Category: Economics: Ch 24

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A free-trade deal? Not really

According to the Brexit trade agreement (the Trade and Cooperation Agreement (TCA)), trade between the EU and the UK will remain quota and tariff free. ‘Quota free’ means that trade will not be restricted in quantity by the authorities on either side. ‘Tariff free’ means that customs duties will not be collected by the UK authorities on imports from the EU nor by the EU authorities on imports from the UK.

Article ‘GOODS .5: Prohibition of customs duties’ on page 20 of the agreement states that:

Except as otherwise provided for in this Agreement, customs duties on all goods originating in the other Party shall be prohibited.

This free-trade agreement was taken by many people to mean that trade would be unhindered, with no duties being payable. In fact, as many importers and exporters are finding, trade is not as ‘free’ as it was before January 2021. There are four sources of ‘friction’.

Tariffs on goods finished in the UK

This has become a major area of concern for many UK companies. When a good is imported into the UK from outside the EU and then has value added to it by processing, packaging, cleaning, remixing, preserving, refashioning, etc., under ‘rules of origin’ regulations, it can only count as a UK good if sufficient value or weight is added. The proportions vary by product, but generally goods must have approximately 50% UK content (or 80% of the weight of foodstuffs) to qualify for tariff-free access to the EU. For example, for a petrol car, 55% of its value must have been created in either the EU or UK. Thus cars manufactured in the UK which use many parts imported from Japan, China or elsewhere, may not qualify for tariff-free access to the EU.

In other cases, it is simply the question of whether the processing is deemed ‘sufficient’, rather than the imported inputs having a specific weight or value. For example, the grinding of pepper is regarded as a sufficient process and thus ground pepper can be exported from the UK to the EU tariff free. Another example is that of coal briquettes:

The process to transform coal into briquettes (including applying intense pressure) goes beyond the processes listed in ‘insufficient processing’ and so the briquettes can be considered ‘UK originating’ regardless of the originating status of the coal used to produce the briquettes.

In the case of many garments produced in the UK and then sold in retail chains, many of which have branches in both the UK and EU, generally both the weaving and cutting of fabric to make garments, as well as the sewing, must take place in the UK/EU for the garments to be tariff free when exported from the UK to the EU and vice versa.

Precise details of rules of origin are given in the document, The Trade and Cooperation Agreement (TCA): detailed guidance on the rules of origin.

Many UK firms exporting to the EU and EU firms exporting to the UK are finding that their products are now subject to tariffs because of insufficient processing being done in the UK/EU. Indeed, with complex international supply chains, this is a major problem for many importing and exporting companies.

Documentation

Rules of origin require that firms provide documentation itemising what parts of their goods come from outside the UK/EU. Then it has to be determined whether tariffs will be necessary on the finished product. This is time consuming and is an example of the increase in ‘red tape’ about which many firms are complaining. As the Evening Standard article states:

Exporters have to be able to provide evidence to prove the origin of their products’ ingredients. Next year, they will also have to provide suppliers’ declarations too, and EU officials may demand those retrospectively, so exporters need to have them now.

The increased paperwork and checks add to the costs of trade. Some EU companies are stating that they will no longer export to the UK and some UK companies that they will no longer export to the EU, or will have to set up manufacturing plants or distribution hubs in the EU to handle trade within the EU.

Other companies are adding charges to their products to cover the costs. As the Guardian article states:

“We bought a €47 [£42] shelf from Next for our bathroom,” said Thom Basely, who lives in Marseille. “On the morning it was supposed to be delivered we received an ‘import duty/tax’ demand for over €30, like a ransom note. It came as a complete surprise.”

In evidence given to the Treasury Select Committee (Q640) in May 2018, Sir Jon Thompson, then Chief Executive of HMRC, predicted that leaving the single market would involve approximately 200 million extra customs declarations on each side of the UK/EU border at a cost of £32.50 for each one, giving a total extra cost of approximately £6.5bn on each side of the border for companies trading with Europe. Although this was only an estimate, the extra ‘paperwork’ will represent a substantial cost.

