America’s defense industrial base is unprepared to meet the wartime demands of the 21st century. The U.S. faces a shortfall in production capacity at a time when the global threat environment is more acute than at any point since World War II.
To see the decay of our defense industrial base, one needs look no further than our inability to rapidly replenish munitions sent to Ukraine or the long timelines for naval construction and modernization. As noted in a recent report by The Heritage Foundation, decades of poor policymaking have led to underinvestment, regulatory drag, labor misalignment and market distortions, which have eroded the readiness of our defense industrial base.
Absent structural reform, the defense industrial base is unlikely to become sustainably healthy. Yet there are clear ways to implement necessary reforms: via strategic grantmaking, procurement reform, workforce development, regulatory modernization and prudent tax policy.
First, the U.S. should adopt output-based grants that promote stable, long-term industrial investments.
The defense industrial base is unique in that it serves a single customer: the federal government. That makes production highly sensitive to annual appropriations. But because Congress funds most defense procurement year-by-year and varies order quantities significantly year-to-year, defense industrial base producers lack incentives to invest in new manufacturing capacity.
Changing these incentives requires the Congress to provide a sustained demand signal; something it can do by adopting output-based grants that compensate manufacturers for maintaining latent capacity.
Under this sort of system, the Department of Defense would issue grants covering any gap between the desired potential capacity and actual procurement. For example, if the Navy wanted to retain the ability to produce four submarines per year but only procured three, it would issue the manufacturer a grant covering the overhead for the fourth.
By doing this, the department can smooth the demand curve, allowing for surge capacity without forcing the military and Congress to purchase weapons it doesn’t think it needs.
Second, the Department of Defense should shift from a primarily cost-plus to a primarily fixed-price contracting model. The current frequently-used cost-plus contracting model, where contractors are reimbursed for expenses plus profit margin, eliminates incentives to cut costs or innovate. Functionally, it’s the complete opposite of a normal market transaction.
In contrast, fixed-price contracting creates incentives for efficiency. When contractors can increase their profit by reducing costs, taxpayers benefit in the long run.
Consumers expect competitive pricing and innovation in the private sector, and the Department of Defense should apply similar discipline in procurement by transitioning to fixed-price contracts, which reduce waste and improve outcomes. Of course, this requires grantmakers to give defined goals with a limited scope focused on incremental gains.
Third, the government should reform regulatory processes currently facing the defense industrial base, such as the onerous National Environmental Policy Act, by modifying approval processes towards a presumption of approval.
Like many other industries, the defense industrial base often waits for years for approval to expand production facilities. The National Environmental Policy Act is one of the roadblocks to approval, requiring duplicative reviews across multiple agencies.
Fortunately, there’s a practical remedy to this: Designate one agency or department as a shepherd that will guide industry through the rest of the permitting process. And if agencies don’t respond within a certain timeframe, applications to expand facilities should be considered presumptively approved.
By streamlining such regulatory reviews, the government can reduce red tape and shorten construction timelines for shipyards, missile factories and drone assembly lines — all without sacrificing safety or environmental standards.
Fourth, state governments should implement a returned-value formula for higher education to alleviate workforce shortfalls.
Like the broader manufacturing industry, defense manufacturers face a shortage of skilled workers. But rather than addressing the problem, federal education dollars continue to subsidize programs that, at best, fail to prepare graduates for the workforce, or, at worst, foster environments of antisemitism and ideological activism.
Instead of continuing this flawed system, state governments should tie funding to outcomes via a returned-value formula like that used by the Texas State Technical College system, in which funding is based on students’ post-graduation earnings. This model rewards institutions that align programs with industry needs.
State efforts to scale such a system nationally, particularly in technical and trade education, would strengthen the talent pipeline for defense manufacturing, all while increasing accountability in higher education.
Fifth, Congress should pass permanent full and immediate expensing for equipment, structures and domestic research and development.
The current tax code penalizes capital-intensive sectors like manufacturing by taxing both the cost of equipment and the output that it produces. This double taxation distorts the market and discourages investment in productivity-enhancing technologies.
By enacting expensing changes, though, Congress could eliminate bias against manufacturing, encourage capital investment and improve the competitiveness of U.S. defense firms. Doing this isn’t a subsidy — rather, it’s the implementation of a neutral tax policy that allows firms to deduct costs the year they are incurred (just as they do with labor expenses).
To maintain peace, America must restore its defense industrial base to deter our adversaries. These five changes would put us on the road to achieving that and, notably, would be net cost-neutral or cost-saving.
By restoring our defense industrial base, we won’t just improve America’s safety — we’ll leverage America’s unique comparative advantage in innovation and use our workforce in the most productive manner possible. Ultimately, this will create strong, stable jobs that will support a new American Golden Age of prosperity and security.
Miles Pollard is an economic policy analyst in the Center for Data Analysis at The Heritage Foundation. Jim Fein is a research assistant for National Security and European Affairs at Heritage.
