Economics and Business

Role of Fiscal Policy in Controlling Inflation in Islamic Framework

Introduction

A focus on inflation presumes inflation is high. The situation in the developed countries has, however, changed recently, provoking some to proclaim the death of inflation. The situation in the developing countries remains worrisome but, excepting a few countries, no longer alarming. So what is the need for discussing the role of fiscal policy in controlling inflation, in Islamic framework? Two reasons to do so. Firstly, to reassure ourselves, and those who care that this problem too can be handled in Islamic way if and when the need arises. Secondly, insofar as the Islamic developing countries are concerned inflation remains high enough to press for a solution.

In what follows we define inflation. Then we describe fiscal policy and explain what is meant by Islamic framework. We note some characteristics of fiscal policy which make it less effective in controlling inflation once it is there even though it can be an effective tool for preventing inflation from occurring. Briefly mentioning other faster acting ways of controlling inflation we also have a glance at Islamic history, how price rises were handled. In conclusion we prefer a fiscal policy oriented towards supply augmentation over the one focused on demand management.

Inflation

Inflation refers to 'a sustained upward trend in the level of prices', its most common measure being the percentage rate of change in a country's Consumer Prices Index. This is, however, regarded by some as a monetary definition, a better way to understand inflation being to focus on aggregate demand overstepping aggregate supply at full capacity. Yet what is visible to the eye remains the same: prices rise and continue rising.

A small rise in prices may go unnoticed in many countries even though it is sufficient to jolt an advanced economy which has been fairly stable in the past. But an annual rise in prices of 10 percent or more is considered serious any where and every where. But what causes real concern in developing countries is double digit inflation with no signs of slowing down.

Why the concern? Because it hurts. For most people incomes do not rise paripassu with the rise in prices. They can consume less, save less. They find planning for the future more difficult because of the greater uncertainty about future prices. The more the uncertainty about the future prices the more deleterious the effect on savings and investment. Inflation distorts the distribution of income and wealth to the disadvantage of the poor. It also stunts real growth due to its negative effects on saving and investment. Economists have established a negative relationship between inflation (even at a moderate rate) and growth of productivity.

Fiscal Policy

Fiscal policy involves government expenditure and revenue, through taxes, borrowing and printing money. Anti inflationary fiscal policy would focus on with- drawing purchasing power from the public so that they spend less, relieving the upward pressure on prices. This can be done by raising taxes and borrowing from the public without spending the proceeds. As the origin of inflation in most developing countries has been increasing government claim on productive resources (required for public sector projects), a decrease in government expenditure leaving taxes undiminished may still be more effective. Fiscal policy is regarded as 'deliberate manipulation of the relation between government expenditure and government receipts with a view to maneuvering the level of aggregate demand in the desired direction.

Manipulation of aggregate demand is not the only way fiscal policy can target inflation. Spending money in a way that increases the supply of goods and services can also help governments check the rising trend in prices.

It has been rightly observed that inflation as we know it (i.e. a sustained rise in prices) is a modern phenomenon. The price level was stable for nearly a century till 1914. But a number of factors, among which debt financing of the two world wars was only one, caused most countries to experience rising prices since the middle of the century till the eighties. The same period also saw a phenomenal rise in public spending which globally reached 43% of the GDP by 1980. As a result inflation is commonly perceived as a consequence of rising public expenditure. This, however, may not always be true. One has to examine specific cases to arrive at a conclusion.

The Islamic Framework

The Islamic framework within which this study examines the role of fiscal policy in controlling inflation is defined, in the first instance, by the goals of an Islamic economy. It is need fulfillment, justice and equity. Also included in these goals is to provide the state with the means required for defense, law and order and fulfillment of other socially obligatory duties (furud kifaya) which the private sector fails to fulfill. In the context of money, finance and government policies the Islamic framework can be further specified by prohibition of interest and gambling, minimization of hazard and uncertainty and keeping government intervention in the market limited to what is necessary for the realization of the above mentioned goals. Furthermore can be mentioned the concept of moderation in consumption and treating public money as a trust which have an impact on our subject matter. That there is a role for fiscal policy in realizing the goals of an Islamic state is quite obvious. But that is not our subject in this study. What needs emphasis is that anti inflationary fiscal policy should not jeopardize the long term arrangements for realizing the goals of Shari'ah. But before we proceed to examine the scope for such policies we have to note another dimension of the matter which shall not be discussed by us: the hypothat the full implementation of Islamic teachings, i.e. the operationalisation of the 'Islamic framework' noted above, will prevent inflation or at the least, minimize its incidence. This is due to the presence of several 'built in stabilizers' in the system.

