A  Short Outline of The Foundations of 

Islamic Economics




The early 1990’s have witnessed the collapse of the  USSR  and the downfall of communism as one of the major events of this century and may be of the history of modern times.  Capitalism has won the day against communism.  But the defeat of communism was preceded and followed by alarming events on the other camp.  The financial crash of October 1987 in the United States, the prolonged high rate of unemployment in Europe, the massive economic crises in what used to be called the economic tigers of south east Asia and now, the deep financial crises of Japan, are only some symptoms of a deeper problem.  This is not to mention other problems that           beset the whole World, including the industrial economies, such as the high rates of pollution, crime, broken families, aids… etc.  In spite of economic prosperity in the American economy over the past five years, some economists have warned that the American economy has actually gone through a long period of a “silent depression” (Peterson, 1994). 


What have caused all of these gyrations?  Does the problem lie in economics alone?  There is a vast literature written about capitalism, its nature, characteristics,  its tendency towards stability or instability.  It will be a horrendous task to review the literature on this issue.  But a few observations may help. 


I. A Note on The Capitalist System:


The economy is an  instituted process”  that  results  from  the  choices and behavior of  society (polanyi, 1944).  Economics, as field of inquiry is essentially a behavioral science. Scientists come up with theories to describe World phenomena, to propose solutions for existing problems and to anticipate future events.  The emergence of Europe from dark   ages (dark for Europe) was manifested in four major events.  The first was the revolt against the authority of church and religion. The second was the rise of nation-states.  The third was the innovation of the machinery.  The fourth was the spread of finance.  The pervasive socio-economic organization was the market.  An intellectual revolution in almost every field of life took place.  The growing importance of  physical capital  (the machine) has brought with it  mass production and greater amenities of consumption.  But it has also brought with it greater chances of unemployment.  The spread of finance facilitated the rise of the corporation, the separation of the craftsman from the ownership of his instruments, and the greater dependence of many people on their physical and mental capacities as the only source of survival.  It was natural to inquire about the causes and consequences of the wealth of nations.  Economics became an independent and distinct field of  Science.  The market became the centerpiece of economic organization and economic thought.  Since Europe has revolted against religion, the reference idea became Man’s absolute rationality.  Self-interest, and the maximization of one’s satisfaction (utility) served both as explanations and desired outcomes of socio-economic organization.  The market was considered the “invisible hand” that coordinates numerous individual decisions and perfect competition was supposed to impose a limit on the ability of anyone to exploit   power.  laissez fair was thus  declared  as the best  policy.  Adam Smith, the  author  of   “The Wealth of Nations “was too optimistic about Man’s independent ability to reason and choose.  He thought that “the laws governing the economic part of the universe are consonant with man’s destiny as are those that govern the rest  (polanyi, 1994).  Two major events, brought       laissez fair to an end. Those were the First World War  (1914-1918) and the great depression of the 1930’s  (1929-1933).  The welfare state replaced  laissez fair, and the pure market economy was replaced by the mixed economy.  The growth  of  government          size and  fiscal deficits have brought  a strong comeback to market organization in the 1980’s and the 1990’s.   Chapra (1991) explains that the welfare state could not succeed because it did not have a supreme organizing principle to guide its works (p. 20).


Regardless of the reforms that capitalism have gone through, the changes were in degree much more than in  substance and the main ingredients of capitalism remained the same. Value judgments in general, but religious ones in particular, were considered as inappropriate   for   scientific  deliberations,  the   individual  is  rational  and,  self-interest  is the major organizing principle.


When there is a mismatch between goals and ends, the situation may be the result of a theory that is inadequately useful, ignorance or inability to apply the theory, or both.  Path finding  requires a World vision that directs  Man about the meaning of life, about what is right and what is wrong,  motivates him to act accordingly, and provides for corrective personal and social mechanisms in case of malpractice.


Chapra (1991) explains that the reason behind the failure  of capitalism to achieve its socially desired goals “was the  severe conflict between its goals and its world view and strategy.  The goals were humanitarian, based on a moral foundation, the world view and the strategy  were social Darwinist” (p. 14).  Economically speaking the schedules of demand and supply reflect what people are willing and able to offer and purchase.  Survival   depends on the underlying conditions of supply and demand.


