In Defence of Liberty

Driven by data; ridden with liberty.

A Non-Economist’s Guide to Brexit models

Membership of the European Union (EU) has multiple effects on public finances and the economy as a whole. This article seeks to serve as a guide to non-economists, who are wondering about all the different economic models and what those models are seeking to forecast.

My qualifications are in mathematics, not economics, but I nevertheless hope this will elucidate the debate for those who are unfamiliar with economic terminology, or the economic dimension of the EU referendum debate. Since these models concern the future, there is inherent uncertainty.

The Institute for Fiscal Studies (IFS) has collated the various different models for the authors expect to happen to the UK’s gross domestic product (the monetary value of all goods and services produced within the country in a year) by 2030, under three broad types of scenarios [1].

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The estimates are almost all negative. (Source: IFS)

Four freedoms

As a member of the EU, the UK is also a member of the European Economic Area (EEA), which is commonly referred to as the single market. A single market is a type of trade bloc where most trade barriers for goods have been removed, and there is a semblance of free movement of goods, services, capital and labour. In the EU, these free movements are typically called the four freedoms [2].

The IFS states that the five characteristics of EU membership are: tariff-free access to the EU’s markets; no customs checks at borders within the EU; a single market of common regulatory standards; access to more than 55 other markets through EU-agreed free trade agreements (FTAs); and common external tariffs on imports to the EU from non-EU countries.

Three scenarios

The first scenario is that the UK exits the EU, but remains within the EEA. There are three countries that have this arrangement: Norway, Iceland and Liechtenstein. From a fiscal perspective, these countries still have to contribute to the EU’s budget.

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The IFS have summarised the scenarios. (Source: IFS)

The second scenario is that the UK leaves the EEA, but continues to lower its tariffs and pursue reductions in non-tariff trade barriers. This is called the FTA option, often dubbed the ‘Switzerland’ option (if it involves free movement of people), the ‘Turkey’ option (if we remain part of the EU’s customs union) or the ‘Canada’ option. It should be noted that Switzerland, as a member of the European Free Trade Association, also contributes to the EU budget.

The third scenario is that the UK does not sign a trade agreement with the EU. This will mean we will face the EU’s common external tariff, and rely on World Trade Organisation rules to trade with the EU. This is called the WTO option.

Budget and Trade Effects

There are six main ways in which EU membership affects the UK’s national GDP: budget, trade, productivity, foreign direct investment, regulation and migration.

The budget (or fiscal, or mechanical) effect is that the UK is a net contributor to the EU budget, that is, the UK sends more money to the EU than we receive in return. There is a gross contribution, from which the rebate is automatically deducted. The EU then spends some money in the UK on payments to farmers, infrastructure support and other projects.
However, some post-EU arrangements could involve further contributions to the EU budget.

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The IFS estimates that the net contribution is likely to be around £150bn in future years. (Source: IFS)

Leaving the EU will affect our trade with the EU. Businesses and entrepreneurs provides goods and services, sometimes across national boundaries. Trading within the EU means these people face no tariffs. Tariffs are generally declining across the world, meaning that non-tariff barriers are becoming increasingly important.

Trade deals are not necessary for trade, but they may assist by lowering tariffs or agreeing to align regulation, or have other components. Even the EU-Canada agreement still contains some tariffs on goods, so totally tariff-free trade with the EU may not be possible on the outside.

Trade with non-EU countries is also affected by our membership, as the EU claims the exclusive competence for trade agreements, since it is a customs union. This does not cover agreements for mutual investment, such as deals between Britain and India.

If we were to exit the EU, even as a member of the EEA, we would regain the ability to make British trade agreements with other countries. Continuation of current EU agreements with other nations, negotiated on Britain’s behalf, would depend on both the EU and the third country [3].

For instance, the HM Treasury analysis presumed that that trade with non-EU nations would not improve beyond its typical growth, and all current trade agreements with those nations would be maintained.

