Defence Expenditure: Trends and International Comparisons

2005/01 2 March 2005 Defence Expenditure: Trends and International Comparisons Executive Summary The use of accrual accounting methods makes New Zealand unique internationally with regard to defence accounting. The amount voted by Parliament for the Ministry of Defence and the New Zealand Defence Force includes GST and capital charges which are returned to the government. The actual amount available for defence expenditure is significantly less. New Zealand expenditure on defence has followed the trend of other western countries since 1990, of relative decline in military spending during the early 1990s, and stabilisation since 2001. New Zealand defence expenditure is low by international standards, both in absolute terms, and as a proportion of the national economy. Accrual Accounting In 1991 the New Zealand Defence Force (NZDF) and Ministry of Defence (MoD), as part of the New Zealand government's public sector reforms, adopted accrual accounting methods and financial reporting based on commercial balance sheet models. 1 Accrual accounting accounts for resources when they are actually consumed and not necessarily when the cash transaction takes place. This provides a more accurate picture of the true costs to a country of defence spending than cash accounting methods (which are used almost everywhere else in the world). 1 The Ministry of Defence is responsible for development of policy, audit and assessment of the NZDF, and arranges the acquisition of military equipment. The New Zealand Defence Force comprises the armed forces. 1

Appropriations The Ministry of Defence and the Zealand Defence Force earn revenue from annual appropriations from the Crown (plus a relatively small amount from transfers from other government departments and third parties), which is spent on certain policy outputs. However, the overall amount voted by Parliament for the Ministry of Defence and the NZDF as Vote: Defence and Vote: Defence Force are not actually the amounts that those organisations will have to spend. For example, in 2003-2004, $1.9 billion was appropriated for Vote: Defence Force. Of this, $285 million was a one-off capital contribution to the NZDF. Another $289 million was returned to the government as a charge on the capital owned by the NZDF. This left about $1.2 billion available to meet the expenses of the NZDF. Statement of Financial Performance Expenditure is divided into four parts personnel, operating, depreciation and capital charge. Table 1: Defence expenditure, 1991-2004 Capital Charge ($000) Total (ex capital charge) FY Personnel ($000) Operating ($000) Depreciation ($000) 1991-1992 557,399 322,934 252,525 381,667 1,132,858 1992-1993 511,337 304,427 237,274 377,694 1,053,038 1993-1994 505,806 287,854 237,585 299,025 1,031,245 1994-1995 498,581 293,415 228,847 307,597 1,020,843 1995-1996 496,518 306,622 201,879 383,857 1,004,919 1996-1997 489,515 316,061 195,211 383,666 1,001,087 1997-1998 520,372 345,414 179,956 355,877 1,045,742 1998-1999 527,408 333,597 185,751 354,559 1,046,756 1999-2000 529,285 374,397 196,144 320,394 1,099,826 2000-2001 517,348 416,675 218,242 332,161 1,152,265 2001-2002 525,005 423,896 209,163 266,528 1,158,067 2002-2003 522,157 343,204 211,171 261,770 1,167,532 2003-2004 557,480 457,011 229,392 289,007 1,243,883 Source: New Zealand Defence Force Annual reports, 1990-2004. Figure 1: Defence expenditure, 1991-2004 1,800 1,600 1,400 1,200 1,000 $million 800 600 400 200 0 91/92 92/93 93/94 94/95 95/96 96/97 97/98 98/99 99/00 00/01 01/02 02/03 03/04 Financial Year Personnel Operating Depreciation Capital charge Source: New Zealand Defence Force Annual reports, 1990-2004. 2

Personnel The largest part of the Defence budget is for personnel. Approximately 80% of the personnel costs are wages and salaries. The other 20% is taken up by allowances, superannuation contributions, ACC costs and accumulated leave costs. In 2003-2004 the Defence Force, with 12,853 personnel (including non-regulars), had personnel costs of almost $557 million. Operating Depreciation Operating expenses are for day to day operations materials, repairs and maintenance, travel, training, and premises costs and leases. Operating costs also include purchases of equipment for less than $5,000. In 2003-2004 operating expenses came to $457 million. Depreciation reflects the actual cost of equipment and property valued at over $5000 as it is used over its life. The annual amount of depreciation for each asset is calculated allocating an equal amount of the value of the asset over its expected life. In theory, the total annual depreciation funding should provide a continual flow of funds to NZDF sufficient to meet the replacement of assets at the end of their lives. The purchase and use of new assets, therefore, will impact on the Statements of Financial Performance as an increase in the depreciation that is spread out over the asset's lifetime. As an example, the cost of light armoured vehicles (NZLAVs), approximately $680 million, will be reflected in depreciation costs, for the term of their expected life of 20 years, of approximately $34 million annually. Another example is the purchase of new vessels for the Royal New Zealand Navy (Project Protector). While there is an initial acquisition cost of $500 million for the ships, this cost will be reflected in the financial performance and the appropriations as depreciation of $25 million a year for the expected life-span of the ships (20 years). Conversely, as items of equipment come to the end of their depreciable lives, there will be a corresponding reduction in overall depreciation. Depreciation funding is expected in theory to allow cash to accumulate so that replacement assets can be purchased at the end of the asset's life. In reality, new assets are usually more expensive than the assets they are replacing. Firstly, changes in technology and global military cost inflation mean that the cost of defence equipment is increasing. Secondly, procurement costs are rarely able to be neatly spread over long periods of time, but come as large up-front costs. In recent years this has been especially compounded by the fact that much of New Zealand s major defence equipment was acquired between 1965 and 1970, leaving the NZDF faced with bloc obsolescence of major items of equipment. Thirdly, most equipment is purchased from overseas, and is vulnerable to exchange rate fluctuations. 2 As a result, actual expenditure in a year on equipment may differ from the depreciation funding set aside to pay for those purchases. 2 See The Cost of Defence, ASPI Defence Budget Brief 2002-2003 (ASPI 2003) for the problems facing the Australian armed forces as amounts allocated for funding future projects have not kept pace with the cost of new equipment. 3

