Chapter 10
Fiscal Policy

Learning objectives:

  1. The goals and objectives of fiscal policy in the conventional and the Islamic systems.
  2. The role and importance of societal welfare in Islam.
  3. The instruments of fiscal policy in the conventional system.
  4. The instruments of fiscal policy in the Islamic system.
  5. The financing (taxation and borrowing) of government expenditures in the conventional and in the Islamic system.
  6. The workings of the multiplier.
  7. The difficulty of achieving full employment and stable prices.
  8. The implications of deficit financing and national debt.
  9. The workings and limitations of fiscal policy in the longer run.
  10. Waqf as a complementary fiscal instrument in Islamic finance.
  11. The role of built-in stabilizers.
  12. The arguments for and against different forms of taxation.
  13. The concept of public-private partnerships.
  14. National participation papers as a financial instrument.

The state plays a key role in every economic system. Only the extent of the state's involvement differs, depending on the common values and belief system shared by the individuals who make up the particular society. The role of the state in an Islamic economy is to ensure that everyone has equal access to resources and a means of livelihood; that there are rewarding employment opportunities for all those who can work; that market rules, regulations, and supervision minimize business uncertainties so that justice is attained and transfers take place from the more able to the less able; and that distributive justice is ensured for the next generation. As has been emphasized in this book, Islam is a rule-based system. In such a system, the state regulates, supervises, and provides an incentive structure for rule compliance, all within the framework prescribed by the Quran and the Sunnah. The role of the government is broadly divided into two functions: a policy function that ensures that private interest does not diverge too far from public interest; and second, an institutional function to design and implement an incentive structure to encourage rule compliance, coordination, and cooperation.

In market economies when the markets fail to clear (i.e., when there is unmet demand or oversupply), it is said that there is a market failure. The presence of market failures can impair economic relations and transactions. In such situations, government intervention is justified to protect the public interest. The state, through the government, is empowered to use all available means permitted by law to achieve the objectives and duties prescribed for society, including synchronization of individual and public interests. An important function of government is to reduce uncertainty for members of society to allow them to overcome the obstacles in making decisions due to lack of information. In this sense, the state becomes the ultimate risk manager of society. The prescribed rules specify what kind of conduct is most appropriate in achieving just results when individuals face alternative choices. The degree of effectiveness of rule enforcement is determined by the degree to which members of society internalize the objective of social justice.

Policies are decisions of the government to undertake actions directed toward achieving certain objectives. At a macro level, policies traditionally have been designed to achieve the objective of the economic system consistent with the view of society. In most cases, the achievement of economic stability, full employment, growth, and development of the economy is seen as the primary objective of macroeconomic policies. In an idealized model, macroeconomic policies create inducements that elicit desired responses from sectors of the economy reflecting the desired level of income, prices, and employment. To achieve these objectives, two main policy tools are utilized: monetary policy and fiscal policy. Monetary policy aims at inducing adjustments in the portfolio of the private sector (producers and consumers) to fine-tune aggregate demand. It uses the instrument of the interest rate to increase or reduce the level of the supply of money and thus spending and production in the economy. Fiscal policy uses the power of the government to tax and spend as a means of influencing aggregate demand and the level of economic activity. Whenever there is a shock to the economy, these tools are used, independently or in combination, to stabilize the economy and nudge it toward a state of full employment and price stability.

Fiscal policy is the use of the government's power to tax and spend to influence economic activities. In most situations, when government spending has increased and revenues have not increased commensurately, governments have financed the resulting shortfalls (budget deficits) by increasing borrowing, raising taxes, or both. Printing money is always an option, but it is not a recommended one. In theory, a stimulus to spur economic activity during slowdowns is normally assumed to be financed by subsequent growth. More often than not, the current and prospective rates of growth of the economy are lower than the interest rate on the growing debt. Growth may not be large or fast enough to validate debt levels that may exceed 100% of gross domestic product (GDP), as is the case today in many advanced countries. The solution of austerity, higher taxes, and lower spending suggested by the dominant policy regime requires a strong political consensus. Increased borrowing by issuing bonds or long-term government borrowing also does not appear to be a desirable long-term solution, as it increases vulnerability to shocks, creates a burden on future generations of taxpayers, and has adverse distributional implications.

