26 March 2015

As has been widely covered, our Brexit report found that, if the UK left the EU, its GDP could be hit by a permanent loss of up to 2.2% in a worst case scenario or, depending on certain choices, a permanent boost of up to 1.6%. Within this the most likely range is between -0.8% and +0.6% GDP impact. But what underlies these figures?

Source Of Impacts On UK Of Brexit On Real GDP And Welfare itemprop=

What drives the potential costs of Brexit?

Border costs

  • This is an aspect which is often underestimated or ignored entirely in calculations around the UK’s exit from the EU. In our worst case scenario 1.2% of the total 2.2% GDP loss comes from the introduction of a hard border between the UK and REU.
  • The costs come in the form of new time and out-of-pocket costs on cross-border trade, for example time spent at customs and the administrative cost of getting through customs. There is a clear advantage to being part of the customs union for quick and easy movement of trade across borders.
  • Importantly, unlike tariffs (see next point), this is a dead weight cost rather than a transfer and therefore is lost from the global economy completely.
  • The cost can be reduced somewhat via a deep free trade agreement with the REU. In our UK-EU FTA scenario the border cost falls to -0.94%, since the border could be similar to that between EU and EFTA members. This is more permeable than under a worst case Brexit since it has less onerous security and administration requirements. We consider it likely that a post-Brexit EU-UK border would be similar to the existing EU-Swiss border.
  • While this reduces the cost, it is also increased somewhat by demonstrating compliance with rules of origin (though this comes in place of tariffs).
  • Our research shows that this element, while often seeming a simple administrative inconvenience, is actually quite a large and lasting cost to businesses. Overtime it has dynamic effects as it impacts import and export decisions.

Tariffs
In the worst case Brexit scenario the relationship between the UK and EU reverts to WTO most favoured nation tariffs. While the EU’s applied MFN tariffs are generally low, the introduction of tariffs on the significant volume of trade between the UK and REU results in a fairly sizeable cost of -0.95% GDP.

Non-tariff barriers (NTBs)

  • As might be expected, outside the single market, higher NTBs on both goods and services have a noticeable impact on GDP and welfare. With the UK no longer being part of the single market, regulation on each side could diverge, while it seems likely that existing NTBs would be exacerbated absent a deal.
  • In the worst case goods NTBs cost 0.47% of GDP and services 0.15%. Under a UK-EU FTA there is little impact on goods and services since the UK effectively stays in the single market. However, it is worth noting that in reality access for services is not guaranteed. As we discuss in our sectoral analysis, we believe that certain services sectors, most importantly financial services, could face significant NTBs outside the EU, so this cost could be an under-estimate.

Foreign Direct Investment (FDI)
The result of our model in FDI terms is quite surprising. In the medium and long run there is little distortion or FDI as it is replaced by domestic and other foreign investment. The cost is negligible. Whether this will happen to an extent depends on what capacity the economy has to replace lost investment and the political decisions the UK makes. There will surely be some short term uncertainty and disruption but in the longer run, the long-term attractiveness of the UK is likely to depend on whether it adopts pro-competitiveness policies and markets itself as a free-trading economy.

What drives the potential benefits of Brexit?

Striking a comprehensive FTA with the EU
An important component of the UK prospering outside the EU is striking a comprehensive FTA which maintains liberal access to the single market and limits the impact of NTBs and the border costs as far as possible. Under our analysis this delivers a 1.2% GDP boost relative to the worst case WTO scenario.

EU budget

  • A significant saving is made from not having to contribute to the EU budget any longer. In our scenarios this ranges from saving the full net contribution (£10.2bn in 2014, 0.53% of GDP) to a 59% saving – meaning the UK saves 0.24% of GDP. It seems possible that, under a very comprehensive FTA with the EU, the UK may have to make some budget contribution (like Switzerland). However, it’s also possible that, as in the best case scenario, the UK saves the entire amount.
  • In addition, it will no longer take part in the recycling exercise whereby it gets cash back from EU, with strings attached. If this money is reinvested in more productive parts of the economy, the boost to GDP would be larger. It’s possible, therefore, that the saving from no longer be part of the EU budget – rightly seen as one of the costliest aspects of EU membership – is an under-estimate in all our four scenarios.

Opening up to global trade

  • Our research suggests that opening up to trade can deliver a significant boost. We model the impact of the UK adopting unilateral trade – this eliminates all remaining border protection.
  • This delivers a benefit of 0.75% GDP. This benefit is generated through a number of avenues. The removal of tariffs on any and all trade introduces a huge amount of new competition into the UK economy via low cost imports, particularly from emerging markets. This new competition will spur on efficiencies, drive a better allocation of capital and produce greater specialisation via a distillation of comparative advantages.
  • It will lower prices for both consumers and businesses (particularly those which import component parts for their own production).
  • This benefit could be further boosted if, before opening up to unilateral trade, the UK negotiates FTAs with large and/or fast growing economies such as the US, China and India. This would provide an additional boost by gaining greater access to these economies. Interestingly though this is not a necessity, significant gains can come domestically from cutting our own tariffs and opening up to more competition.
  • It’s important to note that the more the EU itself opens up to the world, the less is the relative advantage of pursuing aggressive free trade.

Deregulation

  • Outside the EU the UK could embark on a significant bout of deregulation. We look at two scenarios, one which is ambitious but realistic and one which would require an unprecedented push and a shift in the regulatory approach in this country.
  • The first scenario could deliver a saving of £12.8bn (0.7% of GDP). This mostly comes from cutting social and employment law, some of the climate change rules (such as the renewables targets) and some financial regulation.
  • The second scenario could deliver a saving of £24.4bn (1.3% of GDP). The savings come from similar areas, though through deeper and broader cuts. In particular this means cutting or dropping almost all climate change regulations/targets as well as restricting all rules related to the single market to only those parts of each sector which use the market. It also means a much lighter touch approach to regulation in the financial services sector.

So, again, one of the central messages of the report is that the costs and benefits will depend on political decisions taken both in the UK and Europe – if the latter wants to help avoid Brexit then it should look to maximise trade benefits and deregulate.