RUssland’s invasion of Ukraine has suddenly changed Germany’s perception of external threats. The federal government speaks of a turning point and plans to spend significantly more on defense in the future. A special fund of 100 billion euros is to be set up to finance the additional expenditure. In terms of content, the special fund consists of an authorization to take out loans. The establishment of the special fund requires an amendment to the Basic Law, because these loans should not be counted towards the loan amount, which is limited by the debt brake in the Basic Law.
The additional spending on defense planned with the special fund ends a long phase of a declining proportion of defense spending in Germany. After reunification, defense spending as a percentage of gross domestic product (GDP) fell rapidly and significantly. In 1985 the share in the old Federal Republic was still 3 percent. Ten years later it had halved to 1.5 percent in unified Germany, and since then it has ranged between 1.1 and 1.4 percent of GDP. For years, the proportionate decline in defense spending was seen as a peacetime dividend, creating scope for other spending in the federal budget. How will the loss of the peace dividend affect the federal budget?
High taxes, high costs
Without additional credit authorization, increased defense spending would be fully counted against net borrowing in the federal budget. Structurally, ie with normal utilization of economic production capacities, the federal government’s net borrowing is limited to 0.35 percent of GDP. Given that the federal budget will be tight in the future anyway – for example, the repayment of the loans taken out in the corona pandemic is due between 2028 and 2058 – the limit will probably be reached even without additional defense spending. They would therefore have to be financed with additional taxes or expenditure would have to be reduced elsewhere in the short term.
From an economic point of view, there is good reason not to finance a sudden need for additional government spending through short-term tax increases or cuts in other spending alone. Tax burdens trigger legal and illegal evasive reactions, for example emigration abroad or into the informal economy. These evasive reactions lead to economic costs. They do not increase in proportion to the tax burden, but clearly disproportionately. If the tax burden is already quite high, further tax increases lead to very high additional economic costs. It is therefore advisable not to increase taxes sharply in the short term in the event of additional government spending, but to spread the additional tax burden over time and to finance the additional spending at least partially with loans. Economists speak of tax smoothing.
Tax smoothing does not mean permanently replacing tax increases with loans. Rather, additional government spending should not be financed in the short term with significantly higher taxes, but over a longer period of time with more moderate tax increases or spending cuts. The constitutional debt brake allows such a strategy. If the Bundestag determines an exceptional emergency situation, as in 2020 and 2021 in view of the corona pandemic, net borrowing may exceed the basic credit limit. However, such an overrun must be linked to an explicit plan that specifies the period in which the additional debt will be repaid.
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