EU member states face sustained spending pressures: can EU funding or carbon taxes help?

Extra spending by EU states on interest, pensions and healthcare is limiting funds needed for defence and green investment, testing NATO spending targets and climate goals. Shifting spending to the supranational level and carbon taxes could help.

By Alvise Lennkh-Yunus, CFA and Brian Marly , Sovereign and Public Sector Ratings

Higher interest rates, additional pension and healthcare spending coupled with rising defence expenditure and more investment in environmental projects are set to worsen EU member states’ fiscal balances by an estimated 4.5% of GDP on average by the end of the decade. Among large euro area economies, the rise in unavoidable fiscal pressures – interest and ageing-related expenditure – is expected to be steepest in Italy (4.7% of GDP, BBB+/Stable), followed by France (3%, AA/Negative), Germany (2.5%, AAA/Stable) and Spain (1.9%, A-/Stable).

The impact of higher interest rates will materialise at different speeds for individual countries, depending on each government’s debt structure, refinancing profile, and risk premium. We expect the negative impact for EU government fiscal balances to be around 1.5% of GDP over the coming years. However, the additional expenditure is greater for highly indebted countries like Italy, where interest expenditure is set to rise from around EUR 60bn in 2020 to EUR 90-100bn by 2026, an increase of around 2.0% of GDP. Such costs are unavoidable for fiscal policymakers.

Figure 1: Increase in fiscal pressure (expenditure, revenue losses) by 2030 compared with 2020

% of GDP

Welfare costs related to ageing populations represent budgetary challenges

Similarly, demographic trends are already having an adverse impact on government finances. The old-age dependency ratio in the EU will rise to 43.1% in 2030 from 34.4% in 2019, according to the European Commission (EC) in its 2021 Ageing Report. Based on these estimates, we expect the total cost of ageing for EU public finances to rise by around 1.4% of GDP by 2030 on average.

These pressures vary significantly among major euro area economies however, ranging from a 2.4% of GDP jump for Italy to a more benign 0.3% of GDP increase for Spain. In the absence of politically costly reforms to social security systems, these additional expenditures are also de facto unavoidable for EU policymakers.

Long neglected defence expenditure is also set to rise given the sharp increase in geopolitical tensions since Russia’s escalation of its war in Ukraine. Renewed calls for NATO members to raise the share of public spending on defence to meet the 2% of GDP guideline set by the alliance could constitute around 0.9% of GDP for Spain, 0.5% for Germany and Italy, but only 0.1% of GDP for France.

However, unlike interest and social expenditure, EU member states have greater room for manoeuvre over defence spending, with willingness to meet the NATO spending commitment likely dependent on how Russia’s war in Ukraine develops and the outcome of next year’s US (AA/Negative) presidential election.

Finally, meeting the EU’s ambitious climate policy goals in line with the headline target of a 55% cut to carbon emissions relative to 1990 levels by 2030 will require annual green investments of about EUR 700bn over 2023-2030 according to EC forecasts. Assuming that around 1/3 of the effort is shouldered by public authorities, this would imply additional public expenditures of around 1.5% of GDP per year at the EU level. Of the large EU economies, Spain faces the largest expenditure needs at around 1% of GDP, followed by Italy and France (both 0.6%), and Germany (0.4%).

It is unlikely however, that these estimated green investment needs will be fully financed over coming years. Given reinstated fiscal rules much of the EU’s fiscal space will be absorbed by unavoidable interest and social expenditures. In addition, next year’s European Parliament elections could result in a more conservative configuration with a less ambitious climate agenda. Still, even if only half of the additional defence and green expenditure were to be financed, the impact on EU budgets will be equivalent to at least 3.0-4.0% of GDP a year.

Environmental taxes, funding public goods at EU level could relieve fiscal pressure

Given higher public debt levels following the Covid-19 and energy crises, public finances are already stretched. In the absence of higher growth and/or reforms guaranteeing the financial sustainability of their pension systems, EU sovereigns need to increase tax revenues by reducing tax avoidance or raising new taxes, for example, on CO2 emissions, or alternatively, shift investments and expenditures from the national to the supranational level.

Reducing tax fraud and tax avoidance could generate significant government revenue, with some estimates putting the figure as high as EUR 1tn annually (or about 6% of EU GDP). However, effectively tackling this politically sensitive issue also presents significant practical difficulties. These include the need for international cooperation across multiple jurisdictions as well as the sizable resources to address fast-changing tax planning practices.

Eliminating fossil fuel subsidies (estimated at around EUR 50bn per year, or 0.3% of EU GDP) and implementing a comprehensive carbon tax would provide a consistent incentive for reducing emissions while generating important revenues to fund green investments. While some member states have already rolled out carbon-pricing mechanisms (Figure 2), the EC has put forward several measures to raise the level and coverage of carbon pricing by extending the scope of the existing emissions trading schemes and increasing taxation of fossil fuels. However, public support and the social acceptance of some of these measures may be more limited than previously assumed.

Finally, funding public goods at the European level – including the green transition, energy security and defence – could help reduce the direct fiscal impact on member states’ balance sheets. Initiatives such as the push to allow the European Investment Bank (AAA/Stable) to fund joint defence projects could gain momentum in 2024-25. Nevertheless, establishing a permanent fiscal capacity at the European level, for example, borrowing by the EU (AAA/Stable), requires there being significant political will in European capitals, as highlighted by arduous EU budget negotiations.

Figure 2: Effective carbon rates vary significantly across the EU

2021, EUR per tCO2e