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Better Off Out?

    This article is an excerpt from our Growth Bulletin, authored by Ryan Bourne and Tim Knox. To read the full article, click here. To sign up for our mailings, use the form on the left of our newsletter page.

    The great majority of the Conservative party is clear that Britain's relationship with the EU should change, with powers repatriated to the UK at a minimum. They recognise that the EU is changing anyway as a result of measures designed to deal with the Eurozone crisis: the status quo is not an option.
    While the coming years will no doubt see the issues of democratic accountability and political sovereignty discussed, many voters in a referendum are likely to put large weight on what they consider to be the economic implications of a new relationship, or even withdrawal. There is much uncertainty here: Would we maintain our position within the European Economic Area? What would happen to Foreign Direct Investment? How would the saved gross contributions be used? How many of the regulations the EU imposes might we want to keep or abandon?
    The truth is there are more questions than answers at this stage. Successive governments have failed to carry out a comprehensive cost-benefit analysis on the economic basis of our EU membership. Nevertheless, there have been noble efforts to think through some of the consequences of EU withdrawal from think-tanks, research institutes and several prominent economists and academics. This bulletin seeks to highlight the main issues and conclusions of these studies in four main areas:

    • Trade
    • Foreign Direct Investment
    • Fiscal effects
    • Regulations

    The primary concern about a potential EU exit centres on the high volume of trade currently undertaken between the UK and other EU states. About 48% of all UK goods and services exports go to the EU, though these figures are distorted upwards by the Rotterdam-Antwerp port effects. The UK can currently trade freely within the EU customs union’s internal market, which also enables the free movement of capital, good/services and people, and many worry that a UK exit risks the jobs and export opportunities that this internal market provides.
    Those who believe we would be better off out make a strong case that this is not so much of a problem as the ‘In’ crowd suggest:
    1)    Though an important export market, the proportion of trade done with the EU has been steadily falling over time (the proportion of total exports accounted for in official statistics as exports to the  EU has fallen from 59% in 2002 to about 48% today)
    2)    It would be economically rational for the EU to agree to a bilateral free trade deal with the UK, not least because the UK runs a significant trade deficit with the rest of the EU
    3)    Exit from the EU would enable us to conduct bilateral free trade agreements with some of the fast growing economies in the world, according to our own needs
    4)    The work of the World Trade Organisation has meant that global tariffs are already low
    The key here is that the effect on trade will depend primarily on what new relationship is agreed with other EU countries on exit or renegotiation. Though a bilateral free trade agreement would seem preferable and sensible to both parties, many point to the political risk over whether this could be achieved. Likewise, working through the WTO would take time, and a period of uncertainty.
    A paper by Open Europe (2010) explored some of the options were the UK’s terms of membership to change.
    The EEA option: being in the European Economic Area with free trade and continued free movement of labour, goods, services and capital, but outside of the customs union (so not bound by the common external tariff) and so able to run an independent non-EU trade policy. Alongside the benefit of an ability to negotiate our own free trade deals, the EEA agreement would also exclude us from the Common Agricultural Policy, and Common Fisheries Policy. The downsides are that we would still be bound by all social and employment legislation and product regulations but would have limited influence in deciding them, and no votes in determining them. Goods would also be subject to ‘rules of origin’ and we would still have to make a financial contribution to the EU for access to the single market.
    The Swiss option: membership of the European Free Trade Area with negotiated bilateral agreements giving access to the single market in most areas, with free movement of labour, capital and goods, though with more limited access to services. The key advantages again are: the ability to negotiate our own external trade, maintenance of sovereignty and exemptions from CAP, CFP and regional policy. But under this style of agreement we would also be exempt from EU social and employment regulation. The downsides are largely similar to the EEA option: rules of origin, no decision making power with regard to rules, the constant need to update bilateral agreements and the need to negotiate an agreement for free movement of services.
