The purpose of this paper is to theoretically describe the role of Zakah as a vital tool of fiscal policy in achieving Pareto optimality.
The paper sets a general equilibrium model that describes the long‐run convergence to a Pareto optimal allocation in a theoretical Islamic economy. The model is based on Diamond criteria where the social planner maximizes the utility of all generations subject to the output of the economy.
While the government in the capitalist economy issues debt like T‐bills and government bonds to insure Pareto optimality, the paper shows, theoretically, that constructing a Zakah fund can take the role of issuing debt in financial markets. Furthermore, the paper shows that Islamic economy converges to Pareto optimality by its nature without issuing debt in the financial market.
This result is very important in describing the strength of the theoretical Islamic economics in achieving dynamic efficiency with least possible interventions. More importantly, the results would help the government in setting an optimal tax rate that insures Pareto efficiency without issuing debt.
This paper attempts to model the actual effects of Zakah as a fiscal policy tool in wealth redistribution in an Islamic economy. In addition, the paper opens a wide channel for future research in conducting monetary and fiscal policy in a government's debt tools economies.