Joseph Schumpeter is one renowned contemporary  western economist who anticipated the  social decay of western society because “of the lack of faith  resulting in the absence of leadership…utilitarian philosophy teaches no regulatory social control other than individual selfishness. Consequently, a dangerous principle of irreligious rationalism gained possession over a long time of highly intelligent thinkers.  The market liberalism that this social philosophy fathered, while it brought economic success, did not confront the moral problem  (Waters, 1994).  Schumpeter’s proposed solution is vague.  He calls for a corporative form of social organization, where “cooperation not just competition is a necessary part of the social organism in relationships”.  Schumpter was not optimistic about the possibilities of applying his idea except may be only in catholic societies. (Waters 1994) Schumpeter’s inadequacy was  because, he might not have been informed of any other religion.


In terms of economic theory the individualistic thought has no reference for the individual’s rationality except for consistency in preference ordering.  No discussion or explanation is given about why should one thing be preferred to another. Wasfi (1971) explains that the individualistic thought is essentially non ideological.  The limit to individual rights is determined by man-made laws, and the  human legislators have an  unlimited freedom in legislation. The source of legitimacy depends on the hierarchy of legislation.  The proponents of the individualist thought have tried to come up with what they called the principes generaux,  du driot. Its  basis are ideas such as freedom, equality …. etc.  But the individualist system has no supreme ideal that it tries to reach. Freedom, and equality do not have clear definitions or objectives.  (pp. 15-31).


There has been dissatisfaction with the individualists insistence on man’s absolute rationality as we have seen with Schumpeter.  Some Western economists tried to come up with an alternative paradigm. According to the neo-institutionalist school of thought, human behavior is characterized by (1) limited rationality and  (2) opportunism.  The neo-institutionalist transaction cost economics approach looks at the firm as a governance structure of contracts; the purpose of which is to economize on man’s bounded rationality and safeguard against  his opportunism (Williamson, 1985).  This is a step forward indeed.  For it  recognizes some of the basic weaknesses of mankind.  But it also implies that man is ill-motivated; hardly an optimistic view. While neo-institutionalist economies  tries to explain, and  remedy contractual shortcoming, it has no moral dimension to deal with inner weaknesses of the contractors. The basic problem with Western paradigms is two-fold.  (a) the absence of an “outside” reference of what is good and what is bad  (to rectify for one’s limited rationality), and (b) it is limited in horizon as it does not go beyond this World.  The ideas of Resurrection, the Hereafter and the Day of Judgment are either absent or very weak in the Western “Scientific” thinking.  These concepts act as additional deterrents against opportunism in case the law is absent or powerless. Contracts, then, are necessary but not sufficient to economize on bounded rationality and guard against opportunism.  A search for an alternative system is thus called for.


II The System of Islam: 


A) The Moral Base


A major distinction between religion and philosophy is that religion has a spiritual dimension that philosophy does not have.  This gives religion a source  (but not the only source) of permanency  and supremacy in organizing and directing the behavior of man.  The decoupling of the moral code of Christianity from the common law that organizes the day-to-day affairs of people took place at an early stage of Christianity.  This was followed over the years by sharp disputes among Christians about the essence of belief, and led to the abuse of religion by the church and confusion among the commons about its usefulness.  This has led to the natural revolt against religion in Europe and the separation of science from religion.  Judgment  based on values were denounced as non-scientific as many of these values could not stand to reason.  Nevertheless, it was too unscientific to judge every religion as  every other religion.


Such a conflict did not exist in the history of Islam for  three reasons.  First, Quran , the prime source of the Islamic faith, has been kept the same, unscathed over all times and places.  Second, for the careful mind , there is nothing in  Quran that contradicts Reason.  Third, the teachings of Quran were the driving force for Muslims to investigate the Universe and offer humanity major contributions in almost every field of knowledge. In other words, the religion of Islam has been a source of inspiration rather than an obstacle against development.  This by itself is a historical proof that the Islamic approach to the matters of life is not only scientific, in the sense of  amenability to world proof, but it is also much more firmly grounded than other speculative approaches.  Ekelund and Hebert

(1990) write:


