The financial challenge posed by Brexit

The outcome of the EU Referendum will have profound implications for Wales in constitutional, political, social, financial and economic terms. The purpose of this note is briefly to examine the likely, shorter term financial implications of Brexit for Wales. This analysis indicates that replacing the two principal sources of EU funding in Wales from UK Government sources will be at risk given that the UK public finances are expected to come under even greater strain in the shorter term as a result of Bretix and that the savings accruing to the UK from no longer contributing to the EU will be more than wiped out by lower growth in national income.

Following the nomenclature adopted by the Institute for Fiscal Studies (IFS) ₁ the anticipated financial impact of Brexit can be conveniently analysed in terms of the mechanical effect and the national income effect.

Mechanical effect.

The mechanical effect encompasses those financial factors that can be quantified in the light of the current policy framework. Under this category we will cover funding that the UK and Wales receives from the EU and the contribution that Wales, as part of the UK, makes to the EU.

Table 1 is drawn from an IFS analysis₂ and summarises: the UK gross and net contribution to the EU; spending by the EU in the UK; and the net net UK contribution i.e. the contribution of the UK to the EU after deducting both the rebate and the funds received by the UK from the EU.

Table 1. The UK’s Financial Contribution to the EU Budget (£bn.)₃

	2012	2013	2014	2015
UK Gross Contribution	15.7	18.1	18.8	17.8
Contribution net of rebate	12.6	14.5	14.4	12.9
EU spend in UK	5.1	5.4	8.7	4.4
UK net net contribution	7.5	9.1	5.7	8.54

 

In 2014 the principal funding Wales received from the European Union was from two sources:

• Payments under the Common Agricultural Policy (CAP) of £260 million.
• Payments from the European Structural Funds (ESF) of £396 million.₅

In addition to these funds Wales received other important but less material funding which was paid directly to recipient organisations such as universities and the private sector. Another source of financial value to Wales is the provision on attractive terms of funds borrowed from the European Investment Bank.

As and when Wales leaves the EU the direct funding of £656 million will be lost. To put this sum in perspective it represents ~£212 per person or approximately 2.2 per cent of total identifiable public expenditure in Wales (devolved and non-devolved expenditure totals approximately £31 billion). The question that arises is will this loss of EU funding be replaced by comparable funding from other sources viz. the UK Government? It is not possible to answer this question definitively. Some leading Brexit supporters have claimed that Wales will be fully compensated for the loss of EU funding from the savings arising from no longer contributing to the EU budget but as will be shown these savings may well not materialise.

What is known is that in the case of CAP the agricultural sector not only employs a higher proportion of the working population across the EU (5 per cent) than it does in either the UK (1.3 per cent) or Wales (3 per cent) but that the farming lobby is much stronger at the EU level compared with the UK. There is therefore the danger that the funding from CAP will not be replaced in full by a future UK Government although some alternative form of agricultural support will have to be put in place.

Projecting forward the loss of CAP funding in future years could also be contentious. Clearly ensuring a fair deal for Welsh farmers must be a key objective for the Welsh Government. Any failure fully to compensate for the loss of CAP funding would be carried forward year on year for the foreseeable future once the base level for the block grant has been set and could have a devastating impact not only on Welsh farming but would have wider cultural and social effects across Wales. The NFU estimates that farming subsidies represent 80 to 90 per cent of Welsh farmers’ income₆s.

Replacing CAP payments with an equivalent sum from the UK Government is only part of the response required to shield Welsh farming from the consequences of Brexit. The level of tariffs that farmers will face depends on the trade agreements negotiated but in the case, for example, of the European Economic Area (EEA) agriculture face EU tariffs of 18 per cent or more. Norway, a member of the EEA, gives its farmers subsidies over and above EU subsidy levels to compensate for these tariffs. (In addition to this Norway also pays a substantial contribution to the EU budget.)

In the case of European Structural Funds the EU has a long record of promoting regional economic development with funding being provided to those regions such as west Wales and the Valleys which have a relatively low GVA per capita. Perhaps a cautionary guide to the attitude of UK governments to the funding of regional economic development can be gauged from the attempts by the Treasury in the early days of EU Objective 1 funding to treat such EU sourced funds as Treasury receipts and not to pass on the funding to Wales. It was only after a major political row that the funds were passed on. Such an attitude by the UK Government (a Labour one at the time) does not augur well for the future. This is another area where the Welsh Government will need to be both vigilant and effective in negotiating alternative funding. Again some prominent Brexit supporters have claimed that Wales will be fully compensated for the loss of EU structural funds. However the current ESF programme comes to an end in 2020 and it is important  therefore not only to ensure that the loss of current ESF is fully compensated for but that such funding is sustained in the longer term. Another risk is the Bretix supporters, who are looking to the net savings from EU contributions as a source of such funding, may well find that such savings do not materialise due to a slowdown in economic growth.

