IT SEEMS THAT economists have finally forgiven Adam Smith for not being David Ricardo. From Ricardo through Jacob Viner, most economic theorists have considered "Smith's contribution to the theory of international trade [to be] slight at best and erroneous at worst" (Maneschi 1998, p, 48) The main reason for this lowly opinion was Smith's failure to discover the theory of comparative advantage. This failure seems all the more glaring given that David Hume left Smith with all of the analytical tools necessary to develop such a theory: all Smith had to do was put the pieces together.
This perception of Smith's contribution to trade theory began to turn with Myint's (1958) recognition that Smith's theories of trade were intimately connected with his overall theory of economic development. Today, it is generally recognized that Smith's emphasis on increasing returns and dynamic gains provides an analysis of trade and the gains from trade that is rich with insight (Blecker 1997) and internally consistent with Smith's overall system of natural liberty (Elmslie and Sedgley 2002). (1)
While Smith's theories of trade have enjoyed a renaissance, his work on trade policy has "largely been ignored. This paper is interested in Smith's critiques of bounties (read "subsidies") on exports. I argue that Smith's analysis of bounties foreshadows the basic trade policy framework of distortions and noneconomic objectives that, since Bhagwati (1971), has formed the basis of neoclassical policy analysis. While Smith does not develop a coherent theory of distortions, he captures the logic of the theory of noneconomic objectives and attempts to rank policy alternatives based upon their relative social costs. Moreover, Say extended Smith's analysis of the effects of bounties to develop policy based on endogenous distortions.
Smith and the Theory of Noneconomic Objectives (2)
NEOCLASSICAL THEORETICAL POLICY analysis is based upon a foundation of complete transparency. The policy prescriptions for the elimination of distortions and the most efficient manner to meet noneconomic objectives are the foundation of this analysis. The theory shows that if a distortion exists the first-best option is to eliminate the distortion directly rather than to erect a countervailing distortion in the system. The analysis of noneconomic objectives develops as a corollary to that of distortions: if a noneconomic objective exists, it is best to meet the objective as efficiently as possible by directing the policy measure (tax cum subsidy) specifically at the objective. (3) Given that the government policy is not directed at the elimination of a market-created distortion, intervention will create a distortion in the system. The idea here is to create as few distortions as possible while still meeting the objective. (4)
A noneconomic objective of a government can be represented by a minimum output objective for an industry. The objective could be met, for example, by a subsidy on exports. However, such a policy will create other distortions elsewhere in the economy. If one industry is given a subsidy on exports, two external effects are created. First, the home price of the good will increase. This essentially makes home consumers pay for the subsidy twice. Not only must they finance the subsidy, but they are also taxed indirectly in the form of higher prices for the good in the home market. Moreover, a subsidy on exports of one industry taxes other industries through a Lerner effect. The expansion of the exports of one industry will either reduce the exports of other industries or increase imports that compete with domestic producers.
A preferred solution is a direct production subsidy. A production objective is best met by a production subsidy. A policy directed at the objective creates fewer distortions in the system. The disincentive to other industries is lessened, while consumers pay the tax only once. …