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Introduction toIslamic Economics

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Theory and Application

HOSSEIN ASKARIZAMIR IQBAL

ABBAS MIRAKHOR

Introduction toIslamic Economics

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We dedicate this book to all thosewho feel the pain of injustice and poverty

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Contents

Acknowledgments xi

About the Authors xiii

CHAPTER 1Economic Systems 1

What Is an Economic System? 2Current State of the Global Economic System 9Islamic Economics Paradigm 19Short History of Economic Thought in Islam 20Summary 26Key Terms 27Questions 27

CHAPTER 2Foundation of the Islamic Economic Paradigm 29

Meta-Framework and Archetype of Economic Rules 31Implications of the Agent-Trustee Relationship 33Significance of Rule Compliance 34Impact of Scarcity 35Rationality and Freedom of Choice 38Individual Obligations, Rights, and Self-Interest 39Central Notion of Justice 41Shariah: The Law 44Summary 47Key Terms 47Questions 48

CHAPTER 3Institutional Framework and Key Institutions 49

Key Institutions 53Summary 72Key Terms 72Questions 73

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CHAPTER 4The Islamic Economic System 75

Social and Economic Justice 76Prohibition of Interest (Al-Riba) 81Risk-Sharing Economic System 84Role of the State 91Summary 93Key Terms 94Questions 94

CHAPTER 5Key Microeconomic Concepts 95

Defining Microeconomics 97Issue of Needs versus Wants 100Consumer Behavior 102Theory of the Firm 105Dynamics of Demand and Supply 112Efficiency versus Equity 116Market Models 117Role of the State 121Summary 123Key Terms 124Questions 124

CHAPTER 6Key Macroeconomics Concepts 125

Principal Economic Agents 126National Income 127Consumption, Savings, Investment, and National IncomeDetermination 135

National Income and Output Determination 143Inflation 148Unemployment 152Open Economy: Trade in Goods and Services withOther Countries 154

Why International Trade Is So Central to Islam 156Summary 162Key Terms 163Questions 164

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CHAPTER 7Macroeconomic Equilibrium: Characteristics of anIslamic Economy 165

Models of an Interest-Free Economy 166Summary 184Key Terms 185Questions 185

CHAPTER 8The Financial System 187

Notion of Risk Sharing 190Building Blocks of the Islamic Financial System 191Takaful (Islamic Insurance) 210Summary 216Key Terms 217Questions 217

CHAPTER 9Role of the State and Public Policy 219

Basic Roles of the State in All Economic Systems 220Role of the State in the Islamic Economic System 224Policy Instruments of the State in Islam 228Economic Justice and Public Policy 230Role of Public Policy 232Summary 243Key Terms 244Questions 244

CHAPTER 10Fiscal Policy 247

Role of Fiscal Policy 250Fiscal Policy in an Islamic Economy 254Public Finance 259Summary 267Key Terms 268Questions 268

CHAPTER 11Monetary Policy 271

Role of Monetary Policy 272Monetary Policy in an Islamic Economy 277Summary 303

Contents ix

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Key Terms 304Questions 305

CHAPTER 12Economic Development and Growth 307

Evolution of Western Economic Thought: From Smithto North and Sen 307

Foundation and Framework of Development and Growthin Islam 312

Islamic Perspective on Financial Inclusion 322Summary 330Key Terms 331Questions 331

CHAPTER 13Economic and Social Welfare 333

Social Safety Net Provisions 335Concept of Safety Net and Welfare 337Empirical Evidence on Social Welfare from SelectMuslim Countries 339

Summary 359Key Terms 360Questions 360

CHAPTER 14Economic State of Affairs in OIC Countries 361

Public Policy in the Islamic Economic System 362Dimensions of Economic and Social Achievementsin Muslim Countries 364

Summary 372Key Terms 373Questions 373

Glossary of Arabic Terms 375

Bibliography 381

Index 393

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Acknowledgments

W e are indebted to Omar Fayoumi for assisting with Chapter 5 and toHamid Shafiezadeh for his work on Chapter 6. The suggestions of the

Wiley editorial staff have been invaluable. As always, we are grateful for thesupport of our families.

