The Economic Impact of Brexit - A No-Win Situation?

Updated January 2020

With Great Britain now flying solo, a paper by Swati Dhingra, Gianmarco Ottaviano, Thomas Sampson and John Van Reenen at the Centre for Economic Performance at the London School of Economics and Political Science is particularly pertinent.  This paper examines the economic consequences of the United Kingdom's exit from the European Union on both the U.K. and the European Union as a whole.  With the European Union being the U.K.'s largest trading partner, Brexit will obviously have a significant impact on both economies since tariff and non-tariff barriers to trade would change.

For the purposes of this study, the authors looked at two scenarios:

1.) an optimistic scenario where the U.K. has a relationship with the EU similar to that of Norway which has full access to the EU single market as a member of the European Economic Area (EEA).  In this case, there would be no tariffs on trade between the U.K. and the EU, however, there would be some non-tariff barriers that do not apply to EU members.

2.) a pessimistic scenario where there are larger increases in trade costs because, in this scenario, the U.K. is not successful at negotiating a new trade agreement with the EU.  This means that trade between the U.K. and the EU is government by World Trade Organization rules, implying larger increases in trade costs than the optimistic scenario.

Let's look at the optimistic case first.  In the optimistic scenario, the authors assumed that in the ten years following Brexit, intra-EU trade costs fall 20 percent faster than in the rest of the world with non-tariff barriers within the EU falling by 5.7 percent over the decade.  They also assume that the U.K.'s contribution to the EU budget would not drop to zero, rather, it would drop by 17 percent or 0.09 percent of national income; in the case of Norway, on a per capita basis, Norway's financial contribution to the EU is 83 percent of the U.K.'s payment.

Here are the results of the effects of Brexit on U.K. living standards for the optimistic case:

Trade effects: -1.37 percent

Fiscal benefit: + 0.09 percent

Total change in income per capita: -1.28 percent or -£850

In the pessimistic scenario, the authors assumed that in the ten years following Brexit, intra-EU trade costs fall 40 percent faster than the rest of the world with non-tariff barriers within the EU falling by 12.8 percent over the decade.  They also assume that, since the United Kingdom is outside the EEA, the U.K. would save more on its current contribution to the EU.  The savings would rise to 0.53 percent which includes only the public finance components and excludes the transfers that the EU makes directly to universities, firms and other non-government bodies.  Assuming that the U.K. government does not cut this funding, the net savings would be 0.31 percent.

Here are the effects of Brexit on U.K. living standards for the pessimistic case:

Trade effects: -2.92 percent

Fiscal benefit: +0.31 percent

Total change in income per capita: -2.61 percent or -£1700

Please note that in both of these scenarios, the authors have used a static trade model that does not account for the dynamic impacts of trade on productivity.  For example, trade can have positive economic effects since it increases competition and promotes economic efficiencies.  Recent research shows that these dynamic impacts on trade may be two or three times larger that the static effects.  Using an estimate that a 1 percent decline in trade reduces income per capita by between 0.5 percent and 0.75 percent, Brexit would reduce U.K. per capita income by between 6.3 percent and 9.5 percent or between £4200 and £6400 per household per year.  This shows that the dynamic impacts of trade could significantly worsen the situation for U.K. households when Brexit takes place.

Now, let's look at the effects of Brexit on other nations.  Obviously, the nations with the greatest trade with the United Kingdom will see the greatest effects.  According to the authors' calculations, all EU member nations are worse off with Ireland suffering the largest proportional losses from Brexit followed by the Netherlands and Belgium.  Countries outside of the EU will experience economic gains as trade is diverted toward them and away from the EU; these include Russia, Taiwan and Turkey.

Here is a graphic showing the effect of Brexit on GDP by nation:

In total, the EU loses between 0.12 percent and 0.29 percent of its GDP whereas the nations outside the EU gain between 0.01 percent and 0.02 percent of GDP.  When looking at actual losses, the United Kingdom will see its economy shrink by between £26 billion and £55 billion and the rest of the EU will collectively see the economy shrink by between £12 billion and £28 billion or about half of the negative economic impact experienced by the United Kingdom.

Obviously, Brexit is going to have a significant impact on the European community as a whole.  The authors note that, when all is said and done, the economic consequences of leaving the EU will depend on the political policies that the United Kingdom adopts after Brexit takes place.

Brexit - Does Anyone Win?

