Aggregate and Distributional Implications of a Military Buildup

Figure 1. Aggregate consumption crowding out versus changes in consumption inequality

Non-Technical Summary

European governments have recently committed to a substantial increase in defence spending. While this reflects a rapidly changing geopolitical environment, it raises a key economic question: how should a lasting rise in public expenditure be financed, and who ultimately bears the cost?

This paper analyses the aggregate and distributional consequences of a permanent increase in public spending of this scale. We examine medium- to long-run adjustments, focusing on how alternative fiscal measures influence work, consumption, and saving decisions, and shape macroeconomic outcomes.

To address these issues, we build a quantitative macroeconomic model with overlapping generations and heterogeneous households. Differences arise both across cohorts, where life-cycle changes in productivity, labour supply, and saving matter, and within cohorts, where idiosyncratic productivity shocks create substantial heterogeneity in income, employment, and wealth.

A core feature of the framework is its detailed fiscal structure. The model includes taxes on labour, capital, and consumption, as well as transfers and a pay-as-you-go pension system. Government spending and public debt are explicitly modelled, allowing us to analyse how the burden of higher defence spending is distributed. The model distinguishes between the return on productive capital and the lower interest rate on government bonds.

To rationalise this gap, we introduce a preference for liquid assets such as government bonds, providing convenience services and enabling the model to match both observed asset returns and government borrowing costs—crucial for assessing fiscal capacity.
We then study several strategies to finance the defence-spending increase implied by the new NATO guidelines.

The government may adjust pensions—by raising the retirement age or reducing benefits—or increase revenues through higher labour, capital, or consumption taxes, individually or combined. A central theme is the trade-off between aggregate efficiency and distributional outcomes. Financing higher spending reduces private consumption, yet different fiscal tools distribute this burden unevenly. Some policies minimise aggregate losses but concentrate costs, while others spread the burden more evenly at the expense of greater distortions.

Our results, summarised in Figure 1, highlight key mechanisms. Policies expanding labour supply—such as raising the retirement age—can finance much of the spending increase with limited macroeconomic cost by enlarging the workforce and tax base. In contrast, relying heavily on labour income taxation discourages employment, shrinks the tax base, and causes substantial consumption losses.

Other fiscal instruments generate their own trade-offs. Increasing labour tax progressivity shifts the burden toward higher-income households but weakens saving incentives. Capital taxation affects investment and the capital stock directly, while consumption taxes distribute the burden broadly. Pension adjustments influence disposable income and labour-supply decisions, especially for older workers. The choice of fiscal mix therefore shapes both macroeconomic performance and the distribution of costs, with some combinations limiting aggregate consumption losses and inequality effects, while others create deeper distortions or highly uneven outcomes.

Keywords: Overlapping Generations, Heterogeneous Agents, Government Spending, Inequality

Codes JEL : C62, D15, J11