Just weeks after two "No" votes to its new constitution, the EU has been plunged into a row over its finances and the UK's budget rebate. Nick Morrison looks at the rights and wrongs of the dispute - and what it means for the EU's future.

IT was one of Margaret Thatcher's most famous "handbaggings". After holding European leaders to ransom and five years of arguing, she finally secured a rebate on Britain's contributions. The deal meant Britain got £1 back for every £1.50 it paid into the EEC coffers, but came only after Mrs Thatcher threatened to block any further expansion of spending, and to withhold Britain's payments to Europe.

Now, 21 years after that Fontainebleau summit when exasperated European leaders gave in to her demand of "I want my money back", the rebate is again on the agenda. Over the past week, the war of words has been hotting up, ahead of the Brussels summit of EU leaders on Thursday and Friday.

And it is the French who have been leading the charge. France's European Affairs minister Catherine Colonna declared the rebate undermined EU solidarity, and reducing and then abolishing it was a necessity. But, so far, Tony Blair has remained firm, telling MPs that the rebate would remain and would not be negotiated away, although he did not rule out making changes in the amounts involved or how they were calculated.

It is not the first time the rebate has cropped up. During talks over EU expansion, the French again called for it to be scrapped. But this time the pressure is greater than ever, leaving Mr Blair looking increasingly isolated.

But although there may be a case to reconsider the British rebate as part of an overhaul of the EU budget, the rebate itself is still justified and should remain, according to Dr Phil Daniels, senior lecturer in European politics at Newcastle University.

'When the rebate was negotiated in 1984, there was a very strong case for Britain to get it," he says. "At that time, Britain was one of the poorer members but it was the second largest net contributor.

"Britain has become wealthier but in net terms it is still the second largest net contributor after Germany, although the situation is not so bad when you look at net contributions per head."

When the rebate was agreed, the UK was the third poorest country in the EEC, but was about to become the largest net contributor, disadvantaged by the arrangements used to decide how much each country paid in - and how much they got out.

These contributions are based on four factors: levies on imports from outside Europe; levies on agricultural imports; a proportion of VAT, and a payment related to a country's Gross National Product, or the value of the goods and services it produces.

As Britain tends to import more than other countries, its contribution under the first two headings is relatively high. As a high consumption society, it pays more under the third heading. It is only the fourth factor, related to GNP, which worked in Britain's favour in the past, but the strong performing economy of the last few years has made this a disadvantage too.

When it comes to being on the receiving end of any EU hand-outs, Britain also fares poorly. The biggest single item in the EU budget goes on subsidising farmers, accounting for 42 per cent of the total budget. Britain's small farming sector means it gets to see relatively little of this - as a proportion of national income, less than any EU country apart from Luxembourg.

The result is that without the rebate, Britain would be paying close to £8bn a year into the EU, making it the biggest net contributor. It would also mean Britain would be paying 14 times as much as France, as opposed to one-a-half times under the present arrangements.

"That is difficult to justify, and if the rebate were entirely removed, Britain would be put in a very unfair position," says Dr Daniels. But he concedes that there is a case for reviewing the rebate, in the light of Britain's strong economy and the last year's expansion of the EU, which saw ten mainly Eastern European, and considerable poorer, countries join.

As well as this, the European Commission calculates that over the period 2007-13, Britain will fall from being the fourth largest net contributor, as a proportion of national income, to ninth, and that Germany, Sweden and the Netherlands make comparable contributions although their economies are less prosperous. Naturally, other countries are keen to see the rebate scrapped, as it would mean a reduction in their contributions.

For French President Jacques Chirac, concentrating on the rebate provides a distraction from his failure to persuade the French public to support the EU constitution in last month's referendum, and with the convulsions caused by the French, and the Dutch, "No" votes, the rebate is a black and white issue on which all EU leaders can focus.

'It is throwing up anomalies, because relatively poor countries are going to have to contribute to Britain's rebate, but it can only be reviewed or renegotiated as part of a much wider assessment of the budget," says Dr Daniels.

"The underlying problem, which was there when Britain first joined, has not gone away. It is difficult to justify the amount being spent on agriculture."

Farming subsidies make up 42 per cent of EU spending, but, as Chancellor Gordon Brown pointed out yesterday, agriculture employs only five per cent of the EU workforce. No other sector has had the support which has been granted to farming, at the expense of keeping food prices artificially high for European consumers, and squeezing out imports from the Third World.

But changes in the Common Agricultural Policy would be unacceptable to the French, who are among its chief beneficiaries. France receives around £7bn from the CAP, more than the size of Britain's rebate, predicted to be £4.3bn in 2004/5.

All this leaves the EU in some disarray, with disputes over the rebate and reform of the CAP threatening to derail attempts to set a framework budget for the next seven years, a process which was already causing consternation among some countries anxious to limit spending. A failure to agree a seven year budget would not be fatal - budgets could run on a year-by-year basis - but a deal would have sent a powerful signal that the EU could overcome the problems caused by the referendum results.

But Mr Blair's veto means he can block any attempt to change or scrap the rebate, and other European leaders can only look on in frustration. The result could be a period of considerable uncertainty for Europe, compounded by a lack of leadership, with the two drivers of integration, President Chirac and German Chancellor Gerhard Shroeder, both looking shaky. Chancellor Shroeder looks likely to be replaced after this autumn's German election, and the referendum has severely weakened the French president.

"It is certainly a difficult phase, although I don't think we're witnessing the unravelling of the whole project," says Dr Daniels. "A lot has been invested in the EU over a long period of time for it all to fall apart now, but over the course of the next two years there will be some difficult decisions.

"Europe may start looking like something with which Britain is more at ease, with much more limited political ambitions and towards an Anglo-Saxon style economy. It is not a crisis in terms of seeing the end of this project, and there are other countries still wanting to join, but there are severe difficulties."