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Written by Pieter Baert.

Financing defence spending

Following Russia’s brutal invasion of Ukraine, defence spending by EU Member States rose sharply, from 1.2 % of GDP to an estimated 1.9 % in 2024. Nevertheless, the protracted war in Ukraine and other security challenges, including evolving US foreign policy priorities, have forced EU Member States to double down on rearmament and the development of a robust defence industrial base. With an elevated defence spending target expected to be agreed upon at the forthcoming NATO summit in June, this task arrives at a challenging time for many EU Member States, marked by muted economic growth, high deficits and competing spending priorities such as an ageing population and the green transition. To respond to this new geopolitical reality, several options are being considered, including issuing joint or national debt, reallocating budget funds (national or EU), or generating additional revenue through (new) taxes. Given the uncertain outlook, such financing will be structural rather than temporary. The EU’s economic governance framework permits a degree of flexibility through the national escape clause, enabling Member States to deviate from fiscal rules under exceptional circumstances beyond their control; in this case, it would be to accommodate increased defence spending while ensuring overall fiscal sustainability.

Against this backdrop, taxation represents a key policy instrument. EU Member States have significant autonomy to adjust their tax systems as they see fit, as taxation is an area of national competence. They can choose to adjust their direct taxes, such as personal and corporate income taxes, or rely on indirect taxes, such as VAT or excise duties, taking into account their own national tax mix, tax burden and policy preferences. Aside from implementing new or elevated taxes, strengthening the fight against tax fraud and avoidance, and improving tax collection efficiency may also significantly bolster tax receipts (for instance, EU Member States lose €89 billion in VAT revenue each year). Naturally, strengthening the EU defence industrial base would also generate additional fiscal and economic effects through tax revenues and overall economic activity.

Some Member States have recently introduced dedicated tax measures, in order to boost financing for military support (see Table 1 below).

Table 1 – Tax measures adopted by selected Member States to support defence spending

Member StateTax measuresEstoniaThe national parliament adopted a Security Tax Act in December 2024, introducing tax increases to finance additional military support: The standard VAT rate will be increased from 22 % to 24 %, effective from July 2025.A 2 % security surcharge will be levied on corporate profits and personal income from January 2026. However, the new Estonian coalition government has announced its intention to abolish this measure.LatviaThe country has imposed a mandatory ‘solidarity contribution‘ requirement on credit institutions to help bolster its defence efforts. The measure covers the period from 2025 to 2027.LithuaniaA defence fund package, agreed upon in June 2024, comprises several tax measures aimed at increasing defence funding. These measures, which have been in force since January 2025, include: raising the corporate income tax rate by one percentage point to 16 % for businesses, and to 6 % for small businessesraising the excise duties on alcohol, tobacco and energy products such as petrol and diesel;extending by one year the application period for a temporary solidarity contribution by credit institutions.

The urgency of these measures also raises the question of how swiftly tax systems can be adjusted to meet sudden increases in revenue requirements. Changes to the income tax framework are typically introduced at the start of a fiscal year to ensure consistency with accounting practices and to avoid political and legal concerns about retroactive taxation. Adjusting VAT rates is somewhat easier to implement at shorter notice, as companies remit VAT on a monthly or quarterly basis. While VAT rate increases carry significant revenue potential, they may also give rise to concerns about their regressive impact. Health or environmental taxes can generate substantial short-term revenue and support broader national objectives, but their long-term reliability may be uncertain due to behavioural changes that result in reduced taxable activities.

However, securing sustainable financing is just one aspect of the challenge at hand. The production of weapons, military technology and related infrastructure will require significant strengthening of the defence industrial base in Europe. In this context, the fiscal needs of the defence sector may align with broader calls from corporate taxpayers in general for a simplified, more efficient tax compliance framework. In March 2025, the Council of the EU called on the European Commission to present a road map by the end of the third quarter of 2025 aimed at reducing reporting burdens for taxpayers, eliminating outdated and overlapping tax provisions, improving the clarity of tax legislation and streamlining the application of tax rules and procedures, and thereby enhancing the business environment across all sectors.

Additionally, given the defence industry’s heavy reliance on research and development (R&D), ensuring that existing R&D tax incentives are both effective and easy to administer will be crucial for supporting innovation capacity within the sector.

VAT provisions

As a general rule, the supply of goods or services to, or the import of goods by defence authorities or their armed forces for their activities is subject to VAT in the EU. However, subject to certain conditions, Article 151(1) of the EU VAT Directive provides for a VAT exemption on supplies made to the armed forces (and the civilian staff accompanying them) of one NATO member state stationed in an EU country that is another NATO member state, whenever these armed forces and civilian staff are participating in a common NATO defence effort. The exemption also applies to the armed forces (and the civilian staff accompanying them) of an EU Member State involved in an activity under the EU common security and defence policy in another Member State. Cooperative defence projects and programmes run in the European Defence Agency are also exempt from VAT, subject to certain conditions. Additionally, the recently adopted Security Action for Europe (SAFE) instrument – a €150 billion financial tool to boost EU Member States’ defence industrial production – includes provisions for VAT exemption on defence products procured through this instrument.

Read this ‘at a glance note’ on ‘Tax challenges facing the European defence union‘ in the Think Tank pages of the European Parliament.

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