It is quite clear that the principle of substitution admits of very wide extension, as Adam Smith himself observes.

§ 10. Proposed Extension of the Principle
to all Home Taxes.

"This second limitation of the freedom of trade, according to some people, should upon most occasions be extended much farther than to the precise foreign commodities, which could come into competition with those which had been taxed at home."

The case that he gives by way of illustration is the taxation of necessaries in the home country by which the general cost of labour is raised. At the time there were excises on various necessaries, such as salt, soap, candles, leather, etc. Adam Smith is of opinion (as shown in his treatment of taxation) that such taxes do increase the cost of labour in the home country. But he objects to the extension of the method of countervailing duties of a general character on all foreign imports, so as to balance this increased cost of production on two grounds: first, that the effect cannot be exactly known as in the case of a particular tax; and secondly because the remedy proposed would probably only aggravate the disorder. Taxes on necessaries, he says, "when they have grown up to a certain height are a curse equal to the barrenness of the earth and the inclemency of the heavens, and yet it is in the richest and most industrious countries that they have been most 1 See above, Chapter X.

generally imposed. No other countries could support so great a disorder. To lay a new tax upon them, because they are already over-burdened with taxes, and because they already pay too dear for the necessaries of life; to make them likewise pay too dear for the greater part of other commodities is certainly a most absurd way of making amends."

§ 11. Difficulties of such Extension.

At the present time it is often maintained that the system of taxation in any country (national as well as local) must be taken account of as an element in the cost of production of all commodities.1 And then it is argued that to put the home producer on a fair footing all foreign imports ought to be taxed. This case is the same in substance as that noted by Adam Smith, and may be met by the same arguments. The first of these as to the precise scale of equivalence brings to the surface a difficulty that is presented by every system of general protection, the difficulty, namely, of an equitable adjustment of a complex system of differential duties. It is properly considered under the negative argument for free trade.

The second of Adam Smith's objections to the proposed general countervailing system involves the theory of the incidence of taxation. The popular opinion which he is attacking really assumes that the taxes on the foreign imports fall on the foreign producer; and Adam Smith, on the other hand, really assumes that the taxes fall on the home consumer.

1 See below, Chapter XVI. § 10.

A great deal of attention has been devoted to the subject of the incidence of taxes on imports-confessedly one of the most difficult in economics; and the general result appears to be that only in exceptional cases does the tax fall to an appreciable extent on the foreign producer.1 It may, and if heavy enough surely will, cut off the foreign supply, and in general such a reduction in supply and lessening of competition will raise prices. On the other hand, account must be taken of competition in the home country itself, and the price may not eventually rise to the full extent of the duty.

§ 12. Countervailing Duties on Foreign Bounties.

Another application may be made of this extension of Adam Smith's second exception. He rests the principle of countervailing taxation on the idea that by such a method trade will be simply restored to its natural channels. Later on he justifies the methods of drawbacks on exportation by a similar argument. If the duty is drawn back, it simply restores trade to its natural channels.

It seems to the present writer that this general argument of Adam Smith may be applied to the case of the countervailing duties imposed on bounty-fed sugar. Bounties are most severely condemned by Adam Smith as disturbing the natural course of trade, and ostensibly the object of the countervailing duty is simply to bring back the status quo ante. If it be

1 See Principles of Political Economy, Book v. chap. xiii., by present writer.

objected that our consumers benefit by the bounty, and that the bounties only injure the foreign countries which grant them, Adam Smith would reply that it is not to our advantage that other nations should adopt bad economic methods, and that the richer its neighbours so much the better for any trading nation; a principle to which he constantly appeals. We have also to consider the interests of British producers engaged in the sugar industries. In theory, a bounty is a negative tax; and if the home producer ought to be compensated for an excise duty, he ought similarly to be compensated for a bounty given to his foreign rival.

If, however, this extension of the exception is admitted, the way is open for a still wider extension.

§ 13. Extension of Countervailing Duties.

It may be said that if foreigners impose taxes on our commodities, and in that way divert trade from its natural channels, we are justified in imposing exactly corresponding duties on the similar goods which they send to us. The justice may be admitted, if justice is to be on the simple plan of an eye for an eye. But the case is, in general, to be decided not on primitive notions of justice but on grounds of expediency. And we are again confronted by the difficulty of the incidence of the proposed taxes.

The case is altered if the taxes on the foreign goods are imposed not merely by way of revenge, in which case they may do more harm than good, but with the idea that the foreign nation may be induced

to take off the offending duties. This leads up to the celebrated exception to free trade that is considered by Adam Smith under retaliation.

§ 14. Third Exception: Case of Retaliation.

"As there are two cases in which it will generally be advantageous to lay some burden on foreign for the encouragement of domestic industry, so there are two others in which it may sometimes be a matter of deliberation; in the one how far it is proper to continue the free importation of certain foreign goods, and in the other, how far or in what manner it may be proper to restore that free importation, after it has been for some time interrupted." The first is the case for retaliation.

"The case in which it may sometimes be a matter of deliberation how far it is proper to continue the free importation of certain foreign goods, is when some foreign nation restrains by high duties or prohibitions the importation of some of our manufactures into their country. Revenge in this case naturally dictates retaliation, and that we should impose the like duties and prohibitions upon the importation of some or all of their manufactures into ours. Nations accordingly seldom fail to retaliate in this manner." Here, as usual, Adam Smith appeals to history, and shows by important cases the dangers of the plan. A war of tariffs, begun by the great Colbert, led to a real war with Holland, and after six years' fighting (1672-1678) there was a mutual reduction of duties.