MBF707: Monetary and Fiscal
Framework in Islamic Finance
COMSATS Institute of Information
Technology (Virtual Campus)
Lecture 32
Summary of the Course
(Part 2)
2
Fiscal Policy
Introduction
Elements of FP
Constraints
Three Sector Model
Allocation Function
Role of the Government
3
Main Elements of the Theory
1. Islamic economy is a three-sector economy, (the
private sector, the voluntary sector, and the public
sector). The three sectors working in conjunction,
furnish the institutional framework of an Islamic
economy.
2. Zakah provides the base of the fiscal system and
defines its scope of operation within the general
institutional framework of the Islamic economy.
4
Main Elements of the Theory
3. The allocation, distribution and stabilization
functions of an Islamic economy are processed and
implemented through all these sectors jointly.
4. Public sector’s role is minimal but crucial in so far as
it operates continuously to ensure an optimal
allocation of community’s resources, rectifies suboptimal distribution of income, and introduces an
element of stability.
5
Is a Fiscal Policy Possible in an
Islamic State?
The socio-economic policy goals of an Islamic state are
as follows:
1. Justice and equity.
2. Provision of the socio-economic needs of the
community or socioeconomic welfare.
3. Enhancement of the community’s economic
resources or economic growth.
4. Improvement in the cultural milieu of the
community.
6
Is a Fiscal Policy Possible in an
Islamic State?
 Zakah is the most important fiscal and distributive
mechanism of an Islamic economy.
 But Zakah may generate certain incidental effects on
the economy, which can be redressed only by an
appropriate mechanism of secular levies.
 A situation may arise where Zakah levies may lead to
such a diversion of resources that is not desirable
from the point of view of general socio-economic
goals of the society.
7
System Constraints on Taxation
 The transfer of resources may exert an upward
pressure on the price level.
 Taxation policy will be suitably adjusted to arrest the
price spiral.
 Zakah levies may cause a sudden diversion of
resources from savings to overspending; from
investment in Zakah-able to Zakah-free economic
activities whose overall impact on the economy is
likely to be detrimental to general welfare of the
Islamic community, tax policy will have to be
readjusted.
8
ISLAMIC ECONOMY: A THREESECTOR MODEL
 Modern economies offer two institutions to tackle the
allocation and distribution problems, (market &
government or the private and the public sectors).
 Private sector is characterized by the forces of
demand and supply, price and profit motive.
 The public sector acts as a corrective mechanism and
as a supplement to it.
9
FP-Automatic Stablizers
Automatic stabilizers
a)Progressive & Proportional Taxes
b)Price Ceiling & Price Flooring
Discretionary fiscal policy
a)Contractionary Fiscal Policy
b)Expansionary Fiscal Policy
10
The Beginning of FP
Classical economy
 Classical economic theory has always claimed that the economy is
always at full-employment.
 Guarantee that, all output produced by firms will be taken up by
consumers on the principles that, supply creates its own demand.
 In the short-run there will be temporary disequilibrium in the
capital, labor and product market, but in long run the economy is
always in equilibrium or full employment.
 The market is therefore perfect and there is no need for government
to interfere in the economy.
 However classical economy was proven wrong as the US economy
got into the Great Depression in the 1930’s. There was huge amount
of unemployment due to business shut downs and bank failures. It
clearly shows that something went wrong with the market.
11
The Beginning of FP
Keynesian economics
 In criticizing the classical economist, J.M Keynes
(1936) says that there is not enough demand in the
market.
 In his explanation of short run, it is the demand for
goods and services that will determine the level of
GDP, rather than the supply of factor inputs.
 The Great Depression was a result of low spending by
consumer and business.
 The spendings were not enough to bring back the
economy to full employment. The only way to raise
demand and GDP is increasing government spending.