The government has a crucial role in ensuring economic activity and prosperity. There is no guarantee that the economy will be operating at full employment (NAIRU, the nonaccelerating rate of unemployment). It is highly unlikely that the economy will be humming along at NAIRU for any length of time. There will be periods when aggregate demand is too low (aggregate supply is high) and others when it is too high (supply is low), requiring government intervention to nudge the economy back to the NAIRU level of activity. Stabilization policies—monetary and fiscal—are crucial in moderating economic fluctuations and maintaining employment, something that is crucial in order to avoid economic hardships for families and for society in general. But government's role in stabilization goes beyond monetary and fiscal policies to include industrial, trade, exchange rate, and income policies.

The current public sector borrowing policy in a conventional economy that is interest based is putting countries in a highly leveraged position. As borrowing increases, the country runs the risk of producing income only to service the interest on debt. The problem of debt repayment must be passed on to the public, as tax revenue must increase in order to pay for the debt. Thus the risk of mismanaging the economy is shifted from the present to future generations. As internal borrowing continues to fund increasing government spending, the problem will be passed on to future generations of taxpayers. In addition, to the extent that the government borrows from the rich and taxes mostly the middle and lower income groups, income and wealth distribution skew in favor of the wealthier segment of the population. When government borrowings are funded externally, the problem is exacerbated by the outflow of resources on debt servicing that will add pressure to the balance of payments. As was experienced by the emerging markets in Asia and Latin America in the late 1990s, external borrowing exposes economies to “sudden stop” shock, whereby economies are prevented from any progress whatsoever. So far the solution to the problem has come in the form of providing more borrowing to help countries out of their recession. But is solving a debt crisis with more debt the right solution to the problem?

Role of Fiscal Policy

In Chapter 6, we discussed the form of the consumption (savings) and investment functions in an Islamic economic system and how national income is in turn determined. Importantly, we saw that there is no guarantee that the conventional economy would always operate at full employment and with stable prices. In fact, it is highly unlikely that the economy would operate at an equilibrium level that is characterized by full employment and stable prices. Fluctuations in investment, and to a lesser degree in consumption (savings) and external economic shocks, are the major cause of fluctuations in national income. Business conditions hardly ever stand still. Economic booms may be followed by economic panics and crashes. Invariably economic expansions lead to economic recessions with a fall in national output and employment; business profits fall; and an economic bottom is reached followed by economic recovery, which may be slow or fast and may lead to another economic boom with little inflation or with rapid inflation. The process of economic expansion and contraction, inflation and deflation, and rising and falling employment is captured under the umbrella term “business cycles.” No two business cycles look exactly the same in their four phases—recession to a trough (bottom), expansion to a peak, recession, and expansion. Governments use macroeconomic policies to moderate business cycles.

Prior to the Great Depression of the 1930s, economists believed that the appropriate fiscal policy for a government was to maintain a balanced budget. But the Great Depression changed this widely held view. As we have mentioned, John Maynard Keynes put forward the idea that fiscal policy should be used in a countercyclical manner so that the government moderates the expansion and contraction phases of the business cycle in a process of leaning against the wind. Thus the government budget should be in deficit when the economy is in the doldrums and contracting and in surplus when it is booming with no excess capacity and inflation. But fiscal policy has not been an effective tool to smooth these cyclical movements because of political constraints and also because the economy has what are called built-in stabilizers, such as a progressive tax system and unemployment insurance. Politicians resist raising taxes when the economy is booming, as this is not a popular policy with the electorate; and automatic stabilizers cushion the impact of booms and busts, reducing the incentive for discretionary policies. (During a recession, incomes will be shrinking, but because of progressive taxation, the loss of income or purchasing power is cushioned, which will lead to a decline in government tax revenues. So long as the government does not reduce expenditures, the end result will be a moderation in the decline in the level of economic activity.)

The effectiveness of discretionary fiscal policy has been questioned on other grounds as well, primarily the policy's “inside lag” and its long-run impact on economic output. Inside lag is the time when the need for fiscal policy arises and when the policy makers actually implement it. In practice, the art of economic forecasting is such that forecasts are uncertain and policy makers realize the need for policy months after the need should have been recognized; and it takes policy makers (parliaments and parties) time to reach a political compromise and to take remedial action. In part because of these limitations, some economists argue that discretionary fiscal policy to counteract business cycle fluctuations may do more harm than good. Others prefer monetary policy and see little need for fiscal policy. Others argue that the longer-run impact of fiscal policy may be seriously limited because the higher aggregate demand resulting from a fiscal stimulus translates into higher prices, not into permanently higher output, as sustainable economic output is determined by the supply of the factors of production (capital, labor, and technology).

