A key debate for some months has been the UK’s membership of the European Union. The debate has centred around the desire to return some powers back to the UK, but this has extended into the possibility of a referendum on our membership of the preferential trading area. So, let’s take a step back and consider why any country would want to be a member of a preferential trading area.
Preferential trading areas can be as basic as a free trading area or as advanced as a currency, or even political union. The eurozone is clearly a currency union, but the European Union, of which the UK is a member, is a common market. A common market has no tariffs and quotas between the members, but in addition there are common external tariffs and quotas. The European union also includes the free movement of labour, capital and goods and services. Membership of a preferential trading area therefore creates benefits for the member countries. One such benefit is that of trade creation. Members are able to trade under favourable terms with other members, which yields significant benefits. Countries can specialise in the production of goods/services in which they have a comparative advantage and this enables greater quantities of output to be produced and then traded.
Other benefits include the greater competition created. By engaging in trade, companies are no longer competing just with domestic firms, but with foreign firms as well. This helps to improve efficiency, cut costs and thus lower prices benefiting consumers. However, from a firm’s point of view there are also benefits: they have access to a much wider market in which they can sell their goods without facing tariffs. This creates the potential for economies of scale to be achieved. Were the UK to completely exit the EU, this could be a significant loss for domestic firms and for consumers, who would no longer see the benefits of no tariffs on imported goods. Membership of a preferential trading area also creates benefits in terms of potential technology spillovers and is likely to have a key effect on a country’s bargaining power with the rest of the world. As is a similar argument to membership of a trade union, there is power in numbers.
There are costs of membership of a preferential trading area, but they are typically outweighed by the benefits. However, estimates suggest that the cost of EU regulation is the equivalent of 10% of UK GDP. Furthermore, while the UK certainly does trade with Europe, data suggests that only 13% of our GDP is dependent on such exports. The future is uncertain for the European Union and Britain’s membership. There are numerous options available besides simply leaving this preferential trading area, but they typically have one thing in common. They will create uncertainty and this is something that markets and investors don’t like. Vince Cable warned of this, saying:
There are large numbers of potential investors in the UK, who would bring employment here, who have been warned off because of the uncertainty this is creating.
The impact of the UK’s decision will be significant and not just for those living and working in the economy. The world is no interdependent that when countries exist (or typically enter) a preferential trading area the wider economic effects are significant. While any change in the UK’s relationship with the EU will take many months and years to occur and then further time to have an effect, the uncertainty created by the suggestion of a change in the relationship has already sent waves across the world. The following articles consider the wider single market and the current debate on UK membership.
European Union: if the ‘outs’ get their way, we’ll end up like Ukraine Guardian, Vince Cable (16/5/13)
Conservative MP James Wharton champions bill to guarantee EU referendum Independent, Andrew Grice (16/5/13)
Nick Clegg shifts ground over EU referendum The Guardian, Patrick Wintour (15/5/13)
Cameron tells EU rebels to back referendum law Reuters, Peter Griffiths (16/5/13)
The EU and the UK – the single market BBC Democracy (4/3/13)
Single market dilemmas on Europe BBC News, Stephanie Flanders (14/5/13)
Lord Wolfson: I back the single market – but not at any cost The Telegraph, Lord Wolfson (19/1/13)
EU focuses on returning single market to health Financial Times, James Fontanella-Khan (8/5/13)
Questions
- What other examples of preferential trading areas are there? How close are they to the arrangement of the European Union?
- In each of the above examples, explain the type of preferential trading area that it is.
- What are the benefits and costs of being a member of a preferential trading area such as the EU? How do these differ to being a member of a) a free trade area and (b) a customs union?
- What options are open to the UK in terms of re-negotiating its relationship with the EU? In each case, explain how the benefits and costs identified in question 3 would change.
- Why is the UK’s decision so important for the global economy? Would it be in the interests of other economies? Explain your answer.
VAT was introduced on the 1st of April 1973, as part of the conditions for the UK entering the Common Market. Designed by a French tax expert, Maurice Lauré, it was initially envisaged as a straightforward replacement for purchase tax, which would be applied to most goods and services.
Forty years on, VAT is increasingly complex, with numerous exemptions, many anomalies in its scope, and increasingly expensive challenges to its imposition. How did we get to this point? And is it time for VAT to undergo a mid-life makeover?