VAT

Previously, goods could be imported into the UK without paying VAT in the UK on value added up to that point as VAT had already been collected in the EU. Similarly, goods exported to the EU would already have had VAT paid and hence would only be subject to the tax on additional value added. The UK was part of the EU VAT system and did not have to register for VAT in each EU country.

Now, VAT has to be paid on the goods as they are imported or released from a customs warehouse – similar to a customs duty. This is therefore likely to involve additional administration costs – the same as those with non-EU imports.

Services

The UK is a major exporter of services, including legal, financial, accounting, IT and engineering. It has a positive trade in services balance with the EU, unlike its negative trade in goods balance. Yet, the Brexit deal does not include free trade in services. Some of the barriers to other non-EU countries have been reduced for the UK in the TCA, but UK service providers will still face new barriers which will impose costs. For example, some EU countries will limit the time that businesspeople providing services can stay in their countries to six months in any twelve. Some will not recognise UK qualifications, unlike when the UK was a member of the single market.

The financial services supplied by City of London firms are a major source of export revenue, with about 40% of these revenues coming from the EU. Now outside the single market, these firms have lost their ‘passporting rights’. These allowed such firms to sell their services into the EU without the need for additional regulatory clearance. The alternative now is for such firms to be granted ‘equivalence’ by the EU. This has not yet been negotiated and even if it were, does not cover the full range of financial services. It excludes, for example, banking services such as lending and deposit taking.

Conclusions

Leaving the single market has introduced a range of frictions in trade. These are causing severe problems to some importers and exporters in the short term. Some EU goods are now unavailable in the UK or only so at significantly higher prices. Some exporters are finding that the frictions are too great to make their exports profitable. However, it remains to be seen how quickly accounting and logistical systems can adjust to improve trade flows between the UK and the EU.

But some of these frictions, as itemised above, will remain. According to the law of comparative advantage, these restrictions on trade will lead to a loss of GDP. And these losses will not be spread evenly throughout the UK economy: firms and their employees which rely heavily on UK–EU trade will be particularly hard hit.

Articles

Official documents

Questions

  1. Explain what is meant by ‘rules of origin’.
  2. If something is imported to the UK from outside the UK and then is refashioned in the UK and exported to the EU but, according to the rules of origin has insufficient value added in the UK, does this mean that such as good will be subject to tariffs twice? Explain.
  3. Are tariffs exactly the same as customs duties? Is the distinction made in the Guardian article a correct one?
  4. Is it in the nature of a free-trade deal that it is not the same as a single-market arrangement?
  5. Find out what arrangement Switzerland has with the EU. How does it differ from the UK/EU trade deal?
  6. What are the advantages and disadvantages of the Swiss/EU agreement over the UK/EU one?
  7. Are the frictions in UK–EU trade likely to diminish over time? Explain.
  8. Find out what barriers to trade in services now exist between the UK and EU. How damaging are they to UK services exports?
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The UK economy – facing a double whammy

The LSE’s Centre for Economic Performance has just published a paper looking at the joint impact of Covid-19 and Brexit on the UK economy. Apart from the short-term shocks, both will have a long-term dampening effect on the UK economy. But they will largely affect different sectors.

Covid-19 has affected, and will continue to affect, direct consumer-facing industries, such as shops, the hospitality and leisure industries, public transport and personal services. Brexit will tend to hit those industries most directly involved in trade with Europe, the UK’s biggest trading partner. These industries include manufacturing, financial services, posts and telecommunications, mining and quarrying, and agriculture and fishing.

