Scratching for taxes

Build domestically from scratch, or buy "off the shelf" from abroad?

It's an age old debate. Involving a bloody big shelf. And anytime it comes around, someone will inevitably mention the issue of tax recovery. That is to say that money spent in the UK can be recovered through taxes, both corporate and private, thus essentially providing the UK with a form of discount on domestic purchases.

But just how much of a discount? I've seen figures thrown about that go as high as 40% (which I believe was once used by RUSI, but could be remembering that wrong). That seems very high to me. Unrealistically high. And so about a year ago I started to look into the subject, albeit very much on the back burner. 

Here is my current thinking on just how much of a "discount" the UK receives from buying British.

The first thing to consider is the raw levels of tax. When buying British, the first thing to consider is that from a corporate level a lot of the money is not taxable, being expenses in one form or another. It's only the profits derived from the project that are actually taxable and that is only going to be at a rate of 20% now (because when you're short of cash, naturally the first thing you do is reduce your income levels, eh government?).

Most defence companies, like a lot of big companies, seem to average quite low profit to revenue ratios. 1:20 is not uncommon, so £1 in profit for every £20 brought in through sales. Obviously we can't be sure how much profit manufacturers make on individual items, but 5% would appear to be a good basic figure to work with. That means your corporation tax haul from a defence project will be just 1% of the overall value of the contract.

As for the expenses? They predominantly take two forms, one being materials and the other being wages. Materials is a difficult one to track. If sub component parts are made in the UK, then there is additional tax recuperation taking place as that company is in turn taxed. But any materials/components that are brought from abroad mean that money is going overseas anyway.

Wages is a little easier in one regard, but not completely. Obviously we know the tax rate (incl. national insurance) which (once you take into account the tax free allowance) will roughly even out at about 30% up until you hit the middle income threshold. From here until you hit the higher rate things are a lot more tidy, and then from the higher rate onwards (especially over £100,000) we fall into a type of bizzaro land where your marginal tax rate first goes up and then comes down again.

Evaluating who falls into which bracket is also difficult, not least because no two companies are likely to be the same, and because they're not inclined to publish lists of their employees and how much they get paid. I suspect most employees would not even be aware how much some of their colleagues were receiving. In lieu of detailed data, one thing we can do is trawl employment sites for job adverts issued by the major defence contractors, just to give us a very rough idea. And I do mean a very rough idea.

(Ironically enough BAEs career section is poorly designed and looks half finished, yet probably cost them an arm and leg in design and construction).

The first thing that strikes me is how poorly paid many people in the defence industry seem to be, relatively speaking that is (keep this in mind for later). Given their tax allowance, we can surmise that an average 35% tax recoup across the whole workforce is getting close to the true number. And that's leaving aside the fact that many people would still qualify for a variety of government funded benefits.

If we go with 35% for arguments sake, we next need to deduce how much of the cost of various defence projects is covered by the human factor. This is a bit like asking how long is a piece of string and, again, without detailed break downs handed over by the manufacturers that is almost impossible to gauge accurately. We can do one thing though, which is to use logic to take an informed guess, using other manufacturers of a similar nature to compare against.

Logic tells us that defence companies are a) not charities and b) not stupid. All those sales and marketing people don't work for free, nor do those fancy video packages shoot and edit themselves. Like most companies we can expect defence companies to factor their whole business overheads (even those not related to that specific project) into their prices. A whole lot of people need paying and debts need covering for a start. 

In all likely hood, anywhere as much as 50% of the cost of each new ship, plane, tank etc could be accounted for by non-material expenses (and in case some of you are wondering, trust me, about 50% of the cost of that brand new car you bought recently was related to non-manufacturing expenses). This is by no means a precise figure, but for rough calculations it will suffice. Of this 50%, I estimate so far that around two thirds, perhaps a bit less, is attributed to taxable individuals (employees). 

So perhaps as little as 30% of the total contract value ends up in the pockets of taxable individuals, who in turn average a real tax contribution of about 35% of their wages. That's just 10% of the total contract value being taxed, added to the 1% of total value being covered by corporation tax.

11% then. Quite a way off from the 30-40% that often gets bandied about. Keep in mind that's rough work and that the number could creep up depending on how much of the materials/components are produced in the UK. Even that you would have to treat with care, depending on how labour intensive the processes are. Perhaps add another 2-5%.

But even then that tax income is strongly up for debate, as is the other form of tax income that often gets raised in these sorts of discussions, that being the Value Added Tax paid by employees on things like petrol to get to work. To understand why, we need to talk about opportunities.

Or more specifically, opportunity cost.

For those that don't know, a quick primer. Broken down to its very basic level, opportunity cost is the perceived or actual value placed on alternative courses of action. Example time.

Let's say that you're standing at the counter in your local shop. You've just been handed your change, which amounts to a perfectly round £1. You look curiously at the stack of scratch cards placed next to the till and wonder whether - as you've been feeling lucky all day - you might just chance your last pound coin before payday on the hopes of a big win.

