James Arnell is a partner at Charterhouse. He writes in a personal capacity.

Back in November 2017, ConservativeHome was kind enough to publish a series of four articles entitled “Ready on Day One For Brexit”. Given the increasing possibility of a “no deal” Brexit, ConHome is re-running the series.

I have taken the opportunity to read back over my thoughts from what now seems like an age ago. Many seem to me to remain pertinent. Some (not enough) have been overtaken by events, and other issues have emerged over time. I have therefore marked them up where I feel that is required. Where the text matches my current opinion, I have let it stand.

Today, in the first of my series of articles on contingency planning for a no deal Brexit, I will focus on the money, covering –

  • What we should be prepared to pay in the absence of an agreed free trade agreement (FTA).
  • A mechanism for resolution of rejected claims.
  • What we should be prepared to pay if and when a satisfactory FTA is in place.

The EU has taken its cue in these negotiations from Tom Cruise in Jerry Maguire. “Show me the money” has been the demand from the very beginning. When history looks back on these negotiations, if they fail, it will not treat this venal attitude kindly.

The EU will be seen to have put short-term budgetary interests ahead of its longer-term strategic interests. The UK has been a massive net contributor to the EU, despite sharing few of its ambitions, over many years. A serious, sensible EU would take this into account, and would seek to reach a creative agreement with the sixth largest economy in the world, right on its doorstep. But history is for tomorrow, and we have to live in the present, so here’s what I would do as regards the money.

First, if there is no deal. We are signed up until March 2019, so we should pay our share of the budget until then, with the possible exception of funds to be drawn for projects which will extend beyond it. I have previously calculated the exit bill at around €5 billion, plus a share of the pension liability at around €7 billion. I would set out these figures and I would also set out what the EU has been demanding, showing what has been accepted and what has been rejected. UPDATE: Comments from my previous series convinced me that this would not be wise. I would no longer recommend “laying it all out” in this way.

Technically, legally, it seems that we are not obliged to pay a penny on leaving the EU but, in the interests of goodwill, I would propose that we agree to pay a total of €12 billion as our “divorce bill”, payable even in the absence of a free trade agreement.

However, I would not pay this immediately. I would make payments subject to three undertakings:

  • First, an undertaking by the EU to invest in facilities and staff to administer trade flows between the UK and the EU, and undertakings that all efforts will be made to ensure smooth trade flows.
  • Second, an undertaking by the EU to mirror the rights we give to EU citizens in the UK with similar rights for UK citizens in the EU and then preservation of those rights.
  • Third, confirmation by the EU commission of the regulatory equivalence of the City of London and its various entities.

I would agree that delayed payments (over five to ten years) will accrue interest at the blended financing rates of the EU member states, so that no member state is put out of pocket by the delayed payments.

If these undertakings are not given, or if they are not subsequently respected, I would pay nothing whatsoever, as we are legally entitled to do.

Our Government has rightly made much of the fact that the UK respects its legal obligations. I would propose that the EU be invited to bring any claim it believes it has against the UK government before an international tribunal, as already suggested by Charlie Elphicke and by Martin Howe.

We should also set out what we would be prepared to pay were there a comprehensive free trade deal between the UK and the EU. I would propose that this figure be capped at what we have already offered: an additional circa £17 billion for the two year transition period. (UPDATE: the actual Brexit divorce bill has been set at £37 billion (according to the IFS) as compared to the £29 billion I had assumed.

This would imply dangling a carrot of £25 billion for a free trade deal. I am neutral on whether it is right to continue to hold out such a large sum to tempt the EU to agree a free trade deal. On balance, I probably would, but what I would not do is pay this sum for what Michel Barnier is now calling “a political declaration on our future relationship”. That is worthless.

I see two options: promise the money when the final agreement is signed, or, better (as it reflects the need for the EU to secure its short term funding), loan the money to the EU, with an agreement to waive repayment of the loan when the deal is ultimately signed. This is fully justified by the fact that our agreement to pay the divorce bill was always subject to “everything being agreed”.)

The basis for this figure (UPDATE: by which I mean my original figure of £17 billion) is not driven by EU budget logic. It is driven by an assessment of the likely costs of tariffs and damage to the City to the UK taxpayer. I would leave this figure on the table for the EU to take up when an acceptable FTA is agreed, but I would be clear that we will deduct the costs we incur in preparation for a no deal Brexit if they make us wait.

