SIPRI explores global defence spending

1 February 2023

To varying degrees, Canada and its allies have been, and continue to commit to Ukraine’s almost year-long counter-offensive against Russian President Vladimir Putin’s “special military operation” in Ukraine. It’s too early to say what the eventual financial cost will be, but it’s a butcher’s bill which eventually must be settled. The question is: how?

The Stockholm International Peace Research Institute (SIPRI) in Sweden tries to address that very question in an “insight” paper released January 31. Its three in-house authors in the think-tank’s military expenditure and arms production program explore the links between military spending and taxes.

Before the First World War, Canada didn’t have an income tax. The federal government generated revenues from trade tariffs and import duties. The provinces relied on revenue, transferred by Ottawa, from natural resources.

Long story short: our involvement in the 1914-1918 First World War (remember, we were legally still a British Dominion subject to Westminster’s policies) resulted in what the government in Ottawa described as a “temporary” income tax to cover the soaring cost of that involvement. It didn’t even come close. When the war ended, the government found itself unable to end the income tax due to the $2-billion debt it had incurred.

Enormous for its day, when Canada’s population was just over 7.6 million, that $2 billion could almost be a rounding error in today’s military balance sheets.

This new SIPRI paper explores the links between taxation and defence spending from 1990 to 2020, drawing on data from 100 countries, including Ukraine. It offers evidence “not only to understand how the announced increases in military spending may affect tax structures, but also how low-income, autocratic and conflict-affected countries in particular fund military spending.”

Its authors say that if governments opt for taxes to cover defence costs, it can choose a direct approach, income tax, or an indirect one, sales tax and suchlike. Choosing the latter can be consequential, they say, because it can disproportionately burden the poor and can have a regressive effect on income inequality. In contrast, direct taxation is based on income levels (theoretically reducing income inequality).

Research on how defence spending is funded is relatively scarce, and focused mainly on government borrowing. “The findings seem to be context dependent and hard to generalize.” For instance, a study published in Defence and Peace Economics in 2021 found that military spending is associated with more external debt only in countries with a weak debt-management system.

“Other studies do find a relationship between debt and military spending, but their evidence often relates to a specific country, region or period. This suggests that debt is not always used to fund military spending – its use depends on national or regional characteristics and political conditions that may change rapidly.”

SIPRI says its paper “offers food for thought to policymakers on the economic and social consequences of military spending.” Using debt can be politically beneficial in that future administrations are left with the difficult and, hence, less appealing decisions.

“For a developed country with high credit rating, debt can be an affordable way to finance military spending that avoids the unpopular policies of increases in tax or cutting spending in other government sectors or the inflationary effects of printing money,” it says. “Sometimes, the appeal of debt is irrelevant, as necessity imposes itself: for countries lacking adequate fiscal revenue, debt is one of the few other means to finance additional spending.”

But cumulative debt can have severe economic consequence and while it is a major financing stream for government spending, taxes are the main vehicle for governments everywhere. The World Bank estimates that the global average of taxation as a share of gross domestic product (GDP) was 14% in 2020. For the wealthier countries in the Paris-based Organization for Economic Cooperation & Development (Canada is one of 38 members), taxes averaged 34%.

“Despite the importance of taxation as a source of funding for the state, no study has tackled its relationship with military spending,” SIPRI says. “At most, taxation has only featured peripherally. […] Instead, studies tend to use GDP as an indicator of resource availability or a state’s capacity to collect tax.” But larger economies as measured by GDP – China and India, for example – don’t have large tax bases so using it to explain variations in military spending may not be the best option.

Then there are the indirect taxes; usually collected in relatively small point-of-sale amounts, they are “less visible” to taxpayers. “In a scenario where a state requires immediate and substantial resources for higher military spending (e.g. in reaction to a perceived threat, during an armed conflict or to fund an expensive military procurement), using indirect taxes as a funding source is a particularly attractive option.”

Non-tax revenue is another politically attractive option. In countries with natural resources such as fuel and non-fuel minerals, a large portion of non-tax revenue is typically from the sale of state-owned natural resources and in many cases such as Chile and Venezuela have become “a well-established form of funding military spending.”

Currently, defence spending is on the rise globally. Japan recent announced it plans to nearly double its budget by 2027 in response to its growing threat perception of China and in Europe, in response to Russia’s evidently imperialistic tendencies, Sweden, Poland and others have signalled significant budget growth.

“Russia’s illegal annexation of Crimea in 2014 set in motion a conflict that, by early 2023, still has no end in sight,” the SIPRI paper states. Tensions between Kyiv and Moscow continued to build, setting the stage for Putin’s euphemistically labelled invasion.

“Ukraine’s war effort has been costly and increasingly difficult to sustain,” the paper’s authors say. Military spending began to increase after the annexation of Crimea in 2014, nearly doubling by 2020 and probably at the expense of social support programs, and economy shrank by 14% in 2014-2015, not returning to relative normalcy until 2021.

The combination of economic losses and growing demands on its military drove Ukrainian defence spending from 2.2% of GDP in 2014 to 3.8% in 2020. As a share of government spending, it surged from 3.3% in 2013 to 8.3% in 2020.

Taxation as a share of GDP rose only slightly in 2015 due to inflation, excise taxes on alcohol and tobacco, and introduction of a military levy which, like Canadian income tax, began as a temporary measure but is still in place.

“During the war, the shadow economy  – the production of goods and services that is deliberately concealed from the state to evade taxation and compliance with administrative procedures – has grown larger,” the SIPRI researchers say. “Its growth began to slow down after the government reduced social contributions and replaced progressive income tax rates with a flat rate of 18% in 2016. These changes contributed to a shift in Ukraine’s tax composition: direct taxes as a share of GDP fell in the first years of the war, mostly due to a drop in income tax; conversely, tax on goods and services pushed up reliance on indirect taxes from 14-17% of GDP.”

Because Ukraine didn’t increase taxation but rather changed the mix of taxes, it had to rely on alternative financing sources, principally foreign-held debt after the loss of Crimea, to sustain its military. Repayment became increasingly difficult with the depreciation of the Ukrainian hryvnia. Coupled with economic recession, it quickly pushed the debt-to-gross national income to 124%.

But the researchers say that debt wasn’t a source of financing after Crimea’s annexation Having risen substantially at the start, it peaked in 2016 and began to fall. Indirect taxation as a share of GDP stabilized while direct began to recover, partly filling the gap left by declining external indebtedness.

Then there was foreign military financial aid, 98% from Britain and the U.S. from 2014 to 2020. On average, that covered 5.2% of Ukraine’s defence spending, rising from a negligible 0.3% in 2014 to 8.7% in 2016. Up to 2020, the U.S. had provided more than $1.6 billion within the framework of the 2014 Ukraine Freedom Support Act as approved by Congress.

The SIPRI paper says the situation in “conflict-affected, lower-middle-income and historically autocratic” Ukraine “shows the difficulties of funding military spending during a conflict” because of how taxation is undercut by the loss of control over territory. Moreover, it “illustrates how certain strategies to continue the war effort and maintain military spending at high levels may be unsustainable.”

Even before Russia’s expanded invasion of Ukraine began on February 24 last year, the world was returning to superpower competition between China, Russia and the U.S. and global military spending rose as countries looked to improve national security.

The bottom line for SIPRI’s researchers is that higher taxes are the obvious option for almost every government seeking to bolster their military. That only underscores the accuracy of the maxim that “nothing can be said to be certain, except death and taxes.”

Ken Pole