Europe does not have to choose between guns and butter. There is another way | Shahin Vallée and Joseph de Weck

European governments face a critical fiscal challenge to finance increased defense spending, with NATO members targeting 3.5% of GDP by 2035. Challenging the prevailing "guns or butter" narrative, the article contends the true choice is "guns or taxes," noting the 1990s "peace dividend" largely funded tax cuts and deficit reduction, disproportionately benefiting the wealthy. To sustainably fund this military buildup without undermining social cohesion, the piece advocates for higher corporate and capital gains taxes, necessitating greater EU-wide tax harmonization and reduced tax competition, implying significant shifts in European fiscal policy and potential EU-level financial coordination.

Analysis

European governments face a significant fiscal policy shift, driven by the necessity to increase defense outlays to a target of 3.5% of GDP by 2035 for NATO members, effectively ending the post-Cold War "peace dividend". The central argument presented is that the financing choice is not between military and social spending ("guns or butter"), but rather between increased defense spending and tax levels ("guns or taxes"). The analysis refutes the narrative that the peace dividend solely funded social programs, pointing out it largely enabled significant tax reductions and deficit cuts since the 1990s. Specifically, corporate income tax rates within the OECD have fallen by approximately half since the mid-1980s, and capital gains taxes have also dropped substantially. The proposed path forward advocates against cutting social welfare, which could risk domestic political stability, and instead suggests raising taxes on corporations and capital. This approach, however, hinges on greater European Union-level fiscal coordination to harmonize corporate taxes and limit tax competition from member states like Ireland, representing a potential deepening of EU integration. Relying on sovereign debt alone is viewed as a limited and potentially regressive solution, especially for high-debt nations like France or Italy, unless a common EU borrowing facility is established.

Key Decisions for Investors

• Investors should anticipate a structural, long-term tailwind for the European defense, aerospace, and cybersecurity sectors as spending commitments ramp up towards 3.5% of GDP.
• Monitor the European political debate closely, as a policy shift towards higher corporate and capital gains taxes, as advocated in the article, would represent a material headwind for corporate earnings and equity valuations across the continent.
• The push for EU-wide tax harmonization introduces both risk and opportunity; successful coordination could reduce sovereign risk for indebted member states, while failure could amplify fiscal pressures and widen sovereign debt spreads.
• Consider the increasing political risk associated with how this defense spending is funded, as financing through social spending cuts could lead to greater domestic instability compared to the proposed route of higher corporate taxation.