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Comparative Economic Systems: A Brief Review

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 M PRA
Munich Personal RePEc Archive

Comparative Economic Systems: A Brief

Review

Salman Shaikh

Islamic Economics Project

28. February 2012

Online at http://mpra.ub.uni-muenchen.de/42499/
MPRA Paper No. 42499, posted 7. November 2012 15:46 UTC
 Comparative Economic Systems: A Brief Review

Salman Ahmed Shaikh1

Abstract
This paper analytically compares the theoretical foundations of major
economic systems i.e. Capitalism, Socialism, Mixed economy (a hybrid of
Capitalism and Socialism) and the Islamic economic system. The research
identifies that lack of an ethical base, unbridled pursuit of self interest in
production as well as in consumption and interest based financial and
monetary system are the major problematic issues in the current
economic order. Socialism promises to create heaven on earth, but takes
fundamental human rights and profit motive away and in the extreme
case, it gives way for an autocratic regime. The paper provides brief
outline of Islamic Economics and explains that Islamic economic system is
a blend of natural features present in Capitalism i.e. right to private
property, private pursuit of economic interest and use of market forces
etc. Along with this, Islamic economic system uses some distinct features
derived through Islamic economic teachings i.e. Interest free economy,
moral check on unbridled self-pursuit and provision of socio-economic
justice to achieve the goals of Socialism as far as is naturally possible
without denying individual freedom and profit motive.

Keywords: Economic Systems, Capitalism, Socialism, Communism,

Islamic Economic System.

JEL Codes A13 B52 A14

1. Introduction

An economic system is a set of principles based on which an economy can

run and make decisions about which goods and services to produce, how
to produce and exchange them, how should the income from the
production be distributed among the factor resources and what shall be
the right balance between public sector and private sector and that
between free market mechanism and regulation. Broadly speaking, there
are following economic systems in the economic literature:

1. Capitalism
2. Socialism
3. Mixed Economy
4. Islamic Economic System

1
Salman Ahmed Shaikh is a researcher in Islamic Economics. He is pursuing PhD in Islamic Economics at IBA,
Karachi. He also serves as a Research Associate & Lecturer at IBA, Karachi. He has authored 12 papers and a
book on Islamic Economics in past.
 2. Capitalism

Capitalism is an economic system based on certain principles, like

provision of private property rights, free market economy and allowing
economic agents (consumers and producers) to purse private motives and
self-interest with no or minimal government intervention.

Capitalism, unlike Islamic economic system and Socialism regards capital

as a distinct factor of production worthy of a distinct factor payment i.e.
interest. It supports the capitalists to benefit from wealth accumulation
without having to put factor i.e. capital at similar risks that an
entrepreneur faces. In this regard, interest has a huge influence on
allocation of resources. It influences the basic economic decisions like
what and for whom to produce.

2.1. Economic Management in Capitalism

2.1.1. What to Produce?

In an open economy and free trade environment, countries should

produce the goods domestically in which they have comparative
advantage. Comparative advantage principle states that if a country can
produce a particular good at least opportunity cost comparatively than the
rest of the world, then the country has comparative advantage in
producing that good. In addition to that, the principle suggests that
countries shall buy the rest of the goods from other countries if they do
not have a comparative advantage in producing those goods.

2.1.2. How Much To Produce?

While producing goods in which a country has comparative advantage,

the opportunity cost principle determines the level and variety of output
for that country in each good it decides to produce. In an open economy
and free trade, specialization and trade maximizes the aggregate
combined production and hence leaves greater volume of goods for
consumption and distribution in the society.

2.1.3. How to Produce?

The objective is to economize on the use of scarce resources that leads to

efficient production. Countries sometimes use such input combinations
which makes extensive use of factor endowments that are in abundant
supply in the economy.
 2.1.4. When to Produce?

Countries have to make decision about future production well in

advance to meet the demands of increase in population, changes in
tastes and preferences and changes in income. Countries have to produce
domestically the goods in which they have comparative advantage and
import the other goods to meet demand and to avoid inflation.

