The reasons for increased regulation are simple – the EU is structured precisely to keep the costs of crossing a border down. This means that taking away even one component of that structure raises the regulatory costs of trading with the EU. As highlighted below, examples of this are how EU structures deal with tariff evasion, as well as reducing regulatory costs through passporting.
Governments oppose tariff evasion, meaning any trade deal needs a mechanism to ensure it cannot happen. Under the EU’s common trade policy, the tariffs due on imports from third countries are the same throughout the EU. Therefore there are no opportunities for firms to avoid tariffs, so goods can move freely throughout the EU without the need for special documentation.
However, this is not the case for the movement of goods between the EU and countries with a trade deal allowing them preferential access to EU markets (such as Switzerland and Norway), because the existence of separate trade deals with third countries creates opportunities for tariff evasion. For example, if following a vote to leave the UK and EU introduced a free trade agreement, but the EU also had separate deals with third countries that did not have agreements with the UK, then exporters from those countries could ship their goods to the EU first (to take advantage of tariff free entry to the EU) and then from the EU across the border to the UK, so avoiding UK tariffs. This is not something the UK government would allow, and governments in the remainder of the EU would be similarly concerned.
For this reason all preferential trade agreements contain what are known as rule of origin regulations. These set out how companies must demonstrate that enough of the production of the goods they are shipping originated in their home market and are therefore eligible for the reduced tariffs.
Rule of origin regulations are complex and depend on the product. There are several different ways in which the rules can be specified and for some products more than one type of rule will apply. ‘Notice 828: tariff preferences – rule of origin for various counties’ sets out the rules for imports and exports covered by the trade agreements between the EU and Albania, Norway and Switzerland amongst others (including some parts of trade with Turkey). In other words, it covers the main alternatives to EU membership, at least if we do not want to pay tariffs.
Notice 828 runs to 140 pages and is extremely detailed. For example, if you are a bicycle manufacturer, whoever is responsible for administration will need to understand the manufacturing process, because the rules set out in Chapter 87 include a separate set of rules for bicycles without ball bearings, including what materials are allowed and the maximum share of non-originating materials.
Complying with rule of origin regulations is therefore costly, particularly as you may need to keep track not only of what you are doing, but also where inputs from all of your suppliers come from. Furthermore, as the EU is the biggest cross-border market for intermediate inputs in the world, costs could be increased at multiple stages in the value chain.
Estimates suggest that the rule of origin regulations for EU trade deals increase compliance costs by 8% and general administrative costs by 6.8%. The cost of these rules will be particularly high for small and medium sized firms, who typically lack the scale to justify sophisticated tracking systems, meaning some may conclude that it is simply easier pay any tariffs due, rather than fill out the paperwork. Either way the increased costs of trading will undermine the competitiveness of UK exporters and push up the cost of UK imports from the EU. As over 80% of UK exporters export to the EU, the impact on some of the UK’s most productive firms will be widespread. The CEPR has calculated that the increase in costs from having to apply rule of origin regulations to trade with the EU will reduce UK exports by 1.3% of GDP per annum.
Reducing regulatory costs through passporting
For exporters one of the big costs is the need to meet different standards and talk to different regulators. The EU aims to reduce these costs through the Single Market, by ensuring that standards are common. Common rules mean that governments do not need to worry about whether different standards create risks, including the risk of unfair competition. Therefore a firm regulated in one part of the EU can operate elsewhere under the same rules.
While the Single Market is not complete, many of the gaps reflect our preferences. For example, enabling a UK pension provider to sell the exact same product in both the UK and Germany would require the harmonisation of pension tax regimes across EU states, and this is something that politicians have preferred not to tackle. However, in other areas the Single Market has had a significant beneficial impact on how markets function. This is particularly true in sectors such as financial services, where passporting rights can allow firms to serve multiple EU markets while only dealing with one regulator.
The use of passporting is pervasive. Almost 50% of authorisation requests for firms’ activities received by the Prudential Regulation Authority between March 2014 and February 2015 related to passporting, roughly two-thirds of which were requests from UK financial services firms wanting to passport their services elsewhere in the Single Market.
Over 60% of firms operating in the UK’s general insurance market are headquartered in another European market and passport in under the EU Third Non-Life Directive and almost 50% of those operating in the UK’s life insurance market do the same under the EU Third Life Directive. If passporting did not exist, then these firms would have to decide whether they can still compete in the UK after the additional expense of dealing with two sets of regulators, the relevant UK regulator and their domestic regulator. The alternative will be for them to withdraw from the UK market, reducing competition and choice. The same will be true for UK firms currently operating in the rest of the EU under passporting rules.
Passporting rights are associated with the Single Market, and are possible because membership of the Single Market depends on applying an equivalent set of regulatory rules. If the UK did not want to be part of the Single Market after it left, these rights would not be available. Without passporting UK financial services firms would need to set up a separate entity, domiciled in the EU, to handle any EU business, with all the inefficiencies entailed in duplicating regulatory processes and increasing the costs of managing capital requirements. It is not hard to suspect that the UK’s withdrawal from the Single Market could bring significant disruption.
Historically the 11% of UK firms that export have been responsible for 60% of our productivity growth – hardly surprising as in general they are our most productive and most innovative firms. Unfortunately for our future prosperity, leaving the EU would increase costs for these firms, reducing their ability to compete. While a depreciation of sterling might help compensate for these cost increases, it will do so at the cost of rising import prices, with the associated fall in living standards, and a reduction in the value of our assets. Politicians may bemoan its structure, but the reasons that the EU is structured the way it is are precisely to keep the cost of crossing internal EU borders down. It is one case where the maxim “rules are there for a reason” holds true.