31 October 2018

There are just five months to go before the UK leaves the European Union in March 2019. Yet in Philip Hammond’s Budget speech in the House of Commons yesterday, Brexit was conspicuous by its absence, mentioned just once by name. However, the Budget was predicated on an exit deal which has not yet been reached, and the uncertain outcome of Brexit therefore raises questions about the Government’s future spending plans. The consequences of the Budget for the domestic politics of Brexit also need to be assessed.

The figures in the Budget are predicated on the UK reaching a deal with the EU

The spending commitments in the Budget are based on economic forecasting by the Office for Budget Responsibility (OBR). The OBR’s surprisingly low borrowing forecasts gave the Chancellor a revenue windfall, allowing for significant additional spending on public services.

The OBR’s forecasts are also based on the following set of “broad-brush” assumptions about the impact of Brexit:

  • The UK will leave the EU in March 2019;
  • There will be a 21-month transition period, ending in December 2020;
  • Changes to the UK’s trading relationship to the EU will cause trade growth to slow;
  • The UK will adopt a tighter migration regime after Brexit;
  • The UK will pay the so-called ‘divorce bill’ to the EU;
  • Reductions to the UK’s financial contribution to the EU will be recycled into extra spending;
  • There will be no changes to the UK’s membership of EU tax systems, such as for VAT.

The OBR do not make any assumptions as to the specific arrangements of the future UK-EU trading relationship, simply assuming that Brexit will result in a lower intensity of trade-based economic activity after the end of the transition. However, as both the OBR and Hammond have noted, a deal on the Withdrawal Agreement – including the transition period – cannot be taken for granted while negotiations are ongoing.

The “double deal dividend” remark was primarily political

In the Commons on Monday, the Chancellor claimed that reaching a deal with the EU would create “a double deal dividend,” owing to “a boost from the end of uncertainty, and a boost from releasing some of the fiscal headroom that I am holding in reserve.” The detailed impact of this “deal dividend” on public spending is not expected to be announced until the spring spending review, by which point the Government hopes a deal will have been struck.

It should be qualified, however, that the ‘deal’ Hammond refers to will be the Withdrawal Agreement, not the future UK-EU relationship. Though the release of fiscal reserves and restored business confidence may indeed provide a temporary ‘dividend’ for the UK economy, uncertainty about the UK’s future trading relations with the EU will remain. Even if the Withdrawal Agreement is signed, a WTO-terms Brexit in 2021 (or later) remains possible – depending on the nature of any agreement on the backstop. Delivering a long-term ‘deal dividend’ will require more clarity over the shape of the long-term UK-EU future trading relationship – as well as wider changes to the domestic taxation and regulatory landscape.

Ultimately, the “deal dividend” remark was more about politics than economics. Hammond has repeatedly warned against the consequences of a No Deal Brexit, and suggesting the end of austerity is contingent on a deal fits into this pattern. It could also be interpreted as a veiled threat to Conservative MPs considering voting down the Withdrawal Agreement, by implying that doing so would jeopardise the extra public spending many of them have lobbied for. Additionally, it provides the Government with an incentive to stick with its current Brexit plan.

No Deal will require a new Budget, but it is unclear what this would look like

Speaking to Sky News on Sunday, the Chancellor openly admitted that, if there was no Brexit deal, “We would need to take a different approach to the future of Britain’s economy… frankly, we’d need to have a new Budget that would set out a different strategy for the future.” This is no empty threat; given that the OBR’s figures are predicated on a deal, the absence of a deal would require the figures to be reworked. But Hammond’s reference to “a different approach to the future of Britain’s economy” suggests that a No Deal Budget would be much more radical than mere technical adjustments to forecasting.

Although Hammond refused to rule out a return to austerity in the event of No Deal, Number 10 insists that “all of these spending commitments… are funded irrespective of a deal.” Moreover, as James Forsyth points out in the Spectator, it would be counter-productive to respond to No Deal by taking demand out of the economy; a No Deal Budget is therefore more likely to be expansionary than contractionary. Alternatively, some newspapers, as well as Shadow Chancellor John McDonnell, interpreted the Chancellor’s “different strategy” comments as hinting at radical tax cuts and deregulation in the event of No Deal – a strategy Hammond has previously flirted with.

Meanwhile, it remains unclear what action the Government would take on tariffs in a No Deal scenario. WTO rules would require to treat the EU and non-EU trading partners with which the UK has no preferential deal equally on tariffs, but that does not mean the UK must fully replicate the EU’s Common External Tariff (CET). Instead, the UK could ensure a revenue-neutral outcome for the Treasury by setting a lower overall tariff rate, which would apply to EU and non-EU imports alike. The economic case for easing any new tariff burden on businesses is strong, and the government should resist any political pressure to engage in tit-for-tat protectionism with the EU. In the medium-term, there is a strong economic case for unilateral tariff liberalisation in the event of no agreement between the UK and EU; Open Europe’s recent research found that this would reduce the negative impact of trading on WTO terms on medium-term GDP growth to just 0.5% by 2030.

Brexit and the Political Consequences of the Budget

Many of the Budget’s measures were arguably political, rather than economic. Investing the unexpected windfall into additional public spending seems an unusual decision for a Conservative Chancellor to make in the middle of the electoral cycle, prompting speculation that it is an insurance policy in the event of an early general election. Although the Government has repeatedly ruled out a snap election, it may be the only way forward if, for example, it is impossible to get the Withdrawal Agreement past Parliament. On the other hand, increased public spending on salient issues such as defence, Universal Credit and preparations for No Deal may also satisfy the demands of various groups of Conservative backbenchers.

Other aspects of the Budget are also likely to be aimed at internal Conservative politics. Recent unrest among the Scottish Conservatives over the Government’s Brexit plans may be mollified by additional funding for both the Scottish Government and the UK fishing industry. Additionally, by directing the bulk of the additional spending towards the NHS, the Government will be able to make the political argument that it has fulfilled one of Vote Leave’s most controversial campaign pledges.

Similarly, the Budget’s £1 billion of additional spending for Northern Ireland could be interpreted as a stipend for the Conservative’s confidence and supply partners in the Democratic Unionist Party (DUP). However, although the DUP have now retracted their earlier threat to vote down the Budget, it is unlikely that extra money for Northern Ireland will be enough to keep them onside.

On the other hand, the Budget’s impact on the Brexit negotiations at EU level will be negligible; it may have been predicated on a deal with the EU, but does little to make that aspiration a reality. It could be argued that more detailed plans for No Deal spending might have made Brussels sit up and take notice. But there seems little sense in publicising a No Deal Budget while a deal remains both possible and desirable. Ultimately, the key determinant of a deal is a solution to the ongoing impasse over the Northern Irish backstop. With the Budget out of the way, both the UK Government and the EU must redouble their efforts to find a solution which all sides can accept.