22 February 2018

Alasdair Smith is an Emeritus Professor of Economics at the University of Sussex, and is a Fellow of the UK Trade Policy Observatory.

This week  Economists for Free Trade (EfFT) suggested that if the post-Brexit UK were to embrace unilateral free trade (UFT), the net effect of Brexit would be positive rather than negative. Earlier work on unilateral free trade has focused exclusively or largely on tariff reductions – and this latest paper has the merit of recognising that border costs and non-tariff measures (NTMs) should be brought into the analysis. Unfortunately, as Jonathan Portes and Chris Giles have observed, the EfFT assumptions are not credible.^[1]

In our Briefing Paper ‘Which Manufacturing Sectors are Most Vulnerable to Brexit?’, published on 6 February 2018, we used a disaggregated economic model to consider the effects of different versions of Brexit on the UK manufacturing industry. We found that for manufacturing industry as a whole (and for most manufacturing sectors), all variants of Brexit are likely to be costly, raising prices for consumers and reducing output for producers.

To evaluate the predictions of the EfFT on the potential benefits of Brexit if accompanied by unilateral free trade, we have now run a UFT Brexit scenario in our model. The fact that we consider only manufactures is helpful to the analysis, because unilateral tariff reductions have no meaning in services trade where tariffs are not applied. Trade in goods is where EfFT have their best shot.

UFT is meaningful only in the context of a hard Brexit in which the UK exits the Customs Union, the Single Market, and the FTA with the EU. The EU is not going to roll forward any of the current trade arrangements with the UK if the UK is going to remove all tariffs on agricultural products, on textiles and clothing, and on cars. Our benchmark should therefore be a hard Brexit.

What do we find? A hard Brexit with no deals with the EU or the EU’s FTA partners would raise UK prices by 5%; and that’s a simple measure of the cost of Brexit to UK consumers of manufactures. If, however, the UK were additionally to adopt unilateral free trade, the cost of Brexit would be halved, to 2.5%. But even with UFT, Brexit is costly.

On the producer side, it is widely recognised that UFT has a negative impact. We project that a hard Brexit with no UFT might reduce overall demand for UK manufactures by 5.5% (with the likelihood of larger long-run reductions as some producers decided to exit the UK). A hard Brexit plus UFT more than doubles the hit on UK manufacturing, to over 12%.

The difference between our negative projections and the positive projections of EfFT lie in how we model post-Brexit trade barriers.

In our modelling of the UFT Brexit scenario, we assume that while the UK sets zero tariffs on all imports of manufactures from the EU and from all non-EU countries, these tariff cuts are not reciprocated. The EU imposes tariffs on imports from the UK at the rates that it currently imposes on countries with which it does not have Free Trade Agreements, and those countries with whom the UK currently has Free Trade Agreements as a member of the EU do the same. This is the same set of assumptions as EfFT made for non-EU countries; their assumptions about UK-EU tariffs are not entirely clear.

Assumptions about NTMs require some care. We assume that currently UK-EU trade is not impeded by NTMs (because both are part of the Single Market),  that imports from FTA partner countries face low levels of NTMs, and that NTMs are high with respect to all other partners. In the UFT Brexit policy simulation we assume that in the spirit of UFT the UK will treat imports from most countries as acceptable from a regulatory perspective. We model this by assuming that NTMs on imports into the UK from all countries are set at the lower level that apply to trade flows between countries that have FTAs and that therefore recognise each other’s regulatory regimes. This contrasts with EfFT’s unrealistic assumption of zero NTMs on UK imports. NTMs on imports cannot be zero – the UK is not entering a single market arrangement with the whole world in which imports will face no regulatory requirements at the border.

In a similar vein, while EfFT assume zero border costs, we assume, both in the base and in the policy simulation, that all trade flows to and from the UK face border costs of 3.5% (at the low end of the literature estimates). Even if there are no tariffs to be collected on imports, border controls will be needed to ensure that regulatory and legal requirements are met. (Is it credible that trucks loaded with heroin, dangerous toys, and diseased agricultural produce should enter the UK uninspected and unhindered?).  With the UK out of the EU, border controls will be required to collect VAT on imports too. With the UK out of the Single Market, there would be border inspections of imports from the EU as well as from the rest of the world.

EfFT assume that the approximately half of our imports that currently come from the EU free of tariffs, of regulatory barriers and of border costs will continue to arrive on the same terms. The other half of our imports which currently face tariffs, NTBs and border costs will – on EfFT’s assumption – face none of these costs, and the UK economy will unambiguously gain from lower-cost imports.

We have run our model also on these incredible assumptions and find that in this scenario, UK output of manufactures falls by only 6%, and prices fall by 2% giving a modest gain to consumers from Brexit. This confirms that the difference between us and EfFT does not lie in arcane details of the respective models, but in our different assumptions about trade costs.

Our more realistic analysis of a hard Brexit plus UFT is that on non-EU imports the UK will apply zero tariffs, face reduced NTBs, and unchanged border costs; while on EU imports, tariffs will stay at zero, but NTMs and border costs are introduced. The simple arithmetic is that the reduction in costs on non-EU imports does not compensate for losing the easy access to EU imports that results from the Customs Union and Single Market. The only way that EfFT can obtain a positive impact on the UK economy is to make assumptions which, as Chris Giles suggests, are simply ‘absurd’.

Does unilateral free trade offer the UK the prospect of a costless hard Brexit? In a word, no.

 

Footnotes

^[1] In addition and in support of their conclusions the EfFT cites the work of Ciurak et.al. (2015), who they claim find a positive outcome from unilateral free trade of 0.8% of GDP. However, and somewhat worryingly they have failed to read Ciurak et.al. properly. The gain of 0.8% is relative to the losses from leaving the EU and Ciurak et.al. make it quite clear in their conclusions that “our estimate of UK unilateral liberalization is a gain of 0.75% of GDP; this still leaves the UK underwater relative to the cost of Brefta”. Hence they conclude the net effect is negative.