What have you got?

It is a well-known physical property that when heat is added to a substance the molecules vibrate faster and usually maintain a greater average separation. Ultimately the object expands in size and takes up more space. If we take away the heat source, the molecules move more slowly and if we were to freeze an object containing water, it would actually contract.

The Brexit debate feels a bit like that. The two years following the referendum have generated more heat than light and the whole issue has expanded to take up an increasing amount of media space. Politicians such as Jacob Rees-Mogg and Boris Johnson fan the flames by making outrageous claims as to how to achieve Brexit and what the benefits will be, generating a counter response which fills up a lot of column inches. If, however, we were to dial down the rhetoric a little and think about what the end game might be, we might be better served in terms of working out how to proceed. 

Basic premise: Neither side wants no deal 

We should start from the premise that neither the UK nor EU want a hard Brexit next March. It may not seem that way when we are assailed with stories telling us that the government recommends stockpiling essentials in the event that cross-border trade is about to come to a halt. It certainly does not seem that way when self-serving British politicians fly in the face of all the evidence to argue that “the UK has agreed to hand over £40 billion of taxpayers’ money for two thirds of diddly squat … In adopting the Chequers proposals, we have gone into battle with the white flag fluttering over our leading tank.” Boris Johnson may know how to pen a decent newspaper column but as a frontline politician with a track record of deliverance he has been found wanting and he is as guilty as anyone of pouring fuel on the raging Brexit fire.

What the Brexiteers fail to understand is that the EU has little choice but to act in the way it does. It has consistently been made clear to the British government that access to the single market is based on the four freedoms of goods, services, labour and capital. The EU cannot therefore allow the UK to pick and choose. And whilst both sides agree on the need to maintain an open Irish border, the British proposals to realise this outcome are either unnecessarily complex or unworkable. But with just over six months until the UK leaves the EU, we need to see more flexibility – ideally from both sides – in order to generate the breathing space which can keep negotiations alive.

The UK government’s Chequers Plan clearly does not satisfy anyone domestically, nor in its current form is it acceptable to the EU. But it is the only idea on the table at the moment so it is the point from which we have to start. There have been some reports suggesting that Michel Barnier believes the plan to be ”dead” whilst others indicate that he sees some possibilities. One of the biggest sticking points is that the UK is not prepared to accept free movement of labour. But it may be possible to form a basis in law for a compromise which satisfies both sides. 

A fix for the freedom of movement problem 

As it currently stands the law grants residency rights to EU citizens irrespective of whether they work. For periods of less than three months the only requirement is that they possess a valid identity document or passport (although they may be required to register with the authorities – a requirement never imposed in the UK). For longer stays EU citizens and their family members “must have sufficient resources and sickness insurance to ensure that they do not become a burden on the social services of the host Member State during their stay.” But what if we were to impose quasi-freedom of movement in which the only restriction is that EU citizens require an employment offer before taking up residency?

Admittedly, it is not free movement as envisaged by the Lisbon Treaty but it is a good compromise. Moreover, articles 48 and 49 of the Treaty of Rome make it clear that cross-border flows of people were originally supposed to be conditional on an offer of employment. To enhance the fiction of “taking back control” the government can give the illusion that EU citizens be required to register – as is the case in Germany – via an application for a National Insurance number. In that sense, EU citizens working in the UK experience no obvious changes in their circumstances but the government sells a message that it has stiffened up border controls. Granted, it is far from ideal but it is a far better option than simply throwing up the drawbridge and would at least show that the British are trying to find a solution. 

The government has already proposed a solution for the Irish border 

With regard to Ireland, the UK government has already proposed a solution: The backstop plan outlined in June calls for a "temporary customs arrangement" which keeps the UK in a customs union with the EU for a limited period after the end of the proposed Brexit transition period in December 2020. At the same time, the government proposes that the UK be able to sign and ratify trade agreements with the rest of the world during the temporary arrangement. There are a couple of problems with this: (i) The EU has not (yet) agreed to it and (ii) Brexiteers do not like the idea because they are sold on the idea of leaving the customs union (Theresa May has tried to pacify them by suggesting that such a solution would only need to remain in place until end-2021).

But imagine that the EU does agree. The UK will find it extremely difficult to ratify any meaningful trade deals by end-2021 and thus continues to extend its membership of this arrangement. The longer the UK remains in the customs union, the less likely it is to want to drop out, resulting in a BINO solution (Brexit in name only) which is probably the least damaging economic option. 

