Scotland's place in Europe: people, jobs and investment

Chapter 1: Economic Implications of Leaving the Single Market and Customs Union

14. The UK Government has made clear that it intends for the UK to leave the European Single Market and Customs Union ^[7] but has yet to set out its assessment of the economic consequences of its decision, including the costs of being excluded from the raft of preferential trade agreements which the EU has concluded with third countries, and from which our exporters currently benefit. Despite the UK Government undertaking some analysis of a number of industrial sectors, there has been no public estimate from the UK Government of the (sectoral or overall) impact on the UK economy of a being outside the European Single Market and a Customs Union.

15. Pre-referendum calculations published by the Treasury indicated that the UK would become ‘permanently poorer’ as a result of leaving the European Single Market - estimates that have since been confirmed by a number of independent studies. ^[8] Most recently the National Institute for Social and Economic Research suggested that the effects of the Brexit-related economic slowdown and in particular the depreciation of sterling following the referendum (while the UK was still a member of the EU) has already made UK households worse off by around £600 per annum. ^[9] Beyond this, analyses of individual elements of the post-Brexit UK, such as the imposition of customs checks, or loss of access to EU negotiated free trade agreements have produced a range of estimated costs to our future economic prosperity. For example, the Institute for Government has estimated that the costs to business - arising solely from customs declarations - could be in the region of £4bn to £9bn annually. ^[10]

16. The first two chapters of this paper bring this analysis together for the first time. Initially focusing on the economic costs of leaving the Single Market and Customs Union across a range of sectors, as well as some of the practical issues this will create for future trade with the EU. This is followed by the presentation of new macro-economic modelling bringing together these issues and presenting the cumulative effect on the economy in Scotland, in three scenarios -

a. trading on WTO terms;

b. a comprehensive Free Trade Agreement ( FTA); and

c. EEA membership for the whole of the UK

17. While a so called ‘no deal’ scenario has not been modeled explicitly, we are clear that this would be even more economically damaging than a planned shift to WTO terms as modeled. In the event of a no deal the UK could find itself out-with the legal framework of the WTO and the legal protections which this affords our traders.

Economic Costs of Brexit

18. Scotland is home to a strong and productive economy. Our economy is characterised by a diverse business base with international successes across a wide range of sectors including life sciences, food and drink, tourism, financial services, energy and creative industries. Our labour market is performing strongly, with unemployment falling over the year and employment rising. Our productivity performance has also improved, with Scottish growth in productivity between 2007 and 2015 higher than any other country or region of the UK, including London.

19. Brexit puts this at risk. The economic consequences of leaving the EU, and in particular no longer being a member of the European Single Market and Customs Union, will be significant across all sectors and regions of Scotland’s economy. We have undertaken further research to estimate the likely costs of Brexit to Scotland’s economy under different post-Brexit scenarios.

20. Continued EU membership has consistently been shown to be the best outcome for our businesses, our consumers, our workers, and for the economy as a whole. These benefits primarily come from the four key channels summarised below.

• Trade - EU membership allows Scottish companies to trade on an almost unrestricted basis within the world’s largest Single Market, allowing them to grow their operations and create new jobs in Scotland.
• Investment - Unimpeded access to EU markets ensures Scotland remains an open economy that is attractive to inward investors.
• Migration and Labour Mobility - Free movement of people allows Scotland to attract the workers that our economy needs in order to fill skills gaps and help address the challenges of an ageing population. It also allows Scottish citizens to travel and work freely in the EU, helping them gain new skills and business contacts.
• Productivity - Having an open, internationally focused economy inside the European Single Market results in increased competition, specialisation, innovation and investment and in turn boosts Scotland’s competitiveness and productivity.

21. Each of these channels has implications for the drivers of economic growth set out in Scotland’s Economic Strategy ^[11] and as highlighted in the Programme for Government. The Scottish Government is committed to ensuring that Scotland continues to develop a sustainable and innovative economy.

22. All of these channels are also supported by the UK’s current participation in the so-called four freedoms, notably the free movement of people, goods, capital and services. While we will deal separately with the free movement of people in chapter 4, the interlinked issues of the free movement of goods, services and capital are considered in this chapter. In essence, they allow for goods to be moved freely within the European Single Market and for companies to establish themselves in another member state, or to operate in that member state from a base elsewhere in the EU. With the addition of the free movement of people, this allows for labour, or in the case of services, the people delivering the service, to move freely throughout the European Single Market to undertake economic activity. This has underpinned the development of the European Single Market into the most integrated market in the world.

23. All options short of full EU membership will impose a cost on our economy and reduce the effectiveness of these channels as a source of economic growth. However, the costs would be considerably less under some alternative agreements. In particular, continued membership of the European Single Market via the European Economic Area Agreement, would offer a range of significant economic advantages compared to the type of hard Brexit sought by the UK Government.

