The legal and constitutional complexities involved in Britain’s convoluted negotiations with its European Union (EU) counterparties have made it easy to lose sight of the opportunity costs of any putative settlement. Governments have no resources of their own, only those that they can expropriate from their citizenries, implying that all the expenditures that appear on one side of the public balance sheet – including the monies handed over to the EU – need to be matched by tax receipts or borrowing on the other. This truism is sometimes called the government’s budget constraint.
This blog* considers the tax implications of the financial transfers that the UK seems prepared to hand over in order to achieve an ’orderly Brexit’. To be specific, the sums involved are compared with the tax ‘ready reckoners’ set out each year in Direct Effects of Illustrative Tax Changes published by Her Majesty’s Revenue and Customs (HMRC).
HMRC calculations make it possible to translate the sums being pledged to the EU on the expenditure side into the number of percentage points that have to be added to income tax or Value Added Tax on the revenue side of the public accounts, for example. The HMRC numbers represent ‘static’ first-round calculations, however, and do not allow for the consequences of changes in the rate of tax on wider economic behaviour. As a consequence, the second round and ultimate effects may end up very different from the initial static effects estimated by HMRC.
In order to capture some of these longer-run ‘dynamic’ effects, a number of simulations have been run on the Beacon Economic Forecasting (BEF) macroeconomic model. The basic simplifying assumption employed is that Britain crashes out of the EU at the end of March 2019 and then refuses to hand over any more money. Instead, the money that has been saved is assumed to: 1) reduce public sector borrowing; alternatively 2) to cut the standard rate of income tax, or 3) to reduce VAT. There is no limit to how many such scenarios might be performed but these seem sufficient for this short note.
One conclusion is that there would be substantial macroeconomic benefits from using a large proportion of the £15.1bn VAT and Gross National Income (GNI) to be contributed by the UK to the EU in 2019-20 to fund tax cuts. The HMRC calculations suggest that cutting income tax by 1 percentage point would cost £4.85bn in 2019-20, for example, while a corresponding reduction in VAT would cost £6.2bn. In theory, such arithmetic suggests that an ultra-hard Brexit might allow 3p to be taken off standard rate income tax or 2½% of VAT, other things being equal.
Such a development would not only have powerful demand effects in the short term, but also major, semi-permanent, supply side benefits in the long run. This does not mean that other losses resulting from Brexit, such as reduced export demand and the potential disruption to supply chains, might not outweigh the gains of a reduced tribute to the EU . However, it does suggest that a bold reforming government has options that should be explored and considered if it proves difficult to achieve a reasonable settlement.
*This blog anticipates a longer analysis, to which it is linked, by David B. Smith, to be published by Politeia.
1. There is a widespread view that these trade effects would be damaging. For a strongly argued contrarian view see Minford (2018).