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About the Authors

Hossein Askari is the Iran Professor of International Business and Interna-tional Affairs at the GeorgeWashington University. Before coming to GW, hewas a professor of Business and Middle Studies at the University of Texas atAustin and assistant professor of Economics at Tufts University. He has alsoserved on the executive board of the International Monetary Fund and asconsultant to a number of governments, institutions, and multinationalcorporations. He received all his university education at the MassachusettsInstitute of Technology, where he earned a BS in civil engineering and a PhDin economics.

* * *Zamir Iqbal is a lead specialist at Finance andMarkets (F&M)Global Practiceof the World Bank. He heads the World Bank Global Center for IslamicFinance Development in Istanbul. He has more than 20 years of experience inrisk management, capital markets, and asset management at the World BankTreasury. Islamic finance is his research focus, and he has coauthored severalbooks on Islamic finance topics such as banking risk, financial stability, andrisk sharing. His most recent coedited book, Economic Development andIslamic Finance, was published by the World Bank in 2013. He earned hisPhD in international finance from the George Washington University andserves on the professional faculty at the Carey Business School of JohnsHopkins University.

* * *Abbas Mirakhor is currently the first holder of the chair of Islamic Financeat the International Center for Education in Islamic Finance (INCEIF).He served as the dean of the executive board of the International MonetaryFund from 1997 to 2008 and as the executive director representingAfghanistan, Algeria, Ghana, Iran, Morocco, Pakistan, and Tunisia from1990 to 2008. He has authored numerous publications and research paperson Islamic finance; among them are Introduction to Islamic Finance (Wiley2011), Risk Sharing in Islamic Finance (Wiley 2011), and The Stability ofIslamic Finance (Wiley 2010).

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CHAPTER 1Economic Systems

Learning objectives:

1. The differences between economic systems and the role that governmentplays.

2. How the ideal Islamic system differs from the Western market capitalistsystem.

3. The role of markets and how they differ in Islam and in the marketcapitalist system.

4. What institutions are and why they matter for economic prosperity.5. Governments have an important role no matter the system.

O ver the years, a number of different economic ideologies and systemshave been proposed and promoted. As with most other things in life,

economic doctrines and systems have a limited shelf life and evolve withtime. While in 2014 the mixed capitalist market system of the Westernworld, especially that in the United States, may appear preeminent, itreceived a number of shocks at its very foundation. The financial crisisof 2007–2008 with its extensive fallout and the rapid rise of China as aneconomic power have raised new and fundamental questions about thelong-term direction and viability of the laissez-faire mixed capitalist systempracticed in the United States and other Western nations.

After World War I, economists generally realized that neoclassicaleconomics was not well equipped to address the reasons underlyingunemployment, business cycles, and their mitigation and amelioration.During the Great Depression, John Maynard Keynes’s General Theory ofEmployment, Interest, and Money provided some answers.1 As a result,

1Published in London by Macmillan in 1936.

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Irving Fisher and Alfred Marshall’s neoclassical theories were resurrectedand reborn into the Keynesian framework. After World War II, a numberof economists, including Hicks, Samuelson, Tobin, Solow, and Modigliani,further developed the Keynesian approach in what came to be known as neo-Keynesian macroeconomics. Although the Keynesian theory of demandmanagement with its further refinement became the most widely acceptedmacroeconomic framework afterWorldWar II, the Chicago school of econo-mics later criticized it, largely on libertarian grounds and on the grounds thatit could not explain a number of observed economic developments in the1970s and 1980s. These economists argued against discretionary macro-economic policies in favor of the market’s “invisible hand” (Adam Smith’sfamous words that, ironically, were mentioned only once in his famous work,The Wealth of Nations) and passive fiscal and monetary policies. MiltonFriedman argued against the effectiveness of fiscal policy and instead pointedto passive (by a rule as opposed to discretionary) monetary policy. Thisapproach was further supported and advocated in the early 1970s by RobertLucas and his followers in their rational expectations framework to macro-economics. While downplaying the promise of macroeconomic policies tofine-tune the economy, they generally advocated supply-side policies andprograms to enhance economic prosperity. Today, in 2014, with the devas-tating fallout of the financial crisis of 2007–2008 still with us, economists areeven more divided about the effectiveness of Keynesian macroeconomicpolicies and the broader role of government intervention in economicmanagement.

