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The Brexit agreement: An economic guide for the perplexed

Summary:
The last-minute Brexit deal at the end of December 2020 between the European Union and the UK government is misleadingly titled a Trade and Cooperation Agreement (TCA) governing their economic relationship. But the TCA's aim is not to deepen trade and commercial ties but to manage an economic divorce that will diminish economic output and efficiency. In this respect, the TCA is probably unique among trade agreements between advanced economies and in some ways akin to the breakup of Czechoslovakia in 1993.1 The British goal was to expand national sovereignty, including control over UK territorial waters and an end to the role of the European Court of Justice in the UK. Those goals were reached to a degree but at some economic cost detailed here. This blog post compares the status quo and

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The last-minute Brexit deal at the end of December 2020 between the European Union and the UK government is misleadingly titled a Trade and Cooperation Agreement (TCA) governing their economic relationship. But the TCA's aim is not to deepen trade and commercial ties but to manage an economic divorce that will diminish economic output and efficiency. In this respect, the TCA is probably unique among trade agreements between advanced economies and in some ways akin to the breakup of Czechoslovakia in 1993.1

The British goal was to expand national sovereignty, including control over UK territorial waters and an end to the role of the European Court of Justice in the UK. Those goals were reached to a degree but at some economic cost detailed here. This blog post compares the status quo and what the TCA does in trade, immigration and labor mobility, and regulations.

Bad for EU-UK trade in goods

Status quo: UK membership of the EU customs union and internal market imposes no tariffs on goods imported from and exported to members and virtually no border and administrative procedures.

TCA: In principle, the TCA guarantees zero tariffs on traded goods and mitigates the direct tariff elements of Britain exiting the EU customs union. But very few provisions really address the fact that the UK and EU economies are very closely integrated advanced economies relying on complex cross-border supply chains to work efficiently. The TCA tightens so-called rules of origin provisions, requiring that tariff-free status be conferred only on goods with a certain percentage of parts made locally. If a large part of an automobile manufactured in Britain comes from a third country—in Asia, for example—it is subject to the World Trade Organization (WTO) tariff schedule for that country.

The "rules of origin" restrictions raise administrative costs for UK-based firms, most heavily for small and medium-sized enterprises, forcing them to scramble to find more local UK sources for their inputs. Some may have to relocate production to the EU to service this larger market without tariffs.

A further complication relates to the "minimal processing requirements" standard in trade agreements, meaning that exports from the UK have to be "altered or processed" there. This tricky rule will prevent UK-based distribution centers from importing goods from continental Europe for reexport to Ireland or other parts of the EU. This provision deals a devastating blow to the UK-based logistics and distribution sector—including software downloaded online and other IT goods and services—which can no longer seamlessly source and serve other EU markets. Of course the EU could exempt individual sectors heavily reliant on UK-based distribution from the requirements. But unless the UK offers the EU something in return, Brussels would have no incentive to offer such an exemption, as distribution would otherwise likely shift to the EU.

Verdict: The TCA will reduce trade in UK goods, hurting both sides.

Worse for EU-UK trade in services

Status quo: UK membership in the EU ensures participation in the deepest cross-border services trade market in the world, with UK providers generally able to sell their services across the EU, while subject to domestic UK regulation and certification.

TCA: The TCA does not explicitly include many of the existing liberal components for the services sectors, including financial services provided by the City of London, instead reserving the unilateral EU right to determine whether the UK's regulatory framework is "equivalent" to the EU. As a result, EU regulations may compel some services, including trading and clearance of most euro-denominated assets and other back office financial services, to relocate from London to the EU. UK-based cross-border logistical services and freight hauling will also suffer, hurting smaller operations reliant on flexible van transportation rather than multinational truck fleets.

Equally damaging, the EU also rejected many agreements with the UK government on mutual recognition of regulations, out of concern that future UK regulatory methods might become acceptable in the EU market. Agreements no longer exist on mutual recognition of professional qualifications between EU member states and the UK, further inhibiting free movement of labor to the detriment of services trade.

Verdict: In its entirety, the TCA drastically impedes EU-UK services trade.

Makes EU-UK immigration and labor mobility more onerous

Status quo: All EU workers and families have had the right to work and reside in the UK and vice versa, with no restrictions on business travel. Requirements on professional qualifications still apply at the national level.

TCA: The TCA enables visa-free leisure travel for up to 90 days between the EU and UK, enabling holiday travelers and day-trippers to carry on, though an entry fee of €7 will be imposed starting in 2022 by the new European Travel Information and Authorization System (ETIAS) (comparable to the US Electronic System for Travel Authorization (ESTA) charge of $14 for entry into the United States).

A more onerous burden is to be placed on immigration and entry for short-term cross-border work, except to Ireland, where the longstanding bilateral Common Travel Area (CTA) with the UK will continue to allow virtually free entry, work, and settlement. EU workers have lost their previous general preference in UK immigration rules. Similarly, UK citizens have lost their free access to work and settle across the EU.

