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THE UK LEGAL SERVICES SECTOR AND THE EU An analysis by Oxford Economics, commissioned by the Law Society of England and Wales SEPTEMBER 2015 The UK legal services sector and the EU The three scenarios modelled for this report were chosen by the Law Society in order to test the sensitivity of the results to the possible effects of complete UK withdrawal from the EU across four core modelling dimensions (migration, foreign direct investment, trading relationships and fiscal). These represent four areas which could be impacted significantly by how the UK government would opt to use its newly achieved policy autonomy as a result of a BREXIT. It should be recognised that whilst best efforts were made to ensure that the modelling was as comprehensive as possible, certain limitations made it impossible to fully take into account all relevant economic factors. The scenarios were developed based on a set of assumptions by the Law Society Research Unit, guided by research and expertise from Oxford Economics, to reflect the impact of a UK withdrawal on the resulting trade, fiscal and regulatory settlement. Oxford Economics provided guidance on how these scenarios could be formed (based on relevant empirical data) and the type of variations that could be adopted to implement sensitivity testing around a scenario where Most Favoured Nation tariff rates applied in the absence of fresh trade agreements (which were assumed in the central and upside cases). The modelling process was carried out by an independent third party, Oxford Economics, with acknowledged expertise in macroeconomic modelling and scenario analysis. 2 The Law Society of England and Wales An analysis by Oxford Economics, commissioned by the Law Society of England and Wales INTRODUCTION This report discusses how the UK’s withdrawal from the EU could affect the legal sector, relative to the rest of the UK in economic terms. To date, no analysis has been available to demonstrate the range of possible economic effects of a UK withdrawal on the legal services sector specifically, compared with potential impacts on the UK as a whole. Effects on output and employment are negative under all three scenarios. The scenarios will provoke discussion and, read with our Executive Briefing document, will provide an unprecedented picture of the possible futures for the UK legal sector postEU referendum. Our headline findings are that: • Legal services would be disadvantaged disproportionately compared with the UK economy as a whole. • The stronger negative effects on the legal services sector are due to the sector’s reliance on intermediate demand from sectors which are likely to be adversely affected by a UK withdrawal from the EU, particularly the financial services sector and other professional services, and from the subsequent lower levels of business investment. • The scale of the impact would depend on economic drivers shaped by the UK’s withdrawal negotiations and subsequent UK government policy actions. Analysis providing an independent view under three economic scenarios – downside, central and upside – produced forecasts to 2030 for economic output and employment in terms of total numbers of jobs.1 The effects are compared against baseline forecasts for output and employment (what is expected to happen in the status quo situation with the UK’s membership of the EU unchanged). 1 Economic output of legal services is the sector’s contribution to the economy as measured by Gross Value Added (GVA). This measure is used in national statistics to indicate the value of goods and services produced in a sector or geographic area. For the purposes of our analysis legal services GVA is compared with GVA for the UK as a whole (equating to standard, published GDP less taxes plus subsidies on products). The total number of jobs corresponds to the workforce jobs measure from national statistics. www.lawsociety.org.uk 3 The UK legal services sector and the EU Background The government has committed to hold a referendum on the UK’s membership of the EU by the end of 2017. The decision will have profound effects on the UK including, critically, economic implications. The Law Society commissioned consultants Oxford Economics to extend their industry-leading Oxford Global Economic Model to provide an independent assessment of the potential effects of a UK withdrawal on the legal sector relative to the wider UK economy. This is, to our knowledge, the first attempt to date to estimate the economic effects of a UK withdrawal on the legal sector against those for the UK. Figure 1: Possible outcomes following UK referendum on membership of the EU EU MEMBERSHIP RETAINED The outcomes of a withdrawal are uncertain and depend on any arrangements that the UK government could negotiate with the EU upon exit, to safeguard the UK’s interests. Withdrawal is, however, likely to result in one of the range of possible outcomes summarised in Figure 1. “THE NORWAY OPTION” – LEAVE EU BUT BECOME MEMBER OF THE EEA Under the three alternative scenarios used in the analysis (downside, central and upside) the path of economic drivers are affected to different degrees in recognition of the uncertainty over: • The UK’s negotiated arrangements if it were to withdraw from the EU. “THE SWISS OPTION” – FTA PLUS BI-LATERAL NEGOTIATION • How the UK chooses to