    The WTO or ‘full out’ option: outside of the European free trade area and no longer part of the Free Trade Agreements signed already with third countries. This would give the UK a completely independent trade policy, and put us outside of any EU social and employment legislation or product regulations (for non-EU exports). If we were unable to reach a bilateral agreement,  UK exporters to the EU would then face tariffs.
    The Trade Policy Centre has shown the difficulties associated with rules of origin arrangements. Free trade agreements only provide for duty-free trade in products which are largely manufactured in the area it covers. If, for instance, Britain was to export cars to the EU containing parts made in China, they would face the 10% tariff unless they complied with complex ‘rules of origin’ tests. These rules do not apply within customs unions such as the EU single market.
    In part for this reason, Open Europe (2010) concluded that full EU membership within the current customs union is the best option from a trade perspective given the uncertainty and unpredictability of being able to negotiate the other options. But other studies, notably by leading economists Patrick Minford and Tim Congdon have outlined that it would be irrational for the European Union not to accommodate the UK in a favourable free trade agreement; and that most of the gains from the single market are, in fact, gains from free trade. The banner of the single market has, they suggest, been used to extend a raft of regulations which must also be considered.
    It’s worth noting here that the scare-mongering claims of those who resist reform border on the absurd. Several of them have spoken about the ‘3 million UK jobs’ linked to UK-EU trade as if all of these jobs would be at risk from Britain leaving the European Union. This is simply not the case. Even under the WTO-out example Britain would continue to trade with the EU, meaning the implied argument that 3 million jobs are at risk is bogus. Indeed, a NIESR paper in 2004, which modelled an exit from the EU with no free trade agreement, suggested that there was unlikely to be any significant effect on aggregate unemployment.
    Several people have claimed that the UK would suffer significantly from a loss of foreign direct investment if we were to leave the European Union. The UK had the highest stock of FDI of any EU country in 2011 ($1.2 trillion), and the largest inflow in that year ($53.9 billion). There are of course many factors which determine its flow at any one time. But the argument has been made to that, in particular, Japanese and US investment in UK manufacturing takes place to a significant degree because of our access to the Single Market. Were this access loss, foreign direct investment would thus be expected to fall. The Institute of Directors (2000) estimated that the net benefit of FDI as a result of EU membership was equivalent to 0.5% of GDP. Research by NIESR (2004) suggests ‘that integration with Europe has played a significant part in stimulating inward investment into the UK’. Their analysis suggested that leaving the Single Market would permanently lower the level of UK GDP (by 2.25%), because productivity would be lower (FDI tends to bring with it knowledge transfers and the investment tends to come from the most productive firms).
    However, both the arguments that FDI would fall and that this would have a significant effect on the level of UK GDP have been challenged elsewhere. An analysis by Civitas (2004) found that 57% of FDI was in oil and gas and financial services – global industries where decisions other than access to the single market are likely to pre-dominate FDI decisions. Some have claimed that levels of foreign investment in the UK could actually go up if we left the EU because of the on-going Eurozone crisis. Others, such as Patrick Minford (2005), have outlined how the FDI effect could also be offset from our being freely able to scale-back EU legislation which increases business costs. Finally, Minford has also pointed out that the NIESR conclusion on the effect of lower FDI on growth is a non-sequitur – the FDI effect is mainly about technology transfer and where it comes depends on the technological structure of the economy. After we have left the EU, the technology structure of the economy would change – less FDI could therefore occur because the technology level in the new structure is higher, in which case productivity too would still be higher and there would not be the negative effect on the level of GDP that NIESR have suggested.
    According to the House of Commons Library, the UK made a gross contribution to the European Union of £15.4 billion in 2011 and £15.0 billion in 2012. The net contributions after public receipts were £8.1 billion and £6.9 billion, respectively. Evidently, if Britain were to leave the European Union entirely, it would not have to make these contributions, and (assuming tax revenues from the changes from trade do not change drastically) would therefore be at an improved fiscal position. In the event of remaining in EEA or EFTA, the UK would continue to make some financial contribution. If we were to leave the EU entirely, some of the funds would no doubt have to be used on a temporary basis to compensate those who previously received EU funds, such as the Common Agricultural Policy recipients. However, the UK government would of course now be able to decide how to direct the full amount of the gross contribution, or whether to use the funds to close the budget deficit or cut taxes.
