The NATO Pledge Will Transform Federal Finances – Show Us How

From: Colin Busby and Nick Dahir

To: Canadian economic observers

Date: July 21, 2026

Re: The NATO Pledge Will Transform Federal Finances – Show Us How

A rear-view glance to this month’s NATO summit should prompt a concentrated stare to the future, asking how Canada plans to achieve its commitment to spend 5 percent of GDP on defence by 2035.

For Canada to meet that pledge, it will have to make difficult choices on taxes spending and borrowing. Making these choices requires a credible fiscal plan – and it needs to come in the fall budget.

The new five-percent defence pledge is made up of two parts: 3.5 percent is devoted to core capabilities, with at least 20 percent of those expenditures directed toward major equipment and R&D. The remaining 1.5 percent can be spent on defence-related infrastructure and other investments.

Although 5 percent may seem small, this fiscal commitment means core defence spending will need to approach $150 billion by 2034/35 – roughly three times current levels and comparable to the federal government's annual transfers to provinces.

The 2025 federal budget and the 2026 spring economic update did not present a financial plan for meeting the pledge.

NATO countries already spending heavily on defence while carrying relatively modest debt are in the strongest position to accommodate the surge in spending and reach the new target on time. Those that start from a position of both high debt and low defence spending face a much steeper climb.

Canada falls into the latter group. NATO estimates Canada’s defence spending at 2.1 percent of GDP in 2025, well below the NATO average of 2.8 percent. Canada’s government debt-to-GDP ratio – which includes the provinces and the federal government but excludes CPP/QPP net assets – is just over 80 percent, compared with an average of less than 70 percent among other NATO members. This means Canada must substantially increase defence spending while managing an already elevated debt burden.

This makes prudent fiscal management even more important.

Countries with modest debt and high defence spending include Nordic nations, as well as the Baltic countries. They have prudently managed public finances and are likely well positioned to meet expanded military capabilities.

The traditional military powers, such as the United States, the United Kingdom and France, spend a lot on defence but are increasingly in a fiscal crunch, and are not managing those issues well.

In Canada, an aging population will continue to increase spending on programs such as Old Age Security while slowing revenue growth. Plus, weak productivity and uncertainty surrounding international trade further restrain the government's fiscal capacity. Against a challenging economic backdrop, were Canada to finance this increase through borrowing alone it would set the federal debt-to-GDP ratio on an unsustainable path.

Yes, there will be positive economic spillovers with an expanded domestic defence industry, but that won’t fully offset the increase in costs. To do so, annual economic growth would need to average over 6 percent per year for a decade – we have not seen consistent growth like that for more than 60 years. 

The fall budget presents an ideal opportunity to provide a credible plan. It must do more than announce annual defence expenditures. It should also explain how those expenditures will affect the government's finances over time.

This matters because federal finances are recorded on an accrual basis while NATO measures defence spending on a cash basis, counting expenditures when money is spent. Under accrual accounting, costs for capital items such as ships, aircraft and military infrastructure are recognized over time as these assets depreciate.

The result is that the fiscal impact of meeting Canada's NATO commitment will not mirror the timing of the cash outlays. Large defence procurements may have only a modest immediate effect on the deficit, but they create amortization expenses that remain on the books for decades.

We need only look to other NATO members to see the pitfalls of failing to present a credible plan. Spain has said that it is unlikely to meet the new target. Others face political constraints that limit their options. In France, gridlock over pension reform has frustrated efforts to create additional fiscal room for defence spending.

The United Kingdom’s proposed plan was deemed not credible, resulting in ministerial resignations and renewed uncertainty over how the country will meet its objectives. Even the United States has expressed doubt about its need to meet the 2035 target and is eyeing tariffs as a revenue tool to avoid harder political decisions around income and sales taxes.

Canada should avoid similar mistakes.

The next federal budget should set a credible path for meeting NATO’s cash-based spending commitments through 2035, and it should present the resulting impact on the federal government's accrual-based finances. Parliament, financial markets and Canadians deserve to understand not only how much will be spent, but also how those commitments will shape the country’s fiscal position long after the equipment has been purchased.

Colin Busby is director of public engagement and Nicholas Dahir is research officer at the C.D. Howe Institute.

To send a comment or leave feedback, email us at blog@cdhowe.org.

The views expressed here are those of the authors. The C.D. Howe Institute does not take corporate positions on policy matters.

A version of this Memo first appeared in The Globe and Mail.