12
Solving for Y
Y  C  I  G
equilibrium condition
Y  C  I  G
in changes

C
 G
 MPC  Y  G
Collect terms with Y on
the left side of the equals
sign:
(1  MPC)  Y  G
because I exogenous
because C = MPC Y
Solve for Y :


1
Y  
  G
 1  MPC 
THE GOVERNMENT PURCHASES
MULTIPLIER
Definition: the increase in income resulting from a $1
increase in G.
In this model, the govt
Y
1
purchases multiplier equals

G
1  MPC
Example: If MPC = 0.8, then
Y
1

 5
G
1  0.8
An increase in G
causes income to
increase 5 times
as much!
An increase in taxes
E
Initially, the tax
increase reduces
consumption, and
therefore E:
E =C1 +I +G
E =C2 +I +G
At Y1, there is now an
unplanned
inventory buildup…
C = MPC T
…so firms reduce
output, and
income falls
toward a new
equilibrium
Y
E2 = Y2
Y
E1 = Y1
Supply-side Economics
In 1980’s American economy was hit by
stagflation. Most of the economists blamed
over-regulation, decreasing productivity and
motivation to increase output among
producers.
Neoclassical economic thinking surfaced in the
disguise of supply-side economics calling for
changes in taxes to produce more output than
increasing economic activity.
16
Fiscal Policy in Islamic Perspective
 Quran has guides what a good fiscal policy should
be like. Surah Yusuf (12:43-49) tells the story of a
Pharaoh in Egypt who had a strange dream.
 The king of Egypt shares his horrible dream with
his subjects but none of them could interpret it..
Then Yousuf, the holy prophet of Allah was
contacted to interpret it. The Prophet of Allah
forecast famine for couple of years in the future.
The king surrendered and handed over the kindom
to Yousuf to manage the situation which he did very
successfully. .
17
Traditional Revenue Sources of
Islamic State
Zakat
Special levy or tax on wealth and agriculture products.
Kharaj
Land tax
Jizya
Poll tax on non-Muslims
Ghanimah
Spoils of war
Fay’
Properties received from enemies without actual
fighting
‘Ushur
Custom duties
18
FISCAL POLICY:
Empirical Approach
19
Distribution of Zakat
The 8 categories of people,
1. The poor, One who has neither material assets
nor means of livelihood;
2. the needy, one with insufficient means of
livelihood to meet basic needs;
3. Zakat administrator, one who is appointed to
collect and administer Zakat-efficiency.
4. New convert, one who has converted to
Islam;
20
Distribution of Zakat
The 8 categories of people,
4. New convert, one who has converted to Islam;
5. slave, one person who wants to free himself from
bondage or the shackles of slavery;
6. debtor, individual who is in debt when he/she
borrows money to buy basic needs consisting of
halal expenditure;
7. path of Allah, one who fights for the cause of Allah;
8. finally, a wayfarer, one who is stranded in a journey.
21
The market for goods & services:
Conventional Approach
Aggregate demand:
C (Y  T )  I (r )  G
Aggregate supply:
Y  F (K , L )
Equilibrium:
Y = C (Y  T )  I (r )  G
The real interest rate adjusts
to equate demand with supply.
The loanable funds market:
Conventional Approach
A simple supply-demand model of the
financial system.
One asset: “loanable funds”
– demand for funds:
investment
– supply of funds:
saving
– “price” of funds:
real interest rate
Demand for funds: Investment:
Conventional Approach
The demand for loanable funds…
– comes from investment:
Firms borrow to finance spending on plant &
equipment, new office buildings, etc. Consumers
borrow to buy new houses.
– depends negatively on r,
the “price” of loanable funds
(cost of borrowing).
Types of saving: Conventional
Approach
private saving = (Y – T) – C
public saving
= T – G
national saving, S
= private saving + public saving
= (Y –T ) – C + T – G
=
Y – C – G
Conventional Approach
 For any variable X,

X = “the change in X ”
 is the Greek (uppercase) letter Delta
Examples:
 If L = 1 and K = 0, then Y = MPL.
Y
More generally, if K = 0, then MPL 
.