An example of how depreciation and actual expenditure on capital items differ can be shown by the graph below: Figure 2: Capital expenditure and depreciation, 1991-2004 700 600 500 $million 400 300 200 100 0 91/92 92/93 93/94 94/95 95/96 96/97 97/98 98/99 99/00 00/01 01/02 02/03 03/04 Financial Year NZDF capital expenditure NZDF depreciation Source: New Zealand Defence Force Annual reports, 1990-2004. There were notable peaks in defence capital spending in 1994-1995 (mostly due to the purchase of frigates and Aermacchi jets) and in 2003-2004 (due to the purchase of NZLAVs). Because depreciation cannot meet future projected costs of new equipment purchases, the government s Long-Term Development Plan forsees injections of $1 billion over 10 years from 2001/2002. 3 The Long-Term Development Plan (LTDP) is a planning tool to enable decisions on defence acquisitions to be taken in the context of the government s defence policy, the priority of projects and affordability. The LTDP contains a comprehensive list of projects, with preliminary costings, timings, and priorities. It is an active document, which is updated regularly to take account of the impact of movements in purchase prices and foreign exchange as well as the timing of projects. Projects approved to date under the LTDP are the acquisition of Pinzgauer Light Operational Vehicles, and a Multi-Role Vessel and patrol vessels for the Navy (Project Protector). Capital Charge So that the government can gain a better appreciation of the true cost of the use of its funds invested in assets, since 1990 it has imposed a charge on all government departments based on the total taxpayers' funds invested. The capital charge returned to the Crown is calculated according to the current cost of capital charged on the taxpayers' funds invested in the department (in 2003-2004 this was 8.5% on assets valued at $3.5 billion). Thus, the actual amount of money available to the New Zealand Defence Force is Crown appropriations less the capital charge. Internationally, New Zealand is unique in having a capital charge on defence assets. Australia, having adopted the capital charge method into its accounts in 1999, decided to discontinue the capital charge from 1 July 2003. 3 http://www.defence.govt.nz/public_docs/longtrmdevplan/1-introduction.shtml 4

Statement of Cash Flows A second method of monitoring defence revenues and expenditure is through the Statement of Cash Flows. This statement tracks the flow of cash through the MoD and NZDF. Like the Statement of Financial Performance, it records Crown revenue, operating and personnel expenditure and the capital charge. However, it differs from the Statement of Financial Performance in that it does not record depreciation. Instead it reports on cash spent on the purchase of property and equipment (such as NZLAVs or ships) and cash received from the sale of property and equipment. It also reports on financing activities that include cash received from, and paid to, the government. This includes an occasional capital injection to fund the purchase of new equipment that cannot otherwise be met from depreciation funding or the proceeds of asset sales. Table 2: Expenditure by cash flow (less capital charge), 1991-2004: Purchase of FY Personnel and Operating property and equipment Total 1991-1992 865,409 144,940 1,010,349 1992-1993 825,865 89,678 915,543 1993-1994 777,222 121,680 898,902 1994-1995 778,074 618,452 1,396,526 1995-1996 809,808 281,531 1,091,339 1996-1997 808,745 227,939 1,036,684 1997-1998 863,815 192,213 1,056,028 1998-1999 861,192 244,215 1,105,443 1999-2000 910,408 271,723 1,182,132 2000-2001 922,947 200,350 1,123,297 2001-2002 942,024 329,592 1,271,616 2002-2003 945,962 188,588 1,134,550 2003-2004 991,155 519,374 1,510,529 Source: New Zealand Defence Force Annual reports, 1990-2004. Cash flow shows the actual expenditure on defence in a single year. However, the periodic purchase of expensive items of military equipment means that there are considerable fluctuations (e.g. in 1994-1995, when the purchase of frigates caused cash spending to show an increase in defence spending of almost 35% over the previous year). For this reason, financial performance (which evens out capital expenditure over time through depreciation) provides a more consistent picture. 5

