Johnson’s freeport idea is full of holes

(Bloomberg Opinion)—Rishi Sunak hasn’t yet released his first budget as Britain’s new Chancellor of the Exchequer, but already his ideas are shaping the post-Brexit economic landscape and will influence the trade negotiations with Brussels that start next week.

Sunak’s proposal that Britain set up a network of freeports was seized upon by Prime Minister Boris Johnson as a way of delivering infrastructure and opportunity to poorer regions after Britain completes its exit from the European Union. The plan has its roots in a 2016 report Sunak authored for the the Center for Policy Studies, a conservative think tank, arguing that the creation of these special economic zones after Brexit will create up to 86,000 new jobs and boost trade and investment in struggling areas. It’s a neat idea, but one with serious limitations and which is nothing like the Brexit dividend that the government’s suggesting.

A freeport — versions of which have been around since Greco-Roman times — lies within a country’s geographical space but outside its customs territory. Importers get relief on customs duties or can defer the duties while the goods are held in the freeport, and there are simplified customs procedures. If the goods are used in manufacturing within the freeport, only the final good, when exported, attracts duties. 

It’s sometimes the case that tariffs are higher on component parts than on the finished products, which is known as tariff inversion. So the freeport model lowers costs for manufacturers who don’t pay duties on the imported components, but only on the finished product when it’s exported. That’s why a big part of why the U.S. approach to this, called Foreign-Trade Zones, is effective. Governments can also use other enticements to get people to use their freeports, from tax breaks to fewer regulations. 

Britain had seven freeports at one time, and closed the last five in 2012, focusing instead on “enterprise zones” where clusters of companies are offered tax relief and accelerated planning permissions. The results have been mixed. The new proposals for “supercharged” freeports seek to revive their customs benefits and add on other inducements, which were not permitted under EU rules.

That all sounds fine, but Sunak’s analysis overstates the relevance of the U.S. experience, while glossing over the limits of non-tariff barriers that would remain in the new hubs. To arrive at his figure of 86,000 new jobs, Sunak used the total number of jobs across the U.S. Foreign-Trade Zones (420,000) and scaled it to the U.K. labor force. That assumes these were all new U.S. jobs rather than ones that were shifted from elsewhere, which isn’t the case.

Nor would U.K. importers and manufacturers benefit from tariff inversions to the same extent. In British carmaking, for example, tariffs aren’t inverted, meaning there would be no savings. Importers of auto parts from outside the EU’s single market only face tariffs of about 4.5%, whereas they’d pay 10% on exporting finished cars. According to calculations by Ilona Serwicka and Peter Holmes at the University of Sussex’s U.K. Trade Policy Observatory, the savings that importers overall could realize in U.K. freeports would only be a tiny portion of the value of the goods. 

The researchers looked at the five U.K. goods categories where the inversion’s greatest — that is, the difference in the saving from the levy paid on the imported component and what’s paid on the final exported product. They found that, while there’s scope for some savings, the impact on the economy would be minimal. Together, the five categories comprise 1.14% of U.K. imports.

“The U.K. has never had a clear strategy and a clear idea what it wants to do with freeports,” says trade consultant Anna Jerzewska. To create pockets of Silicon-Valley type innovation requires a complex web of policies, not a declaration and some border infrastructure.

Freeports, she notes, also don’t eliminate many non-tariff trade barriers. Their exports still face checks and tariffs. Rules of origin principles need satisfying and are made more difficult in a freeport. “A freeport won’t be viewed as within the customs territory of the U.K.,” she says, which means it would fall foul of the principle of territoriality. It’s easy to see how these could complicate the U.K.’s multiple trade negotiations.

Is the cost of setting up these zones even worth it, when average customs duties (assuming there’s no EU trade deal in place) are only around 3%? Much of Sunak’s upside depends on how far the government can sweeten the zones through tax breaks and other inducements. Leaving the EU certainly provides more scope for doing that, but World Trade Organization rules let countries retaliate against subsidized exports.

Some job creation around the freeports can be expected, but what kind of jobs and will they simply be displaced from elsewhere? The U.S. experience suggests that there are modest employment and wage benefits eventually, but most freeport jobs tend to be manual labor.

There are also worries about whether investing in this would come at the expense of British education and training in general. If lighter regulation and tax breaks are what spurs regeneration and innovation, why limit this to 10 places?

It’s no coincidence that the European Commission has introduced new rules governing freeports, citing concerns over money laundering, tax avoidance and other illegal activity. Such fears are based on past experience, but it’s easy to exaggerate the risks now that the U.K. wants to use freeports to help it compete after Brexit.

For all its limitations, the idea of modern freeports dotted around neglected parts of the country has political appeal. It sends a strong message to voters in the newly Conservative-voting regions in the north that Johnson will put money into port communities and support manufacturing.

But that virtue signalling will come at a price. These hubs only make financial sense with total regulatory freedom and no zero-tariff deal with the EU. Either Johnson wants to use freeports as a threat in the EU trade talks, or he has decided already that freeports offer better value politically; in which case, it becomes more likely that Britain either gets no trade deal this year or just a bare-bones one.

Sunak’s think tank plan for Britain’s freeports may be the tail that wags the Brexit trade dog.