WHAT IS AN ECONOMIC SYSTEM?

Any economic system is essentially a network of relationships (amonghouseholds, businesses, and government), organizations, and the frameworkfor producing, distributing, and consuming the goods and services producedin an economy while protecting the rights of future generations to the earthand the environment that all must share. An economic system includes howthe output of the economy is produced and divided among members ofsociety, how incentives and decision making are formulated, the extent ofgovernment intervention and its provision of goods and services, the roleof markets and their regulation and supervision, and, in the legal system ofproperty rights, ownership of factors of production and contracts and theirenforcement. Although there are a number of ways to classify the range ofeconomic systems, one classification could divide them into these five tradi-tional economies, market economies, mixed market economies, mixed social-ist economies, and command (planned) economies. In 2014, the most

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prominent economic system is the mixed market economic system, which isstill evolving, followed by the mixed socialist economic system, the commu-nist (command) system, and the recent rebirth of the Islamic economic system.

The most critical characteristic that distinguishes economic systems is therelative importance of markets and governments in determining what goodsand services are produced, how they are produced, and who gets the output.A secondary distinguishing attribute has increasingly become the role ofmorality and justice in the economic system.

Traditional Economic Systems

Today, traditional economic systems are those that prevail largely in thetribal regions of a number of developing countries. They are predominantlyagricultural with little or no labor specialization. Government services,where governments exist, are severely limited. These economies invariablyrely on tradition, customs, and religion to decide what and how goodsare produced and distributed, what occupations are chosen, and what formof governance is followed. Paper money is rarely used. Commodities,animals, and land provide a store of wealth, and barter is quite common.

Pure Market (Capitalist) Economic System

The father of modern capitalist market systemwas Adam Smith, the author oftwo books that have shaped the capitalist market economic systems aroundthe world. His most widely cited text is The Wealth of Nations (moreprecisely, An Inquiry into the Nature and Causes of the Wealth of Nations),published in 1776. It was preceded by what we consider his masterpiece, themuch less quoted The Theory of Moral Sentiments, published in 1759. Formany mainstream economists, the year 1776 marks the birth of moderneconomics. In The Wealth of Nations, Smith took the bold stance thatmarkets, left alone, were self-regulating and required no government rules,intervention, and regulation, and that government intervention would, inpractice, do more harm than good. At the foundation of a market economy isthe belief that the best outcome for all involved—namely the maximumoutput of goods that people want at the lowest price—results from individualsellers and buyers, acting individually and independently through the lan-guage of price (as the signaling device). Consumers vote what they want withtheir purchases; producers respond by producing what is demanded byconsumers. If demand goes up, prices increase to balance supply and demand,and the higher price is a signal to producers to increase output. Producers,in pursuit of profits, produce the goods demanded most efficiently dependingon the relative price of factors of production (land, labor, and capital) by

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increasing their inputs into the production process. People acquire goods andservices on the basis of their voting power (ownership of factors of produc-tion and accumulated wealth).

For Smith, markets worked best if largely left alone. He saw markets asbeing self-regulating and having the special feature that they afforded theneeded incentive to market participants. Profit incentives drive producers toproduce the goods and services demanded in the most efficient way.Consumers are given a wide range of choice by registering their demand(what they buy) through the markets and can increase their income througheducation and savings. Smith coined the now-famous term “invisible hand”that would lead consumers and producers to pursue their self-interest and,unknowingly, in the process support the economic interests of all. Smithwent even further and also argued that well-intentioned government rulesand regulations were not needed and might in fact be detrimental to thegrowth of economic prosperity. He thus advocated a laissez-faire economicphilosophy. This was the foundation of the capitalist economic system thatfueled the Industrial Revolution in England and later in the rest of Europeand the United States.