The supply of the factors of production determines a “natural rate” of output around which business cycles and macroeconomic policies can cause only temporary fluctuations. The fact that output returns to its natural rate in the long run is not the end of the story, however. In addition to moving output in the short run, expansionary fiscal policy can change the natural rate, and the long-run effects tend to be the opposite of the short-run effects. The basis of this argument is as follows. A short-term expansionary fiscal policy affects longer-run output because of its impact on the savings rate. Savings are made up of a private and a public component. A fiscal expansion results in government dissaving; with lower aggregate savings, either investment in plant and equipment will decline or external borrowing (for investment) would have to increase; the former (lower savings) would lead directly to lower investment and the latter could be sustained only if the return on investment is higher than the cost of foreign debt. In short, the argument is that expansionary fiscal policy will lead to higher output today but will lower the natural rate of output below what it would have been in the future.

As a final point, we should note that fiscal policy also affects the relative burden of future taxes. An expansionary fiscal policy adds to its stock of debt. But because of the government's obligation to pay interest on this debt or pay back debt in the future, expansionary fiscal policy may impose an additional burden on future generations.

Thus through fiscal policy and monetary policy there is a role, which is open to some debate, for the government to nudge the economy toward full employment and/or restore stable prices as needed. Additionally, the government uses fiscal and monetary policy to enhance economic growth and prosperity. In this chapter, our focus is the instrument of fiscal policy—changes in government expenditures and taxes. The government increases aggregate demand directly by increasing its expenditures and indirectly (through private sector consumption and investment) by decreasing taxes; the change in aggregate demand affects the level of national income. The process of fiscal policy (adjusting government expenditures and taxation) and its financing in turn affects the government's budgetary position. In the next chapter we examine how monetary policy also affects national income, employment, and prices. A US$1 change in investment leads to more than a $1 change in national income because of the multiplier effect.

We begin this discussion with a recapitulation of the standard income determination equilibrium diagram in Figure 10.1. As can be seen, government expenditures (G) can be directly added to the other two components of demand, consumption (C) and investment (I); G adds on to aggregate demand just like investment. An additional unit of G, like an additional unit of I, increases income by more than the increase in G (the multiplier) because one person's expenditure becomes someone else's income. That person spends a part of that increase in income and saves the rest and so on down the line with each additional expenditure less than the previous recipient's extra income because a portion is saved by each recipient. The equilibrium point (E) is stable in the sense that at any other point in the figure, the desired investment of business does not equal the desired savings of families; and as result, if the economy is not at E, it will tend to move or gravitate toward it. Moreover, if F is the full employment level of gross national product, then at point E there is significant unemployment of labor (and other resources). Increasing G could nudge the economy toward F directly or alternatively this could be done by adopting tax policies that increase private consumption or C (see Figure 10.2) and/or I. Alternatively, if there is unwanted inflation—an indication that the economy is operating too close to its capacity and excessive demand is pressuring price and wage increases to clear markets—then the government may be called to reduce G or adopt tax policies that reduce C and/or I. We should, however, note that to offset a US$200 billion upward shift in G, tax collection must increase by more than US$200 billion; if the marginal propensity to consume is two-thirds, then if C is to be lowered by US$200 billion, we need taxes of US$300 billion to balance the government budget and avoid an inflationary gap. We should add that a US$1 decrease in taxes has less of an impact on income than a US$1 increase in government expenditures and would lead to a larger budget deficit; in the former case, the private sector expands, while in the latter case, the public sector expands.

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Figure 10.1 Effect of Government Expenditures on Income Determination

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Figure 10.2 Effect of Taxes on Consumption Schedule

Recall two important points that have been made before. First, there is a continuing debate about the overall effectiveness and benefits of fiscal policy on employment and long-term economic growth. Second, the effectiveness of fiscal policy is further limited by two important lags—the time when the need for policy should have been recognized to the time that it is in fact recognized, and the time after the need for a change in fiscal stance is recognized to the time when the government is authorized to change its expenditure/tax policies (approval by the legislature, etc.). We also should note that a change in government expenditures directly affects aggregate demand, whereas a change in taxation is indirect, as it depends on the private sector to change its expenditures (consumption and investment).

Fiscal Policy in an Islamic Economy

At the outset, we must emphasize that the goals of fiscal policy in the Islamic economic system are broader than those in conventional economics. Yes, while nudging the economy to full employment, limiting inflation, and supporting economic growth are all important, Islam demands more of fiscal policy: poverty eradication, tolerable gap between the rich and the poor, adequate safety net, and enhanced resource allocation to preserve the rights of individuals in every generation, and all under a general umbrella of rule compliance that achieves social justice. Fiscal policy, supported by other initiatives, would be conducted so that everyone has the bare necessities of life—food, shelter, and healthcare. This means that fiscal expenditures, while broadly addressing unemployment, inflation, and economic growth, must also directly alleviate poverty. Similarly, the tax system must be designed so that there is not opulent living alongside economic deprivation.

