The economic consequences of leaving the EU: The final report of the CER commission on Brexit 2016

Britain will hold a referendum on its membership of the EU on June 23rd 2016, three years after Prime Minister David Cameron announced his 'renegotiation and referendum' strategy. In 2013, after David Cameron's announcement, the Centre for European Reform invited leading economists, journalists, business people and EU experts to form a commission to discuss the economic consequences of withdrawal from the EU.

This is an update of the commission’s final report, which includes further evidence about the degree of economic integration between Britain and the rest of the EU; the changes in the relationship between the UK’s financial sector and the eurozone; and the impact of immigration from the EU on British wages and employment. But since our initial report was published in June 2014, we have found no new evidence to change our view that ‘Brexit’ would be economically costly – and the best way to mitigate those costs would be to ensure that the economic relationship between the UK and the EU replicates membership of the single market as closely as possible.

In March 2016, three studies of the economic impact of ‘Brexit’ appeared in the space of four days – from the London School of Economics’ Centre for Economic Performance, Oxford Economics and PwC. (1) All three organisations sought to model different economic relationships between the EU and the UK after Brexit, the results of which can be found in Chart 0.1. Their best cases were those that most closely replicated the current relationship – either through membership of the European Economic Area, like Norway, or remaining inside a customs union, like Turkey. Their worst cases were those in which Britain failed to sign a free trade agreement, and relied on a relationship governed by the rules of the World Trade Organisation (WTO). This would involve the biggest increase in tariff barriers – and, more important, non-tariff barriers – to trade, reducing the British economy’s productivity and curbing inward investment.

The headline figures are obviously estimates, since modelling the break-up of a complex economic and political relationship is difficult. But the three reports are also interesting for what they tell us about the gains and losses of Brexit in different areas. The London School of Economics found that tariffs applied by the EU on British exports would be less costly than higher non-tariff barriers – differences in regulation and behind-the-border protectionism against companies based outside the single market. Neither Oxford Economics nor PwC found that a move to unilateral free trade, by which Britain would eliminate tariffs on imports without demanding reciprocal tariff cuts by its trade partners, would lead to large gains. Nor would free trade agreements signed with the rest of the world do much to boost UK output.

Oxford Economics found that deregulation – one of the benefits of Brexit that the EU’s critics emphasise – would be limited, raising the level of output by 0.13 per cent. PwC’s estimate was larger, at 0.3 per cent. But under their WTO scenario that was offset by larger losses from higher trade barriers, partly arising from different regulations between the EU and the UK, at 2.1 per cent of GDP.

And both Oxford Economics and PwC found that reduced migration flows as a result of Brexit would cut the level of GDP by more than GDP per capita by 2030. A smaller population would mean less output, but would only reduce natives’ earnings a little. Oxford Economics and PwC estimate that continued free movement would cause the level of GDP per capita to be 0.2 per cent and 0.1 per cent higher by 2030. (2)

Their findings closely match our commission’s analysis, which is extended and updated below. This report has two goals. The first is to assess how much Britain gains from free trade in goods and services and the free movement of the factors of production, capital and labour, across the EU.

The second goal is to ‘think through the counterfactual’: from what we know about the costs and benefits of trade and foreign investment, EU regulation, free movement of workers, and the EU’s budget, are the potential gains from Brexit large or small – and how do they compare to the costs? And, since the EU’s single market is a grand bargain, in which member-states share sovereignty in pursuit of mutual benefit, what would the EU demand in return if Britain sought continued access to the single market after withdrawal?

Britain is highly economically integrated with the EU

In this updated report, we show the extent of economic integration between the UK and the EU, using the University of Groningen’s World Input-Output Database. The database allows us to take into account Britain’s exports to the EU and the supply chains that provide intermediate goods and services to exporters. With all of these effects, the share of UK output sold to the EU amounted to 9.8 per cent in 2011. To put that figure into perspective, London’s share of UK output is 22 per cent, and the South East (excluding London), 15 per cent. But every other British region contributes less to UK GDP than the share sold to the EU. Trade with the US or China contributes far less to the UK economy than the EU. The US buys 3.4 per cent of Britain’s output, and China, 1 per cent.

The UK has a comparative advantage in the production of business and financial services – as well as marketing, design, engineering and other services. The Groningen database shows that Britain’s services exports – as well as services provided by domestic firms to exporting companies – are heavily skewed towards the EU. The EU provides two-fifths of the foreign demand for UK services, while the US’s share is 17 per cent and the ‘BRIC’ emerging economies just 10 per cent. (3)

But how much of that integration can we assign to the EU – rather than arising out of a simple fact of economic geography: the UK’s close proximity to the rest of Europe?

• The CER constructed a ‘gravity’ model to quantify how much trade is down to the EU. It shows that Britain’s EU membership has boosted its trade in goods with other member-states by 55 per cent. In 2015, Britain’s goods trade with the EU was £364 billion, so this ‘EU effect’ amounted to around £130 billion. By comparison, the value of Britain’s bilateral trade with China was £43 billion that year.

Britain is highly integrated with the rest of the EU’s economy in other ways.

• In 1997, other EU member-states accounted for 30 per cent of the accumulated stock of foreign direct investment (FDI) in Britain; this proportion had risen to 50 per cent in 2014.
• In 2015, the value of UK banks’ assets held in the eurozone was 45 per cent higher than their US assets, despite the eurozone’s economy being only three-quarters the size of the US economy. The City of London has been a major beneficiary of the single market in financial services: the eurozone is a much larger market for lending originating in Britain than its economic size would suggest.

Would Brexit liberate Britain?

There can be little doubt that some of the EU’s regulations impose more costs than benefits. But many are justified: there would be no single market without them. Moreover, European rules are not a major constraint upon Britain’s economy.

