How Can Germany Strengthen Its Defense Capabilities Without Compromising Economic Stability?

The End of the Peace Dividend

When the Iron Curtain fell in 1989 and the threat posed by the Warsaw Pact dissolved, Germany adjusted accordingly. The German Armed Forces were downsized, defense spending declined to just over 1 % of GDP, and compulsory military service was suspended. This so-called “peace dividend” was widely welcomed, as the German economy and public finances were already burdened by the costs of reunification. Over time, policymakers deprioritized external security and shifted their focus to other issues, such as tax cuts and the expansion of the welfare state.

That era of geopolitical détente is now over. Ever since Russia’s annexation of Crimea in 2014, it has been clear that Moscow poses a direct threat to European security. Meanwhile, amid intensifying geopolitical competition with China, the United States has grown increasingly unwilling to shoulder the financial burden of defending Europe – something Donald Trump made abundantly clear as early as 2016. At the same time, efforts to curb the global spread of nuclear weapons are faltering. A growing number of countries now possess nuclear arms, with Iran and Saudi Arabia potentially joining the ranks soon. If the U.S. nuclear umbrella ceases to protect Germany, the country could face a dangerous security vacuum.

Germany’s Defense Spending Remains Insufficient

It was only after Russia’s attack that German policymakers took meaningful action in response to the changing geopolitical situation. A one-off 100 billion euros special fund was approved to modernize the German Armed Forces. However, this is only a starting point. Federal Minister for Economic Affairs Robert Habeck has called for an increase in defense spending to 3.5% of GDP – which would require an additional 100 billion euros every year, not just as a one-time measure. Donald Trump has even suggested a target of 5%. While not everything Trump says should be taken at face value, it is clear that Germany’s current 2 % target is insufficient – and even that lacks sustainable funding.

The lack of urgency in Germany’s defense debate is evident in the current political discourse. Beyond migration, the federal election campaign is largely focused on handing out benefits rather than addressing security concerns. Despite an aging population, there are no plans to curb pension spending. Instead, political promises include lower VAT and income tax, as well as direct climate-related payments. Meanwhile, Chancellor Scholz has reassured the public that Germany is a strong country and that defense spending can be increased without burdening its citizens – meaning that the costs will be covered by additional debt. But debt does not eliminate the burden – it merely postpones it. The idea that the public can be shielded from the financial impact of higher defense spending is simply misleading.

Less Money for Climate and the Welfare State?

Allocating more resources to defense is difficult given the numerous other pressing challenges. Germany’s infrastructure is aging and in urgent need of investment. The country has committed to significantly reducing CO₂ emissions, a goal that will require substantial financial resources. Since global warming will continue regardless, additional investments will be needed to mitigate its effects, such as enhancing flood protection. At the same time, an aging population is driving up spending on pensions, nursing care, and health insurance.

It is clear that these challenges can only be addressed if the economy remains sufficiently productive. However, economic growth in Germany is stalling. Corporate investment is declining, and reversing this trend will require tax relief and lower energy costs – both of which would initially strain public finances.

How can Germany strengthen its defense capabilities while maintaining economic resilience? A look at other countries that shoulder significantly higher defense burdens can provide valuable insights. Israel serves as a particularly striking example. While Israel faces an exceptionally high level of external threats, it also offers a stark illustration of how high defense expenditures affect economic and fiscal developments.

A Look at Israel

For decades, Israel has repeatedly had to defend itself against attacks from neighboring states, leading to exceptionally high defense expenditures, even with military aid from the United States. In 2023, Israel’s defense spending amounted to 5.3% of GDP. Following Hamas’s attack on October 7, 2023, Israel was drawn into a multi-front war, facing not only Hamas but also Hezbollah, Iran, and attacks from Yemen. The war has exacted a heavy human toll and placed significant strain on the Israeli economy. Defense spending has surged, with reservists being called up and forced to leave their jobs. The construction sector, which relies heavily on Palestinian workers – many of whom live in the occupied territories – has been severely impacted, as many were no longer able or willing to work. Meanwhile, tourism has plummeted.

Before the Hamas attack, Israel’s economy was projected to grow by around 3% in 2024. Current estimates suggest actual growth will be closer to 0.5% – a 2.5 percentage point loss due to the war. Despite these challenges, however, Israel’s economy is still growing faster than Germany’s.

How is Israel financing its increased defense spending? A substantial portion of it is financed through borrowing. As a result, Israel’s budget deficit for 2024 is projected to be around six percentage points higher than originally planned. At the same time, the government has reallocated spending, including reductions in social expenditures, and introduced tax increases. To minimize the impact on economic growth, the Israeli government has opted to raise the value-added tax (VAT) rather than corporate or income taxes.

This approach stands in stark contrast to that of the German government, which –despite its “Zeitenwende” (turning point in defense policy) – has so far rejected both spending reallocations and tax increases to fund higher defense expenditures.

Structural Changes Are Necessary

Beyond short-term adjustments to accommodate sudden increases in defense spending, enhanced defense capabilities require long-term structural changes in the economy. One key factor linking economic strength and military capability is the defense industry. Israel’s economy benefits significantly from innovations and start-ups emerging from this sector. In fact, when measured relative to GDP, Israel has produced almost ten times as many successful start-ups (unicorns) as Germany over the past decade.

If military and economic strength are to become policy priorities, this must be reflected in the structure of public finances. On the revenue side, growth-friendly taxation should play a greater role. The tax burden on labor and investment should be eased, leading to greater reliance on consumption and property taxes.