In an ideal Muslim society, individual Muslims, before or after they have paid levies or taxes mandated in Islam (zakat, khums, and kharaj), cleanse their wealth by helping the less fortunate members of society (especially those who cannot work or find work) in order to close income and wealth gaps to tolerable levels. In Islam, a great deal is expected from every member of society, and the intervention and the role of the state would be minimal if humans lived up to their obligations and commitments as rule-compliant Muslims by complying with the rules of behavior prescribed by Islam. History is full of examples where Muslim societies developed sound institutions of social services based on Islam's instruments of redistribution. Research by Professor Murat Çizakça is evidence of this fact. (See Box 10.1.) If society fails to engage in social development as prescribed by Islam, then the state must levy taxes and focus fiscal expenditures to address societal shortcomings. At the same time, Islamic justice calls for a society where every member of the community has a reasonably equitable opportunity to develop and succeed in life; again, fiscal expenditures must address these concerns.

Similarly, we should note that the fiscal instruments that can be used in an Islamic economy are different from those in the conventional system. If expenditures are financed by taxes (pay as you go), there is clearly no issue, but when the state spends more than it collects in taxes and incurs deficits, then there are limitations on a Muslim government because of the prohibition of interest-bearing debt instruments. The state cannot use predetermined interest-bearing debt instruments to finance its deficit. However, it can use a number of other avenues to finance expenditures that exceed tax revenues. For example, the state can issue non-interest-bearing securities that the wealthier members of society may want to hold as one of their contributions to overall societal goals. But any debt, even non-interest-bearing debt, must be paid back. This would impose an unwarranted burden on future generations unless the state has used the proceeds to finance investments that will generate sufficient revenues to pay back only the debt (as there is no interest) in a reasonable period of time. But the state does not have to resort to deficit financing to the extent that modern governments have become accustomed to.

In short, fiscal policy in Islamic economy stands on two key pillars: taxation and public finance. The degree of reliance on taxation and/or public finance depends on how the society supplements social welfare programs through Islam's redistributive instruments and the developmental state of the economy.

Taxation

The focus of taxation is on increasing government revenue. Zakat in Islam and taxation in conventional terms are similar in that they ensure that resources of a country are more fairly enjoyed by all members of society. Zakat is imposed on the wealth of Muslims (in a sense on their surpluses) to redeem the rights of others in the society who are less able. The difference between zakat and taxation is that distribution of zakat is prescribed to only eight categories of people, whereas taxes are collected to support government spending for the provision of public goods and development.1 Zakat is also compulsory according to divine law, while taxation is a policy imposed by the government. According to Muslim scholars, the state is authorized to collect additional taxes if zakat is insufficient to meet the needs of those requiring assistance and to produce public goods (such as social infrastructure).

While there are numerous reasons for tax avoidance in many countries and in different systems of government, including complex governance issues in general, a good tax policy is one that balances simplicity, efficiency, fairness, and revenue sufficiency. The tax structure needs to be reformed in such a way that the people will be willing to pay taxes without much enforcement, as they believe that they are giving away a fair amount of their income. The tax structure should also be easy to administer and capable of generating the revenue required. A complex system of taxation poses a challenge for taxpayers to comprehend and comply with. At the same time, a complex tax system provides incentives for shrewd taxpayers to identify loopholes to reduce tax payments or avoid taxes altogether. Simplifying the tax system will also reduce costs both to the government (of auditing taxpayers and enforcing compliance) and to taxpayers (of engaging tax consultants and tax lawyers to defend contentious tax positions). With a simple tax system, investors can be certain about the tax costs of doing business. A simple tax system based on the ability to pay also can bring more taxpayers into the tax net. This could reduce the perception that a tax system is unjust because it captures only a small segment of society net. A simple tax system can be designed around a flat tax, reflecting the structure of zakat and other charges prescribed in the Quran.

