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Purpose--The purpose of this paper is to theoretically describe the role of Zakah as a vital tool of fiscal policy in achieving Pareto optimality. Design/methodology/approach--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. Findings--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. Research implications--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. Originality/value--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. Keywords Government borrowing, Equilibrium methods, Islam, Finance, Fiscal policy Paper type Research paper

An idealized financial system built according to the tenets of Islamic doctrine is described. In this hypothetical financial system, where a central bank monitors the activities of Islamic Banks, specially constructed financial instruments are used to ensure that Islamic teachings are upheld. The evolution of such an Islamic financial system is then discussed in the context of the emergence of over 200 Islamic banks and institutions in various in Africa, Asia and Europe.

The study of Islamic economics began in the Indian subcontinent in the 1930s as scholars strove to create a socio-economic manifesto that reflected Islamic ideals. Subsequently, centers for the study of Islamic economics were established in countries as diverse as Saudi Arabia, Malaysia and Sudan. Unfortunately, the field of Islamic economics remains underdeveloped and is still overly dependent on neoclassical economic models of pricing, resource allocation and consumer behavior. Recently, however, advances in Islamic political economy have helped to rejuvenate the field of Islamic economics.

The prohibition against usury and moneylending runs strong in both the Christian and Islamic faiths. However, the Christian Church in Europe was able to resolve the contradiction between usury and business practice in the late medieval period, a development that would allow banking to eventually become acceptable in the West. In Muslim countries, on the other hand, the absolute bar against interest has not permitted clerics and theologians to ever surmount their religious objections to usury, leading to the widespread belief among traditional muslims that moneylending is immoral.

Resource allocation is examined in the context of an interest-free Islamic economy. The conditions necessary for such a system to flourish are also investigated while the implications of interest-free conditions on welfare economics and investment decision-making are analyzed. A critical review of resource allocation issues leads to the conclusion that efficient allocation is possible in an interest-free environment, provided that Islamic welfare criteria are followed and non-neoclassical models are used to shape the tenets of which Islamic economic policies are built.