The effect of Brexit on inequality – a stocktaking

Many interpretations claim that inequality was one of the key driving forces behind the Brexit referendum outcome. In the event that this is true it appears to make a lot of sense to look at how Brexit will affect inequality. In this post I look at some of the most widely anticipated effects of Brexit and discuss their likely impact on economic inequality. This short stocktaking suggests that Brexit will make Britain a more unequal place and much of this will be driven by unproductive (such as rent seeking) rather than productive sources of inequality.

Increasing economic inequality caused by open borders and globalisation seems to be blamed for increasing inequality in the UK. A recent ComRes survey shows that people blame globalisation and technology for lowering wages for British workers. Of course it is extremely difficult for an economist to comprehend how having less globalisation or technology would help anyone. Prices would be higher so the purchasing power of even higher wages wouldn’t improve, nobody would gain but we’d be running the economy much less efficiently. But scepticism aside, these sentiments do call for an examination of how the predicted effects of Brexit would affect inequality.

photo_overlay

Sources of inequality

The way the word inequality is used in general parlance often ignores the variety of sources that contribute to it. This is unfortunate because it tars all sources (good or bad) of inequality with the same negative brush. Think about all the genius ideas, extraordinary achievements, outstanding performances. These can all create global superstars, be that a new business, an athlete, or a performing artist. Becoming a global superstar results in extraordinary wealth, and as such it contributes massively to inequality. But should we worry about the fact that these people become very rich? At the end of the day, their skills enrich all of us, through a new technology, a brilliant football game, or a few hours of entertainment. Without the potential to become a global superstar and the prospect of amassing incredible wealth, many of these achievers would not be inspired to pursue outstanding achievements, and we would all be poorer as a result.

But inequality has got a darker side too. When a business becomes a superstar, it will want to preserve their eminent position. One way of achieving this is by continuously improving what they do. Great! We all benefit from such efforts. But superstar businesses often find ways to remain on top that doesn’t benefit everyone at all. Economists use the shorthand term rent seeking to refer to the use of resources (by a business, or an individual) with the aim of appropriating gains without creating benefits for society. Superstar businesses are in pole position to lobby for changes in law. When the result of such lobbying is a preferential treatment for these businesses everyone but the beneficiary business loses. Inequality is sustained and enhanced by such rent seeking behaviour. Rent seeking is more likely to happen in industries where the Government is more exposed to business lobbying. When discussing inequality ideally one would only want to eliminate the bad rather than the good sources.

So how will Brexit affect these desired and undesired (or unproductive) sources of inequality? On the following pages I do a brief stocktaking that looks at some of the most widely predicted effects of Brexit and discuss what they imply on inequality. I look at topics such as trade, competition, immigration, productivity, and research and development. My main conclusion? Brexit is likely to enhance economic inequality. More worryingly this will happen due to unproductive rather than productive sources of inequality.

Rent seeking caused by Brexit

In periods of economic uncertainty governments are more likely to rely on protectionist measures or measures of industrial planning. When they do this they expose themselves to lobbying pressure from the largest businesses. Think about the period around Brexit. When the uncertainty around access to the single market is high, businesses will do everything to ensure that they come out as the winners of this transition. Large amounts of resources will be spent to secure continued access to the single market, or some form of compensation from the government for losing this beneficial access. Examples from the financial sector or car manufacturing have already been highlighted by recent events.

There is nothing productive in this type of rent seeking and there is nothing consumers can benefit therefrom. On the other hand it can conserve inequality. Why? By leaving the single market by definition no business would enjoy any of the pre-Brexit benefits. If a few can successfully lobby for such preferential ‘sweetheart deals’ like Nissan, it will leave others with a gigantic handicap. As a result of rent seeking, competition suffers, and the ability of markets to transfer the beneficial impact of competition to consumers are limited. I will argue later that this is a perfect avenue to preserving and increasing inequality.

Inequality and freedom of trade

By and large most evidence suggests that trade is like a tide that lifts all boats. But the evidence is less clear on whether it lifts all boats to the same degree. There is a legion of academic papers about the effect of trade liberalisation on inequality in developed countries. The results tend to suggest that free trade does have an increasing effect on wage inequality (see here for example, or here for a review of previous studies). The intuition is, that trade might only benefit some of the industries, which in turn leads to increasing wages in these industries. On the other hand, industries relying on low-skilled labour compete against increased competition from cheap import. This pushes down wages in these industries.

When looking at wealth rather than wages, the picture is much different. Trade can affect people’s wealth in ways that are different to its effect on wages. For example, trade increases competition, which pulls down prices, increases quality, access, and so on. Moreover, there is a growing body of literature that shows how competition can reduce inequality (below I offer more detail on this). When the effect of trade is looked at, these other dimensions are just as (if not more) important as the effects on wage distributions.