Flat Tax

A flat tax system is simple, as there is only one tax rate applicable to all income and to all taxpayers. A simple tax system would naturally lead to efficient tax collection. Implementing a flat tax system would increase compliance by taxpayers and thereby increase tax revenue. A flat tax system, because it is a fairer tax system than a progressive tax system, could lead to less tax evasion. To address the issue of the tax burden of the low-income earners who currently may be paying a low tax rate, a minimum exemption level of income could be determined before taxes would be payable. As mentioned before, Islam places a great deal of emphasis on human dignity. Therefore, the amount determined for the minimum bracket is one that could enable a person to live in the society with dignity. This usually translates into sufficient income to guarantee “basic needs.” This minimum level is called the nisab limit. Two well-known proponents of the flat tax system, Hall and Rabushka, have developed a system that taxes income and eliminates double taxation by excluding taxes on investment.2 It is advocated as a simple tax system that would generate greater tax compliance, as tax filing would become a less painful process. It would reduce tax evasion while raising high levels of revenue for the government. This is not a new tax system. A flat tax has been adopted in a number of countries.

Wealth Tax

As a matter of equity, most argue that taxes should be levied according to the ability to pay. The current focus on taxing income may impose undue burdens on income earners who need the income for their day-to-day living. Income alone may not be a sufficient measure of well-being or taxable capacity. Wealth adds to the capacity to pay tax, over and above the income yielded by that wealth. Taxing wealth means making those who are more financially able contribute more in tax. Wealth represents accumulated assets owned, not just income earned. Therefore, in the interests of equity, it is justifiable to tax wealth in addition to income. Moreover, as wealth generally represents a much larger tax base than income, the rate of taxation can be kept low but still raise substantial tax revenue. In addition, advocates of a wealth tax argue that such a tax may encourage the better off to transfer their assets from less productive uses to more productive ones and from idleness to income-producing ventures. The wealthiest segment of the population, which holds assets in the form of properties and stocks in companies and projects, will probably be paying a relatively low tax as a proportion of their wealth compared to those whose wealth consists mainly of their monthly salary. Collecting tax revenue from the segment of the population with the most wealth could promote equality, as the wealth that is currently concentrated in the hands of a few would become revenue for the government to be used for social development.

Under an Islamic economic system, a flat tax system consisting of an income tax component and a wealth tax component has the potential to be ideal. It reflects the rate structure of khums (literally, a one-fifth charge levied on war booty during the earliest period in Islamic history) and zakat prescribed by the Quran and the Sunnah. The optimum flat tax rate may differ from country to country, depending on the unique economic situation. As a general guideline, it is proposed here that the tax structure be composed of a 20% income tax and a 2.5% wealth tax (with an appropriate level of income and wealth exclusion to reflect the minimum necessities of life). The flat tax system of 20% on income may represent a reduction in the marginal tax rate from the tax rate prevailing in most countries. The reduction in marginal tax rate would incentivize people and firms to work and increase production. The reduction in tax rates also represents an increase in disposable income to individuals that would lead to increased consumption in the economy. With a simple tax system in force, tax administration would be much easier, and government resources could be released to attend to other matters more important and productive to the economy.

Public Finance

Capital markets play a critical role in Islamic finance for both private and public sector financing. The first best instrument of risk sharing is a stock market, which is considered the most sophisticated market-based risk-sharing mechanism.3 It would provide the means for the business and public sector to raise long-term capital. In addition to the standard stock market, another capital market provides a platform for trading securitized asset-linked securities. The notion of “materiality” in Islamic finance of binding capital and financing closely and tightly to a real asset that is financed encourages the issuance of securities against a portfolio of assets. These “asset-linked” securities would be traded in the market through competitive bidding by a pool of investors, which includes individuals, Islamic banks (for their portfolios), institutional investors such as pension funds or insurance funds, and corporate treasuries. These investors trade these securities in primary and secondary markets.

Recent development of sukuk (Islamic bonds or ownership certificates) is an initial step in this direction.4 Sukuk can play an important role in raising finances for public projects as sukuk could be structured in different flavors to match different needs. Government development projects could be financed through sukuk, which could give ownership stakes to investors during the financing period; in return, the investors share the risks and returns of the project. For example, government could issue sukuk against a single infrastructure project or against pools of several development projects with different maturities. Figure 10.3 and Box 10.2 provide some examples of sukuk used to finance infrastructure project by different Muslim countries.

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Figure 10.3 Infrastructure Sukuk Issuance by Country

Source: Kuwait Finance House Research.

