For Europe, the answer to guns or butter is clear: guns and a lot of them. Russia’s invasion of Ukraine in 2022 represented a direct threat to the continent. Yet, it is the ‘Trump shock’ that has jolted policymakers into action. In a bid to appease the US administration, NATO leaders have nearly doubled the core defence spending target from 2.0% of GDP to 3.5%, rising to 5.0% including defence-related infrastructure. As Europe seeks to reduce its reliance on the US for its own defence, the question is how to pay for it?
UK policymakers must be asking themselves this very question, amidst a tricky landscape for public finances. Since the global financial crisis in 2008, debt as share of GDP has more than doubled to 104%[1], while the tax burden is at its highest level in several decades. At the same time, the public is dissatisfied with the state of public services.[2],[3] In the latest spending review, the Ministry of Defence was one of the few winners, receiving substantial increases in its budget through the end of the current parliament. The review, however, came before the new NATO targets were announced.
The current plans fall well short of those required for the UK to meet its NATO obligations. The £73.5 billion limit on spending in 2028/29 amounts to only 2.2% of projected nominal GDP. Fulfilling the 3.5% core defence requirement by 2034/35 at the latest requires a huge increase in defence spending over the following six years. Based on Cebr’s forecast for nominal GDP, we estimate spending will have to nearly double to £146.2 billion. This equates to annual growth in defence spending of 12.1% in each year, faster than all the annual uplifts planned in the current parliament.
Figure 1 – Current budget balance, share of GDP, 2022/23 – 2034/35
Source: OBR, HM Treasury, Cebr modelling
The extent to which this affects the government’s adherence to its fiscal rules varies under different assumptions. First is the allocation of defence spending to capital investment, which is excluded from the rule. We present three scenarios for this. Second, there are non-defence expenditures and current receipts. We assume these both grow in line with nominal GDP, meaning that the relative sizes of the rest of the state and tax burden remain constant over the analysis period.
Only in the high capital scenario does the UK meet its fiscal rule of having a current budget balance of more than -0.5% of GDP under the above assumptions. Even in this case, it only does so narrowly. Under our central and low capital share scenarios, the government of the day would have a deficit of 0.6% and 0.8% of GDP in 2034/35, respectively.
In other words, the UK cannot meet the NATO commitment unless i) defence spending increases are concentrated in capital investment, ii) taxes increase faster than GDP, iii) non-defence public spending falls as a share of the economy, or iv) the fiscal rules are loosened.
Each of these paths faces resistance. The first risks divorcing defence spending from the needs of Britain’s armed forces. The UK already allocates a relatively large share of its defence budget to capital[4], so there are limits to how high this share can go. Further, spending on capital purely to game the fiscal rules risks leaving UK forces ill-prepared for the threats it faces.
The next options appear unpalatable or improbable. The tax burden is near multi-decade highs. As such, the capacity for the UK economy to absorb more tax rises without dissuading economic activity appears slim. On the spending side, an ageing population is likely to exacerbate pressures, with health and pensions-related costs likely to take up ever larger shares of national output. More recently, the rebellion against welfare reforms demonstrates the harsh realities of attempting to cut public spending.
This leaves a loosening of the fiscal rules. A dilution of the fiscal rule undermines the credibility of the UK in international bond markets, likely pushing bond yields higher. This, in turn, risks fuelling a debt spiral, with the interest rate on debt exceeding nominal GDP growth.
All this paints a grim picture of the UK’s public finances. Gross debt is forecast by the OBR to stabilise over the current parliament. However, the 3.5% core defence target, in combination with rising interest payments, places severe strain on the sustainability of the country’s finances. We estimate debt as a share of GDP increases to 119% by 2034/35 under our central scenario. Moreover, with trend growth falling, central banks committed to 2.0% inflation, and yields on long-end gilts close to 5.0%, the fiscal imbalance is likely to grow over time.
The UK has signed up to spending 3.5% of national income on core defence spending as part of its obligations under the NATO alliance. In the near term, this may have placated the US administration.However, the material costs involved in this decision are yet to be endured. If the fiscal position is difficult now, the coming years look set to present even greater challenges.
Cebr’s next Forecasting Eye will be released on 15th August.
Contact:
Hugh Lind, Economist, hlind@cebr.com, 020 7324 2844
[1] IMF, UK General Government Gross Debt (Percent of GDP) https://www.imf.org/en/Countries/GBR#countrydata
[2] Ipsos Public Services Face Crisis of Confidence as Election Looms. https://www.ipsos.com/en-uk/public-services-face-crisis-confidence-election-looms
[3] Ipsos Understanding Society: Putting the Place into Public Services. https://www.ipsos.com/en-uk/understanding-society-putting-place-public-services
[4] Institute for Government. UK Defence Spending Explainer. https://www.instituteforgovernment.org.uk/explainer/uk-defence-spending