Highly indebted European NATO countries should levy a “defense tax” to make their long-term commitment to higher defense spending politically credible and financially sustainable.
This year, 23 out of 32 NATO members are expected to meet the 2 percent of gross domestic product (GDP) defense spending target that the allies agreed to in 2014. While this is an improvement, the failure of nearly one third of NATO members to meet the relatively modest two-percent spending target speaks for itself. To strengthen its political-strategic and deterrence effect, defense spending needs to be made politically credible and financially sustainable. A long-term commitment to higher defense spending would also incentivize Europe’s private sector to make the investments necessary to rebuild Europe’s indigenous defense-industrial base.
European NATO countries have a sufficiently large economic resource base to balance Russia militarily. In terms of economic size, measured in purchasing power parity (PPP) terms to adjust for differences in prices, NATO GDP exceeds Russian GDP by a factor of 12, European NATO GDP exceeds Russia’s by a factor of six, and the combined GDP of Germany, the United Kingdom, and France exceed Russia’s by a factor of two and half. (Measured at market exchange rates, European NATO member GDP is more than 20 times larger than Russia’s.)
The challenge European governments face is how to mobilize the necessary resources in the face of domestic distributional conflict. To the extent that greater resources are allocated to defense, fewer resources will be available for private consumption or non-defense investment (or both), unless they are borrowed from abroad. If the increase in defense spending comes primarily at the expense of private consumption, the population will be economically worse off. If it comes primarily at the expense of non-defense investment, longer-term growth will suffer. Allocating greater resources to defense implies economic tradeoffs and gives rise to domestic distributional conflict.
High Government Debt Constrains Larger European NATO Members
The five economically largest Western European NATO members (Germany, the United Kingdom, France, Italy, and Spain) account for 60 percent of European NATO GDP. Their ability to mobilize resources will have an outsized impact on European defense capabilities. But with the exception of Germany, government debt in these countries exceeds 100 percent of GDP and the International Monetary Fund (IMF) projects debt ratios to continue to exceed this level by the end of the decade. Financing substantial increases in defense spending through larger fiscal deficits therefore would seem at best financially imprudent. (All the other 25 European NATO members have more manageable debt levels of 80 percent of GDP or less, except for Belgium, Greece, and Portugal.)
Admittedly, France and the United Kingdom already spend 2 percent of GDP or more on defense, compared to 1.5 percent of GDP in Italy and Spain as well as Germany (if one discounts the contribution from its €100 billion special defense fund). However, should it become necessary to raise defense spending to 3 percent of GDP, as recently suggested by Poland, they would be faced with financial challenges. All of them are already faced with significant spending pressures as a result of higher spending related to demographic change, climate change, and defense. The European Central Bank (ECB) estimates that eurozone governments would need to raise an additional 3 percent of GDP – and substantially more than that in France, Italy and Spain – to cope with these increasing spending pressures and stabilize their debt-to-GDP ratios at current levels. But this would, according to the ECB’s projection, only prevent debt levels from increasing from today’s already high levels. It would require an additional 2 percent of GDP to bring government debt levels to the eurozone target of 60 percent of GDP.
How to Finance Increased Defense Expenditure
So how should they go about financing higher defense expenditure? First, governments can increase defense expenditure by simply running larger deficits and accumulating additional debt. Germany has some fiscal space to do so in the short- to medium term. The other large European NATO members, as suggested, do not have that option. At the very least, it would be financially imprudent to do so, as it might undermine financial sustainability and therefore also political credibility. In terms of distributional politics, however, it would be the least challenging option, as it largely sidesteps distributional conflict by pushing the costs into the future and leaving it uncertain who will end up having to pay for higher spending.
Second, governments can cut non-defense spending (or, if no major immediate increase is necessary, reduce its increase relative to economic growth over time), thus freeing up resources to be spent on defense. According to the OECD, public social spending, by far the largest single expenditure category in the five countries, exceeds 30 percent of GDP in France and Italy. It is also high in Germany and Spain.
Economically, reducing non-defense spending would be the preferred option, as the concomitant reduction in transfers to households for consumption purposes would help finance higher defense expenditure without reducing national savings. But politically it would be the most challenging option, as reducing social welfare spending or “acquired rights” typically mobilizes significant opposition, not least because who will incur economic losses, even if the materialize in the future, will be far less uncertain than in the case of issuing additional debt. Governments can also reduce public investment or other types of expenditure, like subsidies. But the former is costly in terms of foregone future economic growth, and the latter can just easily lead to significant political opposition if it affects well-organized or highly mobilized interests, such as farmers.
Third, governments can increase revenues, primarily income taxes, social security contributions, and taxes on goods and services. Higher taxes are hardly politically popular, and they, too, can trigger distributional conflict, particularly if they are perceived to exempt or favor one group over another. And increasing social security contributions to finance defense expenditure would be a difficult sell, even if higher contributions simply helped plug existing social security deficits and thereby allow the government to redirect resources to defense. But unlike spending cuts, higher taxes, if properly designed, can help spread the costs more evenly and more widely, thus limiting domestic political opposition.
Economic Effects of Higher Defense Spending Will Vary
The macroeconomic effects of increased defense spending will depend on how they are financed, but also on how the additional funds are spent. If financed by additional debt in the absence of binding financial constraints, higher defense spending would provide a demand stimulus, at least in the short term. In debt-constrained economies, however, higher debt would increase the level of interest to be repaid, thus offsetting some or even all of the fiscal stimulus. In a worst-case scenario, it might undermine economic confidence altogether and force the government into a strategically disastrous fiscal retrenchment.
If financed by higher taxes or lower non-defense expenditure, the impact on short-term economic growth would likely be limited. Much would depend on where higher defense expenditure is directed. Increased spending on personnel, maintenance, and infrastructure would support domestic demand, while spending on overseas operations and equipment, much of which is currently being bought from abroad, would lead to what economists call fiscal leakage. But with spending on equipment typically accounting for about one third of defense spending, the broader macroeconomic drag—all other things being equal—would be limited. Over time, the build-up of intra-EU defense production capacity would also lead equipment spending to be redirected to the EU economy and support domestic and growth in the future.
However, without a complete offset from a reduction of domestic consumption, allocating greater resources to defense would weigh on longer-term economic growth, at least in savings-constrained economies. Here again, Germany’s very large current account surpluses, which reflect “excess savings,” would provide it with much greater leeway to increase defense spending without jeopardizing non-defense investment than France, Italy, Spain, and the United Kingdom, whose current account positions are far less favorable.
European Governments Should Consider a “Defense Tax”
In view of the need to raise defense spending in a financially sustainable and politically credible manner, fiscally constrained EU governments should consider introducing a “defense tax” at the national level. The related recurrent revenues should be earmarked for defense spending and finance the gap between current defense spending levels and current (and future) expenditure goals. If properly designed, such a tax would spread the financial burden broadly across society.
This should help make it politically more palatable, compared to the alternative of financing increased defense expenditure through cuts to welfare spending. After all, the defense of the realm is a public good. So, everybody should contribute to it. Naturally, such a tax would not help governments avoid tackling broader, politically painful budgetary reform to address current and future spending pressures related to demographic change and the green transition. But by earmarking the revenue raised with the new tax for defense, it would go quite some way toward credibly and sustainably committing European governments to higher long-term defense spending, thus bolstering its strategic and deterrence effect.