Trade in Goods and Services

24. The EU is Scotland’s most important international export market. In 2015, Scottish companies’ exports to countries within the EU were estimated at £12.3 billion, which is 43% ^[12] of Scotland’s total international exports and supports, directly and indirectly, hundreds of thousands of jobs across Scotland. ^[13]

25. Evidence suggests that bilateral trade among EU members has grown by between 40% and 90% as a direct result of further development of the European Single Market. ^[14] For the Scottish economy, membership of the Single Market has resulted in the removal of formal and informal barriers to trade thereby ensuring our businesses have unfettered access to a market of 510 million consumers and the largest single market in the world. ^[15]

26. In considering the best option for Scotland’s future, it should be remembered that after Brexit, the European Single Market will still be around seven times the size of the UK market in terms of population.

27. The progress made by the European Single Market in dismantling the obstacles to trade in goods and services has therefore been a key driver of growth and employment in Scotland, and across the EU in general. The project to complete the European Single Market has resulted in the elimination of the vast majority of tariffs and so-called technical barriers to trade in goods in the form of divergent national rules and regulations governing the production, distribution, marketing and sale of the products which businesses buy from each other as part of international supply chains and which we buy in the shops. It is these complex non-tariff barriers to trade, rather than straightforward tariffs, that represent the main obstacle to trade between the EU and (third) countries outside the Single Market. The Single Market is also dynamic, and so is able to address and mitigate any new non-tariff barriers as and when they arise.

28. If the UK Government opts to exit the European Single Market then the UK would become a third country from the perspective of the EU, and trade is likely to diminish as UK exporters (and importers) become subject to a much more restrictive UK- EU free trade agreement. Even the most sophisticated and liberal EU free trade agreement, such as the EU-Canada model, largely excludes provisions for eliminating non-tariff trade barriers and does not provide the unfettered access to the European Single Market that we presently enjoy as members of that market. These types of agreement also provide limited - if any - provision for services, or financial services, which are a key part of the UK economy.

29. The impact of complex regulatory barriers would be felt not only in our trade in goods but also on our exports of services to the EU. This would be highly significant and damaging. Services account for around three quarters of Scotland’s economic output. Presently there are relatively limited regulatory barriers to UK service providers selling their services across the EU - either directly across borders, or by traveling to other EU countries, or by establishing a branch in another member state. No free trade agreement in the world provides for this degree of freedom of movement of services within the European Single Market.

Leaving The EU And The Single Market Could Reduce Scotland’s Economic output by 8.5% By 2030, Equivalent To A Loss Of £2,300 A Year For Each Person In Scotland.

30. The UK Government suggests that these non-tariff (or regulatory) barriers need not obstruct our trade - in goods or in services - with the EU on the basis that UK rules and regulations will continue to mirror our EU counterparts post-Brexit. As a result, the EU would recognise the UK rules and regulations as ‘equivalent’ to their own and permit UK goods and services to be sold in the European Single Market. However, the EU are under no obligation to accept future UK regulations as equivalent to those governing the European Single Market. This proposition ignores the on-going dynamics of regulatory changes, which can quickly outpace any existing equivalence agreements, on which stable trading arrangements ultimately would depend. In any event, under the rubric of “taking back control” which lay at the core of the Brexit argument, there can simply be no certainty that UK product rules and regulations, or any other policies on which Single Market access relies, will remain convergent with European Single Market legislation over time. This inevitably creates a highly uncertain and potentially volatile environment for our businesses to operate in, even if there is an agreed dispute resolution mechanism.

31. An approach which puts the UK outside the European Single Market will also jeopardise the wider conditions which underpin trade. These include data transfer agreements, aviation, transport and the ability for people to move and provide services. These conditions and the lack of non-tariff barriers are particularly important for small and medium enterprises in reducing risk and uncertainty that is otherwise a significant barrier to international trade.

32. These market access complexities would inevitably arise across a vast swathe of the traded goods and service sectors. Financial services which is one sector that may be particularly adversely affected by Brexit. Presently UK (and Scottish) financial service providers are able to supply a range of products directly across the European Single Market under a regime called ‘passporting’, which applies only to firms located within the European Single Market (including non- EU EEA countries). If the UK is outside the European Single Market then our financial services providers would no longer enjoy passporting rights and significant regulatory barriers are likely, at best, to significantly compromise the present level of UK exports of financial services to the EU.

33. However, financial services is only one example where current levels of trade (and so employment and growth) would be jeopardised by a hard Brexit. There are many other sectors where regulatory obstacles to trade are likely to emerge if the UK is outside the Single Market and which would compromise our trade with the EU - pharmaceutical products, food and drink, road haulage, energy, business services and aerospace are just a few other examples.

