How to finance the defense expenditure of EU member states increased to 2% of their GDP? Three options: budget cuts, debt financing, tax increases. We discuss the cost of each of these scenarios.
European governments have committed to increasing defense spending, but reaching 2% of GDP by 2028 will require an additional 470 billion EUR (including 150 billion EUR in Germany, 55 billion EUR in Italy, 48 billion EUR in Spain, and 17 billion EUR in France).
In the face of ageing societies and huge needs related to the green transformation, governments have been reluctant to articulate exactly how they will increase defense spending. To put this in perspective, it would require: (i) expenditure cuts of -8.6% in Spain, -7.7% in Germany, -6.5% in Italy, and -4.8% in France; or (ii) an additional interest burden of about 12.1 billion EUR in 2028 if it relied only on debt financing; or (iii) if it relied solely on increasing tax revenues, such as VAT rates, they would rise by 0.6 percentage points across the EU.
The combination of these three solutions would distribute the financial burdens between generations and within societies, but equal priority on possessing arms, butter, and batteries will still come at a high price.
Faced with an aggressive Russia at its borders, EU governments have committed to increasing defense spending, not just to meet NATO’s 2% GDP target. According to Allianz Trade analysis, since 1995, overall government defense spending in current EU 27 has risen from 104 billion EUR to 204 billion EUR in 2022. However, these have not kept pace with the overall growth of GDP and total spending: in 1995, defense spending accounted for 1.6% of GDP compared to 1.3% of GDP in 2022, ranging from 0.2% of GDP in Ireland to over 2% in Greece, Latvia, Estonia, and Lithuania (Poland 1.6% according to COFOG).
However, a gradual increase in the defense expenditure ratio to 2% of GDP in all EU member states by 2028 would require a total of 470 billion EUR in additional expenditure of the sector of government and local government institutions compared to the scenario assuming maintaining current levels. This would include 150 billion EUR in Germany, 55 billion EUR in Italy, 48 billion EUR in Spain, 17 billion EUR in France, and 11.9 billion EUR in Poland. Achieving a 3% GDP share spent by the US (also advocated by Polish President A. Duda) would require an additional 1110 billion EUR in defense spending (across the EU) in the next five years.
The question is how these increases in expenditure will be financed? Generally speaking, Allianz Trade analysis suggests that there are three ways to finance increased defense spending: cutting spending on other functions, financing debt, or increasing taxes.
Bearing in mind the aggressive Russia on the border, EU governments have committed to increasing defense expenditure, not only to achieve a NATO goal of 2% GDP. Analysis by Allianz Trade shows that since 1995 overall government defense expenditure in today’s EU 27 has risen from 104 billion EUR to 204 billion EUR in 2022. However, they have not kept up with the overall growth in GDP and total expenditure: In 1995, defense expenditure accounted for 1.6% GDP compared with 1.3% GDP in 2022, ranging from 0.2% GDP in Ireland to more than 2% in Greece, Latvia, Estonia, and Lithuania (Poland 1.6% according to COFOG).
However, gradually increasing the proportion of defense spending to 2% of GDP in all EU member countries by 2028 would require a total of 470 billion EUR of additional expenditure by the sector of government and local government institutions compared to the scenario assuming maintenance of current levels. This would include 150 billion EUR in Germany, 55 billion EUR in Italy, 48 billion EUR in Spain, 17 billion EUR in France and 11.9 billion EUR in Poland. Achieving the 3% GDP share presently spent by the USA (and also demanded by Polish President A. Duda) would require an additional defense spending of 1,110 billion EUR (on UE scale) over the next five years.
The question is how these increases in expenditure will be financed? In general, according to the analysis by Allianz Trade, there are three possibilities to finance the increased defense expenditure: cut in expenditure on other functions, financing by debt or raising taxes.
To maintain the overall level of expenditure steady (at a scenario of increasing defense expenditure to 2% GDP) would require cuts in public expenditure of -8.6% in Spain, -7.7% in Germany, -6.5% in Italy, and -4.8% in France.
The largest single item of expenditure in the budgets of EU countries is social protection. In 2022, they accounted for 39% of the total expenditure of the sector of government and local government institutions in EU-27 (38% in Poland), in which 54% of social protection expenses in the EU accounted for pensions; 15% of total expenditure was spent on health (12% in Poland), and 12% each on general public services and economic policy (in Poland, respectively, 10% for public services and 15% for economic policy).
Relying on debt financing would result in a total additional interest burden of about 12.1 billion EUR in 2028. This is roughly equivalent to the amount spent on biodiversity and landscape protection in EU 27 in 2022.
Another option would be to raise taxes to cover the extra defense expenses. Assuming no changes in the structure of tax revenues, based on our calculations the VAT rate would have to rise on average by 0.6% in EU-27 in 2028, from 0.1% in France, 0.5% in Italy and 0.7% in Germany and Spain to 2.4% in Ireland (for Poland an increase of 0.4% from 23%).
Up until now, most governments have been reluctant to identify the exact costs of increasing defense expenditure or how precisely they will manage to do this in the context of ageing societies and vast investment needs linked with the green transformation. Combining these three options could distribute the financial burden between generations and within societies. However, it will necessitate acknowledging that possession of both guns and butter comes with its high price.