You have 10 different cards to chose from, each costing one pound. Like a statistically significant number of human beings who are asked to pick a number between 1 and 10, you naturally gravitate towards 7, having split the difference between the two extremes, and then split the difference again between 5 and 10. 

You place the card down on the counter and excitedly prepare to discover whether Lady Luck has smiled on you this day, ignoring the raised voices from behind saying "Oi you w**ker, get out of the way, other people are waiting". Realising that you've just given away the only change you had left, you remove your key from your pocket and begin to scratch away.

And........ you've done it! You've won a £100! 

Jubilantly you turn around, hands in the air, yelling "One hundred f**king pounds! Eat that you k**b head!"... or something similar.

You go home happy, £99 better off than before you bought the ticket. You've just made almost a hundred pounds, and all you had to do was scratch off a lottery ticket. But what if I told you that you'd actually just lost £249,900? How can this be? Let's go back to the shop.

See, after you left the majority of the other customers in the shop applied the "fruit machine logic" of not putting money into something that has just paid out big (I used to work in the gambling industry when I was younger and can tell you firmly that theory is b******s). But one little old lady wondered whether some of your luck might have rubbed off.

As such she purchases a scratch card as well. Unlike you, she opts for number 10, going right to the extreme of the spectrum. She hunts in her purse for her lucky penny, almost indistinguishable as it is from the hundreds of other bloody pennys that she carries. Finally she draws it out and scratches away.... to find that she's won the top prize of £250,000.

If only. If only you'd taken number 10 and not number 7, that money would be yours. Yes, you won £100. But had you taken a different course of action, a different opportunity, you would have won a quarter of a million quid.

The question you're probably asking right now is; did that example need to be quite that long? The answer is; no, but it amused me and therefore it stays.

The point is that just because someone is currently paid to work for a company like BAE Systems or Babcock, that doesn't mean that if those companies ceased to exist then those same people would not work and pay taxes. We're talking about intelligent people, often highly skilled, who would likely be snapped up by other companies/industries. More importantly as far as opportunity costs go, they might indeed end up being paid more.

Looking through the job listings for defence companies, I came across one position which basically described word for word the job of a lady I know. Except that she gets paid about 50% more than the salary being advertised. I'd also like you to consider the story of a chap called Adrian Newey.

Newey attended the University of Southampton, from which he graduated with a first-class honours degree in Aeronautics. Perhaps at some point in his teaching young Adrian dreamed of designing Britain's next great aeroplane? Maybe. But things didn't quite work out that way for him. Instead he went to work for the Fittipaldi Formula One team. 

For some of you the name "Newey" would have already rung a bell, and the mention of Formula One would have rung it a little more. That's because Adrian Newey went on to become one of the most successful race car designers of all time. In 2006 he signed on to work with Red Bull Racing, for a reported annual salary of over £6 million.

Newey is the living, breathing example that someone with skills that are of interest to the defence sector can end up somewhere else, doing something else, and making a small fortune in the process. Now granted if someone like BAE or Babcock let all of their staff go tomorrow then it's doubtful they would all be signing on the dotted line of multi-million pound contracts the next day. 

But there are a number of sectors in the UK economy that would greatly value the chance to take on some of those highly skilled staff. Demand in a diverse array of sectors, from wind power to offshore oil rigs, would likely result in most of those staff currently employed in the defence sector being snapped up left, right and centre.

I just don't buy the argument that if we don't pump large sums of money into the UK defence sector then we're going to be left with large numbers of highly/usefully skilled individuals sitting around at home claiming jobseekers allowance.

That theory does leads us in another interesting direction though. Because while people claiming jobseekers allowance instead of being in work may have a draining effect on the national economy, it makes absolutely no difference to the Ministry of Defence. The MoD has its budget, and its budget does not include pay outs to people out of work.

That may seem a little short sighted, but when you really think about it, does the MoD get any credit from the treasury for buying British? When the MoD chooses a more expensive domestic manufacturer over a cheaper foreign one, thus "preserving" jobs in this country, does anybody calculate the economic advantage gained and subsequently reimburse the MoD for taking a decision that may not have been in its own interests, but was in the national interest?

No? Didn't think so.

If the government wants to run defence procurement as a make work scheme for domestic industries then I have no problem with that. None at all. I sincerely hope for example that the replacement for Typhoon is designed and built here in the UK, with none of the dreaded "partners" that seem to blight many a procurement project.

I do have a problem though with the government expecting the MoD to meet the additional cost of such decisions from its own budget. If they want to buy a more expensive British option, then perhaps the money could be removed from someone elses budget, like the department for Business, Innovation and Skills, especially considering that this is precisely the sort of thing that the DfBIS should be doing.

In summary then, I'm not yet convinced by the claims of high tax value returned to the government economy by buying British. I would currently put the number much closer to 12-16% of the contract value returned in taxes. Nor am I convinced that defence represents a form of economic activity that would be irreplaceable. It employs a wide variety of skilled individuals, more than capable of seeking other work (probably better paid) if their companies were to let them go.

If a product of equal or greater quality can be purchased from abroad for a cheaper price, especially in the realm of being 12% or more cheaper, then I don't think it makes sense to reject such proposals with crys of the economic value of buying British.