This, however, may not prove to be the best strategy for the Islamic economies since these economies would have to rely more heavily on fiscal policy in achieving economic stability because, as we have already seen, monetary policy is relatively less effective in these economies and because the tax of Zakah has a built-in expansionary effect in the economy.

The best course of action may be to relate government expenditure plus Zakah to the amount of taxation (dues and others) in the following manners.

G =       T          —         Z          at periods of        full employment

G <       T          —         Z          at periods of        inflation

G >       T          —         Z          at periods of        depression

where    G          =          government        expenditure         in         a particular year,

Z = amount of Zakah collected and distributed in a particular time period, and T = amount of taxes corresponding to the full employment level of income.

The magnitude of the surplus during the periods of inflation and that of the deficit during the periods of depreciation would be determined in the light of experience.


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