Despite the fact that largely different sectors will be hit by these two events, the total effect may be greater than from each individually. One of the main reasons for this is the dampening impact of Covid-19 on globalisation. Travel restrictions are likely to remain tighter to more distant countries. And countries are likely to focus on trading within continents or regions rather than the whole world. For the UK, this, other things being equal, would mean an expansion of trade with the EU relative to the rest of the world. But, unless there is a comprehensive free-trade deal with the EU, the UK would not be set to take full advantage of this trend.

Another problem is that the effects of the Covid-19 pandemic have weakened the economy’s ability to cope with further shocks, such as those from Brexit. Depending on the nature (or absence) of a trade deal, Brexit will impose higher burdens on trading companies, including meeting divergent standards and higher administrative costs from greater form filling, inspections and customs delays.

Papers

Articles

Questions

  1. Referring to the LSE paper, give some examples of industries that are likely to be particularly hard hit by Brexit when the transition period ends? Explain why.
  2. Why have university finances been particularly badly affected by both Covid-19 and Brexit? Are there any other sectors that have suffered (or will suffer) badly from both events?
  3. Is there a scenario where globalisation in trade could start to grow again?
  4. Has Covid-19 affected countries’ comparative advantage in particular products traded with particular countries and, if so, how?
  5. The authors of the LSE report argue that ‘government policies to stimulate demand, support workers to remain in employment or find new employment, and to support businesses remain essential’. How realistic is it to expect the government to provide additional support to businesses and workers to deal with the shock of Brexit?
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Economists and the real world

Economists are often criticised for making inaccurate forecasts and for making false assumptions. Their analysis is frequently dismissed by politicians when it contradicts their own views.

But is this fair? Have economists responded to the realities of the global economy and to the behaviour of people, firms, institutions and government as they respond to economic circumstances? The answer is a qualified yes.

Behavioural economics is increasingly challenging the simple assumption that people are ‘rational’, in the sense that they maximise their self interest by weighing up the marginal costs and benefits of alternatives open to them. And macroeconomic models are evolving to take account of a range of drivers of global growth and the business cycle.

The linked article and podcast below look at the views of 2019 Nobel Prize-winning economist Esther Duflo. She has challenged some of the traditional assumptions of economics about the nature of rationality and what motivates people. But her work is still very much in the tradition of economists. She examines evidence and sees how people respond to incentives and then derives policy implications from the analysis.

Take the case of the mobility of labour. She examines why people who lose their jobs may not always move to a new one if it’s in a different town. Partly this is for financial reasons – moving is costly and housing may be more expensive where the new job is located. Partly, however, it is for reasons of identity. Many people are attached to where they currently live. They may be reluctant to leave family and friends and familiar surroundings and hope that a new job will turn up – even if it means a cut in wages. This is not irrational; it just means that people are driven by more than simply wages.

Duflo is doing what economists typically do – examining behaviour in the light of evidence. In her case, she is revisiting the concept of rationality to take account of evidence on what motivates people and the way they behave.

In the light of workers’ motivation, she considers the implications for the gains from trade. Is free trade policy necessarily desirable if people lose their jobs because of cheap imports from China and other developing countries where labour costs are low?

The answer is not a clear yes or no, as import-competing industries are only part of the story. If protectionist policies are pursued, other countries may retaliate with protectionist policies themselves. In such cases, people working in the export sector may lose their jobs.

She also looks at how people may respond to a rise or cut in tax rates. Again the answer is not clear cut and an examination of empirical evidence is necessary to devise appropriate policy. Not only is there an income and substitution effect from tax changes, but people are motivated to work by factors other than take-home pay. Likewise, firms are encouraged to invest by factors other than the simple post-tax profitability of investment.

Podcast

Article

Questions

  1. In traditional ‘neoclassical’ economics, what is meant by ‘rationality’ in terms of (a) consumer behaviour; (b) producer behaviour?
  2. How might the concept of rationality be expanded to take into account a whole range of factors other than the direct costs and benefits of a decision?
  3. What is meant by bounded rationality?
  4. What would be the effect on workers’ willingness to work more or fewer hours as a result of a cut in the marginal income tax rate if (a) the income effect was greater than the substitution effect; (b) the substitution effect was greater than the income effect? Would your answers to (a) and (b) be the opposite in the case of a rise in the marginal income tax rate?
  5. Give some arguments that you consider to be legitimate for imposing controls on imports in (a) the short run; (b) the long run. How might you counter these arguments from a free-trade perspective?
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The costs of alternative Brexit scenarios

A general election has been called in the UK for 12 December. Central to the debates between the parties will be their policy on Brexit.

They range from the Liberal Democrats’, Plaid Cymru’s and Sinn Féin’s policy of cancelling Brexit and remaining in the EU, to the Scottish Nationalists’ and Greens’ policy of halting Brexit while a People’s Vote (another referendum) is held, with the parties campaigning to stay in the EU, to the Conservative Party’s policy of supporting the Withdrawal Agreement and Political Declaration negotiated between the Boris Johnson government and the EU, to the DUP which supports Brexit but not a version which creates a border between Great Britain and Northern Ireland, to the Brexit Party and UKIP which support leaving the EU with no deal (what they call a ‘clean break’) and then negotiating individual trade deals on a country-by-country basis.

The Labour Party also supports a People’s Vote, but only after renegotiating the Withdrawal Agreement and Political Declaration, so that if Brexit took place, the UK would have a close relationship with the single market and remain in a customs union. Also, various laws and regulations on environmental protection and workers’ rights would be retained. The referendum would take place within six months of the election and would be a choice between this new deal and remain.

But what are the economic costs and benefits of these various alternatives? Prior to the June 2016 referendum, the Treasury costed various scenarios. After 15 years, a deal would make UK GDP between 3.4% and 7.8% lower than if it remained in the EU, depending on the nature of the deal. No deal would make GDP between 5.4% and 9.5% lower.

Then in November 2018, the Treasury published analysis of the original deal negotiated by Theresa May in July 2018 (the ‘Chequers deal’). It estimated that GDP would be up to 3.9% lower after 15 years than it would have been if the UK had remained in the EU. In the case of a no-deal Brexit, GDP would be up to 9.3% lower after 15 years.

When asked for Treasury forecasts of the effects of Boris Johnson’s deal, the Chancellor, Sajid Javid, said that the Treasury had not been asked to provide forecasts as the deal was “self-evidently in our economic interest“.

Other forecasters, however, have analysed the effects of the Johnson deal. The National Institute for Economic and Social Research (NIESR), the UK’s longest established independent economic research institute, has estimated the costs of various scenarios, including the Johnson deal, the May deal, a no-deal scenario and also a scenario of continuing uncertainty with no agreement over Brexit. The NIESR estimates that, under the Johnson deal, with a successful free-trade agreement with the EU, in 10 years’ time UK GDP will be 3.5% lower than it would be by remaining in the EU. This represents a cost of £70 billion. The costs would arise from less trade with the EU, lower inward investment, slower growth in productivity and labour shortages from lower migration. These would be offset somewhat by savings on budget contributions to the EU.

Under Theresa May’s deal UK GDP would be 3.0% lower (and thus slightly less costly than Boris Johnson’s deal). Continuing in the current situation with chronic uncertainty about whether the UK would leave or remain would leave the UK 2% worse off after 10 years. In other words, uncertainty would be less damaging than leaving. The costs from the various scenarios would be in addition to the costs that have already occurred – the NIESR estimates that GDP is already 2.5% smaller than it would have been as a result of the 2016 Brexit vote.

Another report also costs the various scenarios. In ‘The economic impact of Boris Johnson’s Brexit proposals’, Professors Anand Menon and Jonathan Portes and a team at The UK in a Changing Europe estimate the effects of a decline in trade, migration and productivity from the various scenarios – again, 10 years after new trading arrangements are in place. According to their analysis, UK GDP would be 4.9%, 6.4% and 8.1% lower with the May deal, the Johnson deal and no deal respectively than it would have been from remaining in the EU.

