Brexit … where are we now?

"Brexit means Brexit"

Even to the simplest mind Brexit should mean that Britain is exiting from the EU, however, as the dust around the referendum begins to settle, we are no closer to a clear view of what it actually means. What does the other side of the EU look like?

Let us look at this as though it means what we think. We will no longer be part of the EU, certainly without any say over their regulations. This does not mean we wont be able to trade with the EU, it simply means that such trading relationship will be subject to their regulations as they change from time to time. Just as our government has an obligation to look after our interests so does the EU have an obligation to look after the interests of the citizens of the EU.

In any negotiation on the trading relationship we must therefore accept that it will not only be about our rights and interests, but theirs as well. So, let us not be taken in by the Boris argument that we will get a better deal having voted to leave.That the EU needs the UK more than the UK needs the EU is a figment of imagination. When we now hear him say that passporting rights for the City of London are essential we must start wondering whether granting those rights will be in the interests of the EU citizens.

The net inflow into the UK from the EU in respect of insurance and Financial services amounts to some £20 billion or approximately 30% of our foreign income from financial services. It is inevitable that the EU will want to get it's share of the tax income generated by that trading, after all, it will be loosing the UK contribution to it's budget. Countries within the EU will therefore be fighting to increase their own tax take, as compensation for the higher contributions they will be making.

While it is feasible that relatively low import duties could be agreed within a WTO trading agreement, totally free trade is unlikely as the UK will be negotiating trade deals all around the world. As David Davies said, before he was swatted down by Theresa, he cannot see us remaining a member of the "Customs Union" and thereby part of the single market. This is possibly the first honest view of what Brexit means. Being a member of the customs union implies that we will not allow ourselves to be a backdoor into the single market and thereby creating quite a lot of difficulties in negotiating trade deals with other nations.    

Nigel Farage's argument that, as they export more to us than we to them, they will be obliged to give us virtually free access, is also naive as it fails to look at things in the round. As he says this would benefit the Exchequer as our tax take from trade tariffs would be greater than theirs, but fails to see that, it impacts directly on our people who will be paying more for their goods and therefore have lower disposable incomes. In considering import tariffs we also need to be aware that because of the relatively stronger fiscal position of the EU countries they will be in a better position to provide their companies with investment incentives that go a long way toward ameliorating the impact of duties on their exports to the UK.

Red Lines

Let us look at what appear to be the red lines for both sides. From the EU side no full access to the single market without accepting the freedom of movement of labour. From our side we cannot accept freedom of movement of labour as this looses our control over our borders.

While this impasse might seem absolute, we do know that there is some sympathy from the EU nations for limiting migration that simply takes advantage of benefits. Regardless of this we should see that to have control over migration we need a system that implies the need for visas to enter the UK … be these work permits or whatever. In all such systems it is a two way story and our limiting of the right to enter the UK will have a corresponding limitation of our right to enter Europe. Once again we enter an era of visas or entry permits of some sort, even if made fairly simple it would introduce a formality that would be necessary.

Understanding the freedom of movement requires us to understand a market, within a market in any country there are inherently markets for labour, capital, goods and services. The freedom of individuals to sell their labour whereever they please plays an important regulatory role, for if wages in one sector (or in the case of the EU, country) become too high there will be competition for those jobs, bringing the wages rates down, or vice versa. This helps both countries, as in the one supplying the migrants will eventually have rising wages, while in the other it acts as a brake on wage inflation. Even though the timescales involved are fairly long.

This primary reason naturally does not include migration for benefits, which does provide an area where we can find a fair amount of consensus in other countries from the EU. However, to several countries within the EU this right of citizens to seek work elsewhere within the EU is an important relief to their fiscus, as it relieves them from having to provide unemployment benefits. I suspect that the two year exemption from paying benefits, negotiated by Cameron, was more than generous. All that was missing from the Cameron negotiation was the right to expel someone who had not found work within whatever time limit.     

Financial Services "passporting" seems a prerequisite of our negotiating position. 

If we lost our passporting rights this would represent a loss of up to £20 billion for the British economy and probably a £6 billion or more loss to the Exchequer, (the costs of financial services are fundamentally labour costs in the high end wage spectrum where tax rates are high). On it's own this is nearly equal to our net contribution to the EU. 

To understand this fully we need to understand that it is generally not allowed for a company from outside a country to carry on trade inside the country, without being a registered business in the country concerned, as that simply results in extracting resources from the country. While we are part of the EU our contributions to the EU mean that we were not simply extracting from the EU.

Already we are seeing moves toward opening subsidiaries in EU countries by the Banking and Insurance sectors. This might protect the profits of those companies, however the tax collection on the income that is generated will take place in the EU and not the UK. As we have seen the EU is already taking a strong position against transfer pricing (The Apple penalty tax) which means these subsidiaries would need to be real with proper staffing and premises and not just a "journal entry" operation. Things like Head Office charges will come under increasing scrutiny as countries grapple to deal with the growth of Internet trading which respects no borders.


From the aforegoing it should be clear that negotiations are going to be particularly tough, and that we might well find "the boot is on the other foot"!

While Theresa may or may not trigger article 50, the longer the uncertainty exists the bigger the detrimental effect on the UK economy. Businesses cannot sensibly make investment decisions without certainty of the markets, and terms of trade with the markets, into which they will be selling. Without business investing in growth and development we can only have stagnation.

If we do succeed in getting "passporting rights" it is unlikely to come free, at the very least I would expect that the EU would demand a transaction tax which might make that trade untenable. We should keep in mind that we have been exempted from this tax up to now, however, looking into the future, this is likely to become the main form of taxation around the world, as it overcomes most methods of tax avoidance, and places the tax take firmly in the country where the transaction takes place.

If, as I expect, we end up with a trade deal that involves relatively low tariffs, then impact on trade in goods will almost be non existent apart from the exporting businesses being involved in much more red tape. Our Financial Services will be required to operate via subsidiaries which should not affect their profitability to any marked degree, it will however affect our National Statistics as only the dividends earned from those subsidiaries will form part of UK income. Our exchequer will also be detrimentally affected because the taxes on staff incomes and profits from the operations will be paid in the EU.    

From this scenario, I foresee, the main impact on the UK will be on exchange rates. While in the short term exchange rates are set by markets, in the long run they will reflect the realities of the economy.  In this post I set out the main drivers of the long run exchange rate. I postulate two potential equilibriums for Sterling an initial equilibrium in the range £1=$1.28/$1.25 and a more sustainable equilibrium of £1=$1.18. 








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