34. The vulnerability of our economy to a hard Brexit cannot be adequately mitigated through a UK- EU FTA. While the EU FTA with Canada does include limited provisions for some degree of third country validation, they are aligned with EU regulations in order to facilitate trade in goods, this falls substantially short of securing the access to the European Single Market the UK - or any EEA member country - presently enjoys. Continued membership of the European Single Market on the other hand will ensure the UK economy continues to benefit from the trading arrangements we presently have. Recent analysis by National Institute of Economic and Social Research ( NIESR) ^[16] demonstrates that retaining Single Market membership could avoid seeing a 60% decline in both goods and services exports to the EEA in comparison to an arrangement based on WTO rules.

Figure 1.0 Destination of Scottish International Exports 2015 (£ Billions)

35. Membership of the EU has also enabled Scotland to benefit from the EU’s FTAs with more than 50 international trading partners. In 2015, Scotland exported around £3.6 billion to countries with which the EU has a FTA. This trade accounted for a further 13% of Scotland’s international exports. ^[17]

36. In addition, although hard to quantify, many of the products from Scotland “exported” to the rest of the UK will form parts of finished goods destined for the rest of the Single Market.

Exports To The EU And Other Countries The EU Has Trade Agreements With, Are Worth £15.9 Billion. That’s 56 Per Cent Of Total International Exports.

37. It has been argued by the UK Government's Global Britain Strategy ^[18] that the UK would offset any decline in trade with the EU from being outside of the Single Market by exporting more to other countries. However, fully replacing the value of EU trade will be challenging, as illustrated by trade flows with emerging economies such as Brazil, Russia, India, China and South Africa (known as the BRICS countries). These nations account for around £2.1bn (7%) of Scotland’s exports (chart 1). In comparison, the EU accounts for £12.3bn (43%) of Scotland’s exports. Even small proportionate losses in trade (or lost growth in trade) with the EU would require dramatic increases in trade with such countries.

Chart 1: Scottish Exports to the EU and BRICS (2015)

38. To replace a 5% reduction in Scotland’s EU exports with increased trade from the BRICS economies would require a 30% increase in exports to those economies. Even if the UK signed agreements with the 10 biggest non- EEA single country trading partners (including USA, China, and Canada), a process which would take many years, this would only cover 37% of Scotland’s current exports compared to 43% of current exports that go to the EU.

39. With most of the alternative markets to the EU, such as Australia and the USA, being a significant distance from the UK, it is difficult to see how the impact of reduced trade with the EU can be fully mitigated by forming new trading relationships with other countries. For example, for goods which are perishable or have low profit margins, the additional time and cost involved in selling to a country such as Australia rather than into the EU will be prohibitive.

40. As an EU member state, our businesses also benefit from being part of the EU Customs Union under which all member states adopt a common trade policy with respect to third countries. This means that once goods from outside the EU have entered, they can move freely within the EU.

41. Our current membership of both the European Single Market and the EU Customs Union, has enabled firms in Scotland to greatly expand their participation in global supply (or ‘value’) chains. These are networks of producers across the world which each contribute inputs, in the form of goods and services, to a production process. For instance, the production of an aircraft wing involves multiple parts crossing many European borders before the finished wing, never mind the aircraft, is complete. Any additional administration in this process at each border crossing would have a significant impact on the continuation of these processes. There are no models which allow the full impact of participation in global value chains to be quantified. As a consequence the impact presented of the FTA and WTO models will not fully capture the negative impact of companies changing their production chains and potentially even the location of elements of their business.

Box One - Global Value Chains

International trade is frequently presented as the buying and selling of final goods and services. However, international trade is increasingly carried out through global value chains ( GVCs) where services, raw materials, parts and components are exchanged between countries. Around three quarters of international trade is businesses buying intermediate inputs ( OECD, 2015), and many jobs are dependent on feeding into the production chains of final goods which are produced in other countries. For example, 715,000 jobs in the UK are dependent on UK exports which feed into products produced in other EU member states which are subsequently exported. ^[19]

GVCs have profound implications for trade policy. Even small increases in tariffs become cumulative, and additional customs requirements become increasingly burdensome when intermediate inputs are traded across borders multiple times. Therefore, tariff-free access, elimination of non-tariff barriers and quick and efficient customs procedures are indispensable to the functioning of supply chains. To compete, businesses need to maintain lean inventories and still respond quickly to demand.

Traditional trade statistics are not well equipped to measure GVCs because they assign the value of all intermediate products to the company, and country, where the product is finished and shipped to its final destination. Value-added statistics are necessary to understand where economic activity and jobs are generated along supply chains. Data from the publically available World Input Output Database ( WIOD), are widely used across academia and in policy development and provide an illustrative example .