How do I get to this figure? Assuming WTO tariffs became payable on imports from the EU, and assuming that the EU applied the external tariff to our exports to the EU, a rough and ready calculation suggests that the frictional costs would be about £18.5 billion a year. We could make changes to our import tariff regime to reduce this by roughly £2.8 billion a year, by suspending or eliminating import tariffs on many categories of products. I will address this proposal in my upcoming article on a suggested tariff regime for the UK in future.

Let’s assume that our importers and exporters suffer an increase in costs of half of the remaining frictional costs of circa £15.7 billion per annum (which is pessimistic given the direction of flows, but let’s be prudent). That will, all things being equal, reduce corporate profits by around £8 billion, reducing income for the Treasury by 19 per cent (the corporate tax rate) of this figure: i.e. £1.5 billion a year.

However, offsetting this, the UK would experience a net increase in tariff income (after applying the proposed tariff regime to non-EU imports as well) of about £7.1 billion a year. So the introduction of even limited tariffs between the UK and the EU would increase government income.

Assuming that corporations seek to restore their profitability by reducing costs and increasing productivity, they will lay off workers. Assuming they lay off workers to save £6.5 billion per annum, the Government would lose taxes worth about 30 per cent of this amount in lost income taxes, or about £2 billion. Layoffs would in theory add up to 230,000 people to unemployment rolls. In a worst case scenario, assuming the benefit cap of circa £400 per week per couple, this would lead to extra costs for the government of £2.4 billion a year.

Those employees laid off would also suffer a drop in their income of about £4 billion a year, which would reduce VAT receipts by about £0.75 billion a year. Clearly, there would be second-order effects, but these become increasingly difficult to calculate and there are likely to be as many positive as negative second order effects, so I would stop the calculations here. (UPDATE: I got a bit of stick for this. I am unable to satisfy myself that it is worth delving further into second order effects to come up with a larger number when this is taxpayers’ money being spent.)

However, as noted above, we are where we are, and I do not think it is worth walking away from a deal, if it is a good deal, for the sake of £8 billion (the difference between my calculation of the value of a deal and the price the government has agreed to pay).)

Where would this leave us, then?

The Government receives a net increase in tariff income of £7.1 billion, loses £2 billion of income taxes, spends £2.4 billion on benefits and loses £0.75 billion in VAT. It is £2 billion per annum better off.

Then let’s give some credence to those who believe that our financial services industry will take a hit. Oliver Wyman estimated this at between £0.5 billion and £10 billion in lost taxes. Taking the mid-point of what is a very pessimistic assessment, there’s around £5 billion per annum of lost taxes.

So my feeling is that the UK exchequer will, all-in, be around £3 billion a year worse off after a hard Brexit as compared to having a free trade agreement (which, vitally, would also have to cover financial services). Obviously, that would be more than compensated by the saving on contributions to the EU, but those will stop whether or not there is an FTA, so that can be ignored in this analysis.

So if the UK going to lose £3 billion in tax revenues per annum, what should we be prepared to pay to get a free trade deal to avoid this? The range is quite wide. On the one hand, if we take the cost of borrowing over 30 years for the UK exchequer, it is currently a little less than two per cent. Using this as a basis, these £3 billion a year would allow £67 billion to be borrowed and repaid over 30 years, so, in theory, we could pay that to the EU and be neutral.

But that would be to assume that the UK economy would not regain those lost tax revenues for 30 years. In reality, the UK economy will respond. My working hypothesis would be that, after ten years at the very latest, the UK economy would have adapted. So I would assume that the impact reduces to zero in year eleven, and therefore would take the annual “cost” of £3 billion and multiply it by five, to come to a figure of roughly £15 billion. A little less than we have already indicated that we would be prepared to pay for the transition period…

That is what I would consider an FTA with the EU to be “worth”. If it came to paying more than that, I would choose to walk away, and use the money saved to borrow for investment in infrastructure and housing, which would boost the UK economy and more than offset the friction of tariffs and the impact on the City.

You, and the Government, may disagree. Perhaps you feel we should pay more, perhaps less. The important thing is not the number: it is the logic. The important thing is to come at it from a cold analysis of our interests, and not simply by responding to the media hysteria by meeting the EU half way between their outrageous demands and our starting-point. And one other thing comes clearly out of this analysis: the only FTA worth having is one that covers financial services and keeps completely free access for and to the City.

I would leave that offer of two more years of contributions on the table for the EU to consider (UPDATE: £25 billion, structured as a loan, with repayment to be waived only if there is a signed deal) and then turn our focus to the contingency planning.

The first issue is our future tariff regime, and that will be the subject of my next article.

31 comments for: James Arnell: No Deal 1) The money

Leave a Reply

You must be logged in to post a comment.