They may be bad ideas but show us something better 

There are all sorts of reasons why these are thoroughly bad ideas. Like the Chequers Plan, they will satisfy neither leavers nor remainers. But they represent an attempt to reconcile the demands of the EU with the apparent need to respect the referendum result. And yes, they are politically devious solutions but Brexit is nothing other than a political issue and it is going to require some chicanery to extract the UK from the mess it has created for itself. But if Johnson or any other of the Brexit zealots has a better plan, we are all ears, because all we have heard so far is what is wrong with the current set of options. C’mon, show us what you’ve got!

End of the Brexit holiday

It has been another funny old week in Brexit Britain as parliament reconvened after the summer. We were treated this week to the views of former BoE Governor Mervyn King who criticised the government’s “incompetent” preparations for Brexit. In an interview to be broadcast next week, he argued that that the government had weakened its negotiating position by “a whole lack of preparation” for a no-deal Brexit and said it “beggared belief” that the world’s sixth-biggest economy should be talking of stockpiling food and medicines.

It is hard to argue with that view. Yet at the end of 2016 King suggested that whilst leaving the EU would not be “a bed of roses – no one should pretend that – but equally it is not the end of the world and there are some real opportunities that arise from the fact of Brexit we might take … There are many opportunities and I think we should look at it in a much more self-confident way than either side is approaching it at present. Being out of what is a pretty unsuccessful European Union – particularly in the economic sense – gives us opportunities as well as obviously great political difficulties.” Maybe King retains his belief that leaving the EU is a good idea and his differences with the government are more about tactics than strategy, but he is the latest in a long line of Brexit supporters whose expectations are not being met.

But I have always struggled to see what the economic opportunities are. In an environment where trade flows are negatively related to distance – as is the case in standard trade gravity models – the UK will require a more-than-proportional increase in non-EU trade to make up for any losses with EU countries in the event of leaving the single market, as King has advocated. It is not as if King has a great track record over the years of being on the right side of the economic argument. In 1981 he was one of the signatories to a letter to The Times arguing that “present politics will deepen the depression” – just before the economy started to recover. More damningly, he was Governor of the BoE when the UK suffered its first bank run since 1866 having failed to deal with the circumstances that led to the failure of Northern Rock and was slow to appreciate its significance. So forgive me for not being a knocked out fan of Mervyn King’s forecasts.

But there is no denying that he is right about the sheer incompetence of the government’s planning so far. Yesterday we were treated to the Treasury’s secret no-deal Brexit contingency plans unwittingly being made public after a photographer snapped an official holding a letter detailing an outline of Project Yellowhammer. The briefing documents state: “The Civil Contingencies Secretariat held a two-day workshop last week to review departments’ plans, assumptions, interdependencies and next steps.” The paper reveals it is an aim of the Treasury to build a “communications architecture” that can “help maintain confidence in the event of contingency plans being triggered.” It added this is “particularly important for financial services” and seems to include a reference to “aviation and rail access to the EU.” Whilst the government is quite right to be considering the possibility of no-deal before March, this all seems a little alarmist.

Indeed, the more we think about it, the less likely is a no-deal. It is not in the EU’s interests to allow the Brexit process to collapse, particularly if Michel Barnier has ambitions to be European Commission president, as has been speculated in the press. Moreover, as recent IMF research has indicated their calculations show “EU output losses of 0.2 to 0.5 percent in the “FTA” and “hard Brexit” scenario, respectively” (see chart). Perhaps this explains why Barnier’s opposition to elements of the Chequers Plan has reportedly softened in recent days, and why Germany is rumoured to be asking for less detail from the UK at this stage, in order to get beyond the March deadline and set up a transition period during which the hard negotiations will take place.

But the UK government has even more to fear. Whether or not people are changing their views on Brexit, the electorate appears to be showing rising distrust regarding the government’s negotiating approach. Boris Johnson’s newspaper article earlier this week suggesting that “The scandal of Brexit is not that we’ve failed but that we have not tried” was met with widespread derision (if only he had had a position of influence in government for the last two years!).  The British government cannot be seen to be delivering a no-deal Brexit for it would damage its credibility beyond repair. So despite all the horse trading which is likely over the next few months, and the associated adverse headlines, it is likely that the EU will bend a little in order to make way for the UK to bend a lot. And in my next post, I will look at ways in which this could be done.  

