Military buildup requires fiscal adjustments, impacting consumption and inequality
A Banque de France working paper analyzes the aggregate and distributional consequences of a permanent increase in government defense spending. The study examines how alternative fiscal adjustments to this shock shape macroeconomic outcomes and consumption inequality.
Financing the defense spending surge
European governments have committed to a substantial increase in defense spending, driven by a rapidly changing geopolitical environment.
This paper, a Banque de France working paper, studies the aggregate and distributional implications of a permanent increase in government spending, specifically of the magnitude implied by the 2025 change in NATO's 'core defense' spending target to 3.5% of GDP.
The analysis employs a calibrated Overlapping-Generations model with Heterogeneous Agents (OLG-HA) and a rich fiscal side, including fully specified tax-and-transfer and pay-as-you-go social-security systems.
The model focuses on medium- to long-run adjustments, examining how different fiscal measures influence work, consumption, and saving decisions across households, ultimately shaping macroeconomic outcomes.
Balancing efficiency and equity in fiscal choices
The model features a detailed fiscal structure, including taxes on labour, capital, and consumption, as well as transfers and a pay-as-you-go pension system.
This allows for explicit modeling of government spending and public debt, crucial for understanding how the burden of increased defense spending is distributed.
The paper explores various financing strategies, such as adjusting pensions (raising retirement age or reducing benefits) or increasing revenues via labour, capital, or consumption taxes.
A core finding highlights a trade-off: choosing among fiscal adjustments involves balancing the mitigation of aggregate crowding-out of private consumption against the reduction of consumption inequality.
A critical roadmap for tough choices
This study provides a crucial quantitative framework for governments facing the inevitable fiscal burden of increased defense spending.
It clearly illustrates that policy choices involve difficult trade-offs between economic efficiency and social equity.
Policymakers must carefully consider these long-term implications to avoid exacerbating inequalities or stifling growth.