Increasing Output
The most important issue facing the defense industrial base is a lack of output. As former Representative (R–FL) and current National Security Advisor Mike Waltz has noted, “[t]he largest shipyard in China could fit every shipyard in the United States inside it.”REF The same is true across the entire DIB.
Perhaps the most intuitive solution to this problem is one currently being used to increase the output of the submarine industrial base. Congress is providing a direct capital infusion of billions of dollars to increase output capacity,REF but while direct capital investments have short-term advantages that may be worth it in select instances, such as with the submarine industrial base, they fail to change the underlying incentives that made industry investment in new capacity unprofitable. Without altering industry’s long-run return on investment and incentive structure, a one-time investment will degrade in the medium term and long term, leaving the targeted part of the defense industrial base exactly where it was pre-investment. Policies that are sustainable and focused on the long run should focus instead on reducing high levels of uncertainty, lowering government-imposed production costs, shifting funding toward procurement, and increasing the size of the labor pool.
Some economic and administrative policy changes that can increase output include implementing output capacity-based grants, expanding the use of multi-year contracts, implementing full and immediate expensing for all capital investments, implementing full expensing for interest costs, repealing the Davis–Bacon Act, reforming the permitting process, making unused or underused DOD land available for use in defense-specific production, increasing the ratio of procurement spending to RDT&E (research, development, test, and evaluation) in the budget, and increasing foreign military sales by reforming regulations such as the International Traffic in Arms Regulations (ITAR). To increase the size of the relevant labor pool, possible education policy changes include improving SkillBridge, decoupling federal financing from higher education accreditation, allowing tax-preferred college saving plans to fund certificate and apprenticeship programs, expanding Pell Grant coverage to include vocational and training programs, reviving Industry-Recognized Apprenticeship Programs, and shifting schools to a returned-value funding model.
Implement a Program of Output Capacity-Based Grants. Because the appropriations process has routinely fallen short of revitalizing the defense industrial base, Congress could use a budget reconciliation bill to create a mandatory funding stream for a grant program at DOD (or a tax credit version of this program) that is not part of the appropriations process to smooth out uncertainty and ensure that the DIB maintains target levels of productive capacity.
Maintaining the desired level of productive capacity and maintaining productive capacity through uncertain procurement cycles are fundamentally the same problem: DOD’s desired level of output capacity is above the level that market conditions will provide funding to establish or maintain. Markets are very good at setting up business parameters to navigate the environment efficiently. However, if Congress’s procurement funding does not create a robust and reliable market, DIB producersREF will have to adapt by reducing their output capacity to the minimum level for which they can be confident that there will be a demand. This means that on their own, DIB producers will never possess the level of output capacity that would be required during a war or a period of peak peacetime procurement levels.
Increasing DOD procurement levels to buy excess material simply to justify more output capacity would be incredibly expensive. Moreover, this would waste national resources that could go toward producing products that benefit the nation instead of piling up in a warehouse only to decay. By far, the most efficient way to ensure desired levels of DIB production capacity is to create a DOD directed grant program to fund the gap in the cost of maintaining the excess productive capital.
A portion of all business revenue is used to cover the fixed costs of production. These are largely costs associated with maintaining a certain level of productive capital (equipment, structures, intellectual property, etc.) that is used to produce the final product of the business in question. Remaining revenue, of course, is used to cover variable costs, such as labor and raw materials, or is turned into profits that are used to expand operations or reimburse shareholders and lenders.
The grant program envisioned here would allow DOD to set target levels of productive capital (and output capacity) for selected DIB producers and sectors. Then, for a selected company, the program would determine the portion of DOD procurement revenues that covers fixed costs. Next, DOD would determine how much that company’s fixed costs would increase if the company maintained the target level of output capacity. The grant amount would be sufficient to cover the gap between the two levels of fixed costs if the company builds up to the target level of productive capacity.
For example, imagine a shipyard that can produce three submarines a year and where DOD has a desired production level target of four subs a year. In this case, if the yard builds out the extra capacity to build four submarines instead of three, DOD, through this new grant, would pay the yard enough to cover the extra fixed costs for maintaining the capital to produce the fourth sub if DOD buys three subs instead of four. But DOD would pay for half the capacity (two of four submarines) in a year where it buys only two subs in that year. In this manner, the grant size would increase to fill gaps in comparison to actual levels of DOD procurement.
