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Where is Brexit in the budget numbers?

Newspaper article

Tomorrow the Chancellor will present the UK’s first Autumn Budget since 1996, giving the latest economic forecasts and setting out plans for tax and spend over the next few years. Brexit looms large over all political and economic debates at present, so where will Brexit show up in the Budget numbers, and what effect is Brexit likely to have on the public finances?

Broadly, there are three ways in which Brexit might affect the public finances.

  • Contributions to the EU budget

The UK currently makes gross contributions to the EU budget worth around £13 billion per year (£250 million per week), and a net contribution (i.e. after taking into account EU spending in the UK) of around £8 billion (£150 million per week). Note that both of these numbers are considerably lower than the supposed ‘Brexit dividend’ of £350 million per week (£18 billion per year), which is the UK’s gross contribution including its rebate, making it an uninformative number.

The Office for Budget Responsibility (OBR, the government’s independent and official forecaster) currently assumes that upon leaving the EU, any payments that would have been made to the EU will be recycled into other forms of spending. This is the OBR’s ‘fiscally neutral assumption’ made in the absence of clear government policy on the matter.

The government could in principle replace all EU funding in the UK and still have around £8 billion (the net contribution) that could either be spent elsewhere, used to finance tax cuts or used to reduce the deficit. While this is some way from £350 million per week, it is still a substantial sum. It is the equivalent of 6.5% of the NHS budget, or it could finance a cut in the basic rate of income tax of almost 2 percentage points. However, this is before we account for the economic impacts of Brexit.

  • The ‘Divorce bill’

It has been suggested that the UK will pay a ‘divorce bill’ – a one off payment, possibly in exchange for a trade deal – upon leaving the EU. This does not currently appear anywhere in the OBR numbers, as we do not know how large such a payment might be, or if the UK will make any such payment at all.

The numbers proposed for this are often large. However, a bill of, say, £40 billion can also be thought of as rolling up five years of our net contribution into a single lump-sum payment (without much impact on the nation’s long run fiscal health).

  • Impact on the economy

While the potential direct effects on the government’s finances already considered seem large, Brexit is far more than simply a change to the pattern of payments into the EU budget. It represents a fundamental shake-up of the UK’s relationship with our largest trade partner – a change which is highly unlikely to occur without some sort of economic impact.

If, as most economists expect, this means lower economic growth, this would quickly wipe out any financial gain from EU budget payments, and a ‘divorce bill’ could quickly pay for itself if, for example, the trade deal it helped deliver had even a modest positive effect on the size of the economy. Lower economic growth means less growth in wages, consumer spending and profits, leading to tax receipts being lower than they would otherwise have been.

In the Autumn Statement after the referendum, the OBR directly attributed a portion of its worsening economic forecast to Brexit. While growth since this forecast was made has been slightly stronger than expected, if anything the medium-term outlook is now gloomier than in November 2016, so this assessment of the effects of Brexit is consistent with the latest forecasts.

The OBR ascribed to Brexit: a downgrade to forecast investment growth and therefore future productivity growth; lower future net immigration than would otherwise have been the case; and greater inflation as a result of the depreciation of sterling that occurred after the referendum. This initial assessment implied that the economic effects of Brexit weakened the public finance by £15 billion per year by the early 2020s, more than outweighing the UK’s £8 billion net contribution.

Of course, there is a large amount of uncertainty over the precise effect of Brexit on the economy. However, the OBR forecast is predicated on a relatively smooth transition – in a ‘no deal’ scenario, in which the UK reverted to World Trade Organisation (WTO) rules, the economic dislocation could be much larger.

The OBR forecast is also mostly concerned with the relatively short-term effects of the Brexit vote on the economy. The OBR numbers do not include long term effects, but it is the long-term effects of being an economy that trades less that could have the largest impacts of all on the economy.

Moreover, even given the size of the OBR’s assumed economic shock, the effect on the public finances is relatively modest. This is because it is forecast to be disproportionately driven by lower investment – a tax favoured activity (in the near term lower investment boosts corporation tax revenues) – rather than consumption. If this feeds into lower firm profits in future, then the long run increase in the deficit may be around £3.5 billion larger. In general, the economy would need to be just 0.8% smaller than it would otherwise have been for the annual £8 billion ‘dividend’ to be wiped out by weaker tax receipts.

Given the uncertainty surrounding all economic forecasts, we do not know precisely what effect Brexit will have on the government’s finances. The current official assessment is that Brexit weakens the public finances and this is what state of the art models typically suggest. But the magnitude is subject to a large amount of uncertainty. Importantly, however, the answer actually has relatively little to do with direct transfers between the EU and the UK, or even how large any ‘divorce bill’ settlement might be. Ignoring economic impacts means you miss the main story.

This blog was originally written for the UK in a Changing Europe initiative and is reproduced here with full permission. The views expressed in this analysis post are those of the authors.