use greater autonomy over policy areas such as business regulation. “THE TURKEY OPTION” – CUSTOMS UNION GO IT ALONE – WTO MEMBERSHIP Source: Oxford Economics 4 The Law Society of England and Wales LESS INTEGRATION The negotiations are likely to feature trade-offs involving access to the single market, the UK’s fiscal contributions, and policy autonomy over areas such as immigration and regulation. These issues represent political and societal concerns. The approach of this report is to present an analysis of a range of possible economic impacts on the legal services sector compared with the UK as a whole. An analysis by Oxford Economics, commissioned by the Law Society of England and Wales The Oxford Economics modelling framework The model captures how the changes in the overall level and composition of demand, as affected by the economic drivers cited below, cascade through industry sectors including legal services.2 Its strength is in being able to capture the interdependencies between sectors and the wider global economy in order to gauge the impact of significant external ‘shocks’ such as the UK’s exit from the EU. No sector-specific drivers are included in the economic modelling, for example, the effects on volumes of work for City of London law firms from the financial services sector due to a shift of euro trading from London to Frankfurt or Paris following a UK withdrawal, are not explicitly taken into account, neither are regulations that might change governing particular industries. This modelling framework used as a standalone tool is not designed to estimate the impact of every specific eventuality (to do so would defy the aim of an economic model). While the economic modelling and long term forecasting does not account for particular industry events or regulations that may affect legal services firms, or indeed a potential positive short term boost for some areas of legal work due to a UK withdrawal, the historical patterns of supply and demand between sectors are reflected in the model. More information on the modelling framework is available on request. London Frankfurt The Oxford Economic model itself consists of thousands of interlinked equations based on historical correlations and economic theory. 2 Paris www.lawsociety.org.uk 5 The UK legal services sector and the EU HEADLINE FINDINGS Following a UK withdrawal from the EU, moderate negative economic effects for the legal services sector would nevertheless be stronger relative to those for the UK as a whole. The effects of a UK withdrawal on key economic drivers are assumed to start in 2020, allowing for a period after the referendum for the UK’s negotiation and effective withdrawal. Details of the drivers and approach to assumptions that underpin downside, central and upside scenarios are described on pages 8-11. The full effects on output and employment will be felt by 2030, with results for that year shown in Figure 2 below. Distinguishing features of the results shown in Figure 2 are: • Effects on output and employment are negative under all three scenarios. • The negative effects range from small to moderate by 2030 relative to baseline forecasts; effects are smaller for employment than output across all scenarios. • Negative effects on the legal services sector are generally greater in magnitude than those for the UK economy as a whole in terms of both output and employment. Figure 2: Effects on legal services output and employment, 2030, under downside, central and upside scenarios (% deviations from baseline forecasts) Downside Central Upside 0% -0.5% -1% -1.5% -2% -0.6% 0% -1.4% -3% -4% -5% -4% Economic output (Gross Value Added) Employment Source: Oxford Economics and Law Society calculations 6 The Law Society of England and Wales Comparable UK deviations An analysis by Oxford Economics, commissioned by the Law Society of England and Wales Although the negative effects by 2030 are estimated to be relatively small in percentage terms, the absolute volumes of lost output forecast can be viewed in the context that: • In the downside scenario, projected annual output loss for the legal services industry in 2030 (£1.7 billion in 2011 prices) equates approximately to the current combined annual UK revenue of Linklaters, Freshfields Bruckhaus Deringer, Clifford Chance and Allen & Overy (on a constant price basis). • The upside scenario implies an annual loss of £225 million legal services output in 2030 – approximately the current annual income of the tenth largest law firm ranked by UK revenue. The losses in 2030 would follow a gradual erosion of legal services output (versus the baseline forecast) over time, such that the cumulative loss of output and employment in the legal services sector (and UK economy as a whole) would be greater than simply the value of lost output in 2030 itself. Moreover the loss of output compared with the status quo (the UK remaining a member of the EU) may persist for a relatively long period if the UK fails to achieve sufficient economic integration with other trading partners to be able to offset the impacts following withdrawal. Although the scale of potential losses are compared with the income of large legal firms named above, the data and modelling framework utilised is not designed to allow analysis of how the effects of EU withdrawal would be distributed across functional or spatial areas of the