22 March 2018

The IFS tariffs study misses the biggest benefits of leaving the Customs Union

by Julian Jessop

Originally published by Brexit Central.

An important advantage of Brexit is that, once freed from the constraints of the EU’s Customs Union, the UK will regain control of trade policy. This will allow the UK to pursue new bilateral deals, join other multilateral free trade agreements, or simply lower its own barriers to trade with the rest of the world unilaterally. Some have questioned whether these new opportunities will actually deliver any significant benefits. on the basis that the EU’s common external tariffs are generally low to begin with. That is, however, only a small part of the story.

The Institute for Fiscal Studies (IFS) is the latest organisation to wade in on the pessimistic side. This week it published a new report suggesting that even the abolition of all tariffs would reduce UK consumer prices by only 0.7-1.2%. The IFS compares this (unfavourably) with the estimated 2% increase in prices that followed the depreciation in the pound after the referendum result.

The IFS analysis is in three steps. First, the study estimates the average EU tariffs on goods that the UK imports (including those on which tariffs are already zero). If the EU imposed the maximum tariffs allowed under the WTO’s Most Favoured Nation (MFN) rules, these tariffs would average out at 4.6%. In practice, the EU has chosen to apply lower rates, which average around 2.8%.

Second, the study estimates the share of consumer spending that might be impacted by the elimination of tariffs. Here the IFS deserves credit for assuming that the cuts will apply to all tradeable goods, whether imported or produced domestically, as competitive pressures would be likely to force UK and EU firms to match the lower prices on imports from the rest of the world. The study also makes an allowance for savings on imported goods used in the production of services. On this basis, it estimates that 26.1% of household consumption would potentially benefit from tariff reductions.

The third stage, of course, is simply to multiply the numbers together: 2.8% of 26.1% gives the lower bound of 0.7% for the impact on consumer prices, while 4.6% of 26.1% gives the upper bound of 1.2%.

So far, so good. This is straightforward maths and the IFS can crunch numbers as well as anyone. But there is actually little new here. The results are similar, for example, to those produced last year by specialist trade economists at the UK Trade Policy Observatory, based at the University of Sussex. Their work suggested that consumer prices would fall by an average of just over 1% if the UK reduced all tariffs to zero.

More importantly, the IFS analysis is only partial. The estimates of the benefits of freer trade with the rest of the world are low because the report only looks at the costs of the EU’s external tariffs. But there are also a wide range of non-tariff barriers and distortions that leaving the EU will allow the UK to review. These include quotas, discriminatory rules and regulations, and the constraints of both the Common Agricultural and Fisheries Policies. Generally, these non-tariff barriers have a much bigger impact on prices than tariffs alone.

Other economists have suggested that the combined effect of tariff and non-tariff barriers is to raise UK prices of food and manufactures by as much as 20%. You do not necessarily have to accept this exact number, or that all such barriers could or should be eliminated, to conclude that the IFS’s range of 2.8%-4.6% is a conservative estimate of the potential savings.

The IFS’s largely static approach – applying savings to current spending patterns – also risks downplaying some potentially important dynamic benefits. Some might argue it has form in this regard. For example, economists from the left have criticised it in the past for paying too little attention to second-round effects when assessing the impact of tax and spending measures.

In this case, the IFS study does take account of the increased competitive pressure on UK and EU producers to match the price cuts resulting from tariff elimination. But there should be additional benefits in the form of efficiency gains and increased consumer choice, especially in those areas where the reduction in tariffs is relatively large (the figures of 2.8% and 4.6% cited above are only averages). Many of the benefits of lowering trade barriers are intrinsically hard to quantify. Indeed, previous studies have often been shown to have underestimated the gains significantly.

Finally, the comparison with the estimated 2% increase in prices that followed the depreciation in the pound is dubious. It might be OK if the intent is simply to put a potential saving of around 1% in perspective. But the implication is that Brexit will still leave consumers worse off. This assumes that the fall in the value of the pound is both permanent and due solely to the vote to leave the EU. It also ignores any economic benefits from a more competitive currency. Plus it ignores any benefits that Brexit might provide to consumers through other channels.

In short, the IFS study is an honorable attempt to quantify one of the potential economic impacts of Brexit. It is at least an improvement on other studies which assume that, under a ‘no deal’ scenario, the UK would inevitably choose to raise tariffs on EU imports rather than maintain the level playing field required under the WTO’s MFN rules by eliminating tariffs on imports from the rest of the world. Nonetheless, there is nothing new here that undermines the case for leaving the Customs Union.