In an Islamic society, the state pays for most, if not all, current expenditures (such as social programs) by taxes and finances, and all needed capital expenditures through private-public programs. The state should develop the project, whether it is a bridge, a power plant, or an airport, and sell either equity shares or ownership certificates; in other words, the state would use sukuk for financing, with stockholders or sukuk holders taking the risk and getting the income generated from the project as dividends or returns. Similarly, in what amounts to the same thing, a number of projects could be combined and equity shares sold in the portfolio of projects; or, again what is essentially the same thing, the combined projects could be the assets that back a sakk (bond) that generates income with the sukuk holders who have access to the underlying assets. To our mind, the Islamic approach is in fact a better way for governments to finance their capital expenditures than the conventional approach in which interest-bearing debt is the instrument of choice and, invariably, with projects receiving less-than-full scrutiny, excessive debt crowds out the private sector (raising the level of general interest rates), governments incur higher funding costs, and the private sector (such as pension funds) are locked out of investments that could afford them interesting opportunities.

Even under conditions where there was no direct revenue from an infrastructure project, the government could resort to private sector financing with dividends paid by the government. But given that there are no fixed interest benchmarks in an Islamic system, the question becomes the appropriate rate of remuneration or dividend. Islam accepts public and joint ownership of assets as long as ownership claims can be priced in the market so that, in the event of dissolution, shareholders can sell and monetize their claims.5 Therefore, capital expenditures can be financed via equity shares, provided there is a market for trading shares. The issue is then one of determining the appropriate rate of return that compensates shareholders in a market where there is no benchmark, such as a fixed rate government security. But given that the rate of return in an Islamic economy is determined by the return in the real sector, it serves as a benchmark for investment decisions, and Mirakhor suggests that such a reference rate can be approximated by calculating the cost of capital using Tobin's q against which expected rates of return to private-public projects can be measured.6 After these securities have been sold, market forces will determine their daily price.

Since the expected earnings of shareholders are derived from the expected returns, it can be argued that the discounted value of expected earnings at the prevailing rate of return is the market value of a security and the supply price of capital. In the case of government securities, this would also constitute the demand side of the market for these instruments. Moreover, the face value of securities, the length of maturity, and the expected dividend constitute the supply side of the market for government securities. At equilibrium, the social rate of return is such that the marginal benefit from public investment projects is equal to the opportunity cost of the provision of marginal services from these projects. But because of the public nature of these projects, the marginal benefits may not be truly measurable. It can be argued, however, that precisely because of this characteristic of infrastructural and development projects, their social rates of return must be greater than, or at least equal to, the rate of return in the private sector; otherwise, there is no financial justification for undertaking these projects.7 As a result, the coupon on non-interest-based government securities can be issued and traded in equity markets that promise on maturity to pay a rate of return represented by an average rate of return on the underlying assets that is equal to the rate of return in the private sector. In addition to financing new projects, this approach can be used to retire government debt to the central bank that has financed previous projects since this debt can be securitized, providing the basis for the flotation of “national participation papers” to be traded on the stock market. These government securities are considered to be in consonance with Islamic law.

Financing a portion of the government budget through the stock market has advantages, 14 of which are summarized here.

  1. It can energize a stock market—provided that all preconditions, in terms of human capital and the legal, administrative, and regulatory framework—are met and can help strengthen the credibility of the market.
  2. It deepens and broadens the stock market.
  3. It demonstrates that stock markets can be used as a tool of risk and financial management.
  4. It reduces budgetary reliance on borrowing, thus imparting greater stability to the budget and mitigating the risk of “sudden stops.”
  5. It has a positive distributional effect in that the financial resources that normally would go to service public debt can now be spread more widely among the people as returns to the shares of government projects.
  6. It enhances the potential for financing larger portfolios of public works projects without the fear of creating an undue burden on the budget.
  7. It makes the task of monetary management simpler by limiting the amount of new money creation.
  8. It promotes ownership of public goods by citizens. This should have a salutary effect on maintenance of public goods as it creates an ownership concern among the people and to some extent mitigates the “tragedy of the commons.”
  9. It has the potential of strengthening social solidarity.
  10. It also has the potential to promote better governance by involving citizens as shareholders/owners of public projects.
  11. It provides an excellent risk-sharing instrument for financing of long-term private sector investment.
  12. It is also an effective instrument for firms and individuals to use to mitigate liquidity and productivity risks.
  13. By providing greater depth and breadth to the market and minimizing the cost of market participation, governments convert the stock market into an instrument of international risk sharing as other countries and their people can invest in the stock market.
  14. It will help demystify Islamic finance and will create an environment of cooperation and coordination with international finance.