All governments have to raise taxes – to redistribute income and to fund public spending. They have a number of mechanisms they can use, but essentially they have to tax incomes (direct taxes), spending (indirect taxes) or a mix of both. The main indirect tax in the UK is VAT, which now raises over £100bn a year, compared with £1.5bn in its first year (see above chart: click here for a PowerPoint version). Initially envisaged as a simple, cross-Europe purchase tax, the current system is complex and at times appears to have been formulated ‘on the hoof’, never a good way to build a tax system.
In the 2012 Budget, the Chancellor decided to apply the standard rate of income tax to hot takeaway pasties; previously they had been zero-rated. However, he had sharply underestimated the ability of the industry to lobby against the tax, working closely with the tabloid press. Perhaps more importantly, he also missed the complex nature of the good; when is a hot pasty just cooling down? And what is hot? The government backtracked and now 20% VAT is only charged on pasties that are deliberately kept hot. You might think that this change of heart avoided introducing an anomaly, but consider how you might feel if you sell takeaway baked potatoes, which are subject to VAT.
Apart from the complexity of the system, VAT is unpopular with some commentators who feel that it falls too heavily on low-income households. Although many foodstuffs are zero-rated and housing is exempt, VAT is charged at 20% on clothing and many necessities such as cleaning materials. Gas and electricity are subject to a reduced rate of 5% and both alcohol and cigarettes have additonal excise duties imposed and yet are disproportionally consumed by the poor. When the standard rate of VAT was temporarily dropped to 15% in 2010, but then permanently raised to 20% in 2011, many felt that this was a shift in the tax burden to the poor.
So complex, irrational and prone to changes following political lobbying or expensive legal cases, VAT does seem to be stumbling into its forties under something of a cloud. However, it remains the case that it raises a large proportion of UK tax revenues at relatively low direct cost and provides the Chancellor with a reasonably effective fiscal policy tool. Even if a government wanted to put in place an alternative, it is likely that the associated political risks would be too high for it to do so. We might hope for some rationalisation of the current system, but there is little doubt that we will be raising a glass to VAT’s 50th birthday in 2023.
The links below include some articles on VAT’s 40th birthday and some more general articles on VAT.
Articles
VAT is 40 years old- and now has middle-age spread The Guardian, Juliette Garside (31/1/13)
Is VAT suffering a mid-life crisis at 40? BBC News, Colin Corder (31/3/13)
VAT at 40, not simple, not popular, but central to government revenue-raising The Chartered Institute of Taxation (28/3/13)
Happy birthday VAT, here’s how not to pay you The Telegraph, Rosie Murray-West (31/3/13)
Poorest spend higher proportion of VAT than richest BBC News (31/10/11)
A Value- Added Tax offers much to love- and hate New York Times, Gregory Mankiw (1/5/10)
EC Standard VAT Declaration European Commission Roadmap (2012)
Data and information
VAT pages HMRC
Public sector finance statistics HM Treasury (follow link to latest Public finances databank (Excel file) and go to Worksheet C2)
Latest European Union EU VAT rates VATLive
Questions
- Explain why VAT might be deemed regressive. Can you formulate an argument that it falls more heavily on the rich than the poor?
- Why is VAT administratively cheap? Other than generating tax revenues, can you think of any advantages of the tax?
- Newspapers and books are zero-rated in the UK, while e-books and news apps are standard rated at 20%. Can you identify some other anomalies in the UK VAT system? Is there an argument that a better approach would be to charge a lower rate on all goods and services?
- Who pays VAT, consumers or producers? Illustrate your answer with a diagram, or two.
- A business has to register for VAT once it has a turnover of £77,000 pa. Does this system give rise to any perverse incentives?
- Countries across the European Union have varying VAT rates, applied to very different ranges of products. Explain why this might hinder the workings of a single European market.
- Imagine you were running a brand new economy; would you use a value-added tax to raise revenues? What are the alternatives open to governments?
Trade is generally argued to be good for economic growth, as it allows countries to specialise in those goods in which they have a comparative advantage and thus produce and consume more of all goods in total. However, trade inevitably leads to winners and losers, especially as countries impose tariffs on imports in order to protect domestic industries. This has been the case in the banana industry.