The question is whether the expected improvement in non-EU trade is likely to compensate for any expected loss in trade with the EU.

Productivity and Foreign Direct Investment effects

Productivity is the measure of how efficiently a good or service, or collections thereof, is produced [4]. Openness to trade is widely recognised as a casual factor in a nation’s productivity levels.

Through greater trade, companies are able to realise economies of scale, identify technological improvements, and benefit from higher competition and better management skills. This impact is thus a secondary consequence of reduced trade levels.

Foreign direct investment (FDI) is, as the name suggests, investment within the country from outside it. FDI directly increases national income.

Membership of the EU may affect FDI levels through numerous means. For instance, the free movement of capital makes it easier to invest within the UK, and access to EU markets makes it a more desirable place to investment.

There are many reasons as to why the UK is such a desirable place to invest, such as our language, currency, timezone and laws.

Regulation and Migration Effects

Regulation is another area that could be affected by leaving the EU. The EU regulates in various areas, such as on the environment, climate change, financial services, and employment protection. These regulations are the common standards of the single market.

Campaigners suggest that regulation is overly onerous, and could be substantially reduced upon exiting the EU, thereby improving economic growth. However, studies by the OECD and World Bank Group suggest that the UK has light regulation by international standards, so potential savings from reduced regulation may be limited [5].

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The OECD does not consider the UK a restrictive nation. (Source: OECD)

Migration plays a prominent role in the public debate on EU membership, but also has an economic impact. As a member of the EU, we have agreed to the free movement of people with other EEA countries. It is not clear what the country’s post-EU migration would be, and this contributes to the uncertainty in the forecasts and analyses.

As the IFS report states:

The OECD notes that EU migrants in the UK have relatively high employment rates and make a positive net contribution to the public finances.

Reducing immigration from the EU would then imply a fall in the UK’s GDP.

A model answer

Ultimately, these different models make different assumptions on what the UK’s policies would be if the public chose to exit the EU. It should be made clear that these are reductions in GDP in 2030, relative to the counterfactual of staying in the EU, as well as what these assumption are.

For instance, the Economists for Brexit study presumed that the UK would unilaterally reduce all tariffs. This would be politically difficult, particularly given apprehension to milder US-EU agreement, and political desire to protect British industries, such as agriculture and steel.

(Video: ITV News)

Membership of the EU and the participation in its single market affects the UK economy in various ways. These economic studies typically suggest that the fiscal effect of no longer being a net contributor to the EU budget is more than wiped out by deleterious effects to trade, productivity and foreign direct investment.

It is a matter for the British people to decide if any negative economic consequences of leaving the EU are worth other gains.

References

[1] Emmerson, C., Johnson, P., Mitchell, I., and Phillips, D., 2016. Brexit and the UK’s public finances. Institute for Fiscal Studies. Available from: http://www.ifs.org.uk/uploads/publications/comms/r116.pdf [Accessed: 1st June 2016]

[2] European Commission, 2016. The European Single Market. Available from: http://ec.europa.eu/growth/single-market/index_en.htm [Accessed: 1st June 2016]

[3] Gehring, M., 2016. ‘Trade relations will remain unchanged’ post-Brexit, claims Lord Lawson. Hardly. London School of Economics. Available from: http://blogs.lse.ac.uk/brexitvote/2016/04/12/trade-relations-will-remain-unchanged-post-brexit-claims-lord-lawson-hardly/ [Accessed: 1st June 2016]

[4] OECD, Year unknown. Defining and measuring productivity. Available from: http://www.oecd.org/std/productivity-stats/40526851.pdf [Accessed: 1st June 2016]

[5] Koske, I., Wanner, I., Bitelli, R., and Barbiero, O., 2015. The 2013 update of the OECD’s database on product market regulation. OECD. Available from: http://www.oecd-ilibrary.org/economics/the-2013-update-of-the-oecd-s-database-on-product-market-regulation_5js3f5d3n2vl-en [Accessed: 1st June 2016]

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