Wednesday, 14 August 2013

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.


  1. I think it also comes into the realm of specalisation aswell, if we can focus on one section of defence industry and produce that well, and get export contracts for that, now the UK industry is potentially big enough to have multiple specalisations, but there is the risk of competeing against firms in other countries that can produce what we can better and cheaper, overall its a complicated issue, and I found this article really good at talking about it!

    1. Thank you Christopher (and what an excellent name you have!),

      I don't mind if we're buying British when there are clear reasons why this is beneficial, even if it means competing against a foreign supplier. I just think the tax take argument is very lacklustre.

      In comparitive advantage terms I think we do quite well, for example with things like Hawk trainers.

  2. One thing you forgot to mention that there can also be more tax generated (both from profits and employees) from exports of a UK produced solution. Even if the whole product isn't exported. Often at least some of the sub components will be.

    Don't really completely buy your argument that if less people were employed by defence companies then they would all or nearly all be employed by other companies. Yes the highly skilled people would most likely be employed, but it is likely that would just mean that lower skilled people currently employed somewhere in the other industries chain would not be employed.

    I don't see the evidence that the total number of people employed in other areas would suddenly increase to cover any decreases in the numbers employed in the defence companies. If there was a sudden high number of very high skilled people looking for a new job, then some companies might think that they could employ extra people and expand. While most would employ those people and cut down the number of other recruits, or even find ways to lay off existing employees.

    If Adrian Newey had taken a job with a defence company, would there be one less person employed in Formula 1? If he taken that job in defence until now and then found himself looking for a job, and got employed by one of the Formula 1 companies. Would they have created a new extra position for him, or would it have meant that someone else didn't get employed. Maybe just that they didn't take on one new university graduate. However what if that new university graduate would have been a even better designer in the years to come?

    I have no actual figures to base this one, but I would think that if a company laid off say 1000 employees. Quite a number of them highly skilled but in no way all of them. Then maybe 5-10% would get absorbed into other industries, without any other job losses or less people employed. Then I would think there is a good chance another 10-15% would take jobs in a different country. So while they wouldn't be claiming benefits or anything, they also wouldn't be paying taxes in this country.
    Another 40-50% might get employed in other areas, but they would mean that either someone else didn't get employed for those jobs, or maybe the companies cut down the number of graduates/new trainees that they employed. 5% might decide to retire early.

    However I do agree that if one of the aims of the MOD is to create or keep jobs, then it should benefit from doing that. If the MOD job is defence, then its task should be to get the best equipment for the forces. However there is the issue of having the ability to design and produce weapons in this country, which is really a big part of defence. If we bought everything from other countries, then in a major war, we could be in serious trouble. You could argue that a major war isn't likely.

    Personally I'm in favour of buying domestically whenever possible. If a foreign item is a lot cheaper or better, and not having it designed or produced in this country isn't a big issue, then go with the foreign one. But most other times, go with the domestic one. However the MOD should benefit from some of those taxes that are recovered.

    1. Evening anon,

      If it's being exported, it probably doesn't need the UK to buy it as well just to keep it afloat. See Rolls-Royce and their significant (and growing) chunk of the airline engine market.

      With regards to the people employed, the proportion of those people filling unskilled, generic type posts is not likely to be overly high. There'll be admin people etc who might have to compete in the market place, but there's little chance that the more highly skilled staff who will make up a reasonable chunk of a defence companies work force are going to have to compete for jobs.

      One thing worth noting is that people like engineers often end up as entrepreneurs, designing the next latest and greatest gadgets. It's certainly a reasonable proposition that you would expect to see groups of people laid off forming partnerships/small companies, that perhaps focused on their particular areas of specialist knowledge.

      As for Newey, his skills and the resulting success that has stemmed from them have done a huge amount for keeping high quality motorsport in the UK. Without him (and the resulting success) there is a strong case to argue that British motorsport would not be at the same level that it is now, he really has been that influential.

      Also, you should remember this is not an outright argument against buying British, just that the tax recuperation argument is somewhat less than is often touted. There should be other reasons to support a UK preferred buy in cases where a foreign buy would be cheaper.

      The answer is probably more along the lines of what the Chris above is suggesting, where the UK buys certain things at home (like Nuclear subs) and shops elsewhere for others.

  3. You have 20% VAT on sales right off the top
    12% ENI on wages
    12% NI on wages
    20% / 40% / 50% tax on wages

    5% VAT on electric and gas (probably reclaimable, I F-in hate VAT)

    Green Levy on gas and electric, 12% maybe, I forget.

    Business Rates

    The idea that taxes are paid on profits is a myth.
    Not taxes so much as the wider economy, but interesting none the less.

    1. Taxes are paid on profits. It's called Corporation Tax.

  4. "
    The idea that taxes are *only* paid on profits is a myth.

    1. Who believes it? Before you mention VAT, that's chargable on imports as well. The tax on energy is low and business rates would make just a fraction of the total cost of the project. You might optimistically add an extra 1% to the 11 above.