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Stay or go? The economic consequences of Brexit

Submitted by on 27 Apr 2015 – 10:00

Swati Dhingra from the LSE predicts the economic consequences of Britain potentially leaving the EU.


The  direction of Britain’s  relationship with  the  European Union  (EU) will  be  decided in this Election.  The Conservatives have committed to an ‘in-or-out’ referendum on membership while Labour and the Liberal-Democrats have opposed this. The political consequences of leaving the EU (so-called ‘Brexit’) are widely debated, but  less attention is given  to the economic consequences. How  would Brexit affect the UK economy and the income  of UK citizens?

Predicting the  economic impact  of Brexit is difficult.   Leaving  the  EU would influence the UK economy in many  ways.  Trade, foreign  direct  investment, immigration and  economic regulations would all be affected.  Also, there is uncertainty over future policies after Brexit or any renegotiation. This is why most analyses of Brexit look at a range of possibilities and give wide- ranging estimates. To reconcile these different views, let’s look at research-based assessment of the past impact  of EU membership, the expected outcomes from Brexit, and its implications for Britain’s future in the world economy.

 Taking stock of the Single Market.

 At the eve of joining the common market, many  in Britain were  concerned that  membership would increase  prices  and  hurt  earnings.  But this  has  not been the experience over the past two decades. The single market increased competition across firms, resulting in lower  prices  for consumers. Employment and  wages  were positively impacted by the product market reforms, and  businesses expanded in response to market integration.

Empirical evidence also dispels widespread fears of immigrants taking  away  good  jobs. Immigration had  positive effects on employment and  wages,  and  did  not put  pressure on public finances.  These  trends have  continued over the crisis period (Figure  0.1). There were  small  negative effects for low-wage earners be- fore 2005, but  these  were  not sustained in the later  period. While this calls for distributional remedies, it does  not imply  an exit from  the EU as the single  market had  an overall  positive impact  on UK consumers and workers.

graph 2

 Jumping  the trade train.  

The most  direct  channel through which  the  single  market affected the UK economy is bilateral trade  with  the EU, which  increased to 50% of all UK exports and imports. EU membership matters primarily because  it leads to lower trade  barriers. This makes  goods  and services  cheaper for UK consumers and allows  UK businesses to export more.  Leaving  the EU would reduce trade  because  of higher tariff and non-tariff barriers (from different regulations, border controls, etc.). Additionally, Britain would benefit less from future integration within the EU. The main  benefit of Brexit would be a lower  contribution to the EU budget.

Our research quantifies the economic impact  of these channels under two scenarios:

(1) An optimistic scenario, in which  Britain  has a free trade  agreement (FTA) with  the EU (much  like Switzerland and  Norway do through the European Free Trade  Association, EFTA).

(2) A pessimistic scenario,  in which Britain is unable to negotiate such favourable terms and there are larger  increases in trade  costs.

Changes in trade  barriers would reduce UK incomes  by 1.1% to 3.1%. This is driven largely  by current and future increases in non-tariff barriers, which  are important for trade  in services, such as finance and accounting, where Britain is a major exporter. The costs of reduced trade  far outweigh the fiscal savings from not having to contribute to the EU budget. In cash terms,  the net loss is £50 billion  in the pessimistic scenario  and  a still substantial £18 billion in the optimistic scenario.

“reduced integration with  EU countries  is likely  to cost Britain  far more  than  the  savings from  contributions to the  EU budget.”

 These results relate  tariff and  non-tariff barriers to incomes,  but do not capture the dynamic gains  from productivity growth or channels such as higher transaction costs from Brexit.  The consequences of Brexit can alternatively be inferred from  empirical results that  relate  membership to trade  and  incomes.   After  controlling for other  determinants of bilateral trade,  EU members trade  40% more with  other  EU countries than  they do with  members of EFTA. Combining  this with  estimates that a 1% decline  in trade  reduces income  by between 0.5% to 0.75% implies  that leaving the EU and joining EFTA will reduce UK incomes  by 6.3% to 9.5%. To put these numbers in perspective, UK’s GDP fell by around 7% during the 2008-09 financial  crisis.

 Missing the next trade train.

 The EU is currently negotiating new FTAs with the United States and Japan.  Based on the impact  of previous EU-negotiated FTAs, we estimate these trade  deals will lower UK prices by 0.6% and save consumers £6.3 billion per year. With Brexit, these benefits would be lost or substantially reduced. As a stark example, import prices for many products in Colombia increased after the Colombia-US FTA because  US exporters exerted greater mar- ket power. The size of the EU economy gives  Britain  a stronger bargaining position in future negotiations.

Leaving  the  EU would also affect immigration, economic regulation and  UK’s position as a recipient of foreign  direct  investment. These effects are harder to quantify than  changes in trade,  but are likely to further reduce incomes.

The economic consequences for Brexit are complex.  But reduced integration with  EU countries  is likely  to cost Britain  far more  than  the  savings from  contributions to the  EU budget. Even if Britain maintained full access to the single market, it would not have a seat at the table when  the  rules  of the  single  market are decided.  Future EU reforms involve  sectors  such  as banking and services, where Britain has a stake in being part of these negotiations.

Swati Dhingra  is a Senior Lecturer in Economics at the London School of Economics (LSE).