2.1.5. For Whom to Produce?

Resources are allocated to produce goods that can be bought in the

market by people having adequate purchasing power. Purchasing power
determines the size of the target market and triggers the producers to
meet expected demand. Decisions about production are driven by self-
benefit and profit maximization objective.

2.2. Fundamental Postulates of a Capitalistic Economy

In the following lines, very briefly, we give an account of important

principles of Capitalism.

2.2.1. Right of Private Property

In a capitalist economy, people have the right to own assets and conduct
any business. Within legal limits, they have the complete freedom to
enter into any business activity, be it socially or morally correct or not.

2.2.2. No Government Intervention

Government does not intervene or its intervention is very minimal.

Businesses are allowed to produce anything and charge any price they
wish as long as they can find buyers who can afford their goods and
services. A capitalist seeks maximum return for his capital and keeps all
things secondary to it.

2.2.3. Freehand to Market Forces

Market forces of demand and supply are allowed to work freely.

Government does not intervene in setting the prices or level of output in a
model capitalistic economy. If it tries to intervene through rationing, price
floors, price ceilings, quota, tariffs, taxes etc, it creates a deadweight loss
and decrease in efficiency as well as in welfare.

2.2.4. Dependence on Invisible hand

It is assumed that when every person act in his/her own benefit, it will
keep the economy running in an efficient way. It is assumed that social
objectives will be met with people working for their own benefits.
Everyone is allowed to work in his/her benefit and is not obliged to think
about society, its needs and negative externalities of any private choices
and actions.

2.2.5. Freedom of Choice in Production

People have outright freedom in production. A capitalist having a higher

incentive to produce luxury bungalows and lower incentive to produce
low cost apartments will produce luxury bungalows. All decisions are
governed by private incentives and self benefit and private economic
agents are not obliged to give consideration to the needs of the society.
Invisible hand is supposed to bring socio-economic order by itself.

2.2.6. Freedom of Choice in Consumption

People have outright freedom to consume whichever goods they like as

long as they can afford them. Consumers seek maximizing utility through
increased consumption of material goods and services and do not have
obligation to share their wealth with the poor masses apart from
compulsory taxes. Hence, materialism, self benefit and apathy are the
hallmarks of the capitalistic society.

2.3. Critical Analysis of Capitalism

Capitalism, the way it is practiced as an economic system, has largely

allowed and provided legal cover to certain exploitative institutions and
their operations based on free market philosophy. Such institutions have
been chiefly responsible for much of distributional inequity in the world
today.

Interest based financial intermediation in theory and in practice has

exhibited increased concentration of wealth in the world. A system is not
an end in itself; rather it is meant to serve the needs of society at large
amicably.

Indeed, when we glance over statistics of poverty on one hand and rising
inequality on the other, we ought to question the merits of such
institutions. Indeed, even in free market philosophy, we do not allow
certain institutions which bring harm to the society and individual liberty.
But, yet, so far, we have turned limited attention towards critically
evaluating the ever more intricate system of interest based financial
intermediation in practice today.

As a matter of fact, problems like poverty have persisted and even got
severe in some regions in last century than in the past. Problem is not
with resource scarcity, it is with distribution of resources which require an
equitable and egalitarian socio-economic system. What is needed is a
system that consists of institutions working towards fulfilling this
objective.

Interest based financial intermediation used as a system of allocation of

resources ensures a fixed return for one and variable/uncertain for
another. This dichotomy in payoffs increases concentration of wealth and
discourages entrepreneurial pursuits, since fixed return on wealth is
ensured by the interest based system to the wealthy capitalists. No
matter what is the initial distribution of wealth in society, interest based
financial intermediation brings concentration of wealth eventually in every
society. Indeed, inequality of wealth is not just a problem of the third
world, but a fact of life in each and every country with the sophisticated
interest based financial system at work.

To put matters in right perspective, income inequality even in OECD

countries is at its highest level for the past half century. The average
income of the richest 10% of the population is about nine times that of
the poorest 10% across the OECD, up from seven times 25 years ago.

Figure 1 and 2 depict current level of inequality and concentration of

wealth in the world.

Figure 1: Global Population Distribution by Income

Source: Credit Suisse Research Institute, Global Wealth Report, October 2010.
Figure 2: Global Income Distribution

Source: Credit Suisse Research Institute, Global Wealth Report, October 2010.

