A UK-EU customs union: half in or all out?

12 minute read
27 February 2018

With so much discussion and speculation around the UK's membership of a customs union of some form after Brexit, we provide an essential Q&A to boost understanding of the key issues and terminology.

What is a customs union?

A customs union is an international agreement under which the parties apply a common (uniform) set of customs tariffs to imports from outside the customs union. The World Trade Organisation (WTO) allows members of a customs union to abolish tariffs between themselves and have common tariff rates for imports from outside the customs union. Although a customs union may apply to products of all kinds, in practice it is of most use - and therefore often limited to - trade in goods. Some types of goods are also often excluded from customs unions - particularly agricultural products.

Does setting common import and export duties mean that other taxes have to be uniform as well?

No. All 'direct' taxes and contributions - for example income tax and national insurance contributions - are completely unaffected by being in a customs union. Most 'indirect' taxes - for example excise duty on alcohol or cigarettes and VAT - are also not usually within the scope of a customs union treaty. However, import duties - including, for example, economic sanctions on goods imported from 'rogue' countries - will need to be agreed by all the countries in the customs union. Also any quotas (quantity restrictions on imports) will have to be agreed in common. These have in the past been applied to imports to Europe from certain countries, for example quotas of bananas from the Caribbean or dairy products from New Zealand.

If the UK enters a customs union with the EU, can it strike its own trade deals with other countries?

Not unless the EU agrees to this. If goods enter the UK under a different tariff to those agreed under the customs union treaty, they could be re-exported to the EU without customs checks. This would mean that, unless there was an agreed mechanism to prevent this - for example by electronic tagging of particular items - the 'new' tariff agreed by the UK would apply to the whole EU by default. This is not likely to be acceptable to the EU or its Member States. Such a tracing mechanism might also effectively mean the reintroduction of a tariff frontier between the UK and the EU - removing the advantage of having the customs union in the first place.

So what are the advantages for the UK of a customs union with the EU?

Having the same tariffs for goods as the EU will mean that there is no need for a systematic check of goods being shipped between the UK and EU countries to ensure that they have paid the right import tax - there will be no import taxes to pay. This should mean that the current 'frictionless' shipments of finished and intermediate goods between the UK and the rest of Europe can continue broadly as at present. It will also mean that the EU will not be able to change its own (EU) Common Customs Tariff without the agreement of the UK - for example in a way which might disfavour certain British manufacturing sectors.

In particular, being in a customs union with the EU will mean that there should be no need for a 'hard' border - with physical frontier posts etc. - on the land boundary between the UK and the Republic of Ireland, something which the UK government has committed to avoid in its December 2017 understanding with the EU.

Is a customs union different from the Single Market?

Yes. Customs unions of various forms are quite common - for example CARICOM, grouping together a number of Caribbean states, or Mercosur in Latin America. The (EU) Single Market goes much further than uniformity of import and export tariffs and quotas. It requires EU members to accept the 'four freedoms' - free movement of goods, services, capital and persons - so as to create a single large European market with a level playing field for all producers and consumers within it.

A customs union does not affect the freedom of the parties to regulate their own capital markets, nor to have their own independent immigration policy. The UK could still stop excessive permanent immigration. Most customs unions also do not affect the regulation of service providers crossing national borders.

For trade in goods, although a customs union will mean that cross-border trade is not taxed, regulation on how goods are made and marketed in the different parts of the customs union are also not normally affected. This would mean that the EU could in future change its own regulation on, for example, the use of chemicals or GMOs without consulting the UK. UK firms wanting to continue to sell in the EU would have to change their products to ensure that they complied. The UK will have no say over what these EU rules might be.

What is the government's 'three basket' proposal?

Broadly, the idea appears to be that economic policy is divided into three areas : (1) where the UK wishes to stay (in effect) in the Single Market; (2) where it wants to be outside the Single Market, but will shadow EU rules to give the same outcomes in return for access to the Single Market; and (3) where the UK wishes to be free to diverge altogether. The 'three baskets' are coupled with a government policy ambition to stay outside a customs union with the EU and not be subject to the jurisdiction of the EU Court of Justice (CJEU) except in certain areas.

The first basket (in the Single Market - minus free movement of people) includes those areas of the economy where, in effect, UK industry would wither unless it is able to be part of the EU regulatory regime for protecting health and safety. It includes the pharmaceuticals and chemicals (REACH) sectors. The UK would remain in the EU agencies regulating these sectors and be subject to EU legislation - including any relevant judgments of the CJEU.

The second basket (convergence of outcome, but not necessarily of means) is probably the largest at present and appears to contain much of the UK manufacturing sector (road vehicles etc) as well as financial services.