Manufacturing of machinery and equipment

Manufacturing of machinery and equipment is an important export sector for Scotland representing around 9% of all manufacturing exports. It encompasses a range of goods, such as engineering systems and subsea and drilling equipment. Using the latest WIOD data release, we calculate estimates of the share of value-added in the production process of UK machinery and equipment that are attributable to international trading partners (see table). For example, in 2014 over a quarter of the value in UK production of machinery and equipment originated from outside the UK.

Share of value-added generated in	2000	2006	2014
UK	79%	76%	73%
EU	10%	11%	13%
USA	3%	3%	2%
China	0.4%	1%	2%
Japan	1%	1%	1%
Others	6%	8%	9%

The analysis shows that UK manufacturing has become more integrated with the EU and the rest of the world over time. The EU remains the main international source of value-added for this industry. This shows that to remain competitive, UK manufacturers have become more integrated with international partners in GVCs, benefiting from access to inputs from outside the UK and providing inputs to firms in other countries.

42. A recent report from Oxera ^[20] noted that the added costs to business as a result of leaving the Customs Union will depend, in part, on the new relationship between the UK and EU. However, they estimated - conservatively - that the UK economy-wide costs would be in excess of £1 billion per year, excluding the additional economic costs of uncertainty that would fall on companies reliant on UK- EU trade.

Investment

43. Foreign Direct Investment ( FDI) is a key feature of the contemporary global economy, and one from which the UK, and especially Scotland, has derived considerable benefits (see Chart 2 and 3). Rather than simply exporting to other countries, companies are increasingly investing in foreign enterprises or setting up their own operations overseas. In addition to creating jobs, and economic activity, this supports the transfer of knowledge, skills, technology and innovation between countries and in turn boosts productivity. There are 2,350 foreign-owned firms in Scotland employing around 318,000 people. Of these foreign firms 1,040 (44%) are EU owned and employ around 122,000 people in Scotland. ^[21]

44. The key drivers for inward FDI decisions include access to markets, access to supply chains and intermediate inputs, access to consumers, or a combination of these factors. Scotland has been a major recipient of FDI and this inward investment has been an important source of job creation. EY estimate that since 2002, FDI into Scotland has supported around 43,000 jobs. ^[22] Current uncertainty, and a changed future relationship with the EU, creates the risk that potential new investors will re-evaluate their investment projects and future flows of FDI will move elsewhere.

Chart 2: Foreign Direct Investment in Scotland - Number of Projects

Scource : EY Attractiveness Survey 2017

45. There is strong evidence that EU membership has been associated with increased flows of FDI. For example, empirical estimates from Bruno et al indicate that between 1985 and 2013, EU membership has increased FDI flows by around 28% across member states. ^[23] Maintained membership of the European Single Market will ensure Scotland continues to attract international investment to Scotland. In contrast, any future relationship short of Single Market membership is likely to result in a reduction in attractiveness to investors and therefore ultimately in lower investment in Scotland and the rest of the UK. Work by the London School of Economics finds that striking a Swiss-style trade deal would not significantly reduce or offset the negative effects of Brexit on FDI. ^[24] We consider this can only be achieved through continued European Single Market membership.

Chart 3: Annual FDI Projects per Million REsidents (2010-2015)

Productivity

46. Improving productivity (output per hour worked), is the key driver to overall economic success in the long-term and has a direct impact on real wages and living standards. OECD analysis, supported by UK and Scotland specific studies, shows that as businesses become increasingly international they become more competitive and productive. ^[25] Membership of the EU and European Single Market has increased openness to trade and thereby increased the movement of goods, services, capital and labour. This in turn helps boost productivity through a number of channels including;

• Scale and Specialisation - Access to a larger market allows the most productive and successful firms to expand, taking advantage of economies of scale in production. There is evidence that greater openness to trade also improves productivity by encouraging firms to specialise in the things they do best;
• Foreign Direct Investment - FDI improves access to investment, new technologies and management practices, all of which help to boost the productivity of firms. Many investors have highlighted that membership of the European Single Market is an important factor in determining the location of their investments;
• Increased Competition - Having fewer trade barriers increases the level of competition in the market, and provides greater incentives for companies to invest and increase the efficiency of their production processes; and
• Innovation and Adoption - Having fewer barriers to trade has been shown to increase the incentives for domestic firms to implement and adopt new approaches and technologies into their business by exposing them to new business practices and competition.

47. Continued European Single Market membership has supported all of these channels and is a significant driver in existing UK productivity, although this is not growing at the same rate as our EU partners. Continued Single Market Membership will result in better outcomes across each of these channels, maintaining economic openness, and retaining and enhancing the competitiveness and dynamism of the economy. For example, analysis by the Treasury finds that productivity would be permanently lower under a WTO scenario, compared to an EEA scenario.