The disincentive to enter in entrepreneurial pursuits because of lack of

willingness of capitalists to risk capital while having the opportunity to
earn fixed interest income brings down investment in the economy.
Decline in the potential investment in productive pursuits retard economic
growth, keep unemployment high, add burden on fiscal position of
government to expend on transfer payments and decrease
competitiveness in the markets, resulting potentially in welfare loss and in
other ills associated with market imperfections.

To get a glimpse of the negative externalities of interest based lending on

poor countries, we present just a few important facts.

 Sub Saharan Africa receives $10 billion in aid but loses $14 billion in debt
payments per year (Africa Action, 2008).

 Currently, Africa‟s total external debt stands at $300 billion. Many

African countries spend more on debt than either on health or
education.

 GNP per capita in Sub-Saharan Africa is $308 while external debt per
capita stands at $365.

 Nigeria borrowed around $5 billion and has paid about $16 billion, but
still owes $28 billion. Regrettably, 7 million children die each year as a
result of the debt crisis.

Even a key revivalist of Capitalism during Great depression, Keynes

(1936, p. 377) in his monumental work “General Theory of Employment,
Interest and Money” reasoned in following words:
 “Interest to-day rewards no genuine sacrifice, any more
than does the rent of land. The owner of capital can obtain
interest because capital is scarce, just as the owner of land
can obtain rent because land is scarce. But whilst there
may be intrinsic reasons for the scarcity of land, there are
no intrinsic reasons for the scarcity of capital. An intrinsic
reason for such scarcity, in the sense of a genuine sacrifice
which could only be called forth by the offer of a reward in
the shape of interest, would not exist, in the long run,
except in the event of the individual propensity to consume
proving to be of such a character that net saving in
conditions of full employment comes to an end before
capital has become sufficiently abundant. But even so, it
will still be possible for communal saving through the
agency of the State to be maintained at a level which will
allow the growth of capital up to the point where it ceases
to be scarce”.

In one of his famous essay, Keynes (1932, p.358) reasoned as follows:

“When the accumulation of wealth is no longer of high

social importance, there will be great changes in the code
of morals. We shall be able to rid ourselves of many of the
pseudo-moral principles which have hag-ridden us for two
hundred years, by which we have exalted some of the
most distasteful of human qualities into the position of the
highest virtues. We shall be able to afford to dare to
assess the money-motive at its true value. The love of
money as a possession — as distinguished from the love of
money as a means to the enjoyments and realities of life
— will be recognized for what it is, a somewhat disgusting
morbidity, one of those semi-criminal, semi-pathological
propensities which one hands over with a shudder to the
specialists in mental disease ... But beware! The time for
all this is not yet. For at least another hundred years we
must pretend to ourselves and to everyone that fair is foul
and foul is fair; for foul is useful and fair is not. Avarice
and usury and precaution must be our Gods for a little
longer still. For only they can lead us out of the tunnel of
economic necessity into daylight.”

Krugman (2009) analyzing the financial crisis of 2007-09 remarked:

“Until the Great Depression, most economists clung to a

vision of capitalism as a perfect or nearly perfect system.
That vision wasn‟t sustainable in the face of mass
unemployment, but as memories of the Depression
 faded, economists fell back in love with the old, idealized
vision of an economy in which rational individuals interact
in perfect markets..”

Having perfect markets leads to efficiency and economic welfare, but the
institution of interest hampers potential investment by arbitrarily making
capital scarce. It encourages concentration of wealth and creates a barrier
in the way of use of funds in productive enterprise. Positive economics
says that given an interest based investment opportunity; consider
productive enterprise only if rate of return exceeds the market interest
rate, but positive economics does not consider negative externalities, e.g.
increased income inequality, poverty and below full employment use of
real scarce resources resulting by artificially making capital scarce.

Providing an Islamic economics perspective on the institution of interest,

Siddiqui (2002) explained that even in commercial loans, the borrower
may suffer a loss, yet interest based lending obliges him/her to
repay the principal plus compound interest. Conversely, the borrower
may reap huge profits, yet the lender gets only the stipulated rate
of interest which may likely turn out to be small part of the actual profits.
It results in inefficient allocation of society‟s resources and increases the
inequality in the distribution of income and wealth as it guarantees a
continuous increase in the monies lent out, mostly by the wealthy, and
puts the burden of bearing the losses on entrepreneurs and through loss
of jobs on the workers.

