Tax neutrality, tax equality and Islamic finance

While writing this week's newsletter, based on an IMF paper released recently focusing on the differences between conventional and Islamic finance in Malaysia, I was surprised to read the following about the tax treatment of Islamic finance in Malaysia: "partnerships formed under the Shariah concept of a joint venture entailing the sharing of profits and/or losses are not recognized as partnerships from the tax perspective".

After doing some very cursory research on the tax rates in Malaysia (helped out by a fact sheet (PDF) from Deloitte), the reason for this peculiar tax treatment of a joint venture is based on the difference in tax rates between income (the corporate tax rate is 25% and the highest personal tax rate is 26%) and tax rate on interest income, which appears to be 15%.

Clearly, the tax treatment was designed to provide tax neturality for Islamic finance, compared to conventional finance.  Taking a step back from the example of Malaysia, one of the underlying ideas for Islamic finance from a theoretical perspective (mostly articulated by Islamic economists) is that Islamic finance benefits society as a whole by shifting the burden of risk onto those with more wealth. Instead of lending with interest, they are supposed to be bearing a higher degree of risk in line with the rewards they expect to earn.  This will, other factors being equal, result in a lower level of income and wealth inequality (zakat will also provide for lowering wealth inequality). 

From the theoretical view, Islamic finance should differentiate itself from conventional finance by focusing on a macro level at lowering income and wealth inequality, and on the micro level at generating income from Shari'ah-compliant sources.  However, subsidizing Islamic finance by providing preferential tax breaks to products which effectively shoehorn Shari'ah-compliant products into structures that are equivalent in economic effect to interest-based lending will provide incentive for Islamic finance to move more towards replication of interest-based products. 

One of the ideas with the current structure of Islamic finance is that it uses replication of conventional products as a stepping-stone to facilitate the growth of Islamic finance.  For example, the regulatory treatment of Islamic finance makes it much easier for banks in particular to use murabaha and ijara, rather than mudaraba and musharaka.  Allowing these products to achieve tax neutrality with conventional loans is important for facilitating the competitiveness of Islamic financial institutions with conventional institutions. 

From a macro perspective, however, it should be important for Islamic financial institutions to recognize that where interest income is treated in a preferential way compared to regular income (e.g. partnership income or wage income), the incentives will tilt the balance towards debt financing and away from equity finance.  It will also tend to provide lower tax rates at the top of the income spectrum and higher tax rates at the bottom, which will increase inequality. 

At the same time as Islamic bankers lobby for tax neutrality between interest income and the profits generated from Shari'ah-compliant debt alternatives, they should also push for equal treatment between debt and equity, which will diminish the subsidy of debt finance.  They should also support tax equality across income sources, as a way of mitigating increases in inequality that preferential treatment of interest income can cause.