Chapter 9: Fundamentals of Islamic Economic System by Dr. Muhammad Sharif Chaudhry



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Fundamentals of Islamic Economic System

By Dr. Muhammad Sharif Chaudhry



  1. What is Capital?

  2. Importance of Capital

  3. Capital Formation

  4. Reward for Capital

What is Capital?:

Capital is the third factor of production. It is that wealth which assists in the production of further wealth. It is “produced means of production” or in other words “man-made instrument of production”. It includes all those goods which are produced not for consumption but for use in future production. Machines, tools and instruments, transport equipment’s, irrigation projects like canals and dams, stocks of raw materials, cash invested in business, etc. are some of the examples of capital. Thus capital is the wealth which man acquires by his own labour and then uses it for producing more wealth.

The above mentioned meaning of capital distinguish it both from land and labour because both land and labour are not produced factors but are gifted by nature. Therefore, land and labour are called primary or original factors of production whereas capital is man-made or produced factor of production.

Capital is generally classified into fixed capital and working capital. Fixed capital comprises durable-use produce goods which are used in production again and again till they wear out. Plant and machinery, tools and instruments, tractors and trucks, etc. are examples of fixed capital. Working capital comprises single-use producer goods like raw materials which are used up on a single act of use.

Fixed capital does not mean fixed in location. It is called so because money spent upon durable-use goods like plant and machinery becomes ‘fixed’ for a long period whereas money spent on raw materials is released as soon as goods manufactured with these raw materials are sold in the market.

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II- Importance of Capital :

Capital plays a vital role in production as production without capital would be very hard to achieve. If man does not use tools and machines in farming, mining and manufacturing sectors and works with his own hands, productivity would be very low. So man has been using some sort of tools and equipment’s to assist him in his work of production. Even primitive man made use of bow and arrow for hunting and fishing-net for catching fish. With the growth of science and technology, man has invented heavy and complex machines to assist him in every field of production such as agriculture, mining, manufacturing, transportation, communication, etc. In the modern age production without aid of capital can hardly be achieved. Economic development of the countries like USA, Japan, Germany, France, UK, is largely due to extensive use of capital.

Capital occupies a pivotal position in the process of economic development as well as in creation of employment opportunities. Besides escalating production, employment is also enhanced when capital goods like plant and machinery are produced and when these goods are used for further production.

Thus capital is indeed like blood in human body which runs into the veins of industry and keeps it going. Because of vital role of capital in production, Islam has given much importance to capital. Al-Qur’an, the revealed book of Islam, in the following verses talks of the use of cattle wealth as capital goods of production :

-          And the cattle hath He created, whence ye have warm clothing and uses, and whereof ye eat…….. And they bear your loads for you unto a land ye could not reach save with great trouble to yourselves……… And horses and mules and asses that ye may ride them……….


-          And Lo! in the cattle there is a lesson for you. We give you to drink of that which is in their bellies…….. pure milk palatable to the drinkers.


-          And Allah hath given you in your houses an abode, and hath given (also), of the hides of cattle, tent-houses which ye find light (to carry) on the day of migration and on the day of pitching camp; and of their wool and their fur and their heir, caparison and comfort for a while.


Thus in the above mentioned verses, the Holy Qur’an has referred to various uses of cattle and horses as factors of production such as in transportation, in production of milk, wool, fur, hides for tent-houses, and so on.

Umar a great companion of the Prophet and second right guided caliph of Islam used to impress upon some of the recipients of state allowances and stipends that they should purchase goats or other cattle so that they could increase their capital and leave after them for their children something to fall back upon.

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III- Capital Formation: Capital formation means increasing the stock of real capital in the country. It involves production of more capital goods, encouraging savings and investments, etc. In modern economics, capital formation is encouraged through many fiscal and financial measures such as rebates and exemptions from taxes, high dividends on investments, attractive rates of interest and above all protection of capital. Islam believes in all such measures except interest on investments as interest is prohibited. Islam in fact, took measures for capital formation in Islamic state much earlier such as condemnation of hoarding of wealth, tax exemption on productive goods and avoidance of extravagant spending. Some of the steps taken by Islam in ensuring capital formation are that :

1.   Zakat has been imposed on hoarded wealth in the form of gold and silver, bank deposits, cash, etc. If this wealth is put into productive channels, its Zakat would be paid out of its income and thus the wealth would grow despite Zakat. But if the wealth is kept hoarded and idle, the regular payment of Zakat out of it every year would reduce it and ultimately diminish it. That is why Prophet Muhammad asked the guardian of the wealth of orphans to put their wealth in business that Zakat should not consume it. Thus Zakat forces a hoarder of wealth to bring it out of idle channels and to invest it in production. This helps in capital formation.

2.       Wealth employed in production has been exempted from Zakat. For example agricultural land is exempt from Zakat; cattle employed in farming are exempt; horses used for riding, transport and jihad are exempt; plant and machinery used in factories and farms for production of goods are exempt; tools and instruments used by a professional or an artisan are exempt, and so on. Thus exemption of capital goods from Zakat Tax is a great fiscal measure which helps capital formation in an Islamic society. And don’t forget that this measure was taken by Islam some fourteen centuries ago when there was no concept of fiscal incentives for capital formation.

3.       Those who dispose of their capital assets like house or land have been enjoined upon by the Prophet (PBUH) to re-invest the cash in the purchase of some other land or house. The Prophet is reported to have said: “God may not bless the price of that land and that house which is not again re-invested in land or a house”.

4.       Squandering of wealth on extravagant spending has been strictly prohibited. Spending on luxuries is strongly forbidden and ostentatious living has been discouraged. The Qur’an says:

-          Eat and drink, but be not prodigal. Lo! He (Allah) loveth not the prodigals.


-          ……….. and squander not (thy wealth) in wantonness. Lo! the squanderers were ever brothers of the devil……..


Since moderation in expenditure and simple living is the golden rule of Islam, so wastage of wealth stops and wealth starts flowing into productive channels. This also helps in capital formation.

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IV- Reward for Capital:

We have already studied that land receives its reward in the form of rent and labour receives reward in the form of wages. Third factor of production i.e. capital receives its reward in capitalist economies in the form of interest. But Islam has prohibited interest on capital. It has, however, tied the concept of reward on capital with the responsibility to risk loss.

In Islamic economy, there is no doubt that savings are encouraged but those who save can neither keep their savings in a bank or financial institution to earn interest nor lend it to a business exterprise on the basis of interest. The saver can either invest his capital as a sole proprietor and do the business, or he can invest in a Mudarabah or a Musharika. In Mudarabah, one person provides capital, the other labour and both share in profit in stipulated proportions, but in case the business results in loss the whole of loss in borne by the capitalist. In Musharika or Shirkat, all the partners put up their capital and do the business in partnership sharing profits and losses in agreed proportions.

However, when capital is not in the shape of money, rather it is in the shape of building, factory, plant or machinery, it can be leased on the basis of fixed rent.

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