The EU’s revamped fiscal rules mark a major change in the way Member States manage their public finances. This comprehensive reform, the most substantial since the financial crisis, aims to reduce national deficits and debt.
However, this renewed emphasis on fiscal consolidation raises crucial questions about the future of public spending, particularly in the context of the EU’s ambitious green and digital transitions.
While the recent decision to exempt additional defence spending will lead to a more expansionary overall fiscal stance, this deficit-financed military spending is expected to increase the share of government interest payments in total tax revenue.
As a result, the expected political reluctance to higher budget deficits is likely to put downward pressure on crucial public investments in the green and digital agenda.
This analysis attempts to critically assess the new EU fiscal framework, focusing on its implications for public spending in these vital areas, and will discuss possible options for strengthening the fiscal space for the “twin transition” within the constraints of these new regulations.
The key elements of the new EU rules
The main objective of the new EU fiscal rules is to ensure that member states reduce their budget deficits to below 3% of GDP and their public debt-to-GDP ratio to below 60%. The revised framework gives priority to the medium-term perspective of public finances, moving away from a purely annual assessment and focusing on limiting the growth of government spending.
Under the new regulations, if a member state breaches either the 60% debt limit or the 3% deficit limit, the European Commission will propose a “reference path”. This path is designed to ensure that the public debt ratio follows a “reasonable downward path” by the end of a fiscal adjustment period of at least four years.
What can Member States do?
Essentially, the reference path serves as preliminary guidance on the extent of fiscal adjustment that each Member State should undertake over a multi-annual period, to ensure that the public debt ratio is on a sustainable downward path within 10 years of the adjustment.
The European Commission and national governments will negotiate multi-annual budgetary plans, covering at least four years, informed by the reference path and supported by a debt sustainability analysis (DSA).
Most importantly, Member States can commit to a package of investment and reform measures, potentially extending the fiscal adjustment period from 4 to a maximum of 7 years.
To qualify for this extension, a country’s package of measures must be growth-enhancing, consistent with debt sustainability, address common EU priorities (such as the Green Deal, digitalisation and security), be in line with the country-specific recommendations under the European Semester and maintain at least the existing national level of investment. It is important to note that the reformed framework does not include broad exemptions for public investment at national level.
Innovative solutions are needed
The incentives for national governments to submit these investment and reform packages to the European Commission are clear: in this way, they can extend the fiscal adjustment period and reduce the required annual adjustment efforts. These packages should incorporate government spending on common priorities related to the twin transition.
However, Member States need to convincingly demonstrate that the planned measures contribute to growth and are compatible with maintaining sustainable debt levels. For example, climate-related spending that is deemed necessary to achieve environmental objectives but does not demonstrably enhance economic growth cannot be supported as part of a package of measures aimed at extending the adjustment period.
Given the absence of broad exemptions, if Member States want to increase spending on green and digital initiatives while respecting the new rules, they will likely have to compensate by reducing spending in other areas.
Due to the restrictive nature of the new EU budgetary rules, policymakers need to explore innovative solutions to ensure sufficient financing for the green and digital transitions.
Establishing an EU investment fund for climate and digitalisation
One option to facilitate a substantial increase in public investment is to create a dedicated climate and digitalisation investment fund at EU level. The key features of such a fund could build on the experience of the Recovery and Resilience Facility (RRF).
The RRF was established during the Covid-19 pandemic to support the economic recovery of EU Member States, while promoting investments and reforms aimed at achieving climate and digital objectives. However, the current size of the RRF is not sufficient to fully address the investment requirements and its grant component is scheduled to end in 2026.
Following the RRF model, the European Commission could issue bonds on behalf of the EU to raise capital on financial markets for a new investment fund, specifically aimed at promoting the green and digital transition. Investments financed by such a fund could prioritise genuine European public goods projects, in areas such as the transformation of energy and transport systems, as well as digital infrastructure, thus creating clear added value for the EU.
In the coming years, significant fiscal consolidation will be needed in many large EU countries to comply with the reformed fiscal rules. However, the temporary exemptions granted for additional defence spending will lead to a more expansionary overall fiscal stance across the EU. Today, the EU’s political emphasis is on industrialisation through rearmament.
Nevertheless, the pressure to finance additional defense spending through deficits will ultimately increase the share of government interest payments in total tax revenues, while the expected political aversion to higher fiscal deficits is likely to put downward pressure on public spending earmarked for the green and digital transitions.