Conversely, the grant would shrink when DOD procurement levels rise. The grant would be perfectly tailored to use taxpayer dollars efficiently to smooth out demand uncertainty and ensure that DIB companies maintain desired levels of output capacity. Further, these grants can be structured and expanded to include initial amounts to help build up to the new desired level of output capacity.
Additionally, tying these subsidies to timely delivery and successful fulfillment of contract would incentivize companies to solve and improve their own production issues and processes. Under the current cost-plus contracting system, these issues—such as labor shortages (resolved by increasing wages relative to the commercial sector or investing in automation) or supply chain shortages—are often excuses for delays.REF If a DIB producer risks losing a grant equal to a substantial portion of its profit margin, for example, it will have a tremendous incentive to invest in fixing its production issues.
The grant program would be relatively cheap for taxpayers and, under certain circumstances, could result in cost savings. Taxpayers are currently paying 100 percent of the cost of many infrastructure investments, such as an investment of more than $6 billion in the submarine industrial base.REF With the grant program in place, government bailouts like this would no longer be justifiable, at least in most circumstances.
Expand the Use of Block-Buys and Multi-Year Procurement. Block-buys and multi-year procurement increase certainty by creating a resourced demand signal. DIB producers see their production level uncertainty reduced, thereby decreasing the risk of investing in production capacity. Block-buys and multi-year procurement can also lead to lower costs by creating economies of scale. According to the Congressional Research Service, programs proposed for multi-year procurement (MYP) can reduce weapon procurement costs by as much as 15 percent.REF By enabling contractor optimization of workforce and production facilities and enabling economic order quantity (EOQ) purchases of long lead time components, MYP allows manufacturers to take advantage of economies of scale.REF
Implement Full and Immediate Expensing for Capital Expenditures. Perhaps counterintuitively, the formation of new productive capital—for example, the construction and equipping of new factories—is one of the most taxed activities in which you can engage under the U.S. federal tax code.REF The current federal tax system, by default, implicitly double-taxes this sort of investment. By taxing expenditures on new productive assets, the tax code also taxes future production from those new productive assets, thereby creating harmful double taxation that discourages investment in new production capacities.
For example, a piece of equipment is used up slowly as it is used to produce a new product such as a blast furnace in a steel mill or a tractor on a farm. These items are used up over time and must be replaced on a regular basis. This replacement cost is embedded in the production costs of each final product that a company makes and sells. Thus, taxes on the final product (steel or crop yields in these examples) are also taxes on capital equipment such as a blast furnace or tractor.
If companies cannot deduct the cost of replacing this capital or the costs of deploying new capital, the tax system will double-tax capital formation, first by denying the deduction and then by taxing the final products. This double taxation serves as a massive roadblock to maintaining and expanding the U.S. industrial base writ large. Allowing immediate and full deduction of the cost of buying capital equipment such as factory equipment stops this chain of double taxation.
This double tax reduces return on investment and therefore reduces the amount of investment made, leading to slower economic growth. This creates a situation in which the incentives are shifted toward immediate resource consumption rather than investment in future productive capacity. Though the current tax code depreciation schedules mitigate this problem, this is far from a full solution. Depreciation schedules require that deductions be taken over many years, not all in the year the expenditure was made. This means that industrial companies never fully recover the full value of the deduction. Further, our patchwork of depreciation schedules creates enormous paperwork and accounting burdens. It requires these companies to keep track of how great a deduction they have left on a particular piece of capital over exceedingly long time frames.
The construction of a new factory, for example, is treated as a 39-year expense.REF This means that industry can fully realize the deduction for the cost of the new building only very slowly over a 39-year period. In essence, the government is taxing a company on money that it no longer has, thereby requiring the company to divert other funds to pay the tax. This denies industry access to the use of these funds (the ones repurposed to tax payments), whereas an immediate deduction would allow the company to apply these funds toward the formation of new productive capital, increased worker pay, or a price reduction for the end users of their products. The delay in being able to utilize this money reduces growth rates.
There is only one proper way to address this intrinsic double taxation: Provide full and immediate expensing (deductions) for expenditures on capital formation. This includes purchases of new equipment and the construction of new buildings, but it also includes research and development (R&D) work to develop new techniques and products. The Tax Cuts and Jobs Act (TCJA) temporarily provided these deductions for equipment and R&D.REF However, it did not extend that tax treatment to construction, has fully phased out R&D, and is in the process of phasing out equipment expensing and returning to current-law depreciation schedules. Permanent full and immediate expensing for equipment, structures, and R&D associated with defense production is essential for DIB development and, if fully implemented across the economy, would likely yield enormous growth generally.
