MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 1

 8
Fiscal Policy

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 2
 LEARNING OBJECTIVES
 Fiscal policy
 The tool governments use to intervene in the free market
economies to promote social good.
 The purposes of and difference between discretionary and
non-discretionary fiscal policies.
 The channels through which fiscal policy operates.
 Public spending and the tax multiplier.
 How to evaluate the effectiveness of a fiscal policy?
 The role automatic stabilizers play in an economy.
 Fiscal policy from Islamic perspectives: Objectives to be
achieved.
 Alternative policy to inflation and recession.
MACROECONOMICS All Rights Reserved
© Oxford University Press Malaysia, 2009 Ch1: 3
 8.1 INTRODUCTION

 Discretionary fiscal policy

– Contractionary fiscal policy
– Expansionary fiscal policy

 Non-discretionary fiscal policy

– Automatic contraction
– Automatic expansion

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 4
 8.2 THE MECHANICS OF FISCAL
POLICY
 Increased spending:
– Increased government expenditures and/or
– Increased transfer payments and/or
– Decreased taxes

 Reduce spending:
– Decreased government expenditures and/or
– Decreased transfer payments and/or
– Increased taxes

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 5
 8.3 TREATMENT OF INFLATION

 Inflation can be treated by:

– Decreasing government expenditures and/or
– Lowering transfer payments and/or
– Increasing taxes

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 6
 8.3.1 Decreasing Government
Expenditures

 Expenditures involving the economic sector such

as roads and highways and the social sector such
as housing, healthcare, education and
environmental programmes.

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 7
 8.3.2 Lowering Transfer Payments

 Less transfer payments will have less money in

their pocket thus reducing the amount they can
spend, as a result aggregate demand in the
economy is reduced

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 8
 8.3.3 Increasing Taxes

 Increase in taxes would lead to decrease in

aggregate demand

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 9
 8.4 RECESSIONARY CURES

 To increase employment, the aggregate

demand in the economy must increase and this
can be done by:
– Increasing government expenditures and/or
– Increasing transfer payments and/or
– Decreasing taxes

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 10
 8.4.1 Increasing Government
Expenditures

 Increased government spending will generate

more income
– aggregate demand will increase

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 11
 8.4.2 Increasing Transfer Payments

 Increase in transfer payments will increase

money in hand
– aggregate demand in the economy is increased

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 12
 8.4.3 Decreasing Taxes

 Tax cuts will increase disposable income and

spending
– Aggregate demand is increased
– Full employment is restored

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 13
 8.5 EVALUATION OF FISCAL
POLICY
 How successful will fiscal policy be?
 Will it be able to bring aggregate demand to the
desired level?
 Will it be able to bring the economy to achieve
the level of GDP that the government would like
to achieve?

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 14
 8.5.1 Problems of Magnitude

 Effect on multiplier
 Crowding out
 Tax changes
 Leakages
 High vs low multiplier
 Unpredictable events

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 15
 8.5.2 The Problems of Timing

 Involves considerable time lags

 Five possible time lags:
– Time lag to recognition
– Time lag between recognition and action
– Time lag between action and changes taking effect
– Time lag between changes in government
expenditure and taxation
– The resulting change in aggregate demand and
national income

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 16
 8.5.3 Side Effects of Fiscal Policy

 Fiscal Policy can also cause undesirable side

effects, such as:
- cost-push inflation
- distributive injustice

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 17
8.6 NON-DISCRETIONARY FISCAL POLICY:
AUTOMATIC OR BUILT-IN STABILIZERS
 Automatic stabilization: the automatic change in
some government expenditures that stimulates or
dampens aggregate spending/demand as the
level of economic activity changes
 Built-in to prevent recession from becoming
depression

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 18
 8.6.1 How Automatic Stabilizers
Really Work

 Increased transfer payments and lower tax

rates are automatic and provide additional
spending to those affected by recession
 When the economy expands, employment and
income rise, and the stabilizers automatically
remove spending from the economy

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 19
 8.6.2 Do Automatic Stabilizers
Really Work?

 Automatic built-in stabilizers alone would not be

sufficient to correct inflation and mass
unemployment
 Help to ensure a smooth business cycle
– Able to keep the ups and downs in the economy
within a moderate range
 It is a complementary tool for fiscal policy

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 20
 8.7 ISLAM AND FISCAL POLICY

 Fiscal policy is very much needed in the

Islamic economic system as it is one of the
most important sources of revenue to the
government

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 21
 8.7 ISLAM AND FISCAL POLICY
(cont.)

 Four main sources of Islamic government

revenue are taxation, zakat, jizyah and
government service fees.

