^[1]I noted with interest Kym Bergmann’s question ^[2] in the context of defence industry policy ‘why is “offsets” such a dirty word here’? The answer is actually straightforward: Australia tried offsets—and the results were hardly encouraging. All they did was result in poorly targeted outlays that imposed additional costs on taxpayers and made the procurement process even more inefficient than it would otherwise have been. Yes, they were simple, at least in theory: but it was a classic case of every complex question having an answer that’s simple—and wrong.

The problem with offsets is obvious. Essentially, they required offsetting defence acquisition expenditure in Australia to ‘balance’ the expenditure on the program. Naturally, the costs of that expenditure are built into the bids for the program; so the expenditure itself increases, rather than reduces, the burden on taxpayers. As raising taxes involves an efficiency loss (because people change their behavior in response to the taxes), every dollar of added outlay costs more than a dollar in income loss to taxpayers—typically around $1.30.  So increasing the cost of a $1 billion project to $1.1 billion, costs at least $130 million in reduced taxpayer income.

At the same time, if the offsets have any effect, it must be because the project proponent is undertaking purchases it wouldn’t otherwise have made; so it must value the goods and services thus acquired at less than their market price. As a result, there’s an inefficiency—goods the market values at $X (and hence whose opportunity cost is $X) are purchased by someone who values them at less than $X. Assuming the goods are exported, the shortfall is basically an export subsidy. This could only result in a gain to the community if there was some spillover benefit that more than compensated for all these distortions.

Yet it’s entirely unclear what that spillover benefit is. Why is Australia better off if everyone who wants to sell the Commonwealth an imported tank has to buy (and perhaps pulp) an Australian-made round of munitions?

Now, the claim being made is that in the case of defence industries, there’ll be wider gains. But how would one know those gains were worth the cost? The whole point of the measures brought in post-offsets was to allow a case by case assessment of whether there were indeed any gains, and if so, how great their quantum might be relative to the costs.

Those measures broadly fall into two groups: the Global Supply Chain (GSC) involvement programs; and the Australian Industry Participation Plans, most recently with Priority Industry Capabilities and Strategic Industry Capabilities attached.

The standard argument for the GSC programs is that it helps Australian firms overcome ‘beachhead’ costs involved in exporting. Whether it does, and at a cost less than the benefits, needs more careful evaluation than it has received. While it’s certainly not impossible for such programs to yield net benefits, they can degenerate into little more than offsets by another name.

As for Australian Industry Participation Plans, it’d be fair to say that successive reforms haven’t worked as well as they should. These were an attempt to better target defence industry programs but there has been little clarity as to exactly what was being sought under the various iterations of industry participation plans. And the identification of priority and strategic industry capabilities hasn’t done much to help. This is for two reasons.

First, disparate goals have been bundled under one heading. In effect, the priority capabilities are of four quite different types:

1. Capabilities with military value: these are really military capabilities, in the sense that they bear directly on national security, rather than industry capabilities as such. In other words, they’re valued for their direct defence value, rather than for strengthening the industrial base
2. Infrastructural capabilities: infrastructure required for specific acquisition programs and/or sustaining particular materiel—for example, some ship building and repair assets
3. Investment in future options: these provide, or help provide, an option to undertake possible future programs and to scale up, modify or decommission existing programs and assets at reasonable cost
4. Sustaining our competitive edge: these recognise the value of particular areas in which we have, for whatever reason, developed internationally competitive capabilities (for example, sonar), even though those capabilities aren’t themselves vital to our defence strategy.

Each of these needs to be valued in particular ways—in other words, the costs and benefits of individual proposals need to be assessed in the light of the type of impact, as valuing an option for example (i.e. type 3) involves a different method to valuing a program-specific impact (as in type 2).

Second, having failed to clearly distinguish types of impacts, we’ve also not properly examined the ways of achieving those impacts. For example the cost of future programs can be done reduced by contracting directly for capacity, acquiring options over capacity (for instance, by contracting on a contingent basis, i.e. where capacity can be called up for a price, as in a call option) and so on. Only if each of these possibilities is properly assessed can an assessment be made of the least cost way of securing a worthwhile capability.

Ultimately, defence industry policy isn’t about promoting manufacturing per se—a goal which makes no sense whatsoever. (Why is manufacturing vehicles better than being a world class miner? And why should we divert resources from mining, which pays its way, to prop up producing vehicles, which doesn’t?) Rather, it’s about ensuring we have the best defence assets we can afford: with defence industry policy being an instrument for so doing.

Finally, I’m wary of comparisons to countries such as South Korea, which have very different factor endowments from Australia, a different industry structure, and so on and so forth. For instance, with its abundant supplies of labour relative to resources, Korea has a comparative advantage in manufacturing; Australia doesn’t. Comparisons which don’t take account of these differences aren’t a sensible basis for spending many hundreds of millions of taxpayer dollars.

Henry Ergas is a senior economic adviser, Deloitte Access Economics, and professor of Infrastructure Economics, University of Wollongong. Image courtesy Australian War Memorial ^[3].