The hypothesis is supported mainly, by four arguments.

In the Islamic economic system debt financing which is the chief source of inflation and instability in the contemporary economies will have been replaced by equity and sharing based finance which are non inflationary and stable. The change from debt finance to share finance also integrates saving and investment decisions making the system more stable than its capitalist counterpart.

Thanks to Zakat, inheritance laws and other redistributive provisions, Islam will effect a less unequal distribution of income and wealth (as compared to the same economy under capitalism). This will change the composition of aggregate demand in favour of the necessities of life thereby reducing the fluctuations in aggregate demand.

Islam will induce people to moderation in consumption, to shun wasteful life styles and conspicuous consumption. This will result in a decrease in aggregate demand.

Islamic governments, treating public money as trust will be frugal, keeping public expenditure within the bounds set by the available means. Public borrowing will be minimum and deficit financing rare. Financing public expenditure by printing new money will be almost non existent.

It is not necessary to examine this hypothesis in a discussion on the role of fiscal policy in controlling inflation. Since the possibility of inflation in an Islamic economy is not denied3 and since it is very likely that an Islamizing regime inherits inflation from the earlier regime, it would be quite logical for us to narrow down our focus on control as distinct from prevention. This is still the more credible a methodology in view of a third and more compelling reason. Inflation may impose itself on an economy from outside, caused by global moves beyond its control, especially if it is a small economy. What follows is, therefore, not affected by one's acceptance or rejection of some or all of these arguments. Those who take the hypothesis skeptically due to lack to empirical evidence will, of course, find the subsequent arguments more compelling. But those who whole-heartedly support the hypothesis will also find good reason to attach due weight to them.

Prevention and Control

There are two significant differences between fiscal policies designed to control already existing inflation and those designed to prevent inflation from afflicting an economy which at the time is free of inflation. The first difference relates to time horizon and the speed at which a policy measure is carried out. The second relates to the size of the change required in the relevant variables e.g. government expenditure, taxes, etc. Policies designed to control inflation have to have an impact now. They must be fast acting showing their results in a matter of months. This in turn may require big reduction in government expenditure, large increases in taxes, huge amounts of domestic borrowing etc. Given these measures successfully implemented over a short period of time aggregate demand will decrease and the trend of prices to rise will be checked. The big question is how far it is possible and desirable to do so.

Let us have a look at the way government decides how much to spend. Part of government expenditure relates to the core of governance, no government can function without these. They can be reduced if they are inflated but there is a limit to such reduction. Expenditure on salaries and offices of the executive, legislative and judicial branches of government come under this category. Then come the expenditure on defense and law and order, both permanently mandated by Shari'ah. The volume of expenditure on these heads may be dictated by circumstances beyond the government control e.g. geopolitical situation, moral degeneration, etc.

Reduction in Public Expenditure

It is only when we come to the other public goods and the welfare activities of the government that reduction in government expenditure becomes a real possibility. But the actual scope of such reduction depends on the historical path followed by (the increase in) government expenditure. Modern day governments have shown little ability to reduce expenditure on education and health care. For an Islamic state in a developing country the idea of reducing expenditure on education and health care is still the less appealing. This is in view of the priority of these items on the Islamic agenda and the neglect from which they suffered in the past. The most a developing country can manage to do is to prevent expenditure on these items from increasing further. Reducing the current levels of expenditure on education and health care are no where a real option. In fact any attempt to do so would be economically disastrous and politically suicidal for the regime.

It has been rightly observed that public expenditure increases as the national output increases, often at a faster rate. It is very difficult to envisage a reduction in public expenditure in an economy where the real output is increasing.