• According to the OECD, Britain has the second least regulated product markets in the developed world, after the Netherlands. Both are EU members.
• The OECD’s labour market protection index shows that Britain has similar levels of labour market regulation to the US, Canada or Australia – and far lower than continental European countries. EU employment rules therefore do little to inhibit Britain’s flexible labour market.

It follows that leaving the EU and ‘de-Europeanising’ British regulation would do little to boost its economy. In any case, Britain would find it difficult to avoid EU regulation even if it left the club. Outside the Union, the UK would lose full access to the single market unless it signed up to EU rules. Membership of the European Economic Area (EEA) would resolve little. This group, which includes Norway, Iceland and Liechtenstein, has almost full access to the single market, but must sign up to all of its rules despite having little say over them. The Swiss relationship is not much better: while it has a set of bilateral accords to give it access to some parts of the single market, it must regularly update its standards to match those of the EU, or risk a suspension of access. It follows that were Britain to sign a comprehensive free trade agreement with the EU, it would have to abide by most of the acquis communautaire – the EU’s body of legislation. And Britain would only be given full access to EU financial services markets if it matched EU rules. As access to the single market is of critical importance, Britain might perversely be left in a position where it would have ‘EU regulation without representation’.

Indeed, outside the EU, the UK could end up with little control over financial rules. The EU insists that non-members’ regulations are equivalent to their own, in return for limited access to the single market. As a result, the City of London – the eurozone’s largest wholesale financial centre – would be unlikely to enjoy unfettered access to eurozone financial markets if it were outside the Union. Eurozone authorities prefer wholesale activities – trading and lending between banks, rather than between banks and customers – to be conducted under their watch. In March 2015, the British government won a case against the European Central Bank (ECB) at the European Court of Justice over the ECB’s attempt to make clearing houses specialising in euro-denominated trading relocate to the eurozone. If it left the EU, and did not join the EEA, the UK would have little recourse to institutions that police the single market. Banks, exchanges and private-equity and hedge funds would relocate some of their activities to Frankfurt, Paris or elsewhere.

But does the EU not hold back Britain’s trade with non-European countries, by imposing tariffs on their goods, for example? The CER’s trade model offers no evidence that Britain’s trade with the rest of the world is constrained by its EU membership. Nor does the EU constrain exporters: Germany’s exports to China have grown so rapidly that China is now its second largest export market, after the rest of the EU. And as multilateral trade negotiations have broken down, bilateral trade agreements have grown in importance. In such agreements, economic size matters: it is difficult to imagine the US contemplating such a far-reaching agreement as the Transatlantic Trade and Investment Partnership (TTIP) with Britain alone.

Fiscal gains?

Ending Britain’s contribution to the EU budget is the most easily quantified benefit from leaving the Union. The UK could save 0.5 per cent of GDP. However, the same trade-off applies: the EU insists that the price of unfettered market access is a fiscal contribution to the EU. EEA members and Switzerland help to fund the economic development of the poorer eastern half of the Union, by paying for infrastructure, R&D and training projects. If the UK were to pay into the EU budget upon the same basis as the Norwegians or the Swiss, its net contribution would fall by 9 per cent or 55 per cent respectively.

By quitting the EU, the UK could also leave the Common Agricultural Policy, which through its tariffs and subsidies drives up the cost of food for British consumers. But it would find it difficult to slash agricultural subsidies to zero. The agricultural lobby is powerful and would resist cuts. For its part, Wales is a net beneficiary of the EU budget. Its economy, particularly in rural areas, would suffer from the loss of agricultural subsidies and regional development funds, and the British government would have to make up at least some of the shortfall. This is also true of Cornwall and other poorer regions of the UK.

Free migration is a benefit for Britain

Alongside frustration at regulation by ‘Brussels’, immigration from Central and Eastern Europe is the other main cause of British dissatisfaction with EU membership. Many fear that Central and East Europeans are damaging the employment prospects of low-skilled Britons and driving down wages. While there is some evidence of a depressing effect on the wages of low-skilled British workers, the effect is very small – our best estimate is that immigration from the EU between 2004 and 2015 has reduced the wages of low-skilled services workers by 0.8 per cent. For comparison, the government’s tax increases and benefit cuts between 2010 and 2019 will reduce the incomes of the poorest tenth of Britons by 10.6 per cent, according to the UK’s Institute for Fiscal Studies. Many Britons forget that there are many high-skilled European immigrants in the UK, who raise British workers’ productivity and hence their wages. But academic research shows that the combined impact of high- and low-skilled immigrants on British wages is small.

However, EU immigration is good for the public finances, as immigrants pay more in taxes than they receive in public spending. There are some costs that arise from higher demand for housing and public services. But current levels of immigration help Britain to deal with the costs of an ageing population, by replacing retiring workers, and by raising more taxes to pay for health and pension costs. Since hostility to immigration is pushing Britain towards the exit door, it is likely that the UK would restrict immigration from the EU upon exit. This would require Britain to increase taxes or cut spending.

Moreover, British people can live freely elsewhere in the EU, and this is a major benefit for the 1.8 million people who do so. The EU’s large labour market gives Britons a bigger range of jobs from which to choose than those available in the UK. If their skills are in shorter supply in another member-state than they are in the UK, their income may be higher if they move than if they stay put. And the rest of the EU – particularly France and Spain – is a major destination for British retirees: over 400,000 are living in other EU member-states.

In short, the high degree of economic integration between the UK and the EU will always require some system of shared governance. The EU will not allow the UK, upon leaving, to have the same level of market access that it now has without paying a price. Britain will not be able to leave the EU and remain in the single market unless it is willing to sign up to EU rules that it did not help to write.