So far this analysis has focused on the funding received directly by Wales from the EU. The other side of the funding coin is the contribution made by the UK to the EU and Wales’s share of this. The UK contribution to the EU in 2015 after netting off the UK rebate was £12.9 billion₇ (Table 1).  To put this sum in perspective it represents approximately 0.7 per cent of GDP or less than 2 per cent of total public expenditure in the UK. Given the expected negative impact of Brexit on GDP growth in the near term (the next two to three years) the gain to the UK Government of not paying the net contribution will be more than lost from the fall in anticipated tax receipts. For every 1 per cent shortfall in expected GDP growth there will be a corresponding shortfall in anticipated tax receipts of approximately £7bn. Given that the consensus shortfall in the previously forecast GDP over the next three to four years is between 3 and 5 per cent (even the most ardent Brexiters concede that there will be a shortfall in forecast GDP growth in the shorter term) the net saving in EU contributions will be wiped out and it is probable that there will be a material shortfall in forecast UK tax receipts over the coming years.

There is therefore a danger that the two principal sources of direct funding from the EU to Wales, CAP and ESF, will not to be replaced in full. Indeed the independent IFS noted that: ‘Future governments might well also decide to spend somewhat less than the current £4 billion or so of EU money that goes to support agriculture and, to a smaller extent, poorer regions such as Cornwall and west Wales. In that case, the public finances would be strengthened by somewhat more than £8 billion a year, though obviously at the expense of the farmers and regions whose subsidies would be cut (my emphasis).’ Thus for Wales the £656 million (CAP plus ESF) is potentially at risk and ensuring that Wales does not lose the equivalent of these funding streams must be a high priority.

National Income Effect.

The second category of effect that needs to be considered is that of the impact of Brexit on the national income of the UK and the knock-on effect on Wales.   A rise in national income would strengthen the UK’s public finances, a fall would weaken them.

Consideration of the national income effect is much more contentious than that of mechanical effects because it relies on modelling both the various scenarios for the UK’s future relationship with the EU post Brexit and the impact of those relationships on UK national income. It is far too early to identify what the future EU relationship will be.

In its report the IFS reviewed the various forecasts for the UK public finances post Brexit made by a range of organisations. The IFS concluded that in the short term their estimates suggest that the overall effect of Brexit would be to damage the public finances. On the basis of forecasts by NIESR, the IFS estimates the negative effect could be between £20 billion and £40 billion by 2019-20, more than enough to wipe out not only the saving on EU budget contributions but the UK budget surplus currently incorporated in the UK Government’s budget plans. In the long run, lower GDP would probably mean lower cash levels of public spending. To quote the IFS: ‘To put this in context, dealing with the public finance effect would require at least an additional one or two years of ‘austerity’- spending  cuts or tax rises – at the same rate as we have experienced recently to get the public finances back to balance.’₈

Thus a key decision to be made by the UK Government is whether: to continue to target a budget surplus within the next two years; to accept that achieving such a balance must be delayed for at least two years; or to accept the case for a more expansionary fiscal policy to mitigate the shorter term, negative impact of Brexit on UK national income and the public finances.

Given this bleak analysis the UK government should be pressed to abandon its unrealistic fiscal plans and to accept that it will not be possible to balance the UK budget for a number of years.

The challenge in Wales will be great and it is to be hoped that Labour, Plaid Cymru and the Conservatives in the National Assembly cooperate to draw up, in consultation with other affected parties such as business and the trades unions, plans to respond to the impact of Brexit both in terms of the danger of losing direct, EU funding but also in the wider UK context of probably further and more intense austerity.

Notes

1. Brexit and the UK’s Public Finances.  IFS Report 116. May 2016.
2. IFS Briefing Note 181. April 2016.
3. European Commission with the exception noted in footnote 4 below.
4. HM Treasury estimate. EU and HMT estimates differ due to timing and categorisation differences. HMT exclude   funding that goes directly to universities and the private sector.
5. Wales and the EU Referendum. Wales Governance Centre. May 2016.
6. NFU President Meurig Raymond quoted in Sunday Times. 26 June 2016.
7. Brexit and the UK’s Public Finances. IFS Report 116.
8. Brexit and the UK’s Public Finances. IFS Report 116.