L
 (YT ) = Y  T , so
C
=
MPC  (Y  T )
= MPC Y  MPC T
THE AGGREGATE OUTPUT EXPENDITURE ANALYSIS
In recent years there have been numerous studies focusing on
Islamic banking and financial sector. These studies introduce
instruments of fiscal policy as Zakat, without considering in the
macroeconomic model to pursue the objectives of fiscal policy
 Zangeneh (1995) formulates a neoclassical macroeconomics
model for an interest free economics system. The model shows
that saving and investment do not necessarily fall in an Islamic
economic system, an Islamic economic system is viable and
the model also provides unique solutions for income,
employment, and prices.
 Metwally (1983) finds that Zakat expenditure has the ability to
increase the aggregate consumption since the marginal
propensity to consume of the Zakat payers is lower than that of
27
Zakat recipients.
THE AGGREGATE OUTPUT EXPENDITURE ANALYSIS
 Zakat expenditure has a role in the national income
determination; the higher the Zakat expenditures the higher the
increase in the equilibrium output.
 Tahir (1989) introduces Zakat in an Islamic macroeconomic
model focusing on the determination of aggregate output
associated with the degree of inequalities in an Islamic
economy.
 He finds that the aggregate output depends on autonomous
expenditures, income distribution, and Zakat flows.
 Awad (1997) advocates a Zakat-based tax structure as a means
to stimulate growth, stabilize the economy, and promotes
social cohesion.
28
THE AGGREGATE OUTPUT EXPENDITURE ANALYSIS
 In this lecture the population is divided into two groups: those
who pay Zakat and those who receive Zakat as transfer
payments.
 This lecture discusses equations for consumption, Zakat, and
taxes and then derive the reduced form consumption equation
and the Zakat multipliers from which we infer the impact of
Zakat on national income determination and its efficacy as
stabilization policy.
29
THE ZAKAT, TAXES,
INVESTMENT AND
GOVERNMENT
SPENDING
MULTIPLIERS
30
Review
GDP = Y = C1+ CZ + I + G + X – M
(1)
C = C1+ CZ , personal consumption expenditure,
 The three sources of income, we obtain the national income as
Y = Yw + YA + Yπ
(2)
 GDP is obtained by adding the indirect taxes and depreciation, that is,
GDP = Yw + YA + Yπ + TIND + δ
(3)
Use of national income (GDP) as:
Y = C1 + S + Z + T
(4)
Consumption of the Zakat Payer, C1, is
C1 = C01 + c1( Y – Z - T) , 0 < c1 < 1
(5)
Consumption of the recipients of Zakat is CZ,
CZ = C0z+ cz ZE ,
0 < cz < 1
(6)
ZE = Zakat disbursed by the government.
When cz = 1 (6) becomes
CZ = C0z+ ZE
(6b)
31
Sum-up
This Zakat identity holds
ZE = Cz + Sz
(6c)
Thus
1 = dCz/dZE+ dSz/dZE = MPCz + MPSz.
The aggregate consumption, C, is
C = C1 + Cz = C01 + c1 ( Y – Z - T) + C0z+ cz ZE
(7)
If cz = 1 then C = C01 + c1( Y – Z - T) + C0z+ ZE
(7b)
 We shall use consumption equation (3) in the subsequent analysis.
The Zakat collection from individuals’ wages and salaries, Zw, is
Zw = zw(Yw- C0w - C0n )
(8)
C0n = nisab (min consumption determined by Islamic State).
C0w = the exemption to the Zakat payers for basic needs,
zw = Zakat rate.
32
Sum-up
 (Yw – C0w - C0n ) = zakatable income.
 A0 = Assets at period 0
 rA= rate of return on assets (A)
 Asset at the end of that year is: A1 = A0 ( 1 + rA)
zA. = zakat rate
(a) If rA ≥ zA at least sufficient income to pay Zakat.
(b) If rA < zA asset’s owner has to liquidate asset to pay Zakat.