The third basket is not yet clearly defined, but may well include such areas as agriculture and fisheries and some 'tech' sectors, which many members of the UK government say are over-regulated by EU norms.

Will the EU agree to this?

Possibly, but likely only on condition of paying substantial annual contributions (above the €35-40 billion termination payment already agreed in principle) to the EU budget in those areas where the UK participates or converges. However, even if the EU is willing in principle to agree to allow the UK to 'cherry pick' the parts of the Single Market it wants when it is outside the EU, it may have to agree the same for other third countries - the idea of the EU as a smooth level playing field could start to unravel quite quickly.

Will a customs union take away the need for a free trade agreement?

An FTA between the UK and the EU will still probably be needed to deal with those areas of Single Market regulation which most closely affect cross border trade - for example, safety standards, rules on provision of services, enforcement of court judgments and IP protection. It is likely to be modelled on the new Canada-EU agreement (but possibly with some 'pluses'). That (recent) FTA also contains minimum standards (on the 'convergence' model) for certain kinds of economic regulation, notably competition law, state aid to industry and public procurement procedures.

Will the competition rules in an FTA restrict the ability of a future UK government to change economic direction - for example by renationalising the railways?

The EU Treaties are clear that they do not affect national systems of property ownership. The competition rules, which apply to all sectors in the EU, therefore do not distinguish according to the ownership of the firms in question: both private and state owned companies must in principle abide by the same rules - including State aid rules.

In some 'network' industries, however, EU legislation has required Member States to 'unbundle' the control of the network from the control of who provides services over them. So, for example, electricity transmission networks must now be open to all suppliers of electricity and not just those owned by the network. The same basic 'unbundling' rules apply to the railways - track networks must be open to all train service providers and not just those owned by the rail network.

Although in many Member States (including the UK), the rail network itself remains in public ownership, both public and privately owned train companies are allowed to use them on fair terms. So it is not open to a Member State under EU law to require all train operators to be State owned. If a free trade agreement is concluded between the UK and the EU, this issue will need to be addressed if a future Labour government wished to bring back a 'monopoly' British Rail in its 'old' form.

The European Convention of Human Rights - which is separate from the EU and which the UK will not be leaving - also includes a fundamental right to property ownership. That Convention too permits nationalisation, despite this fundamental right, but only on condition that the private property owner is fairly compensated.

Will the EU 'State aid' rules still apply if the UK is in a customs union or a free trade agreement with the EU?

There will need to be some UK rules - independently monitored - on State aid to industry whatever the post-Brexit trading arrangements with the EU look like. The World Trade Organisation rules require each WTO member to have a system in place to monitor State subsidies to industry, and in some circumstances the WTO treaties allow WTO countries to impose 'countervailing' import duties on goods where they have been unfairly subsidised by the state where they were made. An FTA between the UK and the EU will certainly have state aid rules - probably similar to those in the Canada-EU FTA. However, the exact scope of the UK's new state aid rules will be largely up to the UK. There is no need to create an exact copy of current EU rules.

Even under current EU State aid rules, Member States still have wide flexibility to support their own industrial and economic policy. State support will only be an 'aid' if it would not have been made available by a non-State investor in similar circumstances - the 'arms length investor' principle. If support is nevertheless an 'aid', it will still be compatible with the UK's future international trade obligations in most cases. For example, the EU regime allows State aid for basic research and development - for example in universities. It also allows aid to support the regeneration of disadvantaged regions of the UK. At present, the EU defines what is a 'disadvantaged' region: after Brexit, the UK would have a freer hand to redraw the regional aid map.

Where will we end up?

It is quite likely that the UK government will be able to negotiate a Canada style free trade agreement with the EU before any transitional period runs out - and it may have a few 'pluses' in it, depending on how expert the UK negotiating team is. However - assuming there is no change in government before 2022 - there will not be a customs union and it is difficult to see how the mooted 'virtual' alternative can work. Certainly it would be a new creature in international law and - for that reason alone - complex and difficult to operate even if it can be agreed with the EU.

Of course, it would still be open to the UK to negotiate a 'traditional' customs union agreement with the EU even some time after it has left the EU. The economic repercussions of 'hard' customs borders between the UK and neighbouring EU Member States may mean that a UK-EU customs union becomes inevitable. The 'end state' proposed by the UK government may therefore in fact be simply a 'medium term' state. In the meantime, the uncertainty over the longer term ability of the UK to continue with FTAs with third parties, due to the possible need to enter a customs union with the EU later on, can be expected to have a chilling effect on the Department for International Trade's ability to conclude FTAs with non-European countries.

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