Smith saw markets at the center of the economic system. Markets are notlimited to those for final goods and services. Markets for factors of produc-tion, labor, and capital work in the same way as those for goods and are justas crucial for a smooth functioning economic system. Without factors ofproduction, goods and services cannot be produced. In fact, one can imaginea market for almost everything in life.

Although Smith preached laissez-faire market economics, he was also aman of God. Smith believed in the deity and that “the Author of Nature”had prescribed the rules of human behavior in all things, including foreconomic behavior. It was left to humans to operationalize these rulesand develop laws to provide the required institutional scaffolding for theideal and efficient economy, an economy in which the government playsa minimal role but where rules (institutions) and especially the rule of law(and rule enforcement) guide the economy along its ideal path. Smithsaw effective institutions as the scaffolding of the economic system. Hewas anything but the cold-hearted promoter of market economics that hasbecome his mantra in most justifications of laissez-faire market economics.The Smith of Moral Sentiments envisaged the market system functioningif market participants complied with rules, including the rules of humanbehavior that had been prescribed by the Author of Nature. In MoralSentiments, he advocated the importance of morality; he believed that formarket participants, the love of self would result in sympathy for others asthey entered market (more on this in the following paragraph). Withoutmorality and government rule/legal intervention, the pure market system

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could lead to a veritable jungle—possibly maximum output but with the riseof harmful monopolies and price gauging; extreme income inequalities(poverty alongside great wealth); inhumane working conditions; discrimi-nation by race, religion, age, and sex; unsafe foods and medicines; harmfulspillovers or externalities (such as environmental degradation that is notcleaned up by those responsible); information that is not shared (asym-metric) with all market participants; and broken social systems. In otherswords, there could indeed be market failure in a number of areas withadverse social consequences. Adam Smith, the champion of free enterpriseand limited government intervention, still acknowledged as fact that busi-nessmen left to themselves could not be trusted and that they might takeadvantage of consumers through collusion or natural monopolies.

Because our description of the “real” Adam Smith may not be familiarto most, it may be helpful to give an extensive quote from his other book—The Theory of Moral Sentiment. Smith expresses his remarkable insightregarding rules of conduct, which he believed were:

the ultimate foundations of what is just and unjust in humanconduct. . . . Those general rules of conduct, when they havebeen fixed in our mind by habitual reflection, are of great use incorrecting the misrepresentations of self-love concerning what is fitand proper to be done in our particular situation. The regard tothose general rules of conduct is what is properly called a sense ofduty, a principle of the greatest consequence in human life, and theonly principle by which the bulk of mankind are capable ofdirecting their actions. . . . Without this sacred regard to generalrules, there is no man whose conduct can be much depended upon.It is this which constitutes the most essential difference between aman of principle and honor and a worthless fellow. . . . Upon thetolerable observance of these duties depends the very existence ofhuman society, which would crumble into nothing if mankind werenot generally impressed with a reverence for those important rulesof conduct. This reverence is still further enhanced by an opinionwhich is first impressed by nature, and afterward confirmed byreasoning and philosophy, that those important rules of moralityare the commands and Laws of the Deity, who will finally rewardthe obedient, and punish the transgressors of their duty. . . . Thehappiness of mankind as well as of all other rational creaturesseems to have been the original purpose intended by the Author ofNature when he brought them into existence. No other end seemsworthy of that supreme wisdom and benignity which we necessarilyascribe to him; and this opinion, which we are led to by the abstract

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consideration of his infinite perfections, is still more confirmed bythe examination of the works of nature, which seem all intendedto promote happiness, and to guard against misery. But, by actingaccording to the dictates of our moral faculties, we necessarilypursue the most effectual means for promoting the happiness ofmankind, and may therefore be said, in some sense to co-operatewith the Deity, and to advance, as far as is in our power, the planof providence. By acting otherwise, on the contrary, we seem toobstruct, in some measure, the scheme, which the Author of Naturehas established for the happiness and perfection of the world, andto declare ourselves, if I may say so, in some measure the enemiesof God. Hence we are naturally encouraged to hope for his extra-ordinary favor and reward in the one case, and to dread hisvengeance and punishment in the other. . . . When the generalrules which determine the merit and demerit of actions comesthus to be regarded as the Laws of an all-powerful being, whowatches over our conduct, and who, in a life to come, will rewardthe observance and punish the breach of them—they necessarilyacquire a new sacredness from this consideration. That our regardto the will of the Deity ought to be the supreme rule of our conductcan be doubted of by nobody who believes his existence. The verythought of disobedience appears to involve in it the most shockingimpropriety. How vain, how absurd would it be for man, either tooppose or to neglect the commands that were laid upon him byinfinite wisdom and infinite power. How unnatural, how impiouslyungrateful not to reverence the precepts that were prescribed tohim by the infinite goodness of his creator, even though no punish-ment was to follow their violation! The sense of propriety, too,is here well supported by the strongest motives of self-interest.The idea that, however, we may escape the observation of man, orbe placed above the reach of human punishment, yet we are alwaysacting under the eye and exposed to the punishment of God, thegreat avenger of injustice, is a motive capable of restraining themost headstrong passions, with those at least who, by constantreflection, have rendered it familiar to them.2

As we shall see through this volume, Smith’s deist views, the sacred rulesof nature, the required legislation, and the well-functioning market systemconverge with what we visualize as an “ideal Islamic system.” Viewed in thislight, Smith’s thoughts then become systematic and complete in the sense

2Smith (2006, pp. 186–198).

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that theMoral Sentiments covers the first part, his Lectures on Jurisprudencecovers the second part, and The Wealth of Nations, the third part. This viewholds the promise of opening a line of communication between Islamiceconomics and conventional economics to illuminate how the original visionsof Islam and Smith converge. Our position in this regard is of coursediametrically opposed to the position held by most that the two disciplineshave nothing in common and that the only way to define Islamic economics isto jettison conventional economics: throw the baby out with the bathwater.

Because of market failures and social considerations, truly pure marketeconomies do not exist today. Instead, market or capitalist economies aremixed systems, with the word “mixed” referring to government participationand intervention. Crucially, the questions have become: How much govern-ment intervention is acceptable? In what areas?

Mixed Market (Capitalist) Economic System

A number of the shortcomings of a pure market economic system have beennoted. We also should add that markets need a “referee” to make sure thatimportant market rules are respected and negative fallouts are containedand limited. Markets are the medium for effective economic performance;they are not an ideology to be placed on a pedestal and untouched, as somewould have it.

Private property rights and secure contracts are essential features of amarket economy. Property rights give individuals the right to own propertyand to use that property as they wish. Property rights, in turn, are of novalue unless they are secure and legally enforced. Similarly, most economictransactions that are outside the simple retail sphere rely on contracts thatmust be secure and enforced. In other words, business development needssecurity and confidence. Without government intervention as the referee,business conditions could become problematic. Moreover, in the absenceof business regulations, supervision, and enforcement, businesses couldcollude and fix prices to the detriment of consumers and society at large.Even without price fixing, monopolies could develop to the detriment ofsociety. At the same time, there are a number of areas where there arenatural monopolies, such as defense and some areas of infrastructure.Again, we see a role for government. Most important, even if marketsare self-regulating and operate smoothly without government intervention,(namely, how market output is divided among members of society) theymay yield results that are socially abhorrent—a few wealthy individualsalongside mass poverty. And most practically, governments needing reve-nues have to collect taxes to provide even the minimum level of public andsocial services.