 Zakat collection from the asset from all individuals, ZA , is
ZA = zA(A1 – C0A- C0n)
(9)
33
Sum-up (Review)
Substituting A1 = A0 ( 1 + rA) and let YA = rA A0 ,
equation (9) can be written as
ZA = zAA0+ zAYA - zA (C0A + C0n )
(10)
C0A = exemption to the individuals earning income from the
transactions of assets.
zAA0 = does not contribute toward the production of currently
produced goods and services and therefore excluded from GDP.
Income generated by the assets, YA , is included in GDP.
Zakat collection on profits, Zπ , is
Zπ =zπ ( Π – C0π - C0n )
(11)
C0π = exemption;
C0n = nisab level;
C0π = exemption for R&D, training etc.
34
Review (Zakat Collection)
Z = Zw + Z A + Zπ
Substituting for Zw , Z A , and Zπ , we have
Z = zw (Yw – C0w - C0n ) + zA(YA- C0A - C0n )+ zπ(Yπ - C0π - C0n ) +
zAA0
(12)
Let zw = zA = zπ, then equation (12) reduces to
Z = z(Y – C0E - C0N ) + z A0
(13)
where
Y = Yw+ Yπ +YA ,
C0E = C0w+C0A + C0π ,
and
C0N = C0n+C0n + C0n .
35
Sum-up
Tax collection
Tw = T0w + tw[ Yw– Zw]
(14)
Net tax collection from profits, TП, is
Tπ = Tπ0 + tπ[ Yπ - Zπ]
(15)
Net tax collection from asset income, TA, is
TA = TA0 + tA( YA – ZA )
(16).
where Tw0, TП0 , and TA0 are the lump-sum taxes.
36
Review (Zakat & Tax Collection
Tax collection
T = Tw+ Tπ+ TA
Substituting for Tw , Tπ and TA, we have
T = T0 + tw[ Yw– Zw] + tA[ YA – ZA] + tπ[ Yπ - Zπ] (17)
whereT0 = Tw0+ TП0 + TA0.
The terms in the brackets are the taxable income which are the income after
Zakat from wages and salaries, asset income, and profits respectively.
Substituting equation (17) for Zw, ZA, and Zπ , we obtain
T =T0 + tw [Yw– zw ( Yw – C0w - C0n )] + tA [YA - zA(YA - C0A - C0n ) ] tA z A0 + tπ [Yπ - zπ(Yπ - C0π - C0n)]
(17b)
37
Sum-up (Total Zakat Collection)
Tax collection
tw = tA = tπ = t
and that the Zakat rates are also equal to
zw = zA = zπ = z.
Y = Yw+ Yπ +YA.
Thus (17b) can be simplified to
T =T0 + tY– tzY + tz C0N + tz C0E - t zA0
(18)
38
Sum-up (Total Zakat Collection)
Tax collection
Substituting the tax equation (18) into the consumption equation
(7) we obtain,
C = C01+ C0z + c1Y– c1Z – c1T0 - c1tz C0E - c1tz C0N - c1t Y
+ c1z t Y + czZE + c1 t z A0
(19)
Substituting Z = z(Y - C0E - C0N) into (19), aggregate
consumption function in reduced form is
C = C01+C0z + (c1– c1z - c1t + c1z t)Y + (c1z - c1tz)C0E + (c1z
- c1tz)C0N – c1T0 + czZE + c1 t z A0
(20)
39
Sum-up (Total Zakat Collection)
From 20 aggregate consumption in an Islamic economy
depends on:
1. Income,
2. Exemption levels,
3. Taxes,
4. Zakat expenditure,
5. Asset holdings of individuals.
Taking total differential of (20),
dC = dC01+ dC0z + (c1– c1z - c1t + c1z t)dY + (c1z - c1tz)dC0E
+ (c1z-c1tz)dC0N–c1dT0 + czdZE + c1tzdA0
(20a)
40
Sum-up (Total Zakat Collection)
Determinants of consumption are as follows:
Effect of Income:
∂C/∂Y = [c1– (c1z + c1t )+ c1z t] > 0
Since c1 > 0; 0 < c1 < 1,
0 < z < 1,
0 < t < 1 and
therefore the term (c1t +c1z) is expected to be smaller than c1.
