Tariffs, Domestic Import Substitution and Trade Diversion in Input-Output Production Networks: how to deal with Brexit

This paper challenges and complements existing studies on the economic impact of Brexit providing a discussion of the UK's decision to leave the EU and how it will affect international trade networks and value-added. Using the World Input-Output Database, we develop a multi-sector inter-country model that allows us to identify the channels through which the economic effects of Brexit would propagate. The inclusion of global value chains and indirect Brexit effects in the model leads to estimates that diverge with the results of the main literature. Indeed our findings, suggest that Brexit could be risky and costly not only for the UK but also for many EU countries. Furthermore, building on the Dietzenbacher and Lahr (2013) method of hypothetical expansion, we develop a second model and present the first empirical analysis on the consequences of domestic import substitution and trade diversion policies in Input-Output schemes. We found that allowing sectors and countries to partly substitute foreign products, leads to significantly lower losses for both macro-regions. In the second model, the UK and EU27 would lose, at worst, the 0.05 and 0.5 percent of value-added, respectively.