This pattern is evident in Israel. There, consumption and property taxes account for around 37 % of total tax and duty revenues, whereas in Germany, the share is only 23%. Meanwhile, taxes on income and corporate profits made up 51% of total government revenues in Israel, compared to 65% in Germany. In this regard, Israel’s tax system is more conducive to economic productivity.

There are also significant differences in public spending. A large defense budget does not necessarily result in higher overall government spending. In 2023, public expenditures accounted for 39 % of GDP in Israel, compared to 48% in Germany. However, the composition of spending differs substantially. In 2022, defense spending made up 13% of Israel’s total public expenditures, whereas in Germany, it accounted for only 2%. By contrast, social spending dominates Germany’s budget, with 58% of total public funds – including health expenditures – allocated to social programs. In Israel, social spending amounts to just 41% of total expenditures.

In Germany, it is sometimes argued that high defense spending can only be financed through increased borrowing. However, Israel presents a different picture. Despite its significantly higher military budget, its national debt ratio stood at 61% in 2023 – roughly the same as Germany’s.

Differences Between Israel and Germany

When making these comparisons, it is essential to recognize the many fundamental differences between Israel and Germany. In terms of security threats, Israel faces a persistent and asymmetric conflict, with groups like Hamas firing rockets at civilian areas while using human shields. Germany and its European allies, by contrast, are primarily threatened by Russia – a heavily armed adversary with both conventional and nuclear capabilities. This difference necessitates fundamentally different approaches to deterrence. Another key difference lies in demographics. In Israel, 12.6% of the population is aged 65 and over, whereas in Germany, this share is nearly twice as high at 22 %. This demographic contrast helps explain variations in spending on healthcare and pensions.

Despite these differences, Israel’s example highlights several key issues that deserve greater attention in Germany. If Germany wants to strengthen both its security and economic resilience, it must develop its domestic defense industry. In Germany, this will only be possible if arms manufacturers are granted greater export opportunities, universities engage in defense-related research, and regulations that have so far hindered investment in the defense sector are adjusted. More European cooperation on defense projects would also be desirable, though such efforts have often progressed slowly.

It also needs to be clarified whether effective deterrence vis-à-vis Russia requires the reintroduction of compulsory military service. Given Germany’s demographically induced labor shortages, economic arguments favor maintaining a professional army. Whether that is sufficient depends, among other factors, on the type of armament needed. In military terms, modern technology is playing an increasingly important role in defense. Satellites, drones, autonomous systems, missile defense, and cruise missiles are gaining in significance. Not least, the question of nuclear deterrence must be addressed. A major advantage of nuclear deterrence is that it offers a high deterrent effect with relatively limited resources. In all these areas, highly trained specialists are needed far more than conscripts.

How to Prioritize Defense in the Budget?

What are the implications for German fiscal policy? If Germany prioritizes defense and economic strength, other key policy areas, such as social security or decarbonization, will inevitably receive lower priority. In political debates, it is often claimed that these objectives should not be played off against one another. However, this is wishful thinking – available resources are finite.

The question is: what level of fiscal prioritization is required? So far, the German government’s financial planning envisions increasing the defense budget to 80 billion euros by 2028. However, it remains unclear how this increase will be funded. The 100 billion euros special debt-financed fund for the German Armed Forces will be depleted by 2027. Unfortunately, the federal government has made no effort to reallocate funds within the core budget to defense. On the contrary, the defense budget has been effectively frozen, set to remain at around 53 billion euros annually until 2027 – meaning it will decline in real terms due to inflation. The government has relied entirely on deficit-financed expenditures through the special fund.

Moreover, it is unclear how the planned surge in defense spending in the core budget to 80 billion euros in 2028 will be financed. The budget framework includes a funding gap, which is diplomatically described as an unspecified financial provision. Although the war in Ukraine began three years ago, German policymakers have yet to develop a credible long-term strategy to sustainably finance defense spending. Relying solely on debt is not a viable solution –defense spending must ultimately be covered by recurring revenues.

Even 80 billion euros in 2028 is unlikely to be sufficient, as it would represent only 1.7% of GDP – far below NATO’s 2% target, which would require 95 billion euros. To achieve a truly deterrent level of defense capability, spending would need to be at least 2.5% to 3% of GDP, amounting to approximately 120 to 140 billion euros. Moreover, effective defense is about more than just military spending alone. Additional resources are needed for civil protection, including shelter construction, critical infrastructure protection such as cybersecurity, and strengthening intelligence services.

A Proposal to Realign the Budget

The next German government must completely replan. On the expenditure side, it is crucial to initiate a multi-year redistribution process immediately. One option would be to limit the growth of pension insurance subsidies to 1% per year, which would require either lower pension increases or a higher retirement age. Additionally, subsidies paid by the federal government – currently budgeted at 41.7 billion euros – could be halved by 2028, as could tax breaks, which amount to 20 billion euros. By reducing inflows and improving the labor market integration of refugees, while simultaneously tightening benefits, the 24.5 billion euros in expenditure for refugees could also be cut in half. Health insurance reforms could reduce the planned federal subsidy of 14.5 billion euros by one-third. On the revenue side, increasing value-added tax (VAT) by one percentage point could generate an additional 17 billion euros, which would flow entirely to the federal budget. Meanwhile, the German federal states could contribute to defense financing by forgoing an additional 10 billion euros in VAT revenue, offsetting this, for example, through civil servant pension reforms. In total, these measures would ease the federal budget by 94 billion euros, not only closing the 2028 financing gap but also enabling defense spending to rise to 120 billion euros, equivalent to 2.5% of GDP.