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Mixed Socialist Economic System

In large part because of significant income inequality, poverty, humandissatisfaction, and increasing social concerns, some mixed market econo-mies adopted a socialist mantle as an offshoot of Marxism. In WesternEurope, socialist parties emerged as strong political contenders to nurturekey nationalized industries and expand the available welfare programs.Some countries adopted limited industrial plans. Key sectors, such as bank-ing, telecommunications, railroads, energy, healthcare, and education, werenationalized. The provision of social benefits was expanded to include freeeducation and healthcare, extended unemployment benefits, early retirementfor those in hardship industries, minimum retirement benefits, and reducedworking hours. These programs increased the role and economic contribu-tions of the state while reducing the role of markets. In the 1980s, the UnitedKingdom reversed a number of earlier socialist decisions, denationalizedsome industries, and reduced a number of social programs. This reversal ofsocialist policies and programs spread to a number of other countries inWestern Europe. It was adopted by the International Monetary Fund as therecommended policy prescription and was even forced on some countriesduring the financial crisis of 2007–2008, in part because of significant publicdebt and the belief that societies could no longer afford what becameconsidered to be social programs that were too generous.

Command (Planned) Economic System

A command or planned economic system is the polar opposite of a market-based economy. In a command economy, a central public authority makesdecisions on the specific goods to be produced, decisions that would bemade by individual producers and consumers in a market system. More-over, in a command economic system, there are no private property rights.Property and resources are collectively owned by groups or by the state. Thestate or planning organization determines the output of each final good andservice sector and those of intermediate goods and services. It decides onwages to be paid and on all remuneration of incomes. From these wage andincome figures, consumption and savings are determined. In order to haveuseful consumption (demand) figures, the planning directives literally godown to the kind and even sizes of shoes to be produced. The output ofshoes is so specified (what to be produced), and the inputs have to bedictated (how the goods are produced and the required materials), and soon down the line. In a planned economy, the authorities use an input-outputmodel to derive the needed inputs of different sectors. The plannersdetermine prices and thus the incomes (who can buy the economy’s output).

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Thus the planning entity determines all that the markets do “invisibly” in amarket system.

In practice, no planner can predict individual demands for goods as wellas the invisible hand of the market as consumers register their votes (by whatthey demand) and prices send the signal to producers. Similarly, plannerscannot tell producers the best (most efficient) way to combine the inputs theyneed to produce the planned output. Instead, producers who have the profitincentive and who know the technologies and the relative cost of inputs arebest placed to produce the highest-quality output at the lowest cost. More-over, there is little incentive to innovate and work hard in a system wherethere are no private property rights and no ownership. It is easy to see why itwould be difficult to develop a thriving economy in such a system. Economicwaste, chaos, and stagnation are the likely outcome.

Planned economies had their heyday after World War II in the SovietUnion and China but lost their cachet as the Soviet economy faltered. Withthe collapse of the Soviet Union, the mixed market economic system began torule almost supreme. Russia turned to a market-supported system throughshock therapy, and China started to gradually move toward a market-basedsystem. We say “almost supreme” because income and wealth inequalitiesbecame glaring in a number of market economies. Economists began toquestion the relative importance of economic output for individual well-beingas material success was no longer seen as synonymous with human happinessand welfare. Since the financial crises of the 1980s, excessive national debtand, more recently, the most serious economic downturn and stagnation sincethe Great Depression have renewed doubts about the ability of markets andgovernments to deliver economic prosperity and well-being.

CURRENT STATE OF THE GLOBAL ECONOMIC SYSTEM

Due to market failure and other reasons, there is no “pure”market economyin the world of 2014. There is a role for governments in any economic system,and hardly anyone denies an important role for the government. Thequestions relate to the areas and extent of government intervention. Generallyspeaking, the wealthy argue for very limited government intervention andlow taxes to maximize their earnings and wealth, while the poor wantextensive intervention to address unequal opportunities (education andhealthcare), wealth disparities, and social safety nets.