Allow Full Expensing (Deductions) for DIB Producers’ Interest Costs. The financing of capital expansion should receive expensing provisions similar to those we propose for physical capital formation. Under the current federal income tax system, companies may only deduct interest costs of up to 30 percent of their Earnings Before Interest and Tax (EBIT).REF EBIT is a measure of company earnings after expenditures for capital investments, including the replacement of burned-through capital. Using EBIT means that the cap on interest deductions shrinks as firms spend more on expansion—a truly counterproductive measure.
Altering the calculation of the cap to use Earnings Before Interest Tax Depreciation and Amortization (EBITDA) would solve this narrow problem. Further increasing the percentage cap would also help to alleviate these issues and not double-tax firms on most interest costs related to financing the expansion of their operations. However, we recommend fully removing the percentage cap from the interest deduction for interest costs related to defense industrial base expansion and development as envisioned in this report.
End the Davis–Bacon Act. The Davis–Bacon Act is a 1931 law that requires contractors on federally funded construction projects pay at least the local “prevailing” wage and benefits so that federal projects do not drag down local compensation. In reality, Davis–Bacon uses selective and inflated union compensation that does not reflect market compensation. For example, in areas with low unionization, Davis–Bacon rates are well below market compensation (for example, only $14 per hourREF for cement masons in Spartanburg County, South Carolina), and in most areas, they are far above market compensation (for example, almost $86 per hourREF for cement masons/concrete finishers in New York’s Nassau and Suffolk Counties). Mandating compensation that does not reflect the market inflates taxpayer costs on federal construction projects by about 10 percent and prevents the overwhelming majority of construction companies and construction workers from participating in federal construction projects.REF
Davis–Bacon’s influence is growing as federal spending grows. The Department of Labor (DOL) noted in its finalization of an 812-page Davis–Bacon Act rule that:
The Davis–Bacon Act and now more than 70 Related Acts collectively apply to an estimated $217 billion in Federal and federally assisted construction spending per year and provide minimum-wage rates for an estimated 1.2 million U.S. construction workers. The Department expects these numbers to continue to grow as Federal and State governments seek to address the significant infrastructure needs of the country, including, in particular, the energy and transportation infrastructure necessary to mitigate climate change.REF
Implement Permitting Reforms. An enormous headwind facing manufacturers, especially defense-related manufacturers, is the federal permitting process. Prospective manufacturers must navigate the National Environmental Policy Act (NEPA) process through more than a dozen federal agencies and must navigate through the processes of state agencies as well. This imposes tremendous costs on businesses and often requires duplicative work to go through the same process with several different agencies.
Further, the current process means that these businesses cannot know with any certainty when they will be able to start their projects or even whether they can complete them. There is no firm timeline for the permitting process, no guarantee of a firm answer from the government, and a potential for arbitrary lawsuits even after a company has broken ground on a project.
We could decrease costs and increase efficiency for defense manufacturers by creating a streamlined permitting process that provides a one-stop-shop process in which one agency would shepherd a permitting application through the system. By narrowly defining what constitutes adverse impact, the streamlined process would ensure that this process is expedited with a firm and short timeline and protection from frivolous lawsuits. In the event of government failure to meet the requirements of this expedited process, the default response to a permit application should be approval. Exemption from state-level permitting requirements should be extended to facilities associated with the defense industrial base as they already are for projects on military bases.
Make Unutilized or Underutilized DOD Land Available for Use by Industry. The U.S. government owns 28 percent of U.S. land, making it the country’s largest individual landowner.REF Much of that land is controlled by agencies within the Department of the Interior such as the Bureau of Land Management. The Department of Defense owns millions of acres of land as well.REF Some of this DOD-owned land is used for bases and U.S. assets, but other parts have been underutilized or unused.REF
DOD should conduct an assessment to identify unused or underutilized land and facilities in locations that could be used by industry—such as land near population centers and facilities like transportation infrastructure—and offer that land for industry use at a discounted rate (for example, $1 per year for 99 years). If conditioned on industry use of the land to build production facilities, this would reduce DIB manufacturers’ costs at no practical cost to taxpayers. The result would be to increase industry investment by lowering capital requirements for new facilities and to create defense industry jobs in local communities by employing people in both the construction and factory workforces.
A General Services Administration estimate placed the cost of maintaining unnecessary federal government land and facilities at approximately $1.67 billion per year as of 2010,REF a number that is undoubtedly much higher today due to inflation and DOD’s ignorance of how much unused/underutilized land and facilities it actually owns.REF Therefore, making unutilized or underutilized land available for industry would likely result in cost savings in addition to land improvements.