Sir James Mirrlees and optimal tax systems

To paraphrase the nineteenth century British Prime Minister Lord Palmerston, only two people have ever understood the tax system: One went mad and the other died. Indeed, one of the few people to have properly understood the tax system was the Nobel Prize winning economist Sir James Mirrlees, who died earlier this week. Mirrlees was best known in academic circles for his work on decision making under uncertainty for which he won the Nobel Prize in 1996, and his most insightful work was his 1971 paper on optimal tax systems in which he showed how and why there was a trade-off between equity and efficiency.

The paper is mathematically dense but it had a huge impact on information economics by introducing models with asymmetric information into contract theory. Until the late-1990s the results of these models were not closely connected to empirical tax studies and had little impact on tax policy recommendations. But a number of authors, including Peter Diamond and Thomas Piketty have since connected Mirrlees’ model to practical tax policy.

He was thus the obvious choice to head up a review of the UK tax system commissioned by the Institute for Fiscal Studies almost a decade ago. It was a follow-up to the Meade Committee report of 1978 which was concerned with the question of how the tax system impacted on the wider economy by distorting incentives. Thirty years later, the IFS noted that the tax system had evolved in a piecemeal fashion “rather than by strategic design” and that it had not adapted to changes in the general economic environment in which it applied. Moreover, as the IFS pointed out, “tax design has not benefited as much as it could from advances in theoretical and empirical understanding of the way features of the system influence people’s behaviour.”

Mirrlees and his colleagues took an in-depth look at the state of the UK tax system “to identify reforms that would make the tax system more efficient, while raising roughly the same amount of revenue as the current system and while redistributing resources to those with high needs or low incomes to roughly the same degree.” They noted that the UK system is “unnecessarily complex and distorting” with tax policy “driven more by short-term expedience than by any long-term strategy” in which policymakers did not seem to grasp the extent to which individual agents change their behaviour in response to changes in tax incentives. This was a damning indictment and it is still true today, with a myriad of small changes having come into effect since the report was published which impact on the way people and companies behave.

The report noted in particular that income inequality had widened, particularly during the 1980s, but that merely soaking the rich was not necessarily the way to go. In any case, corporate and capital gains taxes are at least as important as income taxes in terms of their wider impact, and certainly the combination of all three is likely to be more critical than looking at one in isolation. In this sense the Mirrlees Review took a far more wide ranging view of tax issues. Indeed, a key recommendation was that the complex benefits system should be harmonised with income taxation, in order to increase work incentives for the lower paid (something which the government has tried – and failed – to achieve with the Universal Credit System).

The report also noted that the corporate tax system favours debt finance over equity finance which in turn has increased the reliance on debt, and recommended an allowance for corporate equity (ACE) be introduced into the corporate tax system. Taxation of savings is another aspect requiring radical reform. Savings in the UK are subject to double taxation, with income tax levied on the original income from which the saving is generated and again on interest income derived as a result. With the government having for many years exhorted individuals to save more, this is an obvious anomaly. The Mirrlees Review thus recommended that standard bank and building society accounts should be entirely free of tax. Neither of these recommendations has been implemented (though the interest on bank accounts these days is so low that tax is negligible).

I was heartened by the Mirrlees Review when I first looked at it almost a decade ago because it was an accessible review of the state of the tax system, which looked at how the various parts fitted together without delving into the politics of taxation. It is a shame, therefore, that many of its recommendations have not been implemented. Perhaps it was the right report at the wrong time, with governments then too preoccupied with the day-to-day task of reducing deficits to pay much attention to reforming the tax system itself. Perhaps the passing of Sir James Mirrlees offers us another opportunity to revisit what I believe to be an outstanding piece of work, and to think again about some of its conclusions.

Would I lie to you? Part 2

For all the trials and tribulations which the British media have over the years elevated to the status of great political dramas, none has had the resonance of Brexit – an episode in which the political establishment appears to have lost its collective reason. In many ways, it is reminiscent of the McCarthy era in the US 70 years ago when a political ideologue used the legal process to conduct a witch hunt against those who did not share his extreme distaste for communism. As in the McCarthy era, a small coterie of politicians has hijacked the British parliamentary process and appears intent on delivering their version of an ideologically pure Brexit whatever the cost to the British economy.

Wikipedia defines McCarthyism in a wider sense as “the practice of making accusations of subversion or treason without proper regard for evidence.” Elements of that definition certainly apply to Brexit: Indeed, some of the more rabid commentators even accused those seeking to minimise the impact of a hard Brexit as treasonous – notably this Daily Mail article, lest we forget. Those advocating Brexit not only pay no regard to the evidence – they make up their own. It was bad enough to lie during the referendum campaign but now that we are seven months away from the UK’s EU departure, they are still at it!

