ISSN 2042-2695
CEP Discussion Paper No 1478
April 2017
The Costs and Benefits of Leaving the EU: Trade Effects
Swati Dhingra, Hanwei Huang, Gianmarco Ottaviano,
João Paulo Pessoa, Thomas Sampson and
John Van Reenen
Abstract
This paper estimates the welfare effects of Brexit, focusing on trade and fiscal transfers. We use a
standard quantitative general equilibrium trade model with many countries and sectors and trade in
intermediates, as in Costinot and Rodríguez-Clare (2014). We simulate a range of counterfactuals
reflecting alternative options for EU-UK relations following Brexit. Welfare losses for the average
UK household are 1.3% if the UK remains in the EU's Single Market like Norway (a “soft Brexit”).
Losses rise to 2.7% if the UK trades with the EU under World Trade Organization rules (a “hard
Brexit”). A reduced form approach that captures the dynamic effects of Brexit on productivity more
than triples these losses and implies a decline in average income per capita of between 6.3% and
9.4%, partly via falls in foreign investment. These negative effects are widely shared across the entire
income distribution and are unlikely to be offset from new trade deals.
Keywords: Trade, Brexit, General equilibrium
JEL codes: F13, F15, F17
This paper was produced as part of the Centre’s Trade and Growth Programmes. The Centre for
Economic Performance is financed by the Economic and Social Research Council.
Acknowledgements
This is an updated version of Dhingra, Huang, Ottaviano, Pessoa, Sampson, and Van Reenen (2016).
We would like to thank the ESRC for _nancial support through the Centre for Economic Performance
and Kohei Takeda for excellent research assistance. We are also grateful to the editor, four
anonymous referees, Arnaud Costinot, Robert Feenstra, Michael Goldby, Ivan Werning and
participants in many seminars for helpful comments.
Swati Dhingra is a Senior Lecturer, Department of Economics, LSE and Research Economist
with the Trade Programme at CEP. Hanwei Huang is an Occasional Research Assistant at CEP.
Gianmarco Ottaviano is Professor of Economics at LSE, Honorary Professor of Economics at
the University of Bologna and Director of the Trade Programme, CEP. João Paulo Pessoa is an
Assistant Professor at Sao Paulo School of Economics – FGV, Brazil. Thomas Sampson is Assistant
Professor in the Department of Economics, LSE and a Research Associate, CEP. John Van Reenen is
a Professor with MIT Department of Economics and Applied Economics and a Research Associate
with CEP.
Published by
Centre for Economic Performance
London School of Economics and Political Science
Houghton Street
London WC2A 2AE
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or
transmitted in any form or by any means without the prior permission in writing of the publisher nor
be issued to the public or circulated in any form other than that in which it is published.
Requests for permission to reproduce any article or part of the Working Paper should be sent to the
editor at the above address.
S. Dhingra, H. Huang, G. Ottaviano, J. P. Pessoa, T. Sampson and J. Van Reenen, submitted 2017.
1 Introduction
On June 23
rd
2016 the United Kingdom (UK) voted to leave the Europe an Union (EU) , a club
it had been a member of since 1973. Prime Minister David Cameron resigned the next morning
and was replaced by Theresa May. The vote sent shock waves around the world. Sterling fell
immediately and by the end of the year its dollar value was around 17% lower than on the night
before the referendum. On March 29
th
2017 the UK formally notified the EU of its intention t o
withdraw from the un ion under Article 50 of the Lisbon Treaty, tr i gger i ng the start of a two year
window for the UK to n egot i at e the terms of its divorce with the EU.
The debate over the UK’s membership of the EU raised a number of political questions. Sup-
porters of Brexit argued that leaving would give the UK greater freedom to determine its own
policies to reflect the UK’ s national interests. Opponents of Br ex i t stressed the contribution the
EU has made to ensuring peace within Europe and argued that being part of the EU magnified the
UK’s influence on the world stage. These are important issu es, b ut they are not the subject of this
paper. Instead, we focus on understanding the economic costs and benefits of Brexit, in particular
those resulting from changes in trade.
To estimate these economic costs and benefits of Brexit, we take a medium to long-run per-
spective and abstract away from the effects of increased uncertainty and the transition to a new
equilibrium. Hence, we do not build a dynamic macro-econometric model that include s these ef-
fects,
1
but focus on quantifying the key channels through which the UK leaving the EU may affect
income and consumption ten years or more after Brexit is expected to occu r in 2019.
Since it is difficult to kn ow what the exact form of a post-Brexit deal between the UK and the
EU will be, we c ons id er several possible counterfactual scenarios. The two main ones we analyse
are an optimistic “soft Brexit” and a more pessimistic “hard Brexit”. A soft Brexit is where the
UK continues to be a member of the EU Single Market like other non-EU memb er s of the European
Economic Area (EEA), such as Norway. A hard Brexit is where the UK trades only under World
Trade Organization (WTO) rules like the United States ( US ) or Japan. A soft Brexit would lead
to smaller increases in trade barriers between the UK and the EU than a hard Brexit, but would
also require the UK to continue making fiscal contributions to the EU budget. In January 2017
Prime Minister Theresa May announced that the UK’s goal in its negotiations with the EU would
be to leave the Single Market while st i l l maintaining free trade with the EU to the greatest extent
1
For example,
Steinberg (2017) models the uncertainty costs of Brexit and finds they are small compared to the
long-run effects.