Leaving the single market will stall trade – at least in the short run – and realistically it will take many years of negotiation for Britain to reach the level of trade liberalisation that it enjoyed in the single market (most known studies anticipate reduced post-Brexit trade). Not only the deals with EU countries have to be re-negotiated, but the agreements of the EU with third countries, of which there are numerous, have to be replicated. This is not a trivial job and whilst there is a potential that Britain will evolve to an even more liberalised economy, this will take many years. Throughout this adjustment period competition is reduced and it will be manifested in higher prices and lower welfare for everyone in Britain. On the other hand incumbent businesses who are now (temporarily) protected from competition enjoy all the rents of reduced competition. Those with interests in these businesses gain, but the large majority of us will only suffer the losses of reduced competition.

It is true that trade can reduce low-skilled wages. But at the same time it benefits all (even low-skill workers) with lower prices. Hampering trade on the other hand might have a small (some estimates put this at below 1%) effect of increasing low-skilled wages, but it has a penetrating and overarching effect of making most of us worse off. Put differently, trade might contribute to inequality by skewing the left tail of income distribution, but the lack of trade also contributes to it by skewing the right tail of wealth distribution. The difference is that in this latter case we’re not only more unequal but as a society much poorer.

Competition and inequality

One pivotal benefit of trade is increased intensity of competition. There is a new but growing body of literature that looks at the relationship between competition and inequality (e.g. here, here, and here). Two main conclusions can be drawn from this literature. First, at the aggregate level, reduced competition does indeed have the potential to increase inequality, and the intuition is obvious: in the main, the poor lose relatively most from market power, whilst the rich may on balance benefit from market power because any losses they incur as consumers are balanced by the fact that they are the main beneficiaries of monopoly profits. This general effect is reinforced because the poor are all employees or run small family businesses. Second, at a more micro level, the beneficial effects may vary systematically across different markets, depending on the income and price elasticities.

In all fairness, this literature at this stage remains seriously under-developed. All of the previous papers tackle a dauntingly difficult empirical question, and all have made important contributions. However, they simplify in being based, either explicitly or implicitly, on static models, which tend to ignore any potential dynamic gain from the profits generated by temporary market power. The aggregate studies assume that all profit is paid out as dividends to shareholders (or is spent on rent-seeking). In a recent report for UNCTAD, Prof. Steve Davies and I proposed a ‘rule of thumb’ methodology which is in the spirit of most of the previous literature, but would be relatively easy to apply in practice. It would enable us to quantify the impact of competition policy in aggregate and identify the specific markets in which interventions would have the greatest positive impact on inequality. Our proposal is based on four simple assumptions: (1) Household welfare is measured by consumer and producer surpluses; (2) The economy includes two classes of household by income: rich and poor; (3) RICH own a disproportionate share of firm stocks and shares, and therefore receive a disproportionately large share of producer surplus – both directly in the form of dividends and indirectly in the form of increases in firms’ present value valuations; (4) On average, consumer products have an income elasticity of less than unity. As such, poor account for a disproportionately large share of consumption.

The conclusion? Assuming that increased competition always improves consumer welfare (a fairly weak assumption), more competition always improves equality if the poorer half of the population account for at least half of consumption, but receive hardly any profits from ownership in businesses. Against this background the predicted lessening of competition as a result of Brexit is likely to further increase inequality.

Food prices and inequality

There is an increasing number of signs that food prices will go up after Brexit. There are many reasons this is a realistic possibility, two of these have been highlighted in the news recently, a weakening GBP, and a reduction of cheap agricultural labour force from the EU.

Take the former case for example. At times when the value of the British Pound drops, the price of imported food goes up. In 2015 almost £40 billion worth of food was imported into the UK. Even a small decrease in the value of the Pound Sterling will have a pretty large effect on how much we pay for our imported food. And that’s not the full story. By and large the most likely way food is transported around the country is on the road. Road transport uses fuel and more than a third of oil used in Britain is imported. When the Pound Sterling is devalued, these oil imports become more expensive, making transportation within the UK more expensive. Moreover, home produced food also relies on import, such as petrol, fertilisers, machinery. As import prices rise it will affect all food sold in the UK.

Increasing food prices affect different income groups differently. To understand, it is useful to distinguish between the income effect and the substitution effect of a food price increase. Economists often make this distinction. Income effects are about how a price change affects people’s income, and the substitution effect measures how much a higher/lower price encourages/discourages consumers to use other goods, assuming that their income doesn’t change.

The first thing we’re interested in is how increasing food prices affect the proportion of income people spend on food. In comparison, the poorest and the wealthiest households spend around 18 and 7 percent of their income on food respectively. This implies that as a result of a 10% increase in the price of food, the expenditure increase in food spending goes up by 1.8% for the poorest, and only by 0.7% for the richer. As a result of this, consumers either buy less food, or they give up something else, something other than food. Housing, fuel costs and power costs are typically hard to change. Culture, recreation, and health are much easier to scrap. moreover, when this substitution happens, people might also reduce their savings. Lower income families are less likely to have savings in the first place. Higher food prices make it even less likely. This means that poorer households will have a decreasing amount of return from capital. Richer families with lower expenditure proportions allocated to food will have an increasing relative revenue from capital, increasing inequality.