But how much reliance should we put on such forecasts? How realistic are their assumptions? What other factors could they have taken into account? Look at the two reports and at the articles discussing them and then consider the questions below which are concerned with the nature of economic forecasting.

Articles

Reports

Questions

  1. What are the arguments in favour of the assumptions and analysis of the two recent reports considered in this blog?
  2. What are the arguments against the assumptions and analysis of the two reports?
  3. How useful are forecasts like these, given the inevitable uncertainty surrounding (a) the outcome of negotiations post Brexit and (b) the strength of the global economy?
  4. If it could be demonstrated beyond doubt to everyone that each of the Brexit scenarios meant that UK GDP would be lower than if it remained in the EU, would this prove that the UK should remain in the EU? Explain.
  5. If economic forecasts turn out to be inaccurate, does this mean that economists should abandon forecasting?
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Fiscal policy and Brexit

The Institute of Fiscal Studies (IFS) has just published its annual ‘Green Budget‘. This is, in effect, a pre-Budget report (or a substitute for a government ‘Green Paper’) and is published ahead of the government’s actual Budget.

The Green Budget examines the state of the UK economy, likely economic developments and the implications for macroeconomic policy. This latest Green Budget is written in the context of Brexit and the growing likelihood of a hard Brexit (i.e. a no-deal Brexit). It argues that the outlook for the public finances has deteriorated substantially and that the economy is facing recession if the UK leaves the EU without a deal.

It predicts that:

Government borrowing is set to be over £50 billion next year (2.3% of national income), more than double what the OBR forecast in March. This results mainly from a combination of spending increases, a (welcome) change in the accounting treatment of student loans, a correction to corporation tax revenues and a weakening economy. Borrowing of this level would breach the 2% of national income ceiling imposed by the government’s own fiscal mandate, with which the Chancellor has said he is complying.

A no-deal Brexit would worsen this scenario. The IFS predicts that annual government borrowing would approach £100 billion or 4% of GDP. National debt (public-sector debt) would rise to around 90% of GDP, the highest for over 50 years. This would leave very little scope for the use of fiscal policy to combat the likely recession.

The Chancellor, Sajid Javid, pledged to increase public spending by £13.4bn for 2020/21 in September’s Spending Review. This was to meet the Prime Minister’s pledges on increased spending on police and schools. This should go some way to offset the dampening effect on aggregate demand of a no-deal Brexit. The government has also stated that it wishes to cut various taxes, such as increasing the threshold at which people start paying the 40% rate of income tax from £50 000 to £80 000. But even with a ‘substantial’ fiscal boost, the IFS expects little or no growth for the two years following Brexit.

But can fiscal policy be used over the longer term to offset the downward shock of Brexit, and especially a no-deal Brexit? The problem is that, if the government wishes to prevent government borrowing from soaring, it would then have to start reining in public spending again. Another period of austerity would be likely.

There are many uncertainties in the IFS predictions. The nature of Brexit is the obvious one: deal, no deal, a referendum and a remain outcome – these are all possibilities. But other major uncertainties include business and consumer sentiment. They also include the state of the global economy, which may see a decline in growth if trade wars increase or if monetary easing is ineffective (see the blog: Is looser monetary policy enough to stave off global recession?).

Articles

IFS Report

Data

Questions

  1. Why would a hard Brexit reduce UK economic growth?
  2. To what extent can expansionary fiscal policy stave off the effects of a hard Brexit?
  3. Does it matter if national debt (public-sector debt) rises to 90% or even 100% of GDP? Explain.
  4. Find out the levels of national debt as a percentage of GDP of the G7 countries. How has Japan managed to sustain such a high national debt as a percentage of GDP?
  5. How can an expansionary monetary policy make it easier to finance the public-sector debt?
  6. How has investment in the UK been affected by the Brexit vote in 2016? Explain.