Trends in Defence Expenditure Defence expenditure, after falling in the early 1990s, has slowly increased over the last decade. Figure 3: Defence expenditure, 1991-2004 (excl GST in nominal $) $million 1,800 1,600 1,400 1,200 1,000 800 600 400 200 0 91/92 92/93 93/94 94/95 95/96 96/97 97/98 98/99 99/00 00/01 01/02 02/03 03/04 Financial Year NZDF expenditure MoD expenditure NZDF expenditure less capital charge Source: New Zealand Defence Force Annual reports, 1990-2004; Ministry of Defence Annual reports, 1990-2004. However, over this time the New Zealand economy has grown, meaning that, relative to the broader economy, defence expenditure has fallen. Figure 4: Defence expenditure (less capital charge and GST) as % GDP, 1991-2004 1.8 1.6 1.4 1.2 1.0 %GDP 0.8 0.6 0.4 0.2 0.0 91/92 92/93 93/94 94/95 95/96 96/97 97/98 98/99 99/00 00/01 01/02 02/03 03/04 Year Defence spending as % GDP Defence spending by cash flow Source: New Zealand Defence Force Annual reports, 1990-2004; Ministry of Defence Annual reports, 1990-2004. 6

International Definitions Consistent definitions of military spending are important in order to ascertain the appropriateness of military expenditure and facilitate constructive dialogue on international security policies. International agencies such as NATO, the United Nations, Stockholm International Peace Research Institute (SIPRI), International Institute of Strategic Studies (IISS) and Royal United Services Institute (RUSI), use a common formula for making international comparisons based on the NATO definition for comparing military spending. The NATO definition of military expenditure is cash outlays to meet the costs of national armed forces, reported in operating costs such as salaries and wages for personnel and the cost of maintenance and training, procurement and construction costs, and research and development costs. It excludes war pensions for veterans. 4 New Zealand s use of accrual accounting methods makes direct comparisons difficult. Indeed, many international agencies appear to be confused by this, and appear to record figures for New Zealand which seem to include the capital charge (which is not actually military spending as such but is returned to the Crown). International Comparisons as %GDP Internationally, a fairly standardised system of comparing defence expenditure as a percentage of GDP is used. This is done for several reasons. It provides a picture of the relative weighting a country gives to defence in comparison to the allocation of resources to other fields, and the economic burden of military expenditure imposed on the national economy. It also avoids having to convert local currencies into a common currency or base monetary unit (i.e. the US$), which could result in considerable fluctuations as exchange rates change. Such a system is especially important in the context of international security agreements and alliances, where it is important to be able to have some benchmark of a country's commitment to defence. 5 4 The Military Balance 2002-2003, International Institute for Strategic Studies, London, 2002, p.10. (It should be noted that this excludes any payments made to war veterans and civil defence. This is because these figures attempt to aggregate current defence expenditure, rather than the ongoing historical cost of defence and previous armed conflict.) See also Herrera. R, Statistics on Military Expenditure in Developing Countries (OECD 1994), p.15; Lamb. G and Kallab. V, Military Expenditure and Economic Development, (World Bank 1992), pp.2-9. SIPRI employ the NATO definition, but use estimates from official data reported by governments presented on a calendar-year basis calculated on the assumption of an even rate of expenditure throughout the fiscal year and converted into US dollars. (SIPRI Yearbook 2002, pp.298-299.) 5 http://www.nato.int/docu/pr/2003/p03-146e.htm - in some new entrants to NATO such as Romania defence spending is pegged as a percentage of GDP as a sign of commitment to the alliance; The Cost of Defence: ASPI Defence Budget Brief 2003-2004, Australian Strategic Policy Institute 2004, p.16. 7

Figure 5: International defence spending as % GDP, 1993-2003 5.0 4.5 4.0 3.5 3.0 %GDP 2.5 2.0 1.5 1.0 0.5 0.0 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Year U.S.A. U.K. Aust. Canada N.Z. Source: www.nato.int/docu/pr/2003/p03-146e.htm; The Cost of Defence: ASPI Defence Budget Brief 2003-2004; Yearbook Australia, 1993-2004. Paul Goldstone Research Analyst Law and Government Parliamentary Library For more information, contact Paul at 04 471 9212 or email: paul.goldstone@parliament.govt.nz Copyright NZ Parliamentary Library Except for educational purposes permitted under the Copyright Act 1994, no part of this document may be reproduced or transmitted in any form or by any means, including information storage and retrieval systems, other than by Members of Parliament in the course of their official duties, without the consent of the Parliamentary Librarian, Parliament Buildings, Wellington, New Zealand. 8