Effect of Exemption:
∂C/∂C0E = (c1z - c1tz) > 0
Since 0 < c1 < 1 ; 0< z < 1;
0 < t < 1,
therefore
(c1z > c1tz)
41
Sum-up (Total Zakat Collection)
Effect of taxes,
∂C/∂T0 = – c1< 0
Zakat expenditure
∂C/∂ZE = cz > 0
Effect of wealth
∂C/∂A0 = c1 t z > 0
42
Sum-up-Review (Multipliers)
Y=C+I+G
(21)
 G = G0 is the government spending from taxes,
 I = I0 is the gross private investment (exogenous).
The Zakat, taxes, investment, and government spending
multipliers is derived by substituting the consumption (20) into
the national income identity (21) to obtain
Y = C01+C0z + (c1– c1z - c1t + c1z t)Y + (c1z - c1tz)C0E + (c1z - c1tz)C0N
– c1T0 + cz ZE + c1tz A0 + I0 + G0
43
Sum-up-Review (Multipliers)
Rearranging and simplifying,
Y = [1/(1- c1+ c1t - c1tz + c1z)] [C01+ C0z + (c1z - c1tz)C0E +
(c1z - c1tz)C0N – c1T0+czZE+c1tzA0+I0+G0 ]
(22)
The total differential of (22) is
dY = [1/(1- c1+ c1t - c1tz + c1z)] [dC01+ dC0z + (c1z - c1tz)dC0E
+ (c1z - c1tz) dC0N – c1 dT0 + cz dZE+c1tz dA0 + dI0 + dG0
(23)
Since C0N is fixed therefore dC0N = 0.
The multipliers for C01 , C0z , T0, I0, G0 and ZE are obtained by
taking partial derivatives of (23) with respect to each of the
variables.
44
Sum-up-Review (Multipliers)
Autonomous consumption (Zakat Payer):
∂Y/∂C01 = [1/(1- c1 + c1t + c1z - c1t z)] > 0 (23b)
Autonomous consumption (Zakat recipient):
∂Y/∂C0z = [1/(1- c1 +c1t + c1z - c1t z)] > 0 (23C)
Exemption Level:
∂Y/∂C0E = [1/(1- c1 +c1t + c1 z - c1 t z)] [c1z -c1tz ] > 0
(24)
The tax multiplier:
∂Y/∂T0 = [- c1 /(1- c1 +c1t + c1 z - c1t z)] < 0
(25)
Autonomous investment multiplier:
∂Y/∂I0 = [1/(1- c1 +c1t + c1 z - c1 t z)] > 0
(26)
45
Sum-up-Review (Multipliers)
Government Spending Multiplier:
∂Y/∂G0 = [1/(1- c1 +c1t + c1 z - c1 t z)] > 0 (27)
Multiplier for assets:
∂Y/∂A0 = [1/(1- c1+c1t + c1 z - c1t z)] > 0
(27b)
Zakat multiplier (cz < 1 ):
∂Y/∂ZE = [cz /(1- c1 +c1t + c1 z - c1 t z)] > 0
Zakat multiplier (cz = 1 ):
∂Y/∂ZE = [1 /(1- c1 +c1t + c1 z - c1tz)] > 0
(28)
(29)
46
Sum-up-Review (Aggregate Consumption)
When Zakat collection is not equal to Zakat disbursement:
C = C01+ C0z + c1Y– c1Z – c1T0 - c1tz C0E - c1tz C0N - c1t Y + c1z t Y +
czZE + c1 t z A0
(19)
When Zakat fund is spent then Z = ZE:
C = C01+ C0z + c1Y– c1ZE – c1T0 - c1tz C0E - c1tz C0N - c1t Y + c1z t Y +
czZE + c1 t z A0
 Simplifying, we obtain
C = C01+ C0z + (c1- c1t + c1z t) Y + (cz – c1)ZE – c1T0 - c1tz C0E - c1tz
C0N + c1t z A0
(19b)
47
Sum-up-Review (Multipliers)
Substituting for C of (19b) in national income identity (21) and taking the total
differential, we obtain
dY = [1/(1- c1 +c1t -c1t z)] [dC01+ c1tz dC0E + dC0z – c1dT0 + (cz - c1)dZE
+ dI0 +dG0]
(30)
Multiplier for the autonomous consumption for the Zakat payers:
∂Y/∂C01 = [1/(1- c1 +c1t - c1 t z)] > 0
(31)
Multiplier for the autonomous consumption for the Zakat recipients:
∂Y/∂C0z = [1/(1- c1 +c1t - c1 t z)] > 0
(32)
Multiplier for exemption:
∂Y/∂C0E = [1/(1- c1 +c1t - c1 t z)] [c1t z ] > 0
(33)
The tax multiplier
∂Y/∂T0 = [- c1 /(1- c1 +c1t - c1t z)] < 0
(34)
48
Sum-up-Review (Multipliers)
Investment multiplier:
∂Y/∂I0 = [1/(1- c1 +c1t - c1 t z)] > 0
(35)
Multiplier for government spending:
∂Y/∂G0 = [1/(1- c1 +c1t - c1 t z)] > 0
(36)
Balanced Zakat multiplier
∂Y/∂ZE = [(cz – c1) /(1- c1 +c1t - c1 t z)] > 0
(37)
Zakat multiplier (when cz = 1)
∂Y/∂ZE = [(1 – c1) /(1- c1 +c1t - c1t z)] > 0
(38)
Since 0 < c1< 1, the Zakat multiplier for this special case is
positive.
49
CONCLUSIONS
 In these lectures we incorporate Zakat into a simple
macroeconomic model of an Islamic economy to
analyze the impact of Zakat on the determination of
equilibrium income and see how Zakat plays its role
in the demand management policy.
 We derive the aggregate consumption function in
reduced form and found that the determinants of
consumption are: Zakat expenditure, taxes, income,
and asset holdings of individuals.
 We cannot change the Zakat rate to dampen the
macroeconomic fluctuations.
50
CONCLUSIONS
 The role of Zakat in the demand management policy is through
the non-discretionary (built-in stabilizer) and discretionary
policy.
 The built-in stabilizer mechanism occurs when Zakat
collection is automatically reduced during recession giving
more money to people to spend which tends stimulate the
economy;
 During the boom period more Zakat is collected, reducing the
ability of the people to spend which tends to dampen economic
activities. These reduce macroeconomic fluctuations.
51
CONCLUSIONS
 In the case of discretionary fiscal policy, the government
varies the disbursement of Zakat to the recipients and the
exemption levels to the Zakat payers whenever necessary
during the phases of the business cycle.
 During the expansion phase of a business cycle the
government may want to decrease Zakat disbursement and
exemption levels to reduce aggregate spending of Zakat payers
and thus prevent the economy from overheating.
 This action coupled with the fall in the number of eligible
Zakat recipients will help increase the Zakat surplus in the
Baitul-Mal.
52
CONCLUSIONS
 Zakat disbursement and exemption levels could be increased
when the economy is in the downswing to spur aggregate
spending and economic activities.
 Since the number of eligible Zakat recipients increases during
recession, the government could disburse more Zakat by using
the Zakat surplus accumulated from the boom periods.
 The ulama’ have unanimously agreed that an Islamic State
may impose taxes when its revenues are insufficient to cover
its spending implying that taxation and government spending
are compatible with Islam.
 Therefore Zakat, government spending, and taxation
complement each other as stabilization policy.
53
Thank You
54