“ The death of the last Roman emperor in 476 ushered in a long period of secular decline in the west and a concomitant rise in the fortunes of the east. For five centuries, from 700 to 1200, Islam led the world in power, organization, and extent of government; in social refinements and standards of living; in literature, scholarship, science, medicine, and philosophy.  The Arab world acted as a sort of conduit to the west for Hindu wisdom and culture.  It was Moslem science that preserved and developed Greek mathematics, physics, chemistry, astronomy, and medicine during this half millennium, while the west was sinking into  what historians commonly call the Dark Ages. By A.D. 730  the Moslem empire reached from Spain and southern France to the borders of China and India, an empire of spectacular strength and grace.  Perhaps the most significant,  single innovation that the eager, inquisitive Arab scholars contributed to the west was their system of writing numbers.  They displaced the clumsy Roman numerals of the previous empire with the much more utilitarian Arabic numerals of today.  One of the more eccentric Arab mathematicians, Alhazen, founded the modern theory of optics around the year 1000.  But for our purposes, the most important contribution of Arab Culture was its reintroduction of Aristotle to the west.


After the city of Toledo, Spain, was recaptured from the Moors in 1085, European scholars flocked to that city in order to translate the ancient classics.  The ancient texts were turned from Greek (which Europe had forgotten) through Arabic and Hebrew into Latin.  In this last mode their philosophical gems were mined for the next four hundred years by the Schoolmen of the medieval church.” (p. 26)


But  what is the basic organizing principle of Islam? In a  short verse of  Quran, it says,  “I  have only created Jinns and men , that they may worship Me”. ( L I., 56). This verse implies that all acts,  material and spiritual, has to be in accordance with what the Lord has ordered.  And if such, every act is an act of worshipping.  In such a system of life, material  amenities and spiritual practices both compliment each other, and serve towards the same goal -     the worshipping of the Lord.  To achieve that goal, the Islamic system has three tenets.  These are  (1) Faith in God, The Creator, the Sustainer, and a  belief in the Hereafter  (Day of Judgment), (2) Moral-preserving-enhancing codes of conduct , and  (3) A comprehensive set of rituals and laws that organize every bit of the life of the individual  and society.  Whereas  God is the ultimate Creator and Owner of everything in the Universe, Man is ordained as his vice-gerent on earth for its cultivation and betterment. Chapra (1971) explains that the submission to  the Lord implies that Man is                               subservient to none but to Him.  Thus man is created free, and as a vice-gerent he is not created as a sinner.  Falah   (felicity  in both worlds) can only be achieved through these believes (Siddiqi, 1971). In the economic domain, vice-gerency has three implications: (1) Man’s right of ownership and freedom of exchange must be respected , (2) Contracts must be enforced and , (3) Work is the major source of ownership.  For a Muslim, freedom is an essential ingredient of faith.  By contrast, the European man acquired freedom only by revolt against religion. But Islam emphasizes collective responsibility and solidarity. Obviously then, Islam strikes a balance between  personal freedom and collective interest. Some marxist scholars accused Islam of being akin to capitalism since it protects personal freedom, while some capitalists scholars accused it of being akin to communism,  since it establishes collective interests.  Islam is  neither ; it represents a middle road  between the two.


The general theme of Islamic jurisprudence can be described as one that seeks to attain benefits  (collective and personal) and deter hardships.  This is achieved by protecting the Five Necessities; Religion, Life, (Man) Kind, Reason, and Wealth. Since the preservation of wealth is one of the Five Necessities, one wonders about the nature of the Islamic economy and economics.



B. The Nature of the Islamic Economy and Economics:    


We have already explained that the supreme organizing principle of the Islamic system of life is God worshipping and that the Economic Man is replaced by the Worshipping Man.  The recognition of the freedom of ownership and exchange implies that markets are an important  socio-economic Islamic Institution.  Freedom is incomplete without markets. Markets are a necessary but not sufficient condition for the expression of freedom.  Market competition is guided by moral geniality that promotes cooperation , and state deterrence  that enforces the law.  Government intervention however should be kept to the minimum.  The limited time and space for  this paper  does not allow for a detailed discussion of the nature of government in Islam.  The market has both legal and moral constraints.  The distribution of wealth and the allocation of resources are the outcome of these two constraints, and prices are no longer considered in abstraction.  The market process becomes a reflection of an objective-related exercise of the freedom of choice. The idea of the scarcity of resource is relevant but only in the relative sense  of their  possible abuse.  Otherwise, the universe was created in a state of equilibrium.  Quran says “ And there is nothing but We have its treasures, and We send it down in due amounts”.