It is not difficult for governments to design risk-sharing instruments for issue. These instruments can be traded in the secondary market if shareholders experience a liquidity shock. Their rate of return can be structured as an index of return tied to the rate of return to the stock market. If the domestic stock market is not deep, then an index of regional and/or international stock market returns can be included. The argument is that since the social rate of return to public goods is much higher than to privately produced goods and services, the rate of return for investments in public goods should be at least as high as the return to the stock market to promote efficient resource allocation. Of course, since governments are usually less risky, the rate of return to government-issued shares has to be adjusted downward to take account of the government's risk premium. Depending on the country and the interest rate the government pays on borrowed money, it is not likely that the rate of return it would pay to holders of equity shares it issues—adjusted for the credit rating of the government reflected in lower risk—would be any higher than the interest rate. Even in the unlikely event that a few basis points higher have to be paid, the trade-off is worthwhile, considering the positive contributions the instrument would make to the economy and the society.

Case for National Participation Paper

Haque and Mirakhor proposed an index-based security called a national participation paper (NPP) that can be used to issue government securities for public finance as well as instruments of monetary policy.8 The concept of an NPP is based on the reasoning that such non-interest-based government securities can be issued and traded in equity markets that promise on maturity to pay a rate of return approximated by an average rate of return on the underlying assets equal to the rate of return in the private sector but adjusted for any reduction in risk due to the government's backing. In addition to financing new projects, this method can be used to retire government debt to the central bank that has financed previous projects since this debt can be securitized, providing the basis for flotation of an NPP that is to be traded on the stock markets.

In its most general form, the rate of return on the private sector may be written as follows:

equation

where

  1. I = index growth of which will determine the uncertain (or the nonguaranteed) rate of return on the NPP
  2. w1… w4 = weights that need to be determined
  3. WI = international stock market index
  4. PPI = weighted average of returns in commercial participation paper market as it develops
  5. LSI = measure of market performance index in the country in which paper is being issued (stock index, earnings per share [EPS], dividends, return on equity [ROE], or average Tobin's q for the economy, where q is the ratio of value of a firm's assets to its market value)
  6. ROG = measure of the rate of return on government investments that underlie the NPP

Using this general formulation, the next suggestions should be considered and investigated:

  • ROG only (w1,…,w3 = 0; w = 1). If the ROG could be estimated and reported by the central bank, this would be a simple solution.
  • LSI only (stock index based) (w1, w2, w4 = 0; w3 = 1). Here, it should be borne in mind that the stock market is subject to speculative and other pressures. These should be excluded from the rate of return applied to the NPP.
  • LSI only (EPS, dividend, or ROE based) (w1, w2, w4 = 0; w3 = 1). Given the difficulties with the stock market development, proxies of economy-wide rates of return can be derived from estimates of EPS, dividend yields, and ROEs.
  • PPI only (w1, w3, w4 = 0; w2 = 1). A weighted average of NPP returns could be a useful indicator for the future when the NPP market develops.
  • More general index. Weights can be derived for any and all w1 (i = 1). However, this will require considerable investigation and maintenance work. If desired, investigative efforts should be exerted to derive and maintain the appropriate index. Experimentation with weights and variables mentioned in the expression for I will allow a stable and realistic indicator to be developed for the rate of return.

The choice of weights should be dictated to a large extent by the need to derive a stable measure of the rate of return for the private sector. When local markets—the stock market and the participation paper market—are developed adequately, they should be given due weight in the index. Until then, their weight should be limited. The appropriate determination weights should be based on empirical investigation and then kept under constant review, although the weights should be changed only at discrete, preannounced intervals.

Because of market volatility, asymmetric information, and the possibility of speculative behavior, stock prices as well as market indexes include a risk premium that risk-averse investors require to hold risky assets. In most markets, government paper represents the most secure asset (often considered as the risk-free asset), and its rate of return is used as a benchmark for comparing all investments.9 In equilibrium, the rate of return on government domestic paper would be equal to the rate of return on the stock market after adjustment for the risk premium. The index derived using the techniques discussed represents the rate of return to the private sector. Therefore, a risk premium should be subtracted from the private sector rate of return to obtain the rate of return that should be applied to government paper that is relatively free of market-based risk. The difficulty lies in finding an appropriate measure of the rate of return on assets that are similar in character to the government's to allow the system to begin. Any available bank deposit or loan rate (e.g., adjusted foreign rate, exchange rate, or rate on equity-based domestic transactions) would be a candidate if it were determined on market considerations. Any other reference rate that allows the establishment of a risk-free rate could also be used. This rate could be derived from any borrowing on a government project or a rate of return that has been obtained from such a project. When the NPP system is developed, its rates of return in the immediately preceding period could be used to estimate the risk premium. In this sense, the risk premium, like the index, will be updated on a regular basis. Using this rate, we can derive the risk premium as follows:

equation

where

  1. RP = risk premium
  2. μI = mean of the index I that has been derived earlier
  3. Rcountry = rate of return on bank deposits or government project

The risk premium can be calculated by applying data from the immediately past period. This formula, as well as the risk premium itself, can be revised periodically. But, given that stability of preferences has been observed around the world and through different time periods, there is little reason to assume large changes in this variable.