legal services market, or by size of firm. The box on page 5 contains further detail of the modelling framework. www.lawsociety.org.uk 7 The UK legal services sector and the EU DRIVERS UNDERPINNING CHANGES IN LEGAL SERVICES AND UK OUTPUT AND EMPLOYMENT The UK accesses a single market which promotes free movement of goods, services, capital and people within the EU while contributing significantly to the EU budget (annual net contributions ranged between £8 billion and £10 billion in recent years). The selection of economic drivers to analyse potential changes in output and employment was in the context of macroeconomic factors that stand to be affected by the UK’s departure from the single market, and the fiscal and other policy commitments that the UK currently makes in order to access the market.3 Four key economic drivers are responsible for changes in output and employment within the Oxford Economics modelling framework under BREXIT scenarios: • Trade tariffs on goods. The decision to move to a WTO trade model in the event of EU withdrawal is likely to result, at least initially, in an overall increase in effective external tariffs. • Foreign Direct Investment (FDI). Lack of free access to the single market would affect the UK’s attractiveness as a host location, leading to a likely reduction in FDI. The forecast paths of the four economic drivers determine, along with other economic factors, the baseline output and employment forecasts against which our headline results are compared. The original, baseline forecasts for three of the four key drivers are shown in Figure 3 (FDI, net UK contributions to the EU budget, and net migration). Trade tariffs on goods are not shown, because effective tariffs are assumed to stay as they are under the baseline. To analyse the economic impacts, Oxford Economics considered how the four drivers could deviate from baseline projections under the three alternative economic scenarios, to provide bounds for inclusion in the model. The assumptions for how the four drivers could deviate are outlined in the next section. • Net migration. A decrease in inward migration (both skilled and unskilled) into the UK would follow from the UK government being able to restrict inflows of EU migrants. • Fiscal contributions to the EU budget. A direct fiscal impact would result, to the extent that the UK’s net contribution to the EU budget is affected (the UK’s gross contributions minus receipts). All other economic and demographic changes to baseline forecasts within the Oxford model stem from changes in the four drivers above (for example net migration affects population projections within the model, and FDI influences capital stock). The selection of trade tariffs on goods as a driver, rather than on all goods and services, reflects not only data availability, but also that there is currently only a nascent free market in services within the EU. Country-specific regulations restrict cross-border transactions in tradable services, and these would still apply.4 The available modelling framework also involves some restrictions in terms of the specific economic indicators that can be considered. Further detail is provided in the Review of the Balance of Competences between the United Kingdom and the European Union, The Single Market: Free Movement of Services, HM Government, Summer 2014. 3 4 8 The Law Society of England and Wales An analysis by Oxford Economics, commissioned by the Law Society of England and Wales Figure 3: Forecasts for foreign direct investment, net migration, and UK fiscal contributions to 2030 under the status quo where the UK remains a member of the EU Forecast net UK contributions to the EU budget (£ billions) Forecast total UK inward FDI flows (£ billions) 16 100 90 14 80 12 70 10 60 50 8 40 6 30 4 20 2 10 2030 2028 2026 2024 2022 2020 2018 2016 2030 2028 2026 2024 2022 2020 2018 2016 2014 Source: Oxford Economics 2014 0 0 Source: Oxford Economics Forecast net migration to the UK (thousands) Non-EU net migration Total EU net migration Skilled EU net migration Unskilled EU net migration 120 110 100 90 80 70 60 50 40 30 20 10 0 2014 2015 2016 2017 2018 2019 2020 2021 Source: Oxford Economics www.lawsociety.org.uk 9 The UK legal services sector and the EU SCENARIOS AND THE APPROACH TO ASSUMPTIONS Alternative assumptions for economic drivers used the most appropriate available data, academic studies, and judgement of best and worst case scenarios. Three scenarios involving alternative changes to the economic drivers reflect the uncertainty surrounding the nature of the UK’s exit from the EU should this occur. The extent of deviation in the economic drivers from baseline forecasts under the three scenarios was modelled using the best available current evidence (including academic studies) and, in some cases, judgement to inform: • The likely maximum and minimum deviations that could be expected for each economic driver should the UK leave the EU and, where necessary. • Subsequent changes to UK economic and trade policy that would follow the UK’s exit. Actual changes to domestic economic and trade policy would be a function of the arrangements that Britain negotiates with the EU and other trading partners, and the policies that the UK pursues as a non-EU member. As highlighted above, the assumptions regarding economic drivers have knock-on effects within the model on other economic and demographic factors (population, capital stock, productivity and prices). The table included as an appendix provides a list of all factors within the model that were directly altered to calibrate the scenarios, full details of the approach and evidence used to form assumptions, and the resulting scale of deviations in economic drivers from their baseline forecasts. 