Since faith is the source of law and behavior, Islamic economics becomes essentially policy-oriented, and the distinction between positive and  normative economics becomes blurred, if  ever relevant.  The teachings of Islam act as the agenda of  research in economics and other fields, and as such, research becomes less speculative.  A correct practice may precede a complete comprehension of the underlying theory.   It requires belief before it requires theorizing. This does not imply that  the two can go on indefinitely  separate.  Theory, on the basis of belief, is more required as belief is weakened and/or as new circumstances  develop.  Also, a correct theory should enhance, solidify, and promote the growth of a correct  practice.



There are five areas of Islamic jurisprudence that effect the distribution of wealth and the allocation of resources.  These are:


(1)  The laws of ownership of land and natural resource  ,  (2) The law of inheritance ,  (3) The contract  law    (4) The law on money and credit ,and (5) The law of taxation .


These laws represent a vehicle to operationalize the moral code by giving detailed rules of conduct in every worldly affair. In this paper we are going to discuss briefly only the implications of the last two laws. 



C.  The Economics of Money and Interest:


Discussions about money and interest  ( usury ) are at least as old as the time of Aristotle, if not earlier.  For many centuries interest was understood in many, if not all, parts of the world as a contractual mark  up over loans.  It was only with industrial revolution, the  spread of finance and, the revolt  against the church , that people in Europe started to confuse interest and profit and consider both as acceptable forms of income.  Eugen Von Bohm Bawerk has written three volumes of an extensive survey of the history of the theory of interest in Europe.  (1884).


In Islam, Riba (Interest) is strictly prohibited, and there are many verses in Quran and Hadith (traditions of Prophet Mohammad,  Peace Be Upon Him) that severly warn             against the taking and giving of Riba (Interest). Ibn Taymmiyyah ( 1232-1299)   defines Riba by saying  Riba is prohibited for it implies grievance, since it represents the taking of an excess  (of wealth) that is a counter reward for nothing.”  (vol. xx, p.341). The prohibition is applied to Riba on all objects, money and otherwise.  It is interesting to know that some major contemporary western economists share the same opinion about interest.  In explaining the potential “Social Philosophy” of his General Theory, Keynes writes that “it would mean the euthanasia of the rentier ……… Interest today rewards no genuine  sacrifice, any more than does the rent of land …… I see therefore, the rentier aspect of capitalism as a transitional phase which will disappear when has done its work”   (G.T., 1936, p. 376).





Riba that  Islam  came to forbid is two basic kinds: (1) Riba of debts  (on money loans) and  (2) Riba of Sales.  Without going into the details of each,  the Riba of debts is the one that used to be the most common before Islam and now.  Interestingly enough, there were several variations  of the Riba of debts before Islam that still exist today. One variation is for a person to lend money to another.  On the due date either a principle is paid back, or payment is deferred in return for a mark up.  This sounds like a  penalty on   delinquency in payment such as that when people use their credit cards today. In another variation, the payments of a  mark up is conditioned at the beginning of the loan period.  This is similar to simple interest today.  A third variation, is for interest to be paid every month, while the principle is left intact and paid at maturity.   If the principle is not paid, more interest will have to be paid.  The deal sounds like a regular  bond today. The common feature of debt-based interest is the fact that an increment is paid in return for                  delay in payment.  It should be noticed that there is no difference in Islam between interest usury and . The height of the interest rate makes no difference; both are considered  Riba  (usury), and both are forbidden.


But why does Islam forbid  Riba?  There are two issues here.  The first is the Hekma  (wisdom) of the prohibition of Riba, the second is the  Illah (motive, description) of prohibition.  The Hekma (wisdom) has been already mentioned in the definition of Riba given above;  that  Riba is a source of injustice, because it is a return for nothing, or as Keynes puts it  “interest today rewards no genuine sacrifice”.  What is it then that motivates an interest-based contract?  Interest results from a contract between two capitalists: one wishes to avoid risk  (via a guaranteed return), the other wants to have control together with the speculative possibilities and the risks brought along with it  (Hadley, 1884).  The fulfillment of  some expectations in some endeavors gives the illusion that fulfillment of another may be practically certain  (Boulding, 1951).  Interest then increases cost of production in two ways:  it is a sure markup and it increases risk.  The possible disappointment of expectations not only foils the borrower’s speculation but also defeats the lender’s attempt to avoid risk.  Kenneth Arrow observes a “fundamental paradox in the determination of demand  for information: that its value is not known by the purchaser until he has the information, but then he has in effect acquired it without cost”  (1982).  There is a similar paradox in the  sale” of money in the sense that  the value of its use is not  known  until investment comes to an end or until the loan contract expires, whichever comes first”   (Uthman 1994 b)  Thus, there is an analogy between information  and money  “in the sense that none of them  fits the image of a ‘normal’ commodity.”  (Uthman, 1994 b)


Islamic economists do not stand  uncomfortable alone about interest as an economic institution.  Schumpeter observes  that “Interest acts as a tax upon profit”  (1961, p. 175).  He also observes that  As soon as it comes into existence many entrepreneurs are eliminated, and as it rises more and more of them disappear.  For although possibilities of profit are practically unlimited, they differ in size and most of them are of course only small  (Schumpeter, 1961,  p. 198).  The risk of entrepreneurship  makes the requisite profit rate  (by the borrower) always higher than the market interest rate  (which includes its own risk premium), by a risk sufficiently high premium…. The higher the accumulation of capital, the lower the MEC (Marginal efficiency of capital) and, the higher the profit’s risk premium would be.  There is, thus, an element of stickiness in the requisite profit rate, in addition to the element of stickiness   in the requisite interest rate.  No doubt that the latter reinforces the former and, hence, the existence of interest is bound to kill numerous profit opportunities causing an involuntary unemployment of investment.”  (Uthman, 1994 a)


This is how the issue of risk enters into the prohibition of Interest.  The above discussion investigated some elements  of  Hikmah  (wisdom) of the prohibition of interest.  What is the Illah (motive, description) for the prohibition of interest on money in particular.  In other words, what  particular characteristics of  money that  make interest  bad and thus prohibited?


Ibn Algayyem  (1292-1350)  explains that interest on the two monies  (gold and silver) is prohibited because money is the standard o value.  A measure of value has to be standardized and standardization requires stability over place and time  (Vol. II, pp. 156-7).  For this to happen it should not grow or depreciate on its own.  In other words, the standard of value can be a medium of exchange but must not be  the object of exchange.  Interest, then disturbs the informational content of money.  In other words,  for  Ibn Algayyem  and many other  Muslim jurists, the most important function of money is its service as a unit of account and thus a measure of value  (a numeraire). The other two functions, the medium of exchange and the store of value, are derivative functions  of the prime one.  The major implication of Ibn  Algayyem’s  reasoning is that interest must be prohibited on any object that  serves as a measure of value.   The debate about the prime function of money continues until today.  It is interesting to note that the early Muslim scholars were ahead of some Western scholars in arguing for the primacy of the numeraire function of money.  Aschheim and  Tavlas  (1996)  argue  “that at least  since  Walras, a major strand of monetary economics imparts primacy to money’s capacity to act as a numeraire”.  This  constitutes what may be viewed as embryonic money.  A monetary exchange system appears once a numeraire exists.  The unit of account is a sufficient condition for the existence of a money-exchange economy, whereas the medium of exchange does not constitute a sufficient condition”.  But the discussion of the functions of money by the economists of the  18 - hundreds,  such as  Walras, Walker, and Del Mar was motivated by an inquiry about whether paper money or bimettalic money serve as a better mean to stabilize the price level.  Both arguments  imply a quantity theory of prices.  Aschheim and  Tavlas  (1996)  explain that the importance of a numeraire is explained in  Walras’s general  equilibrium model where “The existence of a numeraire allows market clearing to occur,  through a continuos groping for prices……. Yet this process of  tatonment  takes place without money changing hands  (means of payment) and without money having served as a store of value.  Consequently, it is the existence of money  solely as a numeraire that allows for the distinction to be made between a money-exchange system and a barter-exchange system……….. The contraction in transaction costs  (for example, calculation information, search)  imparts  a non-neutrality character to money”.  This explains the importance of the numeraire function of money but it does not explain the line of  causality between money and prices.  For if abrupt changes  destabilize  the value of money  (its numeraire function)  why would the quantity of money change.  This forces us Back to  Ibn Algayyem and other Muslim Scholars who considered the introduction of interest as a destabilizing element to the prime function of money.  How does it work?  In order to  answer this question,  let’s assume that  the stock of money is constant at quantity Y and interest on loans does not exist to start with.  If interest is introduced into the economy, it will affect prices in more than one way.  First, borrowers-producers will add an increment to the prices of  their goods that is at least as high as the interest rate.  At the end of the period, borrowers will have to payback to lenders an amount of money equal to Y +  interest  .  The introduction of the interest rate pushes the cost of production  upward, raises the price level, increases the demand for money and thus would increase the interest rate.  If the  stock of money is kept constant, the interest rate will rise further and a debt-deflationary  process  sets in.  Bankruptcies many develop. Otherwise, the stock of money has to be increased, an action that tends to validate the inflationary process.  The introduction of  the interest rate   endogenyzes   the money supply. A further complication comes from the fact that production usually takes place in a world of uncertainty. There will be stories of success and other of failures.  To impose  a  penalty of  more interest payments on the ailing firms, only worsens   their position.  A  foreclosure   will make things worse.



The Islamic financial solution, in addition to the prohibition of interest, is to give a     moratorium on debt payment. Better yet, is to forgive the debtor if possible.  If further  debt is to be extended, it has to be interest -free.  Quran  says “If the debtor is in difficulty Grant him time till it is easy for him to repay.  But if ye remit it By way of charity, that is best for you  if ye only knew (II, 280) .” A major remedy to the current financial crises in Japan has been for  banks to write off some of its debts  i.e.  to forgive debtors.


It might be  noticed that  Muslim scholars such as Ibn Algayyem and his mentor, Ibn Teymiyyah (1232-1299), did not come explicitly forward with a quantity theory of money and prices.  Several reasons can be imagined to explain this.  First and for most those scholars , as jurists , were concerned mainly about answering the question on the essential function of money.   Reaching a satisfactory answer seems to have settled the issue for them.  Second  bimettalic money supply was highly  inelastic.  Discoveries of  metals at that time  (the 13th and 14th centuries)  were not easy.  The only way for money

supply to be increased in the short run was either via debasement, or the introduction of a new metallic money, such as  phelos  (copper money).  Both  actions would be encouraged by relaxing the law on interest.  One  would  speculate that sometime during periods of instability  and weakening of belief,   price and output instability occurred when the rules of  Riba were not strictly observed  and gave Ibn Taymmiyyah  and  Ibn Algayyem (T&G) an empirical  support about their interest-based theory of the instability of the value of money.


To see this, in the absence of interest, and when the money supply is constant  in the short run,  the demand for money will be determined by the needs of trade and will be positively related to the profit rate,  Pr,   (see figure 1).









                                                                 Figure 1









If  interest-based lending is permitted, the interest rate will rise from zero  into some positive level.  The emergence of  a new business  (the business of lending)  will generate hoarding and speculation, reduce the money supply available for trade, and reduce the  velocity of money.  Output and the profit rate are going to fall, and prices are going to rise.  The value of money which is the inverse of the price level, will decrease.  The introduction of interest  must be encouraging to debasement and the introduction of other  means  of payment, such as copper-made phelos, or paper  money  later on,  adding a further complication to the economy.  We may say that the  T & G  theory is an interest-based theory of money.


Aschheim and Tavlas  (1996)  disagree with  Dvaid  Laidler  (1991) that the prime function of money is to serve as a store of value and agree with  John Hicks  (The Market Power of  Money) that money’s prime function is the measurement of value.  Aschheim & Tavlas  (A & T), however take an exception to Hicks’ argument that  “Money as a means of payment is just a debt”.  They argue that this fails to illuminate the difference  between a barter-exchange economy and a money exchange economy.  For debt can exist under both types of economy. To them  The essence of money as a medium of exchange is the quality of money as generalized purchasing power”.  A & T are right in a micro-economic sense of the word debt. Money may not be debt in a micro-economic sense, because a person who accepts money in  exchange for some good or service he offers, has no recourse to the person who offered him money.  But in a macro-economic sense, money may be thought of as debt, because the person who accepted money, thinking of it as a generally accepted medium of exchange, will want to exchange it later on for other goods and services.  In other words, the holders  of  money has a claim against society at large and thus money is debt in a macro sense of the word.  This brings the issue of  wealth into the discussion.  For debt, whether it is monetary or in kind, represents  a temporary transfer of wealth from debt acceptors to debt  providers.  If we can imagine this process to go on  indefinitely, then there is a permanent transfer of wealth from the issuers of  debt (monetary or in kind) to the buyers of debt.  This is the essence of interest-based lending in general and the fractional reserve banking system in particular.  Thus the issuance of money  (a macro debt) entails no net addition of wealth to society at large, but money, as  Laidler  (1969) argues in his response to  Pesek & Saving  (1967) expands  wealth  just  as  trade  expands  it , without an increase in initial endowments .  It  may be  argued   that   banks are  entitled a return (a share of  the national pie) because of the role they assume between savers and borrowers (the theories of the evolution of banks). But interest-based lending and the fractional reserve system are neither necessary, nor sufficient for banks to do a good job in intermediation.