There is a strong case for reducing public expenditure when it is necessary to do so for controlling inflation. But the practical scope for doing so is very limited. If there is an across the board reduction in the salaries of government employees many of them may be forced to find better paid jobs in the private sector, even abroad, affecting the quality of the bureaucracy to the detriment of public interest. Reduction in ostentatious expenses on ceremonies, etc. may not involve significant amounts. As we hinted above, reduction in the expenditure on defense and internal security may not be practical. Some relief is expected from elimination of corrupt practices, bribes and kick backs. This will reduce the cost of doing business, expanding trade and investment and, ultimately, boosting production. These reforms may also reduce the cost of public projects, reducing government expenditure.

Increase in Tax Revenues

One should also consider the possibility of an Islamic state eliminating tax evasion and even coaxing people to pay 'donations' ---- over and above taxes --- to enable their government do good things for them. The likely gains in revenue terms are however, likely to be more than counterbalanced by two other inevitable changes. There are certain indirect taxes on basic necessities of life which Islamic economists regard to be antipoor and worth scrapping. Then there is mandatory lowering of tariffs and custom duties as part of ones belonging to a world set to reduce them globally.

Let us now turn to the other policy measure, withdrawal of purchasing power from the public through increased taxation and domestic borrowing not accompanied by a corresponding rise in public expenditure. This in fact is only a textbook proposition insofar as the developing countries are concerned. These countries are not able to meet even current levels of public expenditure through all the taxes and domestic borrowing they can manage, thereby taking recourse to printing new money. As regards an Islamic economy domestic borrowing ceases to be an option as no interest can be paid to the lenders. A resort to compulsory borrowing free of interest as suggested by some1 would be hardly feasible in political terms. Additional taxation with the sole purpose of withdrawing some purchasing power and freezing it implies that the money should be paid back when the time comes to defreeze it. That makes it akin to compulsory borrowing. There is no empirical evidence of any developing country ever having adopted these policies successfully.

Increasing the Supply of Goods and Services

That leaves us with the last option noted under the heading fiscal policy: spending money in a way that increases supply of goods and services. This spending does not have to be done by the government itself, at least not all of it. Tax reduction that encourages private investment may serve the same purpose. Lowering corporation taxes and lowering or scrapping capital gains taxes, even scaling down the income taxes may boost production by increasing the incentive to work and the incentive to save. Another possible measure is to restructure the subsidies, if any, in favor of the intermediate industries whose products are needed for expanding the production of consumer goods. Building the infrastructure --- roads, bridges, irrigation systems, electricity and telecommunication, etc. --- at public cost and making them available to the private sector at affordable prices has also been a favorite policy of mid-century developmental planning. These can be adopted after due consideration of the lessons from the past.

Even though each one of these policies is slow acting and of modest impact their cumulative impact over time would be significant. There can be no surer way to check the rising trend in prices than to arrange for increasing the supply of the very things whose prices are increasing. Fiscal policy has no other way to make a durable contribution to solve the problem of inflation since the two other options examined above are limited in scope and not practical. Unlike the impact of anti inflationary monetary policy which may be immediate but temporary, the impact of supply increasing fiscal policies is slow but durable.

In seems the scope for reducing public expenditure from their current levels is very limited insofar the contemporary Muslim countries are concerned. The same applies to the possibility of withdrawing purchasing power from the public without spending the proceeds. This leaves us with the slow acting option of trying to maneuver public expenditure and taxation in a way that increases the incentives to work, save and invest and / or directly contributes to increasing the supply of goods and services.

Moderation, Abolition of Interest and Zakat

We shall now proceed briefly to examine if the three other Islamic provisions noted above, i.e. moderation in consumption, abolition of interest and gambling and Zakat can play some role in controlling inflation.

In an already inflationary situation prices of necessities and other consumer goods would be rising. In such a situation people can not be expected to spend less in money terms as that would mean drastic reduction in their living standards. In fact they have to spend more to stay where they are. If current levels of consumption are perceived to be extravagant the most that can be expected in the name of moderation is for spending not to increase in money terms. As regards luxuries some additional revenue can be raised by increasing sales taxes with a view to reducing demand. But the rich who buy these goods may be the same people who become richer due to inflation. They could afford higher prices. Then there is always the danger of excessive taxes driving goods into the black market and increasing the incentive to evade taxes. In any case there is no empirical evidence of forced moderation having contributed to controlling inflation in a free market economy.