Updated March 2017

As the United Kingdom's potential exit from the European Union looms closer and closer, a thorough analysis by Holger Breinlich, Swati Dhingra, Thomas Sampson and John Van Reenen at the Centre for Economic Performance (CEP) at the London School of Economics looks at what various changes in income various income groups in the United Kingdom will experience if the UK decides to cast its membership in the European Union aside.

Let's start with a bit of background.  An analysis by the OECD shows that, if the United Kingdom chooses to leave the EU, its economy will see its real GDP change as shown on this graphic:

Obviously, this lower level of economic growth is going to have an impact on British citizens, some more than others, an issue that the analysis by the CEP addresses.

The United Kingdom's exit from the EU could certainly lead to lower trade levels.  The authors of the CEP study looked at 31 industries and tracked how changes in trade will impact prices across each of these industrial sectors.  They consider two scenarios:

1.) An optimistic scenario where the UK remains a member of the European Economic Area (EEA), similar to the relationship that Norway has with Europe.

2.) A pessimistic scenario where the UK remains a member of the World Trade Organization.

Currently, it appears that the EEA scenario is less likely meaning that the pessimistic outcome is more realistic.

Trade costs will likely increase after Brexit for three reasons:

1.) higher tariff barriers between the EU and the United Kingdom.

2.) higher non-tariff barriers to trade resulting from border controls etcetera.

3.) the UK will be unable to participate in future steps that the EU takes toward reduction of non-tariff barriers.

One example of how Brexit will impact consumers is the imposition of higher tariffs on transportation equipment; consumers will experience an increase in the price of imported cars as well as an increase in the tariffs on the steel that is used to manufacture vehicles domestically.

Here is a figure that shows the predicted price changes for 13 groups of commonly consumed household goods and services for both the optimistic and pessimistic scenarios:

Prices would rise the most for transportation (either 4.0 (optimistic scenario) or 7.7 percent (pessimistic scenario)), alcoholic drinks and tobacco (either 3.9 and 7.2 percent), food and non-alcoholic drinks (either 3.1 or 5.3 percent) and clothing and footwear (either 2.1 or 3.9 percent).  Service sectors like restaurants would see smaller increases since they generally consume local products.

Here is a more detailed listing of price changes under both scenarios:

The authors then examined the 10 income groups (deciles) ranging from the poorest 10 percent to the richest 10 percent and then looked at how each group spends their money, in other words, their spending share.  The poorest 10 percent spend 16 percent of their household income on food and non-alcoholic drinks compared to only 8 percent for the richest 10 percent.  The poorest 10 percent spend 7 percent of their household income on transportation (including purchasing vehicles, rail and air travel) whereas the richest 10 percent spend 16 percent of their income on transportation.  Here is a graphic showing the spending share for each of the 13 groups by income decile:

In the optimistic scenario, an average UK household sees real income fall by 1.8 percent which rises to 4 percent in the pessimistic scenario.  Households in the middle income group are hit the highest with income drops of up to 4.2 percent. as shown on this graphic which shows real income loss by household income decile:

The actual "real world" scenario is far worse over the long-term.  When the authors included the effects of changes in trade on productivity and the impact of changes in foreign direct investment in the UK economy (the dynamic scenario), the magnitude of the losses on household income more than triples as shown here:

Under the dynamic scenario, long-term average household real income drops between 6.1 and 13.5 percent annually.  The poorest 10 percent who have an average gross income of £10,019 will see their incomes drop by £1,248 or 12.5 percent and the wealthiest 10 percent who have an average gross income of £110,228 will see their incomes drop by £14,744.  The average household gross income of £41,238 will drop by £5,573 or 13.5 percent.

While some pro-Brexit economists suggest that the economic cost of Brexit will be borne by the wealthy and that lower income households will benefit because the demand for their services will increase, pushing up wages, this analysis suggests that the pain of Brexit would be borne by all income levels and that the middle income British would suffer slightly more than their poorer and wealthier counterparts.  As well, the CEP analysis completely refutes the suggestion that a post-Brexit UK will see household incomes, particularly those at the lower income levels, rise because of reduced immigration from EU nations which is currently blamed for keeping wages lower for low income households.  Additionally, this analysis shows that the cost of lower trade and foreign investment in the UK will not be offset by a reduction in the financial transfers that the UK makes to the EU as part of its commitment to the union of nations and that all British citizens will suffer financially if Brexit really does take place.