    Less commonly assessed is the potential resource misallocation from the way the EU spends its money. Patrick Minford (2005), estimated that the economic gains of no longer having to participate in the CAP would increase UK GDP by 2-3%. This has since been revised down by Tim Congdon (2012) to 0.5%.
    The cost of EU regulation on the economy has been estimated in various studies. Ian Milne (2004) suggested a cost of anywhere between 0.5-3% of GDP (1% of GDP in 2011/12 was approximately £15.3 billion). More recently Tim Congdon (2012) has estimated a cost of 5% of GDP – closer to the 4% of GDP figure outlined by Peter Mandelson in his 2004 CBI speech and with examination of more recent changes. Of course, many would argue that certain regulations are necessary and bring with them benefits to the economy. But work done by Open Europe (2010) suggested that the benefit-cost ratio of EU sourced regulations in the UK is only 1.02. This compares extremely unfavourably to domestically sourced regulation, which is found to have a benefit-cost ratio of 2.35. Open Europe have estimated that the Working Time Directive alone will cost the UK £32.8 billion by 2020.
    Thus, at the very least there appears to be a consensus that the costs of EU regulation are at least double the direct fiscal cost of the current membership. The extent to which the UK would have to maintain these regulations upon exit would of course be dependent on which, or whether a, trade agreement was negotiated.
    More recent concerns have centred on the likely effects of EU-wide regulation on the financial services industry (in particular the City of London). But the City’s official position has often suggested that while it is concerned that regulatory overkill risks undermining its competitive position, it also values EU membership as a means of trying to open up new markets for financial services (particularly China).
    As part of its annual New Year questions, the Financial Times asked a range of economists how much, from an economic perspective, should people worry that Britain might leave the European Union. Opinion was divided: 10 thought it would unambiguously be a good thing for Britain to leave; 35 responses suggested indifference or that there would be little macroeconomic effect; around 40 suggested that people should be worried. The problem, as we have seen, is that calculating whether we would be better or worse off outside of the European Union depends on a range of assumptions about the counterfactual. Most of the commentators who said that we should worry cited uncertainties and the potential loss of favourable trade arrangements as the main areas of concern.
    Would there be a mutually beneficial free trade agreement? Or would the political fall-out from an exit lead to irrational protectionism? How much of the regulatory burden currently imposed would we maintain if free to reverse it? How would the gross contributions which are currently returned to us be used if available to the UK government? This note has attempted to present previous work done on the main economic effects. But what is needed now is a full blown cost-benefit analysis done by the UK government, using relevant counterfactual scenarios.
    The evidence above suggests that the UK would be better off with less of the EU, but would be worse off in the very unlikely event that the attempt to renegotiate harmed relations with other EU members resulted in our exit, coupled with irrational protectionism on the part of the EU. The single market, through the ability to trade freely, brings with it obvious benefits. There is a significant downside from being outside of the customs union in terms of rules of origin requirements. Yet these have to be balanced against the ability to run an independent external trade policy, being exempt from the some of the more oppressive regulation that governs EU members and a much lower budget contribution. A looser membership with a continuation of the advantageous trading arrangements of  the single market alongside an ability not to have to opt in to various EU regulations would seem the ideal scenario from the UK’s national interest. Whether that it possible, and whether David Cameron is able to achieve it, is another thing altogether.

    This article is an excerpt from our Growth Bulletin, authored by Ryan Bourne and Tim Knox. To read the full article, click here. To sign up for our mailings, use the form on the left of our newsletter page.

    Ryan joined the Centre for Policy Studies in January 2011, having previously worked for a year at the economic consultancy firm Frontier Economics.

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