Zakāt, a ‘Use it or Distribute it Tax’ on Wealth

Abstract

Zakāt has a worship dimension (a pillar of Islam) and a rights dimension (a right of the poor ordained by Allah). We focus on the economic dimension only by asking: how is zakāt different from both the capital income tax and the wealth tax?  Economists discuss whether a capital income tax is optimal for welfare or a wealth tax is better. Traditional literature argued that the two are equivalent if the tax on wealth is set equal to the capitalised value of the tax on capital income. However, Guvenen et al. (2019, 2023) have forcefully shown that this equivalence holds only if the rate of return on capital is equal across individuals. When rates of return on investment are heterogeneous across individuals, the two tax systems have opposite implications for efficiency and inequality. A capital income tax burdens the more productive capital, whereas a wealth tax—by taxing all wealth holders—not only increases the tax base but reduces the wealth of low-productivity individuals. If the productivity differences are persistent, then the wealth of low-productivity individuals will be gradually pruned. In this sense, a wealth tax creates a use-it-or-leave-it effect. How is zakāt different from both taxes and what are its efficiency and distributional implications? We bring in some key macro-features of zakāt which is a tax on idle wealth, not on deployed (or employed) wealth. Aimed at promoting wealth circulation and helping the poor, zakāt helps address the wealth gap and income inequality in a different way than what is possible by either the capital income tax or the wealth tax. It has a much stronger “use-it-or-lose-it” effect than a wealth tax.