Another important question, when food prices go up, how much less food people will buy. Again, people on different income levels differ in how responsive they are to a food price increase. According to a large review of all available evidence, the poorest households respond to a 10% increase in the price of food with a 9.1% drop in the amount of food consumed. For the wealthiest measured group, a similar price increase leads to a 7.7% decrease in the amount of food consumed.

Of course people might not be able to just reduce the amount of food they buy. This would be especially tricky for poorer income households who might be already consuming the minimum amount that’s required for not starving. Because the poor are more responsive to price changes, the cuts that poor households have to make are larger than wealthy households have to.

They could also try to carry on consuming the same amount of food but rearrange their consumption basket. This is possible if the food price increase is not uniform across all food. The problem is, that poor households make adjustments that are different from wealthy households. Whilst the lowest income households now buy less meat, fresh fruit and fresh vegetable, their expenditures on confectionary increased by more than 10%. A worrying potential for increasing health inequality as well.

Immigration and inequality

The government has never shied away from the statement that cutting immigration is the main driving force behind Brexit. Does immigration contribute to inequality? Intuition would say yes, as immigrants are more likely to be in the tails of skills distribution (either very low or very high skilled), by definition adding them to the current population increases inequality. Moreover, low-skilled immigration is likely to put a downward pressure on low-skilled wages, worsening inequality for the native population as well. Does evidence back this up? Sometimes yes (here and here), and sometimes it doesn’t (here and here). But previous works seem to be in accord on one thing: immigration is not the main cause of increasing inequality.

Moreover, there is a fundamental flaw in arguments blaming inequality on immigration. Shutting down immigration would stall growth (large body of literature, I’m only including a recent OECD report). The question the government seems to be asking is: Do we want to stop immigration just for the sake of reducing inequality? But the real question should be: Do we want to reduce growth and make everyone’s (including poor and wealthy!) lives worse off for the massively dubious benefit of reduced inequality?

Positive sources of inequality

In the introduction I mentioned that many sources of inequality do make everyone better off – although it makes some much better off than others. When you think of an invention, a new technology, a great music album, they can each make their producers extremely rich. But we all benefit from this process by having access to new technologies and so on. For completeness it is worth asking the question. How is Brexit likely to affect those sources if inequality that we would like to see more of.

Changes in productivity is one of the most obvious potential candidates to look at. A central element of the Brexit campaign was the possibility of eliminating EU red-tape. It is true, unnecessarily bureaucratic regulations can hamper productivity. But in reality, legislation affecting the UK economy is already one of the most liberalised in the UK. It is hard to see much scope for improvement on this front. So it doesn’t seem likely that we’ll witness huge changes in this respect.

OK, so what about research and development? A new technology can rocket anyone to superstardom. Are we more or less likely to witness new technologies coming out of the UK? Again, the picture does not offer much ground for optimism. A study by FTI consulting offers useful figures. The EU is one of the world leaders in R&D. Its strength comes from pooling resources and utilising talent across a large number of countries. The UK has been one of the largest beneficiaries of EU research funding (approximately £1 billion per year, which makes up almost 10% of UK universities’ total research revenue). And it’s not just academic research that’s affected. Between 2007 and 2013 UK businesses received €3.4bn of research funding from the EU. Those large businesses who will continue to have operations in the EU are less likely to be affected because they maintain their right to these funds. But small UK businesses are likely to lose out – again, inequality worsens.

Moreover, with competition losing intensity, and the government being tangled up in industrial planning, the effectiveness of competition laws are likely to suffer. The figure below plots the level of competition enforcement against R&D expenditures. Here country level R&D data is from the World Bank. This includes current and capital expenditures (both public and private) on creative work undertaken systematically to increase knowledge, including knowledge of humanity, culture, and society, and the use of knowledge for new applications. These R&D expenditures are expressed as a percentage of GDP. The level of competition enforcement is measured by The World Economic Forum index (labelled as ‘the effectiveness of anti-monopoly policies’), which assesses which nation’s competition policy promote competition most effectively.

Figure 1 – The relationship between the effectiveness of competition policy and R&D expenditure in EU countries (2006 – 2013)

comprnd

Although these are very aggregate and crude measures of competition and innovation, the visual findings are informative. It appears from the figure below that less effective competition enforcement goes hand in hand with lower R&D. This correlation remains when only comparing countries of comparable economic performance (e.g. only EU countries). Again, not a good omen before Brexit.


To briefly sum up, it appears that Brexit, especially hard Brexit will further contribute to inequality and unproductive sources of inequality are likely to dominate. First of all, Brexit will (and it already does) foster businesses to engage in more rent seeking activities. Second, following exit from the single market there will be a period of uncertainty with increased trade barriers and reduced competition. With rising food prices, the poor (who spend a larger part of their income on food) will bit hit relatively more than others. Changes in immigration on the other hand are unlikely to do much to improve economic equality. Finally, the potential for positive sources of inequality, such as through new innovation, is likely to take a hit after Brexit.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: