How to finance the war?

How to finance the war?

20 November 2024
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Will Trump support or sacrifice Ukraine? We do not know but the early signs do not look particularly promising. Ukraine will continue to have many allies in Europe and elsewhere but, in all likelihood, a heavier burden of the war will have to be carried by Ukrainians. The country will likely have to rely more on internal funding to cover defense spending. 

But where would money come from? 

In a famous essay How to Pay for the War (1940), Keynes described major income sources for the British government during World War II: printing money, borrowing, raising taxes, lowering non-defense spending. He ruled out printing money because inflation can destroy the economy and hence make Britain unable to fight a long war with Nazi Germany. Because taxes distort economic incentives, Keynes argued that the best way to pay for the war is to borrow so that the cost of the war is spread over generations. If debt is not available, then Keynes suggested a strict budgetary discipline in terms of spending (that is, no giveaways of any kind, only essential functions of the government must be maintained, aid must be targeted) and raising taxes. For the latter, he suggested that taxes should be highly progressive to maintain solidarity and to ensure that everyone has access to basic goods and services such as food and shelter. Both borrowing and higher taxes help redistribute limited sources from private consumption to defense without igniting inflation. Interestingly, Keynes preferred taxes on consumption (that is, a high value added tax) but there was no infrastructure to administer such taxes in the past. 

What options are available to Ukraine?

In the early months of the Russian full-scale invasion in 2022, Ukraine relied on printing money to finance an enormous fiscal deficit. This policy very quickly resulted in ~25% inflation. After the Russian illegal annexation of Crimea and occupation of the Donbas, the government used the central bank too and the result was the same: high inflation. These important lessons teach that the National Bank of Ukraine should not be the main funding source for the government. 

The proposed budget for 2025 indicates that the net borrowing (that is, new borrowing minus servicing existing debt) is tiny relative to the funding needs to be dictated by the war. The government can use repressions to extract some more resources from Ukraine’s underdeveloped financial system, but this means that the rest of the economy will have less credit. A more promising source is democratization of war bonds similar to Series E bonds in the U.S. during World War II. In other words, the government should aggressively encourage (and even possibly force) Ukrainians to support the war effort by buying war bonds. Because such a campaign cannot fully close the funding gap (the war has already exhausted the savings of many Ukrainians), according to Keynes, Ukraine has only one long-term solution to the problem: the country has to raise taxes to survive in a war of attrition.

History shows that many countries took this path in desperate times. For example, during World War II, U.S. President Roosevelt declared: “We are asking even our humblest citizens to contribute their mite. It is our duty to see that the burden is equitably distributed according to ability to pay so that a few do not gain from the sacrifices of the many.” 

Not only tax rates were increased dramatically (and especially so for the rich) but also the tax base was broadened so that almost every citizen paid taxes to contribute to the war effort (Figure 1). The government also introduced taxes on excessive profits to ensure that nobody profits from the war. Furthermore, income taxes had a radical change in administration: employers would withhold taxes from workers’ paychecks. All these changes were coupled with a focused media effort (supported by Hollywood stars including Donald Duck among many others) of the U.S. Treasury: patriotic Americans should be happy to pay their taxes aware of the fact that lives are on the line. Consistent with Keynes’ logic, the U.S. Treasury also motivated these tax increases as anti-inflationary and thus desirable because, as observed by US Secretary of Treasury Henry Morgenthau, “An inflation price rise is a source of grave social injustice.”

Figure 1. Income taxes in the U.S.

Source: Concord Coalition

The experience of the United States is hardly unique. In Taxing the rich: A history of fiscal fairness in the United States and Europe, Kenneth Scheve and David Stasavage show that nearly all countries that went through wartime mass mobilization raised taxes dramatically (Figure 2). Scheve and Stasavage argue that this increase in taxes is motivated by more than the ability to pay doctrine (that is, the rich have more money and thus they can afford to pay higher taxes). The other key reason is compensation for a privilege granted by the state. While compensatory theory has many critics and supporters, the key privilege during the war is to not sacrifice his or her life for the country. Because the rich are disproportionately likely to avoid draft (the scandals in medical commissions in Ukraine give a clear sense of how bribes can help the rich avoid military service), the rich should compensate the country by paying higher taxes (historically up to 90% for the highest tax brackets). 

Figure 2. Average top rates across 20 developed economies. 

Source: Taxing the rich: A history of fiscal fairness in the United States and Europe by Kenneth Scheve and David Stasavage.

To support this theory, Scheve and Stasavage show that income taxes increased dramatically precisely in times of mass mobilization (Figure 3). However, this increase in taxation happens only in democracies where governments depend on ordinary citizens and thus governments have to be fair to those who put their lives on the line. Consistent with this theory, as mass conscription has been gradually abandoned across advanced economies since the 1980s, there has been a push to reduce taxes for the rich. In fact, Scheve and Stasavage suggest that the only time when democratic governments can raise taxes and make them progressive was during massive wars. 

Figure 3. Top rates of income taxation in World War I 

Source: Taxing the rich: A history of fiscal fairness in the United States and Europe by Kenneth Scheve and David Stasavage.

In summary, higher taxes (and strict budget discipline) appear to be the only viable option to fund the war effort for an extended period of time. The tax increase recently approved by the Ukrainian Parliament is a first step in this direction (President Zlelensky should sign this law as soon as possible). However, these tax changes are not progressive and they do not target private consumption. Keynes and many others advise for Ukraine would be that future tax increases should aim to minimize distortions (this means raising the rate of the value added tax) and ensure fairness (this means progressive income taxes). Because Keynes was not aware of massive tax evasion observed in Ukraine, one should add a comprehensive reform in the administration of taxes that will reduce the compliance burden, broaden the tax base, and make the system more fair. 

To be clear, few people like paying taxes but the U.S. elections underscored again the importance of Ukraine’s self-sufficiency to fight Russian aggression. If foreign aid dries up, higher taxes are likely the only option to ensure that Ukrainians — rather than foreign powers — determine the future of Ukraine, the largest country in Europe. 

Authors
  • Yuriy Gorodnichenko, Chairman of the Supervisory Board of Vox Ukraine, Professor at the University of California, Berkeley

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