On the behavioral weaknesses of Capitalism, Chapra (1993) argued that

secular societies continue to belittle the need for moral development;
though all of them now profess commitment to development with justice.
He emphasized that even material development with justice is not
possible without moral development. The rationale for this contention is
that development with justice requires an „efficient‟ and equitable use of
all resources and both „efficiency‟ and „equity‟ can neither be defined
nor actualized without the injection of a moral dimension into
economic pursuits.

2.4. Critical Analysis of Arguments in favor of Interest

2.4.1. Interest is the price of risk

It is not correct to say that lending money involves a risk. Because the
lender gets interest in any condition, whereas businesses after taking
operational risk either earn profit or incur a loss. In any entrepreneurial
investment, the investment has to go through the entire process of a
business activity that involves risk taking at each stage and any
compensation on investment is strictly dependent upon the outcome of
the entrepreneurial activity. Time value of money is the problem for the
investor to avoid keeping his money idle and to avoid forgoing the use of
money that may bring positive value to his investment. However, it does
not mean that the investor can demand an arbitrary increase (or is given
as the case may be) as the cost of using money without taking the
entrepreneurial risk.

2.4.2. Share in the profit of the borrower

Interest is not a share in the profit of the borrower because if money is

borrowed for fulfilling needs rather than for conducting business, then,
there is no question of a profit. But, even if money is lent for
commercial purposes, then, how one can determine that the enterprise
will be profitable let alone determining the level of profits. Businesses
earn profits and incur losses, but why the investor doesn‟t share in the
losses and what sort of an effort he has put in to demand a share in
profits that is fixed and confirmed irrespective of the profitability of the
business.

2.4.3. Interest is a rent on money

Those things on which rent is charged are used and given back in the
same existing condition like homes, cars etc, while money and other
consumption goods are consumed. When we borrow money, we consume
it and regenerate it. When the money is consumed, the borrower has to
regenerate it and the lender without taking any risk is entitled to receive
the consumed money with the interest. Can we borrow apples or
mangoes on rent? We can borrow hammer but not the nails based on the
above classification.

3. Socialism

3.1. Fundamental Postulates of Socialism

Marx (1867) described socialism as a specific historical phase that will

displace capitalism as a precursor to communism. Socialism did not
promise to make everyone equally well off in economic terms and pay
everyone the same wages and replace market economy in a complete
sense. However, communism did promise absolute income and social
equality. Socialism was to act as a pre-cursor to Communism. Some of
the well known political activists of Socialist movement were Vladimir
Lenin and Joseph Stalin. Some of the important countries that tried
Socialism include Russia, Hungary, Poland, Romania, Vietnam, Yugoslavia
etc. The salient features of Socialism are discussed below:
 3.1.1. Collective property

In a model socialist economy, there is no right to own private property for

commercial undertakings. All the property collectively is in the ownership
of the socialist government in the country. This means that all the
business enterprises are in the collective ownership, management and
control of the government.

3.1.2. Planned Economy

The government in its own wisdom solves the central problems of the
economy. Decisions about production, allocation and distribution are all
taken by the socialist government. All the economic planning and policy
making rests with the socialist government.

3.1.3. Decisions in Collective Interest

All the decisions are made by the government in the collective interest of
a socialist country. People are directed to follow the instructions of the
socialist government and are not allowed to object to any decision or
policy of the socialist government.

3.1.4. Reduced Income Inequality

Socialist government makes the decisions about the wages arbitrarily and
the wages are forced to remain equal. Socialist government tries to
maintain income equality through setting the wages and disallowing
any objection or bargaining.

3.1.5. Restriction on Market forces

Market forces of demand and supply are not consulted by the government
in a socialist economy. Market mechanism does not prevail and all the
decisions are made by the government in its own wisdom.