But even though they recognize these safeguards and address them,mixed market economies in practice all over the globe have come underconsiderable criticism. In 2014, there are five major criticisms of the mixedmarket economic system:

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1. Wide and growing income and wealth disparities2. Recurring and highly disruptive financial crises accompanied by rising

unemployment and severe economic hardships, especially for the poorersegments of society

3. Neglect of the human and societal well-being dimension of economicdevelopment

4. Irrational assumption of rational self-interest5. Continuing environmental degradation

Growing Income and Wealth Disparities

In the United States, for example, income and wealth inequalities havedeteriorated significantly over time.3 In 1982, those in the top 1% of theU.S. income distribution received 12.8% of the total national income; thispercentage rose to 21.3 by 2006 and fell back to 17.2 in the aftermath of thefinancial crash of 2007–2008. Another popular indicator of growing incomedisparity is a comparison of average chief executive officer pay relative to thepay of an average factory worker; this ratio rose from 42 times in 1960 to ahigh of 531 in 2000 and fell back to 344 in 2007. An often-used comparatorof income distribution across countries is the Gini coefficient (with zerorepresenting perfect equality and 100 representing total inequality, or in otherwords, one person earning the entire national income); the most recentnumbers for some countries are:

United States: 45.0

Iran: 44.5

Japan: 38.1

Egypt: 34.4

United Kingdom: 34.0

Switzerland: 33.7

France: 32.7

Norway: 25.0

Sweden: 23.0

3For the U.S. data cited here, seeG.WilliamAnderson, “WhoRules America?” (http://www2.ucsc.edu/whorulesamerica/power/wealth.html). ForOrganisation for EconomicCo-operation and Development (OECD) data, see “Growing Unequal? Income Distri-bution and Poverty in OECD Countries” (http://www2.ucsc.edu/whorulesamerica/power/wealth.html).

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The rankings among 133 countries (with 1 representing the most equalincome distribution among countries, namely Sweden):

South Africa: 133

United States: 93

Iran: 90

Sweden: 1

A standard method of addressing income inequality in a capitalistsystem is through progressive taxation. But this is not always the case incountries that profess progressive taxation. As the following article excerptnotes:

The lowest 20% of earners (who average about $12,400 per year),paid 16.0% of their income to taxes in 2009; and the next 20%(about $25,000/year), paid 20.5% in taxes. So if we only examinethese first two steps, the tax system looks like it is going to beprogressive.

And it keeps looking progressive as we move further up theladder: the middle 20% (about $33,400/year) give 25.3% of theirincome to various forms of taxation, and the next 20% (about$66,000/year) pay 28.5%. So taxes are progressive for the bottom80%. But if we break the top 20%down into smaller chunks, we findthat progressivity starts to slow down, then it stops, and then it slipsbackwards for the top 1%.

Specifically, the next 10% (about $100,000/year) pay 30.2% oftheir income as taxes; the next 5% ($141,000/year) dole out 31.2%of their earnings for taxes; and the next 4% ($245,000/year) pay31.6% to taxes. You’ll note that the progressivity is slowing down.As for the top 1%—those who take in $1.3 million per year onaverage—they pay 30.8% of their income to taxes, which is a littleless than what the 9% just below them pay, and only a tiny bit morethan what the segment between the 80th and 90th percentile pays.

While income figures represent one measure of inequality, a morecomprehensive measure is wealth; these figures are even more discouraging.In 2000, the percentages of the national wealth held by the top 10% of theadult population in a number of Western countries were:

Switzerland: 71.3

United States: 69.8

France: 61.0

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Sweden: 58.6

Norway: 50.5

Germany: 44.4

Finland: 42.3

The numbers for the United States, where figures are readily available,are even more alarming when we look at the top 1%. (See Table 1.1 andFigure 1.1.) Generally speaking, in 1976, the top 1% held about 20% of thetotal national wealth. This figure nearly doubled to 40% in 1995 and in 2010stood at over 35%. The corresponding dollar figures (wealth and income) forthe various percentiles are shown in Table 1.2.