Banana growers in the former European colonies have long been protected by EU tariffs, helping to prevent competition from their Latin American banana growers. But, now things could be about to change. In December 2009, most of the nations concerned reached an agreement in Geneva for tariffs imposed by the EU to be gradually reduced.
The European Union had imposed no duty on bananas from their former colonies, but had imposed tariffs on banana imports from other countries. This meant that those countries now benefiting from zero import duty could sell their bananas for a much lower price, therefore restricting the other nations (who did have to pay an import duty) from competing effectively.
With the World Trade Organisation in attendance, an agreement was signed that puts an end to this trade dispute dating back over 2 decades. The Director General of the WTO, Pascal Lamy said:
‘This is a truly historic moment … After so many twists and turns, these complicated and politically contentious disputes can finally be put to bed. It has taken so long that quite a few people who worked on the cases, both in the Secretariat and in member governments have retired long ago.’
This trade war has been ongoing for many years and this agreement represents a big step in the right direction. With a fairer playing field in this banana market, countries in Latin America will now be much more able to compete with other nations. As economists argue that trade is good, a reduction in protectionist measures should be seen as a good thing and will benefit the countries concerned. The following articles consider this trade resolution.
Banana war ends after 20 years BBC News (8/11/12)
WTO: Historic signing ends 20 years of EU-Latin American banana disputes 4-Traders, WTO (8/11/12)
EU, Latin America nations mark end of ‘banana war’ Fox News (8/11/12)
Banana war ends after 20 years The Telegraph (9/11/12)
Infamous banana dispute ends Sky News (9/11/12)
Questions
- What is comparative advantage and how does it lead to gains from trade?
- How does a tariff help protect a country’s domestic industry?
- Using a diagram, illustrate the effect of a tariff being imposed on banana imports from Latin America. Is there a cost to society of such a policy?
- Now, show what happens when this tariff is removed by the EU. Who benefits and who loses?
- What is the role of the World Trade Organisation?
- How does a tariff affect a country’s ability to compete with other nations?
International economists have long advocated the advantages of free trade. By boosting competition, increasing choice and market size, trade has long been seen as an engine of growth and efficiency.
For many years, tariffs and other restrictive trade practices have been removed on trade between both developed and developing countries and many rounds of negotiations have taken place, with mixed results.
The World Trade Organisation (WTO) plays a key role in trade negotiations and has the main aim of liberalising trade. The organisation requires its members to operate according to a variety of rules, including the prohibition of quotas and the inability of countries to raise existing tariffs without negotiating with their trading partners.
If any country breaks a trade agreement, the WTO can impose sanctions. A current case that has been referred to the WTO for ‘consultation’ concerns Argentina. Argentina has imposed various import restrictions on trade, such as import licensing and a requirement for countries to balance its exports and imports.
A number of WTO members recently expressed their concerns about these restrictive trade practices. The EU trade commissioner Karel de Gucht said:
Argentina’s import restrictions violate international trade rules and must be removed. These measures are causing very real damage to EU companies – hurting jobs and our economy as a whole. … Argentina’s trade policy has become rooted in unfair trade practices.
Argentina has said that it was expecting the move from the EU, but claims that its protectionist measures are there to support and re-industrialise the country. This case is unlikely to be resolved any time soon and while the ‘restrictive trade practices’ remain in place, EU companies trying to export to Argentina will find barriers, such as a requirement for all imports to receive pre-approval.
The effects of these restrictions have already been felt, with EU exports to Argentina down by 4% in April this year, compared with the same month last year. The following articles consider this issue.
EU takes Argentina trade fight to WTO France 24, (25/5/12)
EU files WTO suit over Argentina’s import restrictions Reuters, Sebastien Moffett and Tom Miles , (26/5/12)
EU escalates dispute with Argentina Financial Times, Peter Spiegel and Joshua Chaffin, (25/5/12)
EU refers Argentina’s import restrictions to the WTO BBC News (25/5/12)
EU steps up challenge to Argentina’s policies Wall Street Journal, Matthew Dalton (25/5/12)
Questions
- What are the rules governing the members of the WTO?
- What are the advantages of free trade?
- To what extent should emerging economies be allowed to impose protectionist measures to help support their economies?