Abolition of interest and introduction of new arrangements for financial intermediation based on profit sharing will ensure financial stability. Savings will flow from households to firms smoothly through financial intermediaries who will be able to plough back to the savers attractive returns gotten from the businessmen. Abolition of gambling and the resulting curbs on speculation will further contribute to the stability of the financial system. A stable financial system is, however, a necessary but not a sufficient condition for price stability. Changes in technology and tastes may throw whole industries out of gear causing the levels of output, employment, and incomes to change despite a stable financial system. For a single country influx of foreign capital, favorable balance of payment or similar causes originating outside may cause the prices to rise by affecting the domestic money supply. What is more important for our purpose in this study is however, the fact that the change over form debt-finance to share-based finance will not by itself bring down prices. Inflationary prices boost business profits which will translate themselves in to higher profits (though not higher ratios of profit sharing) for financial intermediaries as well as for the savers / depositors. Profit-sharing may not necessarily feed the inflationary process but it shall not check it either. More direct intervention may be needed to rectify the situation. Redirection of investible funds by sectorally different ratios of profit-sharing or out right controls on incomes, profits and prices may become necessary in certain circumstances. But these options are outside the scope of this study.

The role of Zakat in reducing inequality in the distribution of income and wealth and thereby contributing to a change in the composition of aggregate demand that would make it more stable has already been noted above. Our focus now is the possible contribution of Zakat in bringing down prices when they are high and rising. It has been rightly pointed out that advance collection of Zakat due in the future and/or delaying the expenditure of Zakat proceeds till a more appropriate time can contribute to controlling inflation. It is also suggested that aggregate supply may be manipulated by collection and distribution of Zakat in kind.

Appropriate Policy Mix

The role of fiscal policy in controlling inflation shouldn't be discussed in isolation from the role of the monetary policy and exchange rate policy. The true picture can be obtained only by considering a mix of these policies in the context of a given situation. The size of a country's economy, the relative sizes of its domestic and external economies, the historical path through which an inflationary situation has come to hold are all important aspects of the situation. Also important is whether the chief source of inflation is in the labor market and/or goods market or in the money supply. The moral standards of the people, the level of corruption, the government's credibility and the degree of the people's trust in government too are forces to be reckoned with. Bereft of these data no meaningful study can be made on the role of fiscal policy in controlling inflation in an Islamic framework. The reason in simple. All the three terms appearing in our title: fiscal policy, inflation and Islamic framework derive their meaning - operational meaning - from these data.

Epilogue

The type of inflation experienced in early Islamic history was different in nature from the one experienced in twentieth century. More often than not the rise in prices was sharp but short lived. Instances of 'a sustained upward trend in the level of prices' are rare. There are, however, instances of a gradual rise in prices at a low rate caused by continued influx of gold and silver. Also there were brief spurts of rising prices due to the same cause as happened in the third and fourth decades of Islamic history. But most of the times it was climatic conditions or disruption in transportation that caused a failure in supply leading to sharp rise in food prices. Also in later Islamic history, especially after the disintegration of the Abbasids, it was debasement of currency, excessive issue of subsidiary (copper) coins (fulus) and circulation of large quantities of counterfeit that caused spurts of inflation. These, were, generally, localized and temporary. Protests from the populace often resulted in cancellation of new issues and rectification of debasement. No special measures are reported to counter the rise in prices due to influx of gold and silver. A fast expanding economy with widespread foreign trade was able to absorb the new money without serious problems.

Price rise caused by famine and disruption in supply caused great pain and suffering. Egypt during the Mamluk period was specially afflicted by these devastations as recorded, among others, by Maqrizi. If and when the situation did evoke a response from the authorities it was in the form of arranging additional supplies of food grains at public expense. Sometimes they also tried to ensure larger imports by reducing import duties.

Putting an end to debasement of currency and meeting rise in prices by arranging for increased supply are policies rooted in Islamic tradition, the difference in the nature of inflation notwithstanding. These policies are likely to evoke public cooperation as well as endorsement by the Ulama. The two other fiscal measures noted above, reduction in public expenditure (with welfare provisions bearing most of the cut) and increased taxation (and domestic borrowing) are doubly doomed. They are not practical. They have no roots in the Islamic past, hence they do not sound familiar, neither to the populace nor to the Ulama.

source: http://www.islamic-world.net/economics/role_of_fiscal_policy.htm

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