Instability of Economic and Financial Systems

A secondmajor criticism of the mixed market system is the recurring financialcrises and the heavy economic toll that follows, especially on the lessfortunate members of society. While the Great Depression and the financialcrisis of 2007–2008 are the two most prominent standouts, they are notalone.4 The conventional financial system is based on fractional reservebanking and debt, whereby banks create money though loans and investors

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1922

1933

1945

1953

1965

1972

1979

1983

1989

1995

2001

2007

Top 1%

Bottom 99%

FIGURE 1.1 Share of Wealth Held by the Bottom 99% and Top 1% in the UnitedStates, 1922–2010

4Kindleberger (2011).

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TABLE 1.2 Income, Net Worth, and Financial Worth in the United States byPercentile, in 2010 dollars

Wealth or IncomeClass

MeanHouseholdIncome

MeanHouseholdNet Worth

Mean HouseholdFinancial (Non-Home) Wealth

Top 1% $1,318,200 $16,439,400 $15,171,600Top 20% $226,200 $2,061,600 $1,719,80060th–80th percentile $72,000 $216,900 $100,70040th–60th percentile $41,700 $61,000 $12,200Bottom 40% $17,300 �$10,600 �$14,800

TABLE 1.1 Share of Wealth Held by the Bottom 99% and Top 1% in the UnitedStates, 1922–2010

Bottom 99% Top 1%

1922 63.3% 36.7%1929 55.8% 44.2%1933 66.7% 33.3%1939 63.6% 36.4%1945 70.2% 29.8%1949 72.9% 27.1%1953 68.8% 31.2%1962 68.2% 31.8%1965 65.6% 34.4%1969 68.9% 31.1%1972 70.9% 29.1%1976 80.1% 19.9%1979 79.5% 20.5%1981 75.2% 24.8%1983 69.1% 30.9%1986 68.1% 31.9%1989 64.3% 35.7%1992 62.8% 37.2%1995 61.5% 38.5%1998 61.9% 38.1%2001 66.6% 33.4%2004 65.7% 34.3%2007 65.4% 34.6%2010 64.6% 35.4%

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and consumers borrow to finance investment and consumption. The assump-tion of excessive debt, or leveraging, exposes the financial system to baddecisions and debt that cannot be repaid, setting off a chain reaction ofdefaults among financial institutions and causing panic and requiring gov-ernment bailouts that become a burden for average taxpayers. Moreover,serious financial crises, most notably the Great Depression and the financialcrisis of 2007–2008, lead to panics, loss of business and consumer confidence,deleveraging, severe and prolonged recessions or depressions, long-lastingperiods of high unemployment, and, ultimately and most ominously,unbearable pressure on families and on the fabric of society and socialcohesion.

Neglect of Human Welfare Dimension of EconomicDevelopment

A third criticism of mixed market economies is the focus on gross domesticproduct (GDP) and not on the happiness, well-being, and welfare of indi-viduals and society at large. In the West, under the mixed market system, thefocus of economic policy is largely GDP and GDP per capita, not onthe condition of all humans. Human beings are not the end result of alleconomic activity but are taken in part as inputs to economic production, andthe economic goal has become how much goods and services are produced.Thus, other goals, especially human well-being, freedom to pursue individualgoals, and social cohesion, have fallen by the wayside. These shortcomingsbecame increasingly recognized in the West during the late 1970s and 1980sthrough the works of Mahbub ul-Haq and Amartya Sen.

Mahbub ul-Haq argued that all development and growth models fol-lowingWorldWar II considered humans, whether as labor or human capital,to be an input into the production process and therefore a means fordevelopment. What was missing, he asserted, was the consideration of thehuman as the end of the development process. He developed the idea of “basicneeds,” which laid the foundation for his later work on “human develop-ment,” culminating in the publication of the Human Development Report in1990. As he says in his book, Reflections on Human Development, “Aftermany decades of development, we are rediscovering the obvious—that peopleare both the means and the end of economic development.”5 In his forewordto ul-Haq’s book, Paul Streeten defines human development as “widening therange of people’s choices. Human development is a concern not only for poorcountries and poor people, but everywhere. In the high-income countries,indicators of shortfalls in human development should be looked for in

5Ul-Haq (1995, p. 3).

14 INTRODUCTION TO ISLAMIC ECONOMICS