The authoritative source for independent research on UK-EU relations

28 Jun 2017

Economy

Relationship with the EU

One year ago, the UK voted to leave the EU. However, voters did not choose what would come after Brexit.

Options for “life after Brexit”

One option is to remain in the Single Market and preserve the free movement of goods, services, capital and labour with the EU. Another is to negotiate a bespoke trade agreement with the EU that keeps trade barriers as low as possible while ending labour mobility and giving the UK greater control over economic regulation. Finally, if no deal is reached, the UK and EU would trade under World Trade Organization (WTO) terms. This means the UK would have much the same economic relations with the EU as with non-EU countries such as the US or Japan. It would lead to tariffs on goods trade and reduced market access for service exporters.

Each of these alternatives was endorsed by different factions of the Leave campaign prior to the referendum. Asking voters what they prefer does not resolve the conundrum: opinion polls show support for maintaining the benefits of Single Market membership. Yet polls also find support for taking back control by restricting immigration and removing the UK from the jurisdiction of the European Court of Justice (ECJ) (though see the section on public opinion).

European integration brings economic benefits by reducing barriers to trade and investment. But, to reap these benefits, countries must give up unilateral control over some areas of economic policy. For example, harmonising product standards across the EU creates export opportunities for UK businesses because they do not have to satisfy different regulations in different markets. But, harmonisation is only possible if all countries agree to adopt the same standards, which means giving up national control of regulation. Similarly, the EU’s Customs Union keeps trade costs low by allowing goods to cross borders without facing customs controls. However, countries that belong to the Customs Union cannot have independent trade policies.

The integration–sovereignty trade-off

As it leaves the EU, the UK must choose whether to prioritise maintaining economic integration or asserting its sovereignty. This choice will have important economic consequences. Research conducted with colleagues at the Centre for Economic Performance at the London School of Economics found that the fall in UK living standards caused by Brexit would be twice as large if trade reverts to WTO terms than if the UK stays in the Single Market.

Faced with these trade-offs, Theresa May’s government wants to prioritise sovereignty. The Government hopes to end free movement of labour and to remove the UK from the jurisdiction of the ECJ. Consequently, Prime Minister May announced in January 2017 that the UK would leave both the Single Market and the Customs Union, and would seek a new free trade agreement with the EU. The Government also signalled it was willing to leave without a deal if a sufficiently attractive agreement could not be reached. This approach was driven primarily by the prime minister’s need to secure support from voters who backed Brexit to take back control from the EU. However, the Conservatives’ failure to win a majority of seats in the general election means the Government is now under pressure to appeal to a broader coalition of voters by developing a Brexit plan that is less harmful to the economy.

Negotiating a free trade agreement

If the UK does leave the Single Market and the Customs Union, what type of free trade agreement should it aim for? The most basic agreement would simply ban tariffs on UK-EU trade. But economic analysis finds the largest potential costs of Brexit come not from the threat of tariffs, but from higher non-tariff trade barriers due to the imposition of customs procedures and the emergence of regulatory differences between the UK and the EU. An ambitious free trade agreement needs to go beyond tariffs and take steps to keep these non-tariff barriers low. This means finding creative ways to minimise border checks and ensure that changes to UK regulation do not create new trade costs – a goal that conflicts with the desire to reassert national control over regulatory policy. As will become increasingly apparent during the Brexit negotiations, giving up control is the price countries pay to keep trade costs low.

It is also important for the UK that any agreement covers services industries. Close to half the UK’s trade is in services, but most agreements do little to reduce barriers to services trade. Even Switzerland does not have a comprehensive services trade agreement with the EU, despite allowing free movement of labour. No trade agreement will offer the same market access that membership of the Single Market provides, particularly for financial services, but the UK should seek to keep barriers to services trade as low as possible.

To secure a good deal with the EU, the UK must be patient and willing to compromise. Trade negotiations are lengthy, complex and often contentious. There is little chance an ambitious agreement can be reached before Brexit occurs in March 2019, so the UK’s first objective should be to negotiate a transition arrangement to govern UK-EU relations until a longer-term agreement is possible. To give adequate time for negotiations, the transition arrangement should last until at least 2022. And to avoid economic disruption, it should mimic the status quo as closely as possible.

Once longer-term negotiations begin, progress will require the UK to make concessions. Possible concessions include making payments to the EU budget, agreeing EU regulations will continue to apply in some industries, and guaranteeing immigration rights for EU citizens offered a job in the UK. The UK has a weaker negotiating position than the EU,so even with these concessions it is
unlikely to achieve all its objectives. But refusing to compromise will guarantee failure. Research estimates that leaving the EU without a deal could reduce UK income per capita by up to 10% in the worst-case scenario.

Where next?

As Brexit approaches, the UK is facing more challenges than opportunities. From an economic perspective, the question is not whether Brexit will harm living standards, but how large the cost will be. Following the general election, the Government needs to ask how much voters are willing to pay to assert their sense of national identity. If leaving the Single Market is viewed as too costly, the UK is headed in the wrong direction.

By Thomas Sampson, Research Leader of the The UK in a Changing Europe and Assistant Professor in Economics at LSE.

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