Increase the Ratio of Procurement Spending to RDT&E in the Budget. When Congress is looking for money to put toward new initiatives, it often asks for offsets from the military’s Operations and Maintenance (O&M) account. Unlike RDT&E and certain procurement programs, O&M spending tends to have no clear advocate in Congress, and this makes it an easy target. However, cutting O&M funding risks significant adverse impacts on the military (personnel must be trained and paid) unless the cuts are narrowly tailored to remove excess bureaucracy. Instead of cutting funding from O&M, Congress should explore cutting money from the Pentagon’s RDT&E account and shifting it to procurement.
In 1983, procurement funding equaled more than 250 percent of RDT&E funding. Now procurement is barely more than RDT&E, reflecting an imbalance in priorities between the two.REF That affects the amount of money available for the generation of defined, useful output from the industrial base: Fewer dollars for procurement means lower procurement quantities, which in turn disincentivizes investment in new production capacity.
There are times when RDT&E funding should be relatively higher and times when it should be relatively lower. The current moment—characterized by a maximal threat environment, potential conflict with a near-peer state in the Indo-Pacific, and underinvestment in military equipment—calls for a switch to relatively lower RDT&E funding to bolster equipment purchases that can be ready before the Davidson Window closes.REF
Increase Foreign Military Sales (FMS) through ITAR Reform. The International Traffic in Arms Regulations (ITAR) process currently serves as a significant barrier to entry for companies looking to break into defense contracting for the first time. The process is both byzantine and expensive: In 2017, for example, British companies spent the estimated equivalent of 0.7 percent of their defense budget on ITAR compliance.REF While some requirements have been streamlined for the U.K. since 2017, the same is not true for almost all other allies. In order to comply, DIB producers must hire expensive law firms and consultants and dedicate huge numbers of working hours to navigating the process, which must be done before contracting.
Compliance with ITAR also constrains the ability of the United States to compete in international markets and enable burden-sharing by quickly providing critical weapons technologies to close allies. In some cases, non-American DIB producers looking to outbid American companies abroad will market their product as “ITAR-free,”REF knowing that the prospective buyer could save time and money by choosing to purchase from a country with a less onerous process. Increasing foreign military sales by removing overly onerous barriers creates a demand signal that encourages industry to increase production capacity. It also increases interoperability, depriving adversaries of opportunities to improve their own defense industrial bases by filling the gap. By reforming ITAR to ensure that weapons go to American allies more easily while preserving security, we can both ensure that our allies are well-armed and create additional DIB capacity that is funded by other countries rather than by U.S. taxpayers.
The ITAR process should be streamlined for key allies. The Five Eyes intelligence grouping,REF which was established to expand intelligence collaboration and distribute the burden of collection efforts, can serve as a model. Intelligence-sharing within Five Eyes requires an immense amount of trust and information security. If the U.S. trusts Five Eyes with our most valuable intelligence, creating a defined, streamlined process for ITAR compliance that better balances risks serves U.S. interests in arming allies and strengthening U.S. and allied defense industrial bases by creating a common framework that strengthens supply chains and enables additional codevelopment, coproduction, and technology transfers. If Five Eyes or other select allies have trusted supply chains and put in place regulatory and compliance frameworks that meet U.S. expectations, some ITAR requirements should be waived.
Another improvement to the ITAR process could be system-level approval.REF If a foreign company is contracted to build a U.S. weapon system, the ITAR process should be completed before the contract is signed rather than having individual components approved after-the-fact. If there are certain systems for which the U.S. is unwilling to waive requirements or that it does not want to approve, they can be specifically written out. If a company is contracted to build something for the U.S. military, it should have all the approvals necessary before it starts.
Ensuring that sensitive U.S. weapons and systems are not compromised is important, but creating a process so onerous that allies turn to American adversaries such as China or Russia for weapons also creates risk. The U.S. has already seen China’s willingness to exploit opportunities to control critical infrastructure—as Huawei has done with telecommunications networks.REF Similarly, Turkey purchased air defense systems from Russia, benefiting the Russian defense industrial base and creating risk to NATO and to such U.S. systems as the F-35.REF
Making certain that American companies can compete with foreign suppliers on an equal basis is an important way to reduce the risk of such encroachment. Foreign military sales encourage the expansion of DIB capacity by increasing the demand signal for production.