Earlier this month, former cabinet minister Peter Lilley argued that the UK had nothing to fear from a no-deal Brexit because “WTO terms are designed to provide a ‘safety net’ ensuring all members can trade without discrimination.” Lilley claims to know what he is talking about because “as Trade and Industry Secretary, I spent 10 days incarcerated in the Heysel Stadium negotiating the Uruguay Round which set up the WTO.” That’s a bit like saying if you incarcerate someone in Ornenburg’s Black Dolphin Prison for 10 days, they will emerge with an intimate knowledge of Russia.

In fact, the WTO fallback option is not much of an option at all. Brexiteers seem to believe it confers some special status which will allow trade to continue much as it does today. But if it is such a great deal, why do countries seek free trade agreements which confer considerably greater benefits? As Alan Winters pointed out in a blog post, “since the WTO came into being, 243 new Free Trade Agreements have come into operation … None of this suggests that 'WTO terms' are viewed generally as a satisfactory option.” Even the head of the WTO has suggested it is “unlikely” the government will have agreed tariffs and quotas with all other member countries by next March.

And most Brexit supporters clearly do not understand the most favoured nation clause. This merely defines the lowest possible set of barriers that a country will be prepared to offer all other WTO members. It does not mean that the EU will offer the UK any concessions that it is not prepared to offer the likes of Russia, China or the US. In fact, Lilley’s article is full of economic nonsense, as Winters points out. Amongst the highlights was the claim that “we will be free to join the Trans-Pacific Partnership.” Wonderful: Except the TPP does not even exist as it was nixed by Donald Trump soon after he came to office. Moreover, “without a trade deal, Parliament will reject any Withdrawal Agreement offering the EU £40bn … That leaves Britain £40bn better off, and ends our annual £10bn net contribution immediately[1] – boosting our GDP, balance of payments and public finances.” It is hard to know whether this is a deliberate parody or just plain stupidity. My own calculations suggest a no-deal Brexit imposes costs which are roughly three times the monetary savings – a view which is broadly in line with the literature estimates.

Then of course, there is Brexiteer-in-chief, Jacob Rees-Mogg who suggests that the UK could maintain an open Irish border but still impose checks “as we had during the Troubles” – a suggestion that is as laughable as it is offensive. In a functioning democracy, the near half of the electorate which voted against Brexit could expect some parliamentary representation. But the opposition Labour Party has refused to oppose the Conservatives which have taken back control of Brexit policy despite being a minority government. Labour leader Jeremy Corbyn is widely seen as a Brexit supporter and in a TV interview last week he refused six times to answer the question whether he believes the UK would be better off outside the EU.

To compound the sense of the absurd the government last week issued a series of reports on how various sectors should prepare in the event of a no-deal Brexit. Although DExEU claims that leaving without a deal “remains unlikely given the mutual interests of the UK and the EU,” the fact that it has seen fit to issue such a series of papers suggests it is taking the prospect seriously in the wake of EU pushback against the Chequers plan. There is no reassuring news in the policy papers which effectively highlight all the things that the experts said would happen in the event of no deal (more red tape, higher compliance costs and a need to stockpile in key areas such as medicines). Whatever happened to “they need us more than we need them”?

In short, Brexit is a looming disaster of the government’s own making compounded by the failure of the opposition to set out a credible alternative. It is hard to shake off the suspicion that it represents a coup by right-wing Conservatives desperate to grasp this one chance offered by a non-binding referendum. But heed the lessons of history: Like Brexit, public support for McCarthyism only ever peaked at around 50% in January 1954. Within six months public support had dwindled to only 34%. Joe McCarthy himself was censured by the Senate at the end of 1954 and he was dead within three years.

As William Bennett, noted in his 2007 book America: The Last Best Hope, “The cause of anti-communism, which united millions of Americans and which gained the support of Democrats, Republicans and independents, was undermined by Sen. Joe McCarthy ... his approach to this real problem was to cause untold grief to the country he claimed to love ... Worst of all, McCarthy besmirched the honorable cause of anti-communism. He discredited legitimate efforts to counter Soviet subversion of American institutions.”

A similar epitaph may yet be written for Brexit: genuine concerns about the EU undermined by the efforts of Brexit supporters. But a no-deal Brexit is like McCarthy unleashing the nukes to solve the Soviet problem. And even he was not that stupid.

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[1] Didn’t the leavers claim the cost savings would amount to £350 million per week, or £18bn per year? Saving £10bn per year amounts only to £192 million per week.