All to play for

Apr 6, 2017

This article was featured on Public Finance

Brexit offers a chance to re-examine the UK’s economic objectives and do things differently. There are many reasons to be cheerful.

When Britain entered the European Economic Community in 1973, there was a tendency to see all of British life through a distorting “European” prism. Yet the major issues that shape English local government are its tax-raising powers and its funding, and these have always been decided at Westminster.

Given the extent to which councils are dependent on government grants – and increasingly on business rates – a major question that Brexit raises is its impact on economic activity and therefore on the tax base. In short, will GDP be lower and, consequently, can the level of public expenditure be sustainably financed in the long term? There are reasons to be optimistic.

Open economies

The first reason relates to policy and decision-making, and to regulation. There is significant evidence that the economic success of a political community is determined not by its size or scale but by the quality of its decision-making and the effectiveness of its policies. The economies that prosper are those that are open, competitive and flexible, and function within a stable institutional framework of reliable property rights, enforced by the rule of law.

All advanced economies need complex regulation. However, much of it will be defective and will need to be adjusted swiftly to correct mistakes; a capacity to change is a hallmark of a successful economy. The EU finds it difficult to adapt and to correct policy mistakes. Its institutions and policies hinder that process, and reaching agreement among 28 countries is hard. Once a policy or regulation has been agreed, it is difficult to change.

Politically, the EU has exhibited a reflex impulse to regulate in a clumsy, expensive manner that rewards and entrenches the status quo. A good example is the EU directive on chemicals, which simultaneously increased the costs to firms while making it more expensive for competitors to enter their markets.

A second reason to be cheerful concerns prices and trade. From its inception, the European project has been associated with these issues. Many businesses and politicians naively perceived the Common Market and the single market as steps towards free trade.

In practice, however, EU trade policy is much less liberal than imagined, because agriculture and manufacturing are protected by a common external tariff that pushes up prices.

Manufactured goods and food prices are higher than world prices as a result. The EU’s insistence on protecting agriculture has impeded progress on liberalising international trade in multilateral forums for many years. This has been a major obstacle to the EU achieving trade agreements with countries such as the US, China, Japan and India.

International trade is not a mercantilist opportunity to sell things to foreigners. It offers the opportunity to open up a domestic economy to greater competition so consumers and firms enjoy more choice and benefit from access to the full international division of labour.

Leaving the EU gives the UK opportunities to reduce tariffs and other restraints on trade in manufacturing, agriculture and the food sectors, and to expose the economy to greater competition.

Growth prospects

Third, there are the prospects for economic growth. The analysis of Brexit undertaken by the Treasury last year, in common with similar work by the International Monetary Fund, relied on the so-called “gravity” models of trade. This approach is analogous to Newtonian physics, where the attraction of planetary bodies is directly proportional to their masses and inversely proportional to the distance between them. Trade analysis tends to reflect this.

The Treasury looked at trade between 120 countries between 1948 and 2013. The impact of EU membership on trade is measured as the differences in actual trade between EU countries and what might have been expected due to gravity model factors.

However, there were issues with the data used. The estimates were based on trade with all countries, including emerging market and former Soviet bloc economies, many of which had defective or nonexistent data. Further estimates about foreign direct investment were based on financial rather than real investment flows and on tenuous correlations between trade and productivity.

A central proposition of the Treasury analysis was that, if the UK left the single market, it would face the full common external tariff, and apply it to trade with the EU and the rest of the world. That was a big assumption and it is inconsistent with the prime minister’s stated objective of placing the UK at the forefront of free trade and trade liberalisation. It is difficult to know how much difference Brexit will make to the performance of the UK economy, but gravity models offer only limited guidance. It is clear though that Brexit will offer opportunities to reduce the costs of regulation and make the economy more flexible.

Since the decision to leave the EU in June, the UK economy has performed not only better than the Bank of England and the Treasury had expected, but better than official forecasts made before the referendum. This outcome was called correctly by Economists for Free Trade. The significant fall in the exchange rate has provided the UK economy with a powerful monetary stimulus in a form that should contribute to correcting the country’s large balance of payments current account deficit.

Back to basics

The political and economic significance of Brexit cannot be exaggerated, and that goes for local government too. The prospect of leaving the EU is provoking a “Mancur Olson moment” where all economic policy is being examined from first principles, as recommended by the late American economist. For the first time in over four decades, trade and farm policy is being closely scrutinised, not within the constraints of the Common Agricultural Policy or the common external tariff but on the basis of what the UK’s policy objectives should be.

This re-examination is not confined to policies where the UK government has been highly constrained before Brexit – for example, in agriculture and fishing – but also extends to areas such as vocational training and further education.

The scope to look at policy afresh will provide opportunities for local government. For example, the UK will be able to look again at the regulation that governs public sector procurement. The present EU directive imposes expensive, complex and burdensome obligations on local authorities transacting their business. Many of the environmental regulations that local authorities work with in areas such as refuse collection and waste management are EU regulated, including those covered by the EU’s circular economy package. This regulation is expensive and burdensome. After Brexit, it will be possible to see where rules can be modified to meet UK objectives more effectively.

Brexit also means the UK will be able to avoid the EU’s latest proposals on waste. These are poorly focused and serve neither the EU nor the UK well, not least because they will result in an additional £1bn bill for the UK. With Brexit, the UK will be able to closely examine these proposed rules and their costs, and decide whether they are appropriate to our circumstances. (Policy Exchange has published a full analysis of this issue on its website).

Part of the UK’s contribution to the EU budget is returned to spend as structural funds in the UK regions, for example in Cornwall. Even though the government has, rightly, guaranteed the continuation of such spending for the life of this parliament, the UK will be able to examine this expenditure to see whether it is achieving its objectives, and the extent to which it meets the criteria of efficiency, effectiveness and economy.

At the moment, much of this spending is subject to scrutiny that is too soft in focus and lacks rigour. Many regeneration proposals that could imaginatively make use of local public contracts are not feasible because of EU state aid rules. In this area – as in so many others – Brexit means the UK will be able to examine proposals on their merits, rather than merely apply an EU state aid test.

Author

Warwick Lightfoot

Warwick Lightfoot
Director of Research & Head of Economics and Social Policy Read Full Bio

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