Changing the UK’s business model – the last throw of the dice?

A thinly veiled threat…

Both Theresa May and Philip Hammond have suggested in their recent speeches that if the UK fails to reach an acceptable agreement with the EU in the Brexit process, the UK would have to consider changing its “business model” to ensure its future competitiveness. The Prime Minister said that for the EU to force the UK down this route would be “an act of calamitous self-harm”. The speeches did not contain many details as to what the changes would be, but Philip Hammond did imply that the UK would move to reduce taxes and regulation, positioning itself as a very different proposition for investors compared to the EU.

Could it compensate for any perceived costs of the “Brexit” deal?

A change to the UK’s business model after Brexit would presumably compensate for any loss of either attractiveness or competitiveness as a result of changes to the trading relationship between the UK and EU as a result of Brexit. The potential adverse effects could include the imposition of tariff and/or non-tariff barriers and restrictions on labour mobility. EY’s 2016 UK Autumn Attractiveness Survey clearly shows that change in either or both areas would have a negative impact on investor perceptions of the UK. The impact would be felt in either:

• The UK’s attractiveness to foreign investors which could hamper the UK’s ability both to retain existing Foreign Direct Investment(FDI) and to attract new FDI; or
• A reduction in the competitiveness of UK exporters and UK domestic producers

I concentrate in the rest of this blog on the FDI related impact, described above, drawing extensively on EY’s work in this field over the last two decades.

Policy changes used to try and improve the UK’s appeal…

The possible changes in policy could include reductions in corporate taxation rates, although the UK is already planning to reduce its headline rate to a very competitive 17%, or business rates, while the introduction of incentives to invest, such as capital allowances, tax holidays or grants could also be part of the new proposition.

The changes would almost certainly not be restricted to financial incentives alone. The UK might also seek to change its regulatory regime to improve its attractiveness to investors and to boost competitiveness. Lighter labour regulation would be an obvious area that could appeal to prospective employers, and banking and financial services arrangements might be another. Other possible options would be energy and climate change regulation and product standards. The UK would be looking to position itself as a business friendly, low cost and lightly regulated location to do business, especially when compared to the EU.

…but the UK is already attractive…

FDI is important to the UK – UKTI estimates that new FDI is worth around ￡45 billion a year and created around 80,000 jobs in 2015. EY’s Attractiveness research shows that the UK has led Europe for the last two decades in attracting project based FDI. According to our annual, proprietary foreign investor research, the UK’s success is based to a significant extent on its relative competitiveness in key policy areas. In 2016, the UK led our European survey on labour costs, flexibility of labour legislation and taxation. It was 20% to 30% better than our primary competitors on the first two criteria and 30% ahead of every country but The Netherlands on taxation. There are therefore real questions, firstly about how much further the UK could do to make a significant shift in its attractiveness on tax, incentives and regulation relative to our European peers. Secondly, whether this would be sufficient to compensate for the negative impact of changes to trading arrangements and labour mobility. Is the UK really willing to enter a race to the bottom?

…and the new business model might have adverse consequences…

Successful policy implementation requires that the moves address key business concerns. EY’s research suggests that tax, incentives and regulatory change are not necessarily the key drivers of investment in the UK. Our Autumn survey in 2016 asked foreign investors what policy changes would improve their perception of the UK’s attractiveness. Incentives did feature in the top four responses, but this was the fourth ranked category. As far as investors are concerned, new trade agreements, especially with the EU and the USA, investment in infrastructure and access to skills are the top three priorities.

These results fit with survey responses we have received over the last few years. Infrastructure and skills are also consistently the top two priorities for investors considering investment in the UK’s regions. However, improving the quality of the UK’s offer in skills and infrastructure will require the investment of additional resources beyond the level currently included in the UK’s fiscal plans. With the possibility of lower migration and reduced trade hitting UK tax receipts and economic activity levels, further cuts in taxes and charges would mean even less resources would potentially be available for investment. There is a real risk that the moves required to implement the new business model would further hamper the UK’s ability to develop a competitive and attractive offer. This is even before we consider how lower tax receipts might negatively impact future public spending levels.

…and would probably not address the key concerns of investors…

The UK’s success in attracting FDI in recent years reflects success in a range of sectors. The UK leads Europe for projects in software, business services and financial services and has improved its performance in manufacturing in recent years – and functions: the UK has been very successful in attracting HQs, over 50% of all European projects in 2015, and R&D facilities, 23% of all European investment in 2016. Success in these areas has not been driven primarily by tax and low operating cost decisions, but by the strength of the UK domestic market, the appeal of the UK as a location to serve Europe and the quality of the UK’s specialist resources such as in science.

It is far from clear that changing the business model will compensate for losses of other attributes. Over 50% of the HQ investments are European HQs and it seems unlikely that tax breaks would be sufficient to offset losses of labour market flexibility and exclusion from EU policy-making post-Brexit. The same applies to software. Open labour markets mean that the UK is typically the first, or only European location for software companies originating in the USA. Access to skills features very highly for software companies, as it does for R&D investments, and it is unclear that the new business model could offset the disadvantages in labour supply and market access expected from Brexit.

…or the UK population.

As we explore the possible options available to the UK post-Brexit, it becomes clear that there is limited room for manoeuvre. In a number of areas: software, business services, manufacturing, HQs and R&D – policy change would most likely be insufficient to offset the negative consequences of Brexit. This would leave Financial Services and Energy as potential growth areas driven by reductions in current levels of regulation. In addition, businesses that are based on low cost, flexible labour might be attracted by the UK’s new business model.

Would this be good for the UK? And how would the population view the changes in the business model?

As far as financial services are concerned, the changes might attract more business to the UK, but is this desirable? The financial crisis is still casting its shadow over the economy and it seems unlikely the UK Government really wants to create more exposure to the sector’s balance sheet in future, especially if the rest of the economy is weaker than it was and hence more exposed to macroeconomic shocks. Is the best future for the UK one based on competition around regulatory arbitrage?

On energy, making energy prices as competitive as possible makes sense, but this has to be balanced against the costs of greater carbon usage. London has started 2017 with warnings over poor air quality and de-regulation has costs as well as benefits.

More generally, while making the UK a flexible, low labour cost and limited benefit economy may appeal to some investors, is this what the public voted for in the referendum on EU membership? The Prime Minister has talked about building an economy that works for everyone. Reducing the rights of workers and reducing business taxes while criticising corporate excess seems inconsistent with this vision, especially when we consider the need for resources to support geographic rebalancing of the economy.

Europe sees a thinly veiled threat.

The reaction in Europe to the speeches by the two most senior members of the UK Government tended to view the suggested changes to the UK’s model as a threat, but one that was unlikely to materialise. Voices in Europe went on to argue that the UK Government was unlikely to be able to change the country’s business model to the extent that would be required to compensate for the expected adverse impacts of Brexit on trade and migration. At least not without creating political and economic consequences of such a scale that would make the implied shift unrealistic.

@MarkGregoryEY

markgregoryeconomics.ey.com

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