Goods In – Services Out: Can the UK Walk on One Leg?

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01 October 2018

Dr Ingo Borchert is Senior Lecturer in Economics, and Dr Peter Holmes is a Reader in Economics, both are fellows of the UK Trade Policy Observatory. 

The UK Government is currently proposing to the EU, broadly speaking, to adopt a common rulebook for goods.  By contrast, not much if anything is sought in the realm of services, let alone movement of people or other areas of the Single Market.  Part of the EU’s response has been that goods and services are so interlinked that one cannot have a goods only single market.  Is this response just posturing as part of the negotiations process, or are there real issues with separating goods and services?

There are at least three principal issues to consider that link goods and services:

1. Manufactured goods exports embodying a good deal of services inputs, called “Mode 5” services exports,

2. The commercial bundling of goods and services, although they are still traded separately, called “servitisation”, and

3. The economic integrity of the all-island Irish economy.

It is likely that the disregard of services in the Chequers proposal is going to make life more difficult for UK businesses post-Brexit because of the way goods and services are nowadays linked (points 1 and 2), but problems are not insurmountable.  The true challenge, however, in our view is the Northern Ireland question.  We argue, first, that the preservation of the all-island Irish economy would face serious problems under the current Northern Ireland backstop if services were excluded.^[1]  Second, if that implied that the inclusion of services would need to be considered more fully in the backstop provision, further issues would arise if the backstop encompassed only Northern Ireland but not the rest of Great Britain as well.

The All-Island Irish Economy

The Backstop agreement of December 2017 states that Northern Ireland will effectively be in a customs union with the EU and will apply all single market rules needed to keep an all-Ireland economy.  The text says: “the United Kingdom will maintain full alignment with those rules of the Internal Market and the Customs Union which, now or in the future, support North-South cooperation, the all-island economy and the protection of the 1998 Agreement” (para. 49).

Earlier UKTPO blogs have suggested that, in order to avoid customs checks at the Irish border, Northern Ireland must be in a customs union with the EU and apply all single market rules for goods.  Furthermore, to avoid border controls in the Irish Sea and in Calais the entire UK should be included in this arrangement, as the UK proposed in its own Backstop paper.^[2] The EU has rejected both the exclusion of services and UK-wide coverage, although the Commission currently appears to be considering a modified backstop option that would allegedly allay UK fears of creating a border between Northern Ireland and the rest of the UK.

Indeed, preserving the all-Ireland economy without including the rest of the UK will be difficult in the realm of services for two reasons.  First, the all-island economy includes cross-border provision of services. A random glance at job advertisements from Northern Ireland websites shows that at present many workers in service industries, plumbers, electricians, etc, are expected to work across the border.  Just how much services trade crosses the border is unclear; a 2018 NISRA Paper^[3] on value chains hardly mentions Irish cross-border services, yet services provision is arguably an integral part of the economy, even if such trade across the Irish border often eludes measurement. It would thus be necessary to include services.

Second, if services needed to be included as well, the question is whether it is possible to do this just for Northern Ireland.  In practice, it will be difficult to tell apart a Northern Irish lawyer from a London lawyer when he or she is practising law in the Republic of Ireland (ROI).  The former ought to be allowed under the backstop that preserves the all-island economy; the latter, however, would not be.  Making a distinction on the basis of domicile (Northern Ireland vs non-Northern Ireland) is practically impossible.  That also raises the question of whether the Republic of Ireland (ROI) could potentially become a backdoor for supplying services to the rest of the EU.  Could an architect (or a bank?) based in London offer services in Lisbon via a Northern Irish office?

The other concern, from the point of view of the ROI and perhaps the EU, is that in the absence of a common rulebook for services and service suppliers, the UK’s regulatory framework may diverge in future, potentially resulting in a situation in which service professionals that no longer meet EU standards may nevertheless be allowed to supply services within the Union.  It is difficult to avoid such a situation without a regulatory split between Northern Ireland and the rest, which is anathema to the UK government.

For all these reasons, the integrity of the all-island economy is probably the biggest reason that the common rulebook needs to cover not only goods but also services.  By contrast, the UK government’s position is more tenable regarding the other important dimensions of goods and service linkages.^[4]

Services as Vital Inputs into Goods

In the age of production fragmentation, the value of nearly all manufactured goods includes a considerable share of services inputs that either become part of the product (such as software) or that facilitate the manufacturing process (R&D) or the product’s distribution (branding, transportation).  In 2017, the value of domestic services inputs alone (i.e. disregarding foreign services inputs) into UK manufacturing exports amounted to over £70 billion. By comparison, this is close to all direct exports of financial and insurance services combined (see UKTPO Briefing Paper 22).