3.1.6. Centralized Economy

All the decision-making authority rests with the government. No one else
is given the authority to make the economic decisions even for oneself.
Everyone has to follow the commands of the government and everyone is
treated like an employee of the government.

3.1.7. Non-existence of Private sector

Private sector is non-existent in a socialist economy. No private economic

activity is allowed. Every person has to work for the socialist government
and earn wages that are set arbitrarily and are not determined on the
basis of quality or nature of the work.

3.2. Critical Analysis of Socialism

On the economic criticism of Socialism, Maududi (1970) explained that

Socialism in its quest to tame capitalists brought one big capitalist in the
form of socialist government accredited with the responsibility to operate,
manage and administer the overall economy without giving society and
individuals any recourse to challenge the socialist government.

In such a case, no government, consisting of humans after all, can keep

itself judiciously pursuing common goals over individual goals. Usmani
(2003) reasoned that socialism kills the self motive which drives
individuals to excel and be efficient.

The problem in distribution of income in Capitalism arises from an Islamic

perspective with the system of interest. Land has an intrinsic value and its
owners receive rent on land. Labor also earns wages for the toil and effort
contributed in the production process. While laborer earns wages for work
he renders and the land owner earns rent for the use of land, money
cannot have a separate compensation of its own until it transforms itself
as capital and take the risk of entrepreneurship along with an
entrepreneur.

Toutounchian (2006) also differentiated between money and capital

and reasoned that if capital is combined with labor, it produces profit,
but if money alone is lent, the interest it earns is not permissible.

On the political criticism of communism, Fukuyama (1992) argued that

following the collapse of the Soviet Union, liberal democracy no longer
faced any serious ideological challenges and thus had proved itself to be
the only sustainable and successful form of government. Marx used the
phrase 'the end of pre-history' to symbolize the victory of communism
over capitalism. Fukuyama claimed that capitalist liberal democracy
would ultimately extend to all nations and this would be 'the end of
history'.

However, as the history unfolded soon afterwards, the negative effects of

ethical emptiness in Capitalism also became more prominent in
contemporary economic and financial crises. Lack of an ethical base,
unrestrained pursuit of self-interest in production as well as in
consumption and interest based financial and monetary system are the
major obstacles to an equitable distribution of income that are inherent
limitations of Financial Capitalism.

Unrestrained chase of self-interest, moral relativism, incentive-led

economic choices and indifference to collective responsibilities has led to
engender societies where economic interests have become the solitary
basis of establishing and maintaining relationships.

Hence, now it is realized that reconsideration is needed of value

judgments which lead to cornering of any thoughtful consideration of the
fact that regulation and oversight is necessary to control and avoid crisis
in today‟s complex economic world which is in bad shape now in terms of
rising inequality of income, wealth and limited public access to influence
and benefit from policy making even in liberal, but increasingly capitalistic
democracies.

4. Mixed Economy

4.1. Fundamental Postulates of Mixed Economy

Mixed economy is a compromise between capitalism and socialism. A

mixed economy takes the valuable features of both. Some mixed
economies can be tilted more towards socialism and some can be tilted
more towards capitalism. However, most countries can be classified as
mixed economies in the real world. In the following lines, few
fundamental features of a mixed economy are briefly stated.

4.1.1. Coexistence of Public and Private Sector

In a mixed economy, public and private sector work in parallel to each

other. Usually, the public sector is responsible to provide transport,
communication, defense, currency management, utilities like telephone,
water, gas, electricity etc. All the other industries are in the ownership of
private sector.

4.1.2. Government Regulation and Prices

Unlike in Capitalism, government intervenes in the market to

regulate prices. Governments give subsidies to encourage production of
necessities and their cheap availability to the poor masses. On the other
hand, high tariff rates are imposed on luxuries with inelastic demand.

4.1.3. Government Regulation and Market Imperfection

Government intervenes in industries where cartels are formed. It

disallows cartels and regulates oligopoly, and monopoly. The government
sometimes set a ceiling price for goods and services to put check on
monopolies and reduce the burden of inflation on poor people.
 4.1.4. Government Intervention and Income distribution

Government intervenes to redistribute income through progressive taxes,

setting price ceilings for necessities and setting minimum wages. The
government also provides tax holidays, tax credits, tax rebates and other
concessions and incentives to promote a particular socioeconomic activity
or class.

4.1.5. Public Sector and Social Objectives

Usually, the public sector is responsible to provide transport,

communication, defense, currency management, utilities like telephone,
water, gas, electricity etc. Government, if necessary, provides subsidies
to public enterprises so that these enterprises do not increase their prices
to cover their losses. Government sometimes bears losses to avoid public
displeasure in the form of inflation.

4.1.6. Promotion of Private Sector

Even though the government intervenes in the hour of need, it still

provides incentive to the private sector and a level playing field to
compete with the public sector. In industries where public sector and
private sector coexist, government lets the market forces work and does
not crowd out the private sector.

4.1.7. Deregulation, Liberalization and Privatization

Governments in mixed economies encourage private sector to take on

public sector enterprises that are not running efficiently or can be better
run by the private sector. It enables the government to act as a regulator
rather than as a business entity.

4.2. Critical Analysis of Mixed Economy

Though mixed economy has solved some of the problems in laissez-faire

and Anarcho-Capitalism, but it still lacks an ethical foundation to foster
social optimization and development at a grand scale i.e. to influence
social and human development. Secondly, it has retained interest based
financial system which has created many economic crises in a short span
of time leading to the Great Recession of 2007-09. Therefore, much of the
criticism on Capitalism holds true for mixed economy as well.

5. Islamic Economic System

First of all, Islam is not just an economic system, but, a comprehensive

doctrine. A comprehensive doctrine is not just concerned with one
particular aspect of human life; rather it is concerned with all aspects of
human life.

As per Islam, this worldly life is a test for humans. Design of this test
requires human interdependence which then requires difference in ranks,
i.e. endowments, abilities etc. This consequently results in difference in
wealth and incomes people have. But, then, both, the rich and poor as
part of this test are going to be judged on the basis of how they each
individually act on the benchmarks of thankfulness, patience, obedience
and upholding ethical guidelines prescribed by their Creator for them
through an inbuilt conscience and through guidance provided via sending
Prophets (peace be upon them all).

Essentially, this test is not to rank people on the basis of wealth, special
material achievements and their social and economic status in society.
People will only be ranked and judged on the basis of discretionary
actions they take in which they have choices and they will be judged
taking into consideration their relative circumstances. Hence, this
worldview put the focus of all human beings towards the fact that
material resources they enjoy are all blessings of Allah and these are
instruments for this test.

Humans are much more than utility maximizing machines. They are
capable of using both material rationality and moral rationality to
differentiate right from wrong and need reinforcement to adopt virtues
influenced by an inner urge other than just material interests.

This inner urge can be reawakened by looking beyond utility maximization

models to re-acknowledge the principal fact that humans are moral being
than just an instrument for maximum material advancement for self.

The unbridled pursuit of greed also requires some external source of

guidance than mere reliance on material animalistic instincts of a human
soul. Religion provides the ethical check and call to balance material
pursuits with attention to misery of the underprivileged people.

History of economic man is fascinating. He has used the nature‟s

blessings to find and create new and innovative ways of maximizing
utility. But, nonetheless, at all points in time, he does not feel satiated.
He remains poor „relatively‟ to the limitless desires and nature‟s
limitations. The dream of being absolutely apart only remains a dream in
everyone‟s life. But, then, everyone achieves it one day. There is one
place that everyone reaches where he is not accompanied by anyone. It‟s
his or her grave. Belief in life hereafter is the only thing that gives
meaning to this world and life and this is the most important pillar of
Islamic Economics.
 5.1. Market Mechanism Filtered by Divine Injunctions

Trade based on voluntary exchange is beneficial as collectively we can

have better and more consumption bundles at our disposal if we engage
in voluntary exchange. Islam also encourages voluntary exchange.

O you who believe! Eat not up your property among yourselves

unjustly except it be a trade amongst you, by mutual consent.
(An-Nisa: Verse 29)

The concept of division of labor, voluntary exchange and that we could

collectively have better consumption bundles at our disposal if we engage
in voluntary exchange than trying to fulfill all needs by ourselves have
nothing contradicting with Islam or wellbeing of a society.