10 The Law Society of England and Wales An analysis by Oxford Economics, commissioned by the Law Society of England and Wales While three scenarios were formulated the bounding scenarios are broadly characterised as: Upside • Trade negotiations proceed swiftly and successfully, meaning new trading relationships are established relatively quickly following the UK leaving the common market. • The UK uses an exit from the EU as an opportunity to liberalise economic conditions, helping to offset some of the negative impact that losing access to the single market has in terms of FDI and migration. • The fiscal windfall (saving from net contribution to the EU budget) is used to cut taxes for workers and businesses. Downside • Trade negotiations reach an impasse resulting in the UK failing to reach any subsequent trade agreements with the EU or outside partners. • The UK fails to use the opportunity offered to enhance the economic and business environment. • The fiscal windfall is used to support an increase in spending on welfare and frontline services. The approach to forming assumptions regarding the paths of economic drivers did not involve predicting changes based explicitly on political choices that the UK may have to make in any post-withdrawal negotiations with the EU, for example, between maintaining access to the single market and autonomy over policy areas that the UK may enjoy as a non-EU member. Rather the approach was to make assumptions about realistic bounds for economic drivers by considering each driver in isolation, and based on what the UK may or may not be able to achieve through its own domestic economic policies and trade negotiations following a UK withdrawal from the EU. www.lawsociety.org.uk 11 The UK legal services sector and the EU APPENDIX Detailed approach to scenarios and assumptions Economic driver Trade tariffs on goods Main other modelling factors affected • UK export prices • UK import prices • Productivity growth Rationale and evidence to inform deviations from baseline forecast Following BREXIT the UK is initially assumed to become a standalone member of the WTO. This would result in tariffs being imposed on UK goods exports to all existing EU member states, and countries which have signed bi-lateral free trade agreements with the EU. It is assumed that the UK responds to newly imposed tariffs on its exports by imposing tariffs on imports from these countries. Bilateral trade and WTO data were used to estimate effective tariff rates of each country (based on Most Favoured Nation tariffs charged by the EU on products to other non-EU nations). Basis for selection of downside, central and upside assumptions Under the three scenarios, new trade agreements are introduced differently, meaning the increase in tariffs vary: • Downside scenario: Sees all barriers remain (no new trade agreements to 2030). • Central scenario: Previous trade agreement with EU countries re-introduced after 5 years, and with countries that have bi-lateral free trade agreements with the EU after another 5 years. • Upside scenario: Barriers with EU countries and others with bi-lateral trade agreements with the EU are removed after 4 years, and further free trade agreements with other major trading partners introduced another 4 years later. Other modelling assumptions Also factored into scenario tariff rates were changes in UK import taxation. The effect of import tariff changes on UK manufacturing productivity was separately estimated for entry into the model using empirical evidence from Bernard, Jensen and Schott (2006), Trade Costs, Firms and Productivity, Journal of Monetary Economics. Scale of deviations from baseline forecast Maximum increase in effective tariff rates (downside scenario): • UK exports: 2.12% • UK imports: 1.95% Reduced increases in tariffs in the central and upside scenarios were introduced through 2030. 12 The Law Society of England and Wales An analysis by Oxford Economics, commissioned by the Law Society of England and Wales Economic driver Foreign Direct Investment (FDI) Main other modelling factors affected • UK capital stock Rationale and evidence to inform deviations from baseline forecast The negative relationship between BREXIT and net FDI flows into the UK was estimated using empirical evidence (Pain and Young, 2005) on the importance of EU membership to UK FDI by sector, from Pain and Young (2004). The macroeconomic impact of UK withdrawal from the EU, Economic Modelling, Vol. 21. Basis for selection of downside, central and upside assumptions The negative impact on FDI flows is felt to different degrees under the three scenarios depending on assumed UK government policy responses: • Productivity growth • Downside scenario: Assumes no policy response from UK government to reform regulation and therefore stimulate FDI. • Central and upside scenarios: Assumes policy response with FDI forecast adjusted upwards based on empirical evidence on the relationship between the quality of regulation and FDI flows – from Daude and Stein, (2007), The Quality of Institutions and Foreign Direct Investment, Economics & Politics, Vol. 19 – and using the World Bank Governance Indicators’ Regulation Score series with differing degrees of catch up by the UK to the top-scoring country (Sweden). Other modelling assumptions Effects are modelled to occur gradually over a 10-year period following withdrawal. Scale of deviations from baseline forecast Cumulative % changes in FDI stock by 2030 compared with baseline: • Downside: -11.8% • Central: -4.8% • Upside: -0.7% www.lawsociety.org.uk 13 The UK legal services sector and the EU Economic driver Net migration Main other modelling factors affected • Working age population • Supply of skilled labour • Supply of unskilled labour Rationale and evidence to inform deviations from baseline forecast End to freedom of movement between the UK and EU member states is likely to restrict both inward and outward migration. Given that net migration from the rest of the EU to the UK has been strongly positive over the past 10 years, the overall impact of withdrawal is assumed to be to lower net inward migration. The UK Government is assumed to impose a points system on EU migrants (similar to the current model operational for non-EU citizens) resulting in reductions in net inward migration of skilled and unskilled workers. The split between skilled and unskilled migration was estimated using ONS Labour Force Survey data showing the share of individuals who had moved to the UK from an EU country in the recent years with at least degree level qualifications. Basis for selection of downside, central and upside assumptions The system brought in to manage inward migration is assumed to favour skilled migrants so their inward flows are reduced at lower rates compared with unskilled migrants. Based on anecdotal evidence of how the points system for non-EU migrants has affected net migration flows the changes in EU net migration in the three scenarios were set at: • Downside scenario: 40% reduction in skilled EU net migration and 60% fall in unskilled by 2030. • Central scenario: 30% reduction in skilled EU net migration and 50% for unskilled by 2030. • Upside scenario: 20% fall in net migration for skilled and 40% for unskilled EU nationals by 2030. Other modelling assumptions The reductions on baseline net migration forecasts are introduced at a gradual and constant rate from 2020 to 2030 and working age population and labour supply forecasts are adjusted accordingly. Scale of deviations from baseline forecast Changes in working age population by 2030 compared with baseline: • Downside: -371,000 • Central: -141,000 • Upside: -79,000 14 The Law Society of England and Wales An analysis by Oxford Economics, commissioned by the Law Society of England and Wales Economic driver Fiscal contributions to the EU budget Main other modelling factors affected • Income taxes • Employer social security contributions • Government consumption • Government investment Rationale and evidence to inform deviations from baseline forecast Historically, the UK has been a net contributor to the EU budget and there is a very high probability that this would remain the case over the forecast period if the UK did not leave the EU. As such, withdrawal should have a positive impact on the fiscal balance, other things equal. The assumption is that the UK saves its entire net contribution to the EU budget for use on other fiscal measures. To estimate net EU budget contributions for the baseline forecasts, for 2015-19 official forecasts from the Office for Budget Responsibility were used. Post-2020, it was assumed that the net contribution continues to average 0.4% of Gross National Income. Basis for selection of downside, central and upside assumptions Under the three scenarios the saving of net EU budget contribution is put towards different fiscal uses: • Downside scenario: The financial savings are put towards increased government expenditure split evenly between higher government consumption (which would be reflected in higher spending on front line services), higher investment and higher transfers (this would include benefits, the state pension etc). • Central scenario: Funds from the EU budget are split between government consumption and economically efficient measures that involve reductions in income tax and employer social security contributions. • Upside scenario: The fiscal benefit of leaving the EU is entirely put towards measures friendly to businesses and enterprise (i.e. what can be thought of as economically efficient measures). The windfall is split evenly between reducing income tax and employer social security contributions. Other modelling assumptions None. The net UK contributions to the EU budget are assumed to be used in full from 2020 on other fiscal measures. Scale of deviations from baseline forecast Total savings from 2020 to 2030 as a result of foregoing the net UK contributions to the EU budget are £128 billion. These are split between government spending uses in the downside scenario and to fund tax cuts in the upside scenario. www.lawsociety.org.uk 15 www.lawsociety.org.uk The Law Society 113 Chancery Lane London WC2A 1PL Tel: 020 7242 1222 Fax: 020 7831 0344 DX: DX 56 London/Chancery Lane www.lawsociety.org.uk @TheLawSociety © 2015 The Law Society. All rights reserved. September 2015. Designed by DTW