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16 June 2018

Options that a clean-break Brexit could present

by David B. Smith

Originally published by Brexit Central.

Britain’s convoluted and acrimonious negotiations with its EU counterparties seemed to have caused almost the entire UK political and bureaucratic classes to lose sight of the opportunity costs of any putative settlement. Governments have zero resources of their own, only those that they can expropriate from their citizenries. This means that all the expenditures that appear on one side of the government’s balance sheet – including any monies conceded to the EU – have to be matched by tax receipts or borrowing on the other.

My recently-published Politeia paper, The Brexit Settlement and UK Taxes, had two objectives. The first was to compare the sums that the UK is expecting to hand over, as set out in the Office for Budget Responsibility’s 13th March Economic and Financial Outlook, with the annual tax ‘ready reckoner’ published by Her Majesty’s Revenue and Customs (HMRC) on 24th April. The importance of this ready reckoner is that, in its own purely static terms, it allows one to calculate how much needs to be added to any specific tax to fund a particular spending commitment.

Britain’s £15.1 billion VAT and Gross National Income (GNI) contribution to Europe in 2019-20 can be compared with the £4.3 billion revenue cost of cutting income tax by 1 percentage point or the £6.2 billion cost of cutting 1% off VAT. In theory, a ‘clean break’ Brexit at the end of March 2019 could allow 3p to be taken off income tax or 2.5% of VAT, for example, if the UK simply refused to hand over any more money subsequently.

There is a limitation to the HMRC calculations, however, in that they do not allow for the second-round dynamic effects that occur when people alter their economic behaviour in response to a change in tax rates. In order to capture these longer run ‘dynamic’ effects, a number of simulations were then run on the Beacon Economic Forecasting (BEF) quarterly macroeconomic forecasting model. The main simplifying assumption was that Britain does not hand over any more money to the EU after March 2019. Instead, the money that has been saved was assumed to: 1) reduce public sector borrowing; alternatively to cut the standard rate of income tax by 2.5 percentage points, or 3) to reduce VAT by 2 percentage points.

Such model simulations are subject to all sorts of caveats. However, the results suggested that even using the £14 billion to £15 billion annual payments to be handed over to the EU in the financial years up to 2022-23 to reduce public borrowing would lead to a modest improvement in economic performance and a noticeably reduced budget deficit by 2025-26, when the simulations terminate.

However, using the bulk of the EU tribute to fund bold supply-side friendly tax cuts appears to give even better results. Both the income tax cut and VAT reduction scenarios leave real GDP roughly 1.5 percentage points higher in 2025, for example, with household consumption and private investment some 3.25 to 3.5 percentage points higher, and the Labour Force Survey measure of unemployment down by some 0.75 of a percentage point. Both tax cutting scenarios deliver reduced public borrowing, although the reduction is more marked with the VAT cut as, hardly surprisingly, is the reduction in the CPI in 2025.

This does not mean that other losses arising from a ‘clean break’ Brexit, such as reduced export demand and the potential disruption to supply chains, might not outweigh the gains of a terminated tribute to the EU. However, it does suggest that a bold reforming government has options that should be explored and seriously considered if it proves impossible to achieve a fair settlement.



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