In an Islamic economy, market mechanism is filtered by divine

injunctions. The divine injunctions are binding, but they do not disallow
market mechanism to work after following these injunctions.

All that these divine injunctions do is to regulate certain actions, provide

broad guidelines and through which certain restrictions are imposed on
humans for their own benefit. But beyond that, market mechanism is
allowed to work and in fact regarded as a just way of organizing economic
exchange in society as explained by the preceding verse.

The distinctive features which enrich the market mechanism in an Islamic

economy include:

5.1.1. Guiding Preferences through Divine Injunctions

As per Islam, the tendency to seek worldly pleasures from certain

goods/services and actions/behaviors is natural. The test is to nurture
one‟s conscience and fight these tendencies to grow beyond a certain
level. This test is for each person in his/her individual capacity. We cannot
completely deny those tendencies. Neither Muhammad (peace be upon
him) nor the pious caliphs (rta) used any means other than moral
persuasion to inculcate a parallel righteous behavior alongside these
natural tendencies so that they remain mere tendencies, i.e. weak
enough to not influence important choices humans make in matters
involving a moral issue.

Rather than complimenting humans in their animalistic instincts to keep

having one-eyed focus on material well-being only, Islam inculcates
piousness, kindness, cooperation and communal responsibility in humans.
In some instances, Islam guides explicitly to avoid extravagance,
lavishness & using certain products and services which harm a human‟s
ethical existence and well being either individually and/or harm the
society in the process.

Religion provides such meaningful conditioning which enables bringing the

right balance between human aspirations and their physical limits.
Religion also promises salvage from the limitedness of this worldly life in
heaven which will be awarded to the most righteous people. This, in turn,
provides a permanent incentive to choose righteous behavior as an end
with the hope and fear of deterministic results in life hereafter.

5.1.2. Inculcating Afterlife Accountability

With the concept of afterlife accountability, Islam immensely influences

intertemporal choice behavior. It helps in private economic agents
(consumers, producers etc.) modifying their actions in such a way that
takes into consideration externalities and also their own welfare, both in
this world and afterwards. Afterlife accountability stimulate positive
change in behavior in a much more comprehensive and permanent
manner than any regulation or material incentive could possibly do.

5.1.3. Complimenting Material with Spiritual Rationality

Islam does not deny private property rights, private rational choices and
individual-specific preferences that do not contradict Islamic injunctions.
Islam enriches material rationality with spiritual rationality. It suggests
some institutional changes in economic environment that alter choices for
more optimal intertemporal outcome and social welfare. Islam has a very
clear view on certain institutions like „interest based lending‟ which has
been chiefly responsible for concentration of wealth, rising inequality and
even poverty and is an exploitative form of earning money. Islam by
disallowing interest based earnings, exploitative forms of trade and
disallowing imposition of excessive taxes from the state beyond Zakah
ensures individual freedom and welfare in a much more comprehensive
manner.

5.2. Market Led Economic Growth

A model Islamic economy is not necessarily a state-led or state-run

economy. In fact, Islamic economic principles are very much open and
favorable towards market based economy.

By enabling market economy to run competitively, an Islamic economy

provides market based sustainable and lasting solutions to employment
creation and improvement in living standards through effective and
efficient utilization of resources.
The market competitiveness is achieved by removing from the economy
the factors which lead to concentration of resources, concentration of
market and underutilization of given labor and non-labor resources in the
economy.

Specifically, this is achieved through two key institutions:

1. Removal of interest based financial intermediation.

2. Introducing lenient fixed rate non-discretionary wealth and income

(ushr and khums) based direct taxation that has a broad base.

In an Islamic economy, the goal is not only to achieve better income

distribution, but to increase the aggregate production as well. Hence,
economic growth is vital.

In an Islamic economy, private investment is incentivized by the

institution of Zakat which favors private investment/spending than
hoarding wealth. Secondly, the Zakat rates are low and hence encourage
the private investment in productive enterprise. Economic theory
suggests that higher tax rates discourage entrepreneurship as they
decrease the incentive to produce. Lower tax rates encourage
entrepreneurship and hence increase the size of the producing sector and
hence production. With the increase in production, tax revenue in value
terms increases. Lower tax rates can still ensure high tax to GDP ratio.