Payment on the NPP coupon will be made according to the growth of the I during the term of the paper. This RP should be subtracted from the growth of I to determine the final rate of return:

equation

where

  1. Rf = final rate of return to be paid
  2. Rs = rate of growth of I that has been suitably smoothed to correct for speculative and other behavior

The case of NPP is worth exploring for issuing government securities with varying maturities and for varying objectives. Once developed, the market of such paper could provide mechanisms for governments to finance development projects and to use for fiscal and monetary policy transmission and execution.

Summary

The principal goal of fiscal policy is to nudge the economy toward full employment and/or restore stable prices as needed. Additionally, the government uses fiscal and monetary policy to enhance economic growth and prosperity. The government directly increases aggregate demand by increasing its expenditures and indirectly (through consumption and investment) by decreasing taxes; the change in aggregate demand affects the level of national income. In the Islamic economic system, the goal of fiscal policy is broader than in the conventional economic system. While nudging the economy to full employment, limiting inflation, and supporting economic growth are all important in Islam, Islam demands more of fiscal policy: It seeks poverty eradication, a tolerable gap between the rich and the poor, an adequate safety net, enhanced resource allocation to preserve the rights of individuals in every generation, and all under a general umbrella of social justice. The process of fiscal policy (government expenditures and taxation) and its financing in turn affect the government's budgetary position.

Rules governing an Islamic economy can address the persistent budget deficit and rising level of government debt. The high level of debt constrains government's ability to take on additional risk in its balance sheet. Apart from the threat of a credit rating downgrade, persistent fiscal deficits also impair the ability of policy makers to respond effectively to future shocks. Additionally, increasing the debt burden could have adverse distributional impacts for current and future generations. This is due to the fact that the middle- and lower-income classes carry the burden of the taxes that are needed to service government debt held by either higher-income groups or foreign investors. The design of policy instruments for fiscal policy in an Islamic economy should reflect concerns such as distributive justice.

Relatively stable fiscal revenue is essential for macroeconomics management and in turn for sustained growth.10 A fiscal deficit is a common phenomenon in many nations, including the developed industrialized countries. This suggests that the policy prescriptions that had been put in place were not sufficient to create a sustainable fiscal position. This may have been due to either multiple structural weaknesses in the current tax system or a breakdown in fundamentals. In either case, a new policy configuration that would lead to a more sustainable and growth-supportive fiscal position would be in order.

An alternative approach to the current policy dilemma would propose a two-pronged solution: reform of the tax system and a radical change in the way governments finance their spending. The tax system needs to be simplified to a flat tax to induce voluntary declaration and compliance from taxpayers and widened to include a tax on wealth. At the same time, financing of economic activities should move away from the current interest-based system to one based on risk sharing through utilization of funds available to the public at large. Therefore, it is imperative that policies to increase revenue are put in place in tandem with a policy to mobilize debt-free public sector financing.

In Chapter 11 we examine how monetary policy also affects national income, employment, and prices, and in conjunction with monetary policy, we assess the transmission mechanisms of both monetary and fiscal policy in an Islamic economic system.

Key Terms

  1. Goals and objectives
  2. Taxation
  3. Income (flat, progressive)
  4. Wealth (flat, progressive)
  5. Sales and value added taxes
  6. Public finance
  7. Expenditures
  8. Budget deficit
  9. National debt
  10. Economic shocks
  11. Inside lag
  12. Automatic stabilizers
  13. NAIRU
  14. Natural rate of employment
  15. Multiplier
  16. National participation papers

Questions

  1. Do you think fiscal policy is effective both in the short and in the long run and why? (Hint: Read the next chapter before answering.)
  2. What would happen if the government just kept on spending to increase GDP? Would output just go on increasing?
  3. Explain why $1 in government expenditures does not have the same effect on GDP as a tax cut of $1.
  4. What form of taxation, if any, do you think is the most fair?
  5. Do you think that the government's budget should be always balanced? Why or why not?
  6. Do you think that fiscal policy should incorporate important social objectives (and which ones) or just stabilize and nudge the economy toward NAIRU?
  7. Do you think that fiscal policy is more limited in Islam because of the prohibition against interest-bearing government bonds, and why or why not?

Notes

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