Thursday, July 19, 2012

Comparative Study on Sources Of Public Finance in Islamic Economy and Capitalist Economy

Comparative Study on Sources Of Public Finance in Islamic Economy and Capitalist Economy
Applicability Of Islamic Public Finance To Preset Trend
ž           Since interest is prohibited in Islam, the Govt in an Islamic economy cannot issue interest based credit instruments like Trade bills/bonds or obtain interest based sovereign debt. Where in general economics interest rate is reward for saving, the govt issues various debt instruments to raise funds from  general public, foreign nationals , banks to fund projects and for deficit financing on the basis of interest rates. Apart from different sources of Non-tax revenues viz fines, fees, revenue generated from Public sector enterprises, revenue including interest or profit from the investments, user fee etc., Based on the literature review, of Islamic economy no taxes levied other than Zakah. Accordingly; this study explores the sources of revenue for a government in Islamic economy. In discussing sources of tax revenue it is maintained that zakah is the only tax the government in an Islamic economy can levy. Where e in general economics taxation is the central part of modern public finance, its objective is to raise revenue necessary in a welfare state to fulfill its obligations. There are various sources of taxes mainly personal income tax, corporate income tax, wealth tax, Value added tax, service tax etc.,
ž           One thing is found common in both the institutes as govt can charge service/performance based fees, duties, surcharge etc in providing public goods. Furthermore, the profitable operations of state owned enterprises form of important part of non-tax revenues.
ž           This study discuss that how the  government can finance its deficit keeping in view that low taxation and  low interest in general economics  as like that of interest rate is prohibited in islam & zakah rate are very low.
ž            The role of government in a economy has always been important issue , economist and policy makers since from the evolution of political economics by Adam smith  in wealth of nation to Keynesian frame work has been accepted government as a not only a regulator of a economy but also as an active economic player.
ž           In the midst of great recession, the role and importance of government has once again reappeared as an important issue. Like bailout package of US govt to financial sector in Dec 2008, providing huge subsidies to its agricultural sector. So one cannot ignore the role of a state as a regulator and as a active economic player.
ž           In this backdrop, this study takes an important issue in public finance in a Islamic economy and general economics, more specifically, it put a glance at sources of tax revenue, how it is raised and utilized for public finance in Islamic point of view. Also to see does this applicable to present trend.
ž           This study analyses public finance literature in general economics and Islamic economy on the other hand source of revenues to the governments for funding ever increasing public expenditure , reduction in budgetary deficits and applicability of Islamic ideology of public finance to present trends
ž The study sets the following important objectives.
ž To suggest the different sources of  revenue for the state in Islamic point of view
ž To explore the ground rules for zakatable assets and zakatable income fund in the study of Islamic faith.
To estimate the potential of tax revenues that can be collected in zakah
ž           The study has significance in academics as well as in public policy making in respect to Islamic faith could be a alternative to policy making and adds to the literature of contemporary developments in both literatures and public finance practice of general economics. To discuss the means of revenue and sources of public finance through and beyond zakah in an Islamic economy.
ž          This study is conceptive and theoretic in nature. It clarifies various charges in the institution of zakah as like taxation in general economics
ž           Comparative study of sources of revenues in Islamic economics (Zakah) and General economics (Direct & Indirect taxation). This study sets to contribute in public policy making as well as add to the academic literature of general economics as a alternative system.
ž          The study is purely theoretic and comparative in analyses the sources of public finance (taxation and zakah only)
 ž In conventional economics, the government has following sources of revenue: general sales tax, excise duty, customs duty, Import& export duty, Property tax , development surcharge, personal income tax, corporate income tax. Apart from that non-tax revenue by way of earning through profitable operations of state owned enterprises, fines and activity based charges & duties are also important sources of revenue to state. In general economics, if government needs to finance deficit it can issue treasury bills/bonds or obtain loans from domestic as well as international sources.
 ž In islamic economy, the problem comes in the issuance of debt( due to prohibition of interest) and imposition of taxes beyond zakah is not recommendable. Zakah is a combination of a net worth tax and production tax.
 ž In islamic thought zakah is a religious obligation to pay a part of wealth and production to the government. However, in most countries, zakah is not collected by the government and is not considered a compulsory payment. Eminent Muslim scholar Ab-ul-ala Maududi (1970) reasoned that zakah is a religious obligation and not a substitute for tax. Taxes other than zakah can be imposed in an Islamic economy if these taxes are levied by the legislative council and used for public welfare. He reasoned that the taxes discouraged in a hadith are those which were imposed by autocratic kings for their own lavish consumption and this kind of usurpation of public property was discouraged.
ž         Disucssing the issue of distributing zakah, islahi(185) and Qardawi (2000) explained that it is not necessary to make some living  person the owner of the zakah. Zakah can be given to any person or cause or an organizaiton working for a cause, not necessary to make some living person the owner of the zakah. Zakah could be distributed on the welfare of the people as well as given to people themselves. If a policy of full employment requires high MPC; then, a progressive taxation like zakah could help in boosting aggregate demand and increasing employment.
ž           As modern day problems in estimation of zakah, Usmani(2003) asserted that zakah on shares would be paid on the net liquid assets/share i.e. by excluding from the total assets, the value of assests used as means of production. And the liabilities owed to the business are deductable. Then, the zakah can be paid on the value of net liquid assets/share multiplied by number of shares held by the investor.
ž           Haque & Mirakhor (1998) classified government expenditure into i) asset creating and ii) non-asset creating. Non asset creating activities can be financed through tax revenues. But, in asset creating activities, equity modes of financing can be used whereby financing would be generated by way of an instrument. As per their recommendation, this instrument would be priced using the formula.
ž           I=w1 WI+W2PPI+W3LSI+W4 ROG
ž          Where
ž WI = worked index
ž LSI=Stock index, a measure of market performance index based on ROE.
ž PPI=index representing average returns on commercial participation papers
ž ROG=return on government investments and project
W1 W2 W3 and w4 are weights assigned to each variable.
ž          Zakah is a religious obligation to pay a part of wealth and income to the government.
ž   For calculation of zakah, people used the cross rate between gold and silver and determined their nisaab in gold as well. This cross rate has changed historically; that is why, we will have to resort to the original base i.e. 612 grams of silver when there is no bimetallic monetary standard in operation. One important implication of this principle is that tax exception amount in silver is much lower than gold using current cross rate and hence taxable assets will increase in magnitude. Zakah would be as per the ceiling rates defined for each category of wealth or production.
ž          The classification is as follows:

ž a) 2-½% on cash, wholesale value of held for trade inventory and capital in excess of need payable once a year at a particular set date.

ž b) 5% on production using both labor and capital. It is charged at the completion of the production process.
ž c) 10% on production using either labor or capital. It is charged at the completion of the production process.

ž d) 20% on production using neither labor nor capital. This is applicable on treasure or any other natural Gift obtained without using neither labor nor capital.

Issues in Estimation of Zakah
ž          Wealth/Assets subject to Zakah include Cash in hand, Cash in Bank, gold and silver not in daily usage (for women), gold and silver owned by men, held-for trade inventory, property/plot purchased for the purpose of resale. Production is not limited to agriculture nowadays, but the major part of it is coming from industries as well as services sector. Therefore, industrial production could also be taxed just like agriculture. Services income could also be taxed on the same principle.
ž           Khan (2005) stated that investment in stocks should be interpreted as any other investment with some means of earning income. Stock is a means of earning dividend or capital gains. Just like means of production/income are exempt from Zakah, investment in stocks should be exempted from Wealth Zakah as investment in stocks means that the money is not kept idle rather it is invested and even its value could reduce to zero or increase by a long way theoretically. Therefore, any income arising from investment in stocks i.e. capital gains or dividend must be subject to Income Zakah. Similarly, this argument could be extended to introducing Income Zakah on mutual funds, investment in NSS, debentures, bonds etc. Furthermore, if land/building/house is leased, the land/building/house becomes the means of earning rent. Hence, income Zakah could also be introduced on rental income on houses, assets, buildings etc.
Non-Tax Revenues
ž           Non-Tax Revenue can come from profitable operations of State Owned Enterprises (SOEs). State Owned Enterprises (SOEs) in postal services, railways, airline industry, steel industry, communication industry, public utilities, transportation industry, aviation industry etc can be run effectively and generate profits as they operate in industries which have significant potential for economies of scale, economies of scope and face relatively inelastic demand. With deficit financing not an option available, there will be an automatic check on government to run these State Owned Enterprises (SOEs) effectively and efficiently.
ž           Fines and Penalties is another source through which government will generate funds. Ideally, this is not a source of revenue as the objective of fines and penalties is to enforce law, improve competition and put right market imperfections. But, this will materialize only when the good practices are rewarded and bad practices penalized.
Funding Non-Revenue Generating Activities
ž          The real problem arises in funding operations of non-revenue generating activities like the operations of courts and police etc. It is to be noted here that in Muslim societies under the rule of Caliphates, there was no concept of jail which is a later invention. The Islamic punishments like Capital punishment on Murder, Forced Rape etc, monetary fines and physical punishment in extreme cases of stealing, fraud, robbery etc do not require people to be imprisoned. As a matter of fact, these prisons become the usuries for bringing societies even more seasoned criminals rather than a place for rehabilitation. Besides the convicted person, the family of the convicted also gets heavily affected by such imprisonment. Therefore, reforming the penal law based on Islamic principles will significantly reduce expenditure on making, developing and maintaining such prison cells. If we study the judicial system in Caliphates time, the judicial system did not have high cost of advocacy. Infact, there was no concept of 3rd party advocacy
ž           As the law of the land was simple and its implementation enforced strictly. The society put huge emphasis on honest testimony. The judicial system was highly centralized and that too in Umar (rta) and Usman (rta) period when the Islamic state was spread all over Arabia and touching North Africa as well as Eastern Europe.
Alternative for Public Finance Other Than Zakah
ž            Next, we discuss how the budget deficit could be financed in an Islamic economy. First of all, it is to be noted that sources of revenue (tax and no-tax) will be substantial enough to meet necessary development and non-development expenditure. Furthermore, if true Islamic values are adopted, non-development expenditure in providing perks to the government officials will also reduce. Looking beyond imposing more taxes, Usmani (2003) proposed issuance of GDP growth linked Instruments to finance public debt. In public finance, a Nominal GDP linked bond could be issued. In public projects valuation, this benchmark rate would be used to find PV of Cash Flows.
ž This would be appropriate due to following:
ž i. It will not lead us into falling in time value of money as we are using an enterprise or output related
ž Benchmark rather than interest based benchmark.
ž ii. The Cash Flows are obtained using equity contractual modes like Mudarabah and Musharakah.
ž iii. In this case, we are calculating valuation models for the investor and not for the borrower. Borrower
ž or financee will be obliged to provide the returns based on these valuations. But, the investor can
ž Use this “indicative valuation” to rank investment alternatives.
ž   This study brings the sources of revenue for a government in an Islamic economy. Though Zakah rates are low, but Zakah base is very broad and can include all productive activities.
ž                  The government in an Islamic economy can manage its operations without resorting to interest based deficit financing.


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