By Ayan Banerjee
When Britain voted to leave the European Union in 2016, it set in motion a variety of predictions around the positive and negative economic consequences. This post focuses on the likely macroeconomic effects of leaving the customs union: a trade block consisting of free internal trade and a common external tariff.
The major consequence of leaving the customs union is the effect on tariffs around trade. In the EU's customs union, tariffs are placed on all trade with countries outside of the customs union and the complete removal of tariffs from internal countries. These have incentivised trade relations within the EU while disincentivising trade with non-EU nations. Therefore, leaving the customs union will increase tariffs on EU trade and reduce them on non-EU trade. The effect that this would have on consumers can be illustrated graphically. The supply curve for EU trade would shift vertically as there is a uniform increase in price due to new tariffs. Total surplus is also proportional to welfare which suggests that the increase in EU tariffs would result in a decrease in total societal welfare since total surplus would decrease. Furthermore, 45% of total exports and 53% of total imports are from EU nations. Since the proportion of trade with the EU is so significant, the effect on total welfare would be far greater than if the proportion of trade was smaller.
On the other hand, leaving the customs union would result in a decrease in tariffs for external countries. Before Britain joined the EU, it imported most of its wheat from the US. However, when the EU’s common external tariffs were implemented, US wheat trade ceased, and the UK began to buy its wheat from France at a higher consumer cost than the un-tariffed US price. This is an example of how joining the customs union incurred a net cost on the British economy. Consequently, Britain would have to allocate more resources to improve exports to pay for wheat imports resulting in being worse off overall3. In summary, whether the customs union is desirable depends on the extent of trade creation with respect to trade diversion. In this case, since the proportion of total trade with the EU is so large, it will most likely have greater trade diversion effects which would have an overall negative effect.
Another economic consequence is the effect on the Balance of Payments. If the UK leaves the customs union, it would likely result in a current account deficit as tariffs and other barriers to trade such as border checks would reduce exports. In the long run, a current account deficit can result in some negative consequences. Deficits are often financed by governments through borrowing which in the long run would lead to countries burdened with high-interest loan payments. Furthermore, a large deficit has the possibility of causing depreciation of the exchange rate which may lead to cost-push inflation. The value of a countries trade with another can also be evaluated using the Gravity Model of trade. With Y being income and D being distance for countries x and y (a is a constant).
Txy = a.YxYy/Dxy
As can be inferred using this formula, the value of trade with the EU is relatively large compared to other nations for two reasons. The income of the UK’s main EU trading partners, such as Germany and France, is large. This in addition to the distance being small, suggests the value of trade with EU nations is far more significant than most other non-EU nations. On the other hand, the distance effect can be outweighed by the large Incomes of nations such as Japan and the US which have greater Gross National Incomes than any EU countries. Overall, leaving the customs union may cause negative economic effects surrounding the Current Account. In addition to this, the value of trade with the EU may be larger than non-EU when considering the Gravity Model which indicates leaving the customs union to have further undesirable consequences.
Another economic effect to consider would be changes in Foreign Direct Investment (FDI). The UK has attracted the most FDI in the EU, partly due to its access to the customs union. FDI has led to greater integration with the EU and reinforced its comparative advantage in several sectors. It also leads to other positive effects including an increase in GDP, creation of jobs and an increase in productive capacity. Many international companies prefer to invest in countries in the single market which also have certainty with trade relations for non-EU nations. Additionally, complex supply chains used by these companies (for example car manufacturers) would incur significant costs with the removal of access to the single market making Britain would be less attractive for FDI. This would reduce the positive effects associated with FDI illustrated in a reduction in the capital account. In summary, leaving the customs union will likely lead to a reduction in FDI which would have harmful effects in several areas in the UK economy.
The overall effects of the UK leaving the customs union will most likely be negative. The extent of trade diversion is expected to be greater than that of trade creation. Additionally, new trade deals usually take decades to form and are an expensive process. These factors combined with reduced amounts of FDI indicate that overall the negative consequences outweigh the positive ones for the UK leaving the customs union.
Pg. 300, Krugman P.R, Obstfeld M, Melitz M.J (2018), International Economics: Theory and Policy, Eleventh Edition, Pearson Publishers.
Pg. 2, Dhingra, Swati, Ottaviano, Gianmarco I. P., Sampson, Thomas and Reenen, John Van (2016) The consequences of Brexit for UK trade and living standards. CEP BREXIT Analysis No.2 (CEPBREXIT02). London School of Economics and Political Science, CEP, London
Pg. 301, Krugman P.R, Obstfeld M, Melitz M.J (2018), International Economics: Theory and Policy, Eleventh Edition, Pearson Publishers
Pg. 40, Krugman P.R, Obstfeld M, Melitz M.J (2018), International Economics: Theory and Policy, Eleventh Edition, Pearson Publishers
Pg. 24, Kierzenkowski, R., et al. (2016), "The Economic Consequences of Brexit- A Taxing Decision", OECD Economic Policy Papers, No. 16, OECD Publishing, Paris, https-//doi.org/10.1787/5jm0lsvdkf6k-en
 Pg. 25, Kierzenkowski, R., et al. (2016), "The Economic Consequences of Brexit- A Taxing Decision", OECD Economic Policy Papers, No. 16, OECD Publishing, Paris, https-//doi.org/10.1787/5jm0lsvdkf6k-en