By discontinuing interest-based financial products, people with surplus

income (savers) will then have two choices, either to keep idle wealth and
then pay Zakat on it or to avoid decrease in wealth by going for
productive investments with the start of one‟s own business or by
participating in the business of others through equity investments. In this
way, the whole economy will gradually transform from debt-based
financing to equity-based financing.

Competition makes the market more efficient than what the government
intervention alone could do. Hence, an Islamic economy allows markets to
function effectively by removing hurdles which exist in the form of rules
and institutions that create imperfection in markets.

Furthermore, economic growth in an Islamic economy is achieved through

interest free financial intermediation and fiscal incentives due to which
investment, both local and foreign is expected to increase, bringing in
more employment, making industries competitive and hence more
responsive to their stakeholders i.e. customers and shareholders without
the need for active government intervention.
 5.3. Improved Income Distribution in Islamic Economy

If we study the classical and neo-classical literature on growth and

development, the theories and policies based on them have felt short to
improve income distribution.

Islam economics has many non-state mechanisms to ensure income

redistribution without interfering with individual freedom and market
mechanism; we discuss three main mechanisms below:

5.3.1. Prohibition of Interest

Interest as a system of allocation of resources ensures a fixed return for

one and variable and uncertain for another. In contrast, Islam encourages
equity financing in which the loss/profit would be shared. This ensures
better results from the perspective of redistribution and better co-
operative behavior since payoffs for all parties are linked with productive
sector of the economy. Consequently, markets will not have to produce
speculative surplus output just to service exorbitant amount of debt and
that could stabilize business cycles.

5.3.2. Family System & Inheritance Distribution

Family system of Islam brings social capital into existence. It ensures

empathy and responsibility. It brings a very lasting and durable social
safety net. Islamic injunctions about how to treat orphans ensure social
security for individuals with special circumstances. Furthermore, Islamic
inheritance laws ensure that the wealth of the deceased is distributed
widely among the members of the family of the deceased. This
permanently and systematically ensures doing away with the
concentration of wealth in every generation at the most micro level
possible. Hence, when wealth distribution gets equitable, the income
distribution too is expected to become more equitable.

5.3.3. Zakat & Infaaq

Zakat is a combination of wealth and income levy. It includes all heads of

income and forms of wealth excluding only the means of production,
items of personal use and value below Nisab. With a Wealth Zakat,
redistribution objective is directly achieved. It reduces confinement of
wealth in few hands. The flow (income) and the stock (wealth) both are
taxed and hence it ensures appropriate transfer of wealth and transfer of
asset ownership to the needy. If an economy is in disequilibrium and
policies fail to immediately recover and boost incomes, wealth Zakat
enables the distributive allocation that works independently of business
cycles and help stabilize the extremes of business cycles.
 5.4. Provision of Distributive Justice

Islam directs Muslims to abide by justice in all circumstances. It allows

access to all people to legal courts and directs the rulers to provide justice
to all the members of the society without any discrimination.

Islam by prohibiting interest eliminates one important source of

distributive injustice. But, it does so in a just manner by allowing all
people with capital and labor or one of these to contribute in productive
enterprise and earn the rewards out of actual return on productive
enterprise rather than forcing the incomes of all people to become equal
artificially as espoused in Communism.

5.5. Emphasis on Productive Enterprise

Money itself has no intrinsic value and is neither a rentable asset nor a
tradable commodity as per Islamic principles. If capital is combined with
labor, it “could” produce profit, but if money alone is lent, the interest it
earns is not permissible as per Islamic principles. Interest is neither a
justifiable reward of money nor capital. Money holder/owner has to
convert it in one of the other factors of production, namely 1) land with
natural resource, 2) physical capital stock and 3) or become an investing
entrepreneur to have any justifiable compensation out of the production
process.

If people do not invest, their wealth would shrink and distributed among
poor masses of the society through Zakat. If they want to avoid erosion in
wealth, they are obliged to either enter in productive activities themselves
or invest in such venture with their capital contribution. This will increase
productive investment in the economy, bring more employment
opportunities and make markets more competitive.

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