 Other sources are equity financing, public

enterprises, kharaj, al-usur, waqaf and sadaqah.

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 22
 8.8 SOURCES OF REVENUE IN AN
ISLAMIC ECONOMY

 Sources of government’s revenue from Islamic

perspective:
– Taxation – Public enterprises
– Zakat – Kharaj
– Jizyah – Al-usur
– Government service fee – Waqaf
– Equity financing – Sadaqah

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 23
 8.8.1 Taxation

 Taxation is a major source of government

revenue in a modern Islamic state
 The government’s rights to impose taxes is
justified by its responsibility to fulfil the needs of
the citizens
 The bulk of tax revenue should come from the
rich
 The impact is more direct to the recipient

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 24
 8.8.2 Zakat

 Zakat is an obligatory financial levy on all surplus

wealth and agricultural income of the Muslims
 To provide financial support to specified
categories of people
 Charged at varying rates and collected by the
state
– 2.5% on all financial assets and stock-in-trade of
business

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 25
 8.8.2 Zakat (cont.)

– 10% on all agricultural produce purely dependent on

rain
– 5% on produce of artificially irrigated cultivation
 Zakat is simple to administer – the money paid
is proportionate to the amount of wealth/income
 Major instrument for providing social security,
eradicating poverty, curbing excessive income
disparities and stimulating economic activity by
transferring some purchasing power to the
have-nots

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 26
 8.8.2 Zakat (cont.)

 Two types of zakat:

– Zakat fitr
• Paid in the month of Ramadhan by the leader of the
family for himself and his dependants
• For consumption of the poor during festivity
– Zakat al-maal
• Imposed on wealth/property that had reached a
specified limit, after a specified period of ownership
(haul)

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 27
 8.8.3 Jizyah

 Jizyah was the tax the non-Muslim adults living in

an Islamic state had to pay in the early days of
Islam in view of exemption from military duties
 The government had to ensure the security in
relation to their lives and properties and other
social rights

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 28
 8.8.4 Government Service Fees

 Fees charged by the government on economic

services provided
 The fees charged should not exceed the cost of
services provided

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 29
 8.8.5 Equity Financing

 Projects for which the public is invited to

participate through shares on a profit and loss
sharing basis
 Priority should be given to local investors

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 30
 8.8.6 Public Enterprises

 Natural resources that contribute significant

revenue to the government

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 31
 8.8.7 Kharaj (Tax On Land)

 Tax on agricultural land

 Imposed on land that becomes a property of
Muslim government
 Tax rates depended on the quality of land, such
as the fertility level, irrigation requirement, etc.

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 32
 8.8.8 Al-usur

 A commercial or business tax—similar to export

and import tax
 Collected from three different groups of traders:
– Traders from foreign countries: 10% annually
– Non-Muslim local traders: 5% annually
– Local-Muslim traders: 2.5% annually

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 33
 8.8.9 Waqaf

 A charitable endowment
 Signifies a foundation set up by keeping a
property in perpetual existence and making its
income available for specified beneficiaries
 Plays an economic and social role

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 34
 8.8.10 Sadaqah

 A moral obligation on every Muslim

 The money contributed is for the benefit of the
needy
 Sadaqah is not compulsory

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 35
 8.9 PUBLIC EXPENDITURE AND
ISLAM
Eight permanent heads of government
expenditure of an Islamic state:
 Defence
 Law and order
 Justice
 Public administration
 Basic need fulfilment
 Da’wah activities
 Enjoining right conduct and forbidding wrong
 Fulfilment of socially obligatory duties when the private sector
fails to perform
MACROECONOMICS All Rights Reserved
© Oxford University Press Malaysia, 2009 Ch1: 36
 8.9 PUBLIC EXPENDITURE AND
ISLAM (cont.)
 There are another five heads of essential
expenditure of an Islamic state in the modern
era
 These are:
– Protection of the environment
– Economic development
– Scientific research
– Subsidies for priority sectors
– Expenditure and stabilization policies
MACROECONOMICS All Rights Reserved
© Oxford University Press Malaysia, 2009 Ch1: 37
 8.9 PUBLIC EXPENDITURE AND
ISLAM (cont.)

Expenditure functions of an Islamic state are

classified into three groups. These are:
 Expenditure functions assigned by the Shariah on a
permanent basis.
 Expenditure functions derived from the Shariah on the
basis of the institution of ijtihad for the present situations.
 Expenditure functions assigned to the government by
the people through the process of consultation

MACROECONOMICS All Rights Reserved

© Oxford University Press Malaysia, 2009 Ch1: 38