One fear that the EU might have is that the UK could deregulate the supply of service inputs such that a greater variety of services at lower prices are available, thereby conferring a competitive advantage to UK firms that the EU may perceive as unfair.  Think of transportation, finance, distribution and professional services. Yet using newly-won regulatory freedom to that effect would only be possible if hitherto EU regulation had governed the usage of such inputs comprehensively.  That is only partially true, though, as only some service sectors are regulated via the single market, eg. certain aspects of providing engineering or auditing services, whereas other service sectors are not covered by the Services Directive or other EU legislation (eg. technical testing or certain parts of the creative sector).

This means that national governments enjoy considerable leeway to regulate service sectors and the conditions for services trade.  Therefore, the regulatory level playing field is incomplete across the EU, and the UK government could make services sectors more competitive whilst staying in the EU.  Moreover, if less regulation and oversight resulted in these service inputs being of lower quality (less qualified architects or auditors), then this will not help the sales prospects of UK goods abroad.  Aarti Shankar has argued that based on OECD-TiVA statistics, the Commission seems to overstate the case of potential unfair competition arising from services inputs.^[5]

It is true that, apart from sector-specific regulation, the EU might still be worried about the wider “level playing field” as far as e.g. competition policy, gig economy rules, or consumer privacy are concerned.  But in case of any deal, the EU will presumably insist on broad alignment in such cross-cutting policy areas.  As in the case of cross-border data flows, for example, in most areas being aligned with EU rules will be in the UK’s best economic interest.

Bundles of Goods and Services

As part of a trend to “selling solutions rather than products,” goods and services are often delivered as a package in which the constituent parts cannot easily be disentangled.  This could be a loan to finance a newly purchased vehicle or a maintenance/optimisation contract for aircraft engines.  As such, many companies derive a large – and growing – part of their revenue from services; IBM and Rolls-Royce are well-known examples.  To the extent that the delivery of products and services are closely linked, freeing up goods trade might still not allow the bundled transaction to occur if divergent rules for services prevailed.  This could be because the qualifications of the UK engineer, who is to perform after-sales maintenance on an elevator, are not recognised in the country in which the service is to be discharged.  Or it could arise from legal uncertainty as the UK is also set to leave EU jurisdiction and dispute settlement mechanisms.

This is a relevant issue as more and more UK firms engage in such bundling activity.  Andy Neely of Cambridge finds on the basis of 12,000 firms that nearly 30% of firms from the manufacturing sector also sell associated services.  And this trend is increasing as the share of such firms is up from 25% two years earlier.^[6]

Conclusions

Goods and services markets are linked in various ways, e.g. by services being inputs into traded goods (mode 5) or by bundling goods and services in a comprehensive business solution.  In our view, neither one constitutes a fundamental practical objection to a goods only Single Market, which after all does operate with Switzerland.  On the alleged issue of unfair competition through deregulation of service inputs, the post-Brexit situation might not be much worse than the current flexible rules.  On bundling, restrictions on services accompanying goods would in the worst case hurt the UK in market access terms, and European consumers (and UK producers) would suffer as a result.

The key challenge is the need to preserve the all-island economy in Ireland and the UK internal market.  Our analysis shows that a goods only backstop from Northern Ireland would be seriously problematic.  It is increasingly hard to avoid the conclusion that only a Single Market deal including services and Great Britain would jointly satisfy both constraints.  It would, therefore, appear to be difficult to reconcile the UK’s current Chequers plan, which essentially proposes a common rulebook for goods trade, with the backstop agreement; in particular, the ambition to preserve the all-island Irish economy.

 

References

^[1] The UK proposal for the Northern Ireland (NI) backstop provision is mainly, if not exclusively, concerned with goods trade: “The UK’s proposal is that in the circumstances in which the backstop is agreed to apply, a temporary customs arrangement should exist between the UK and the EU.” See HM Government “Technical Note: Temporary Customs Arrangement.” See also Chris Morris: “Reality Check: What do Brexit backstop proposals mean?” and the UKTPO blog on the backstop proposal.

^[2] See HM Government “Technical Note: Temporary Customs Arrangement.”

^[3] “Cross-Border Supply Chain Report (2015, 2016)” Northern Ireland Statistics and Research Agency and the Department for the Economy (Northern Ireland).

^[4] See UKTPO blog “How can the UK persuade the EU to accept an all-UK backstop?”

^[5] “Mode 5” does raise some interesting issues for measurement of Origin in an FTA but we do not have space to address them here.

^[6] Andy Neely: “The Servitization of Manufacturing: An Analysis of Global Trends”.

 

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