Instead, the UK has been implementing a global points-based immigration system to try to focus work-based immigration on higher-skilled individuals. An earlier Brexit withdrawal agreement enabled EU workers already in the UK to apply for—and typically be granted—the right to continue to work and reside in the UK, but this opportunity has now expired. In another blow to British youth, the TCA has ended the EU student exchange program ERASMUS, likely sharply reducing student exchanges between the EU and UK.

Short-term work visits by British citizens remain legal in the EU for up to 90 days in each period of 180 days, but with severe restrictions. UK residents will still be able to go to business meetings, conferences, and trade fairs. They can conduct R&D and training, engage in sales to other businesses (but not individuals), make purchases, do translations, and represent UK businesses in Europe. But everything else is not permitted, unless individual member states allow it in their jurisdictions.

Verdict: For a major services-oriented economy like the UK, which has traditionally run large services surpluses with the rest of Europe, the TCA will thus severely curtail a major economic sector and potentially lead to labor shortages in some low-skilled UK sectors like agriculture.

Imposes significant costs on the UK if it diverges from EU regulations

Status quo: As a member of the EU, the UK is subject to all EU rules covering internal market standards and other areas and the jurisdiction of the European Court of Justice. The UK, like all EU member states, remains able to implement national rules covering areas outside the EU's competencies, including most social and labor market regulations.

TCA: In the name of achieving a "level playing field" between businesses in Europe and the UK, the EU insisted on a reciprocal and stringent prohibition against UK domestic regulations of the environment, labor markets, state subsidies, and other issues that would bestow a competitive advantage to UK businesses. The rule allows the EU to establish, through an independent arbitration, that such an advantage has been created. If such an advantage is determined, the EU can impose retaliatory trade tariffs and other restrictions on UK exports of choice. Such forceful "level playing field" provisions are generally not present in free trade agreements among countries around the world. But clearly the EU felt that because of Britain's size and proximity, zero-tariff access to the European market could not be contemplated without them. In principle, the "level playing field" provisions in the TCA grant the UK the sovereignty to diverge from existing EU regulations but simultaneously give the EU the equally sovereign right to retaliate against such regulatory divergence, if it is material in nature. Uncertainty exists over the difficulty of proving market distortions, so it is not clear how often the EU and UK would get into disputes in this area. Nor is it known what the UK might do to exercise its now unconstrained regulatory rights.

The TCA further lacks agreements on mutual recognition of regulations to protect against human, animal, or plant diseases or contamination—so-called sanitary and phytosanitary (SPS) rules—which will make cross-border sales of fresh produce much more difficult and expensive. The UK imports much of its food from the EU. Fresh produce is far more expensive to import from suppliers farther away. Accordingly, the TCA will likely reduce supply of fresh food and increase UK food prices. The EU would of course suffer similarly in getting fresh food from the UK.

The TCA also keeps the UK outside the EU's chemicals registration database (REACH), which collects required research and testing results to prove that chemicals are safe to use in products for the EU market. Instead, the UK will now build its own "UK REACH database" largely replicating the existing EU one. This step will come at significant cost of time and money for the UK chemicals industry. The TCA, therefore, does not prevent regulatory trade barriers from emerging in the chemicals and other related sectors.

Verdict: In the end, the UK is likely to incur significant economic costs if it diverges from existing EU rules. The cause of "sovereignty" could be costly, though the impact of such costs on the UK's ultimate willingness to diverge is uncertain.

Reduces EU-UK trade overall

Overall, the breakup of the UK from the EU customs union and internal market, even in a theoretically tariff-free TCA trading environment, seems likely to add significant costs and obstacles for many trade-dependent sectors. These burdens flow from the TCA's lack of facilitation of many features that exist in closely integrated 21st century economies. For UK small and medium-sized businesses accustomed to trading freely with other EU members, the increased administrative costs from Brexit and the TCA are likely to discourage them from exporting to the EU. Many are likely to not trade at all with other countries. Their turning away from exports will affect larger UK firms and existing multinationals far less, while relatively fewer EU firms will have a high enough dependence on the UK market to stop trading altogether.

The TCA is hence likely to reduce overall EU-UK trade and, in the absence of a significant depreciation in the value of the pound, increase the overall UK trade deficit with the EU.

Note

1. Violent breakups of countries are obviously not comparable to Brexit.

Jacob Funk Kirkegaard
Jacob Funk Kirkegaard, senior fellow, has been associated with the Institute since 2002. Before joining the Institute, he worked with the Danish Ministry of Defense, the United Nations in Iraq, and in the private financial sector. He is a graduate of the Danish Army's Special School of Intelligence and Linguistics with the rank of first lieutenant; the University of Aarhus in Aarhus, Denmark; the Columbia University in New York; and received his PhD from Johns Hopkins University, School of Advanced International Studies.

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