Paying for war: Taxes versus debt

PSCI 2227: War and State Development

Prof. Brenton Kenkel

brenton.kenkel@gmail.com

Vanderbilt University

February 23, 2026

Today’s agenda

Revenue and war — where we’ve been so far

Levi: rulers want max revenue, but must bargain with elites
War shifts bargaining power in favor of rulers (mostly)
- War should increase revenue in short run
- And long run too, via ratchet effect
Karaman and Pamuk’s stats: war raised fiscal capacity in Europe

Problem for this tidy story: what about when foreign debt pays for war?

Debt and war: Theory

War increases tax revenue…

…and war increases debt

Who do states borrow from?

1500s: personal networks (e.g., the Fuggers)

today: central banks, intl. institutions, publics…

Advantages of debt finance

Why fund a war with debt instead of taxes?

The Klarna logic.

Why pay now when you can pay later?
War threat \(\leadsto\) might be dead tomorrow \(\leadsto\) shorter time horizon

Loosening the bargaining constraints.

Domestic constituencies demand political concessions
- Already squeezed by war: conscription, inflation, trade restrictions…
Banks just demand future payment with interest

Debt finance, war, and statebuilding

Standard logic of war and revenue

War \(\leadsto\) greater revenue need, less elite bargaining power
Efficient tax collection systems and successful elite bargains develop
These persist even after war (ratchet effect)

How does debt finance break this chain?

Less incentive to cultivate/measure tax base
Less incentive to grow the economy in the long run
No need to share power with elites and reach long-run bargains

Hypothesis: War makes the state only when funded by taxes, not debt

Debt finance and war: counterpoints

Hypothesis: War makes the state only when funded by taxes, not debt

…but there are some reasons for skepticism

Ricardian equivalence: debt’s gotta be paid, so taxes will be raised sometime
Political logic: if debt breaks the state, shouldn’t rulers use taxes?

Counter-counterpoints:

Debt sometimes defaulted or “paid” w/o taxes (oil, land, monopolies)
Short time horizons → repayment might be someone else’s problem
Did rulers understand that war made the state?

Why not always pay for war with debt?

If war loans solve political problems, why do we ever see rulers raise taxes instead of taking out debt?

Lack of credit access — endogenous.

Bad war prospects, prior defaults \(\leadsto\) high market interest
At some margin, better to eat the political costs now
Eventually, lenders simply won’t loan to bad enough credit risks

Lack of credit access — exogenous.

Financial crises and stock crashes dry up supply of capital
Particularly in 1800s, when Britain was >50% of foreign capital market

Debt and war: Evidence

How to study the effects of war debt

Causal hypotheses:

War paid for by taxes \(\leadsto\) high long-run fiscal capacity
War paid for with debt \(\leadsto\) no/negative change

Suggests a tempting but problematic method of analysis

Count up taxes each state raised for war
Count up debts each state incurred for war
See how well each predicts future fiscal capacity

Why would we go wrong doing it this way?

The endogeneity problem

Actual debt incurred for war represents multiple things

Exogenous credit supply — how much capital is out there to lend
Endogenous credit supply — how risky is this borrower?
How well the war is going — how much damage has the domestic economy taken?

Endogenous credit risk + war performance are confounding variables

Could directly impact long-run capacity, aside from effects on debt finance
Hard to trace differences in long-run outcomes to the choice of instrument rather than the competency and reliability of the government

The endogeneity problem

Queralt’s solution

Britain was the “world’s banker” between Napoleonic Wars and WWI

Localized shocks to British markets \(\leadsto\) exogenous contraction of credit supply

Research design

Dependent variables: long-run fiscal capacity

Income taxation as proportion of GDP, 1995–2005
Tax administration staffing per capita
Value-added taxes

Independent variables:

Years at war, 1816–1913, when British capital flow “stopped”
Years at war, 1816–1913, when British capital flowed normally

Expectation: War participation only builds the state in periods of credit stops

Statistical findings

Why does war-without-credit make the state?

Apparent mechanism: Forcing the ruler to share power

Wrapping up

What we did today

Debt as an alternative to taxes for war finance
- Advantages: pay later, avoid political concessions to elites
- But: breaks the war \(\leadsto\) state chain
- Why not always use debt? Credit is limited by risk + market shocks
Queralt’s evidence on debt, war, and statebuilding
- British capital market shocks as exogenous credit supply variation
- Finding: war builds the state only when credit is unavailable
- Mechanism: forced power-sharing with domestic elites

From here, we’ll dig deeper into that “forced power-sharing” — look at effects of war on parliaments

To do for next time

Read Kenkel and Paine 2023, “A Theory of External Wars and European Parliaments”

Do external threats make rulers more likely to share power with parliaments?
We say: sometimes yes, sometimes no
Threats make ruler more willing to share… but affect elite incentives in countervailing ways