Interest is, as Schumpeter describes it,  a tax . Islam prohibits it. What about other taxes ?


D.  The Economics of Taxation in Islam:

The taxation system of Islam includes ,but is not limited to, Zakat.  An understanding of the economic underpinnings of Zakat should prove helpful on how to go about imposing other taxes, whenever necessary. At the end of a fiscal year, Zakat is imposed on residual money holdings that could have been spent (but were not), on the pecuniary value of items that are intended for trade (but were not traded), and (In-kind) on durable agricultural products and livestock.  Consumption, items intended for personal use such as one’s own house or car, assets that are means of  production but are not capable of growing themselves, such as buildings, machines and equipment, are all exempt from Zakat.  It can be concluded then that Zakat is an inventory tax on the  Zakatable items.  It is a tax on some stocks of the balance sheet .  This is in contrast to other flow taxes in  the Western economic system such as the income tax and the sales tax.  A tax on a flow may impair it while tax on  a stock may mobilize it.  It can be shown that the full incidence of Zakat as a tax falls on producers ,with no welfare loss associated with it.  Unless it becomes necessary, the Islamic system of taxation avoids in rem taxes (taxes on objects or activities). Zakat is  imposed on asset-holders, and such  imposition  relates payments of taxes to the taxpayers’ ability to pay and provides for more equity in the tax system (Uthman, 1997).


Zakat is not a tax on savings.  It is a tax on  hoarding, be it monetary or physical . Savings that are invested , let’s  say in financial stocks and are intended for keep, are not subject to Zakat, while if the stocks are for trade, they are taxed like any trade  object.  Garadawi  (1969) warns that trade for the purpose of Zakat requires two conditions.  First, intent, and second actual, active work on trade.  A person  who bought a car for his own use, but thought he may sell it , if he is offered a mark up, is not considered a trader, and thus the object kept is not subject to Zakat.  If it is sold  however , and the money kept until the end of the year,  money balances that are equal to, or exceed  nisab  (the minimum tax exempt) will be subject to Zakat . The anti-hoarding principle implies that neither income from salary nor invested savings are subject to Zakat.  Idle money balances are .  It may be argued that Zakat on  live stocks is a direct tax on some form of capital. Why not tax other forms of physical capital such as buildings, factories…etc.??  The answer is that a livestock is a kind of capital that  reproduces itself with  very little, or no effort from the owner.  An excess supply ,that reduces its prices and return , can be reduced much more easily than other forms of physical capital.  The amount of work and degree of risk is usually  (much) less with livestock capital than with physical capital.  Also, in  primitive economies, livestock represents a major form of wealth,  and thus the need to tax it is greater.  In advanced economies, livestock is much less important and nevertheless can be more easily and more abundantly produced, and thus can afford more taxes.  The more advanced the economy is the more specialized and specific the physical assets are, and the more risky they become. They should never be taxed directly.


The importance of Zakat goes beyond its fiscal and distributional aspects.  The spiritual dimension is very important as it promotes the values of sharing, caring, and   alteruism . The Islamic economic system is one, and probably the only one system that combines moral values, economic policy and economic theory as three non-separable elements of the system.


