Defence spending needs to be materially higher. It is now 2.3% of GDP. Yesterday, the Prime Minister announced an increase to 2.5% of GDP by 2027, paid for by a cut in overseas aid, and that it would rise to 3% over the next decade. This reflects the changing geopolitical landscape and US pressure for other Nato countries to foot more of its bill. Previously the target had been 2.5% by 2030-31.
The Annex to the Sunak government’s April 2024 document ‘Defending Britain’ lays out the spending plans which have formed the bedrock of this thinking. In 2024-25, Nato-qualifying spending was £64.6 billion, as part of this sits outside the MoD budget and includes part of the Single Intelligence Account Armed Forces pensions and the Integrated Security Fund.
As the Office for Statistics Regulation mentioned at the time of last year’s general election:
Nato-qualifying defence spending rises steadily from £64.1 billion or 2.3% of GDP in 2024-25 … to £87.1 billion or 2.5% of GDP. On this basis cumulative spending over the six years from 2025-26 to 2030-31 is projected to be £460.9 billion, compared to £384.4 billion if annual spending remained flat in cash terms at £64.1 billion.
UK GDP, based on the Office for Budget Responsibility’s forecasts at the time, was set to rise from £2,786bn in 2024-25 to £3,483bn in 2030-31. Thus, by 2030-31, each increase of the defence budget by 0.5% of GDP would add £17.4bn to defence spending each year. So 3% of GDP would necessitate Nato-qualifying defence spending of £104.5bn by 2030-31.
At a time when growth is sluggish and the headroom to meet the Chancellor’s self-imposed fiscal rules is limited, these types of sustained spending rises are hard to imagine, and imply difficult political choices if overall public spending is to be kept under control.
In the forthcoming fiscal year (2025-26), each increase of Nato-linked defence spending by 0.1% of GDP would cost £2.9bn.
It’s not just the cost, but the IFS notes the UK has not spent 3% of GDP on defence since 1993-94, 4% since 1986-87 and 5% since 1967-68. However, because of changes to the measurement of various components of defence spending over time, even these historic comparisons may understate the challenge.
Also, the speed at which defence spending needs to increase may have to be quicker than expected. This is to address shortfalls in defence capability after a prolonged period of low defence spending, including replenishing munitions used in Ukraine.
The implication may be the need for a one-off significant spend, followed by a higher ongoing annual percentage increase. The challenge of defence needs versus fiscal reality is too evident.
So, how should the UK pay for this?
Ideally, other areas of spending can be squeezed to allow defence spending to rise. To boost defence spending in an environment of high debt, tax and borrowing requires an approach that financial markets believe is credible and inspires confidence that funds raised will go to defence
Here are four options, with my preference being for one of the first two if they could be made to work. However, option three seems the most likely to actually happen.
One option is to raise fresh capital to boost defence spending quickly. Raising money fresh with short-dated debt from the capital markets may be expensive and difficult.
A radical approach could be a loan from the US. This would mean adopting an approach that worked in the past and to adapt it to the times. The UK has faced pressure to boost defence spending before, at a time when its debt level was high and it was suffering from balance of payments problems. In the second half of the 1940s and in the 1950s, the US provided loans which the UK repaid at relatively low rates.
Alongside defence spending, the loans were also aimed at helping the UK economy stabilise in the post-war era. It may be hard to repeat this exactly now as it requires a mindset shift and the pros and cons, relative to alternative options, need to be discussed but it has the benefit of necessitating working closely with the US.
As in the past, this approach would allow the US to achieve its aim of western countries like the UK having the financial resources to boost defence spending immediately, which in turn would ease demands upon the US. It may be seen as a transactional approach that allows both the UK and the US to achieve their strategic objectives.
The loan could be structured with a long repayment period. For instance, the final payment for the 1946 Anglo-American loan was made in 2006 and for another US loan in 1950 the final repayment was made in 2016. In the past, the UK also issued long-dated bonds, to help finance these loans, thus spreading the repayment over a considerable time span.
Repeating this approach now could be made to work, with the UK – taking into account market circumstances – funding it through issuance of long-dated defence bonds, aimed at UK funds and other institutional investors.
The obvious question is why not just raise the money directly through the markets – but the challenge here is whether the markets will believe such direct capital market borrowing will be allocated to defence solely, as it would have to be under a loan, and not just swallowed up into general spending.
This is not without challenges, as market conditions and thus the borrowing rate are vital. For instance the opportunity to have borrowed and issued longer-dated debt would have been ideal around 2012-13 and in 2019 when long-term interest rates were around zero. Now rates and borrowing costs are higher than then – even though they are now falling – so the timing and flexibility re locking into longer-term borrowing is more complex. That doesn’t prevent this, but this has to be recognised.
A second option is a new approach of a hypothecated tax to pay for defence spending.
Taxes have a legally mandated destination account. For instance, income tax goes into the consolidated fund, while national insurance goes in the national insurance fund. Yet, behind the scenes these are inter-changeable and there are explicit provisions where the consolidated fund can be drawn upon in support of the national insurance fund’s responsibilities.
With a hypothecated tax, instead, the receipts of the tax are used solely to pay for a specific purpose. Given how high government spending is, and how difficult it seems to be to control it, a hypothecated tax makes sense for both health spending – because of its scale – and for defence — given the extent to which it needs to rise.
Increased transparency and greater accountability are necessary criteria to keep public spending under control. The benefit of a hypothecated tax is that it provides an immediate ability to raise fresh money and to attach tax receipts to spending outcomes. The push back is that it is another way to raise the tax take, when it is already at an all-time high and rising. The fear against hypothecation has often been that it might mean policies are constrained by revenues raised, but this could be addressed by raising sufficient funds and doing so in a transparent and efficient way.
The UK has a progressive tax system and many workers do not pay any payroll taxes, but perhaps in the area of defence there would be a case to apply it at a far lower level of the income tax spectrum, and below where the tax-free allowance currently applies, so everyone, except those on very low incomes, contribute.
A third option is a continuation of the present setup, where defence has to compete for a larger slice of government spending which continues to be funded in the same way as now, through general taxation and borrowing via gilt issuance.
Yesterday’s announcement of a cut to overseas aid only gets Keir Starmer so far. In future, the comprehensive spending review and Budget would be the main focuses for such decisions. Defence would have to take a bigger share of the spending pie at the expense of areas like health or more likely non-ringfenced areas.
To all intents and purposes, it means that in the absence of stronger economic growth or a sea-change improvement in public sector productivity, this will add to upward pressure on spending, taxation and borrowing.
A fourth option is one that I am not in favour of, as I am not convinced it would work. The aim would be to work with others to establish a new multilateral European, but non-EU, agency to pay for defence. The benefit of this is that it would recognise the need for more countries to pay, but like most such setups, it would take time to establish and outcomes may play a secondary role to politics and bureaucracy. Just as many countries free-ride off the US in Nato (although whether this is actually the case is up for debate), so they may do the same here in terms of the UK and France. It’s also unclear how it would work alongside EU treaties.
Last October’s Budget showed that total government spending in 2025-26 was planned at £1,335bn. The top five areas of spending were social protection (£379bn), health (£277bn), education (£146bn), debt interest (£126bn) and defence (£83bn). This defence spending included the departmental expenditure limit of £59.8bn, which is seen as a more realistic indicator of defence spending.
Importantly, much defence spending can spill over into other areas, creating a bigger industrial footprint in the UK and thus helping the wider economy.
Click here to subscribe to our daily briefing – the best pieces from CapX and across the web.
CapX depends on the generosity of its readers. If you value what we do, please consider making a donation.