2
possible (May, 2017), thus making a hard Brexi t appear more likely than a soft Brexit. The key
political constraint preventing a soft Brexit is that Single Market membership requires allowing
free movement of people with the EU, which the UK government oppose s.
Our methodology is based on Costinot and Rodr´ıguez-Clare (2014). We set up a general equi-
librium trade model which covers 31 sec t ors and aggregates the world into 35 regions. We mod el
the effects of alternative post-Brexit scenarios by simulating changes in trade costs and calculating
how each scenario affects welfare as measured by real consumption per capita. Th e welfare loss
from Brexit is obtained by comparing welfare when the UK remains a member of the EU with
welfare following Brexit. We find that increases in bilateral tariffs and non-tariff barri er s (NTBs)
between th e UK and the EU and the exclusion of the UK from future EU integration le ads to a
fall in UK welfare even after accounting for the savings the UK makes from lower fiscal transfers
to the EU. The estimated welfare losses range from −1. 3% in the optimistic soft Brexit scenario to
−2.7% in the pessimistic hard Brexit sc en ar io. We carry out a l ar ge number of robustness checks
based on alternative assumptions regarding the post-Brexit EU-UK trade deal. In all cases Brexit
reduces the welfare of the average cit i z en .
The UK is not t h e only loser from Brexit. Within the EU, countries that trade intensively
with the UK are most affected. For example, in the pessimistic scenario Ireland’s welfare declin es
by 2.4%. Nevertheless, the costs to the UK are much larger than those for the rest of the EU,
implying the UK has the most to lose from Brexit. Countries outside the EU tend to experience
a very small welfare gain, mostly du e to a trade diversion effect. As a whole, however, the world
beyond Britain’s s hores is poorer after Brexit.
In our quantitative model, trade liberalisation tends to increase welfare because it allows coun-
tries to specialise in thei r areas of comparative advantage and reduces the costs of goods, services
and intermediate i n pu t s (
Eaton and Kortum, 2002). Our baseline calculations, however, leave out
many f act or s that could lead to further productivity and welfare losses following Brexit. For exam-
ple, reductions in the variety of goods and services (Krugman, 1980), weaker compe t it i on (Melitz,
2003), the erosion of vertical production chains (Melitz and Redding, 2014), falls in foreign direct
investment (FDI) (Wacziarg, 1998), s l ower technology diffusion (Sampson, 2016; Wacziarg, 1998),
less learning from exports (
Albornoz, Calvo Pardo, C orc os, and Ornelas, 2012; Egger, Larch, Staub,
and Winkelmann
, 2011) or lower Research and Development (Bloom, Draca, and Van Reenen, 2015;
Keller, 1999, 2002).
An al t er n ati ve way to evaluate the impact of Brexit and take into account some of these addi-
3
tional effects of trade integration (which we label “dynamic effects”) is to use the re su l t s of reduced
form empirical studies of the effects of EU membership on trade.
Baier, Bergstrand, Egger, and
McLaughlin
(2008) find that, after controlling for other determinants of bilater al trad e, EU mem-
bers trade substantially more with other EU countries than t he y do with members of the European
Free Trade Association (EFTA). Their estimates imply that, if the UK leaves the EU and joins
EFTA, its trade with countries in the EU would fall by about a quarter. Combining this with the
estimates from
Feyrer (2009) im pl i es t hat leaving the EU (and joining EFTA) would reduce UK
income per capita by between 6.3% and 9.4%. These estimates are much higher than the costs ob-
tained from the static analysis, implying that dynamic effects from trade are important. We show
evidence that lower FDI in the UK following Brexit is likely to account for part of thi s difference.
Our main analysis focuses on aggregate outcomes, but we also discuss the possible distributional
effects of Brexit through immigration, price changes that differentially affect the consumption
baskets of rich and p oor households, and relative wage effects. We conclude that the pain of Brexit
is l ikely to be shared quite democratically across the income distribution.
The structure of the paper i s as follows. We first discuss the options for UK-EU trade relations
after Brexit in section 2. We lay out the concep t u al framework we use to model the welfare effects
of Brexit in section 3, present the data and counterfactual analysis in Sect ion 4 and undertake
robustness checks in section 5. Section 6 presents our reduce d form estimates and section 7 discusses
distributional effects. Finally, section 8 offers some concluding comments.
2 Options for UK-EU Trade Relations After Brexit
It is highly uncertain what Brexit wil l end up meaning for the terms under which the UK trades with
the EU.
Dhingra and S amp son (2016) review the alternatives facing the UK and the EU. Broadly
speaking there are three types of relationship to choose from. Th e UK could remain par t of the
Single Market like Norway; the UK could negotiate bilat e ral agreements with the EU as Switzerland
and Canada have done; or the UK and the EU could trade under World Trade Organisation terms.
In thi s section we describe how each of t h ese options would affect trade barriers between the UK
and the EU. As will become clear, the key trade-off the UK will face after Brexit is the same
trade-off it faced withi n the EU. There are economic benefits from integration, but obtaining these
benefits comes at the political cost of giving up control over some areas of policy. Inside or outside
the E U, this trade-off is inescapable.
4