The Islamic concept of consumption and wealth can be illustrated by two hadiths, ( Traditions of Prophet  Muhammad  ,Peace Be Upon Him)  . He said “You have (actually own) of your wealth none but what you ate and  (thus)  destroyed, what you wore and depreciated, or what you donated and kept (as a good deed)” . In another  hadith,  Prophet  Muhammad  Said  “Whoever became secure  in his neighborhood, healthy in his body, and acquired the needs of his day, verily has  acquired everything in the world.                                                                                                    .”. The intuition , or implications of the two hadiths is that one’s actual wealth  (and income) is what he actually consumes of it. It is for this that Zakat  does not tax income, consumption, or invested wealth .  What is being taxed is idle, or potentially idle , and hoarded wealth.  The problems associated with the taxation of income, consumption, and savings are well-known in the economics literature.  One of the expected effects of such taxes is their impact on work incentives.  Zakat on inventory, or hoarding does not seem to affect work incentives.  It encourages  either consumption, investment or both (see Uthman, 1997).


The timing of all Ibadat ( worships ) in Islam follows  a lunar calendar.  For example, the time period between any two prayers in the day is not fixed by the hour  , but rather by the length and shortness of the day and night. This is related to the movement of the moon around the earth.  The fasting month, Ramadan, starts with observing the new moon the of the  nineth month of the lunar year.  Hajj  (Pilgrimage) falls on the twelveth  month of the lunar year. While the timing of these worships is fixed relative to a lunar year, it is variable relative to the solar year. The production mode of basic economic products such as livestock and agriculture ,follows basically a solar calendar, even though technological advancement now made it  possible to produce plants and animals out of the regular seasons.  The timing of these Ibadat  being at times  close and  at  times different from  the times of production, influences the time of economic exchange.


Zakat is also to be paid on a lunar calendar basis.  It is usually argued that taxes act as                 built-in stabilizes of economic activity.  Tax proceeds rise with high income and fall with  low income, helping to reduce thus, the excessive moments of the aggregate demand curve. Tax payments, in magnitude and timing , are to  the taxpayer  procyclical  , and help to stabilize the economy in that sense.  In the same sense ,  Zakat has the same economic impact; rising with high  “income” and decreasing  with low “income”.  It is well known that the beginning of the lunar and solar year coincide every   33 years and that  every one hundred solar years are equivalent to  103  lunar years.  This implies that the timing of paying  Zakat  coincides at times and diverges at others from the production mode of basic goods  that follow a solar calendar.  It is possible during this astronomical cycle that negative supply shocks, due to drought for example, may take place.  It is at this time  when government revenues need to be increased to support  people on welfare.  Since incomes at a negative shock are low, taxpayers will not be hurt in terms of how much they will pay.  Tax dues go in line with their wealth and incomes.  But the timing of the tax payment becomes so crucial that it should  help to stabilize  tax revenue and incomes of the poor. This should help to sustain demand and prolong the business cycle.  The length of the cycle is prolonged on the other side of the cycle when the economy is booming. If Zakat  payment falls due before the peak, it helps to restrain  the excessive upward shift of the aggregate .If  Zakat payment is due after the peak it helps to sustain demand.  In  both cases it helps to prolong the business cycle.


In short the payment of Zakat may coincide  predate, or past-date the turning points of a business cycle, helping to smooth out and prolong the cycle.


In other words there are two concepts of timing in the payment of taxes.  The first is timing relative to the ability of the taxpayer.  The second is timing relative to the need of the tax recipient.  The payment of taxes in the Western economies is fixed on specific dates on a solar calendar.  The choice of the beginning of a fiscal year in Islam is the decision of the taxpayer on a lunar calendar.  Furthermore,  the government can borrow from people their tax dues for the next two or three year, if needed.


Conclusion:  Islam is a very comprehensive and integrated code of life.  It guides  Man in every sphere.  Islamic economics is part of that integrated system,  the purpose of which is the betterment of life on the bases of the teachings of the Lord.  While the contributions of the Islamic civilization in the areas of  science, medicine and philosophy …etc have been recognized by many historians, it is all curious why the contributions of  Muslims to economics are rarely mentioned in the books of the history of economic thought ,if ever!




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A  Short  Outline  of  The  Foundations  of

Islamic  Economics





Usamah  A.  Uthman

Associate Professor of Economics

Department of Finance & Economics

King Fahd University of Petroleum & Minerals  (KFUPM)

Dhahran  31261,  Saudi Arabia


E-mail:  osama@kfupm.edu.sa

Fax: 966-3-860-5564

Phone: 966-3-860-2778



This paper is submitted to Harvard Second  Forum on Islamic Finance,  October 9-10, 1998


The  author  is  very  grateful  to  KFUPM  for  financial  support

To  conclude  this  project


July 15, 1998