Offset Multipliers and Defence Industrial Policy Efficiency

Mandatory offsets are policy instruments to leverage defence procurement projects to conduct industrial policy. The prime contractor commits to generate new business in mutually acceptable sectors equivalent to a large percentage of the project value. Offset multipliers “relax” this constraint by discounting the prime contractor’s offset obligations if investments flow to sectors prioritized by the purchasing country’s industrial policy objectives. This endogenizes the relationship between the original project and the offset contracts. This paper provides a new theoretical analysis of the following three questions that have gone unaddressed in the literature. First, the efficiency of such policies depends on the absorption capacity of a targeted industry. If this capacity is low, import substitution is expensive and the prime contractor may rather choose to invest elsewhere in the economy to satisfy the overall mandatory offset constraint thereby thwarting the original objective. Second, whereas a uniform relaxation of offsets through multipliers can reduce distortions introduced by mandated offsets, multipliers may enhance distortions as an unintended consequence. Third, the prime contractor’s response to offset credit incentives may be weak due to transaction costs arising from having to find new domestic partners to satisfy the offset requirements and manage the contracts.