- What action could the EU take in response to the ‘restrictive trade practices’ imposed by Argentina?
- What is import licensing?
- How will the import restrictions affect EU companies and the growth of the EU as a whole?
In the third and final part of this blog, we look at the G8 summit at Camp David on 18 and 19 May 2012. Ways of averting the deepening global economic crisis were top of the agenda.
In terms of the global economy, the leaders agreed on three main things. The first was that they supported Greece remaining in the euro. According to the communiqué:
We agree on the importance of a strong and cohesive eurozone for global stability and recovery, and we affirm our interest in Greece remaining in the eurozone while respecting its commitments. We all have an interest in the success of specific measures to strengthen the resilience of the eurozone and growth in Europe
The second was a commitment to ‘fiscal responsibility’ and the clawing down of public-sector deficits.
We commit to fiscal responsibility and, in this context, we support sound and sustainable fiscal consolidation policies that take into account countries’ evolving economic conditions and underpin confidence and economic recovery.
The third was commitment to boosting economic growth. (Click on chart for a larger image.) On the supply side this would be through measures to stimulate productivity. On the demand side this would be through policies to stimulate investment.
(For a PowerPoint of the chart, click on the following link: Quarterly Growth.)
To raise productivity and growth potential in our economies, we support structural reforms, and investments in education and in modern infrastructure, as appropriate. Investment initiatives can be financed using a range of mechanisms, including leveraging the private sector. Sound financial measures, to which we are committed, should build stronger systems over time while not choking off near-term credit growth. We commit to promote investment to underpin demand, including support for small businesses and public-private partnerships.
But the communiqué was short on details. How will fiscal consolidation be achieved? Does this mean a continuation of austerity measures? And if so, what will be the impact on aggregate demand? Or if fiscal consolidation is slowed down, what will be the impact on financial markets?
If a growth in investment is central to the policy, what will be the precise mechanisms to encourage it? Will they be enough to combat the deflationary effect on demand of the fiscal measures?
And how will productivity increases be achieved? What supply-side measures will be introduced? And will productivity increases be encouraged or discouraged by continuing austerity measures?
Lots of questions – questions raised by the articles below.
Articles
Capitalism at a crossroads Independent (19/5/12)
Barack Obama warns eurozone to focus on jobs and growth The Telegraph (20/5/12)
G8 Summit: World leaders push for Greece to stay in the eurozone The Telegraph, Angela Monaghan (19/5/12)
Obama sees ’emerging consensus’ on crisis Sydney Morning Herald, Ben Feller and Jim Kuhnhenn (20/5/12)
G8 leaders tout economic growth, fiscal responsibility CNN (20/5/12)
G8 focuses on Eurozone Gulf News (20/5/12)
G8 leaders back Greece amid tensions France 24 (20/5/12)
G8 splits over stimulus versus austerity Financial TimesRichard McGregor and Kiran Stacey (19/5/12)
Cameron is consigning the UK to stagnation Financial Times, Martin Wolf (17/5/12)
Time to end ‘Camerkozy’ economics Financial Times, Ed Miliband (18/5/12)
Obama: Eurozone ‘must focus on jobs and growth’ BBC News (20/5/12)
World leaders back Greece, vow to combat financial turmoil Reuters, Jeff Mason and Laura MacInnis (19/5/12)
Germany isolated over euro crisis plan at G8 meeting in Camp David Guardian, Patrick Wintour (19/5/12)
G8 leaders end summit with pledge to keep Greece in eurozone Guardian, Ewen MacAskill (19/5/12)
G8 summit ends with few tangible results Xinhua, Sun Hao (20/5/12)
Final communiqué
Camp David DeclarationG8 (19/5/12)
Questions
- To what extent are economic growth and fiscal consolidation (a) compatible; (b) incompatible objectives? How might a Keynesian and a new classical economist respond to these questions?
- What supply-side measures could be introduced by the EU?
- Why might dangers of protectionism increase in the coming months?
- What would be the impact of a Greek default and exit from the eurozone on other eurozone economies?
- What monetary policy changes could be introduced by the eurozone governments and the ECB in order to ease the sovereign debt crisis of countries such as Grecce, Spain, Portugal, Italy and Ireland?
