Extra defence spending way to boost UK manufacturing industry

Prime Minister Starmer has announced plans to raise defence spending to 2.5% of GDP by 2027, with an aim to further raise this to 3% of GDP in the next parliament. While cuts to the overseas aid budget will cover the initial rise to 2.5%, further increases in defence spending will have to come from bigger cuts in spending elsewhere, higher taxes or tweaking the fiscal rules to allow for more borrowing. However it’s paid for, boosting defence spending offers an opportunity to support the UK and Europe’s flagging manufacturing industries.

How much will the defence spend cost?

Compared to keeping defence spending at the current level of about 2.3% of GDP, raising it to 2.5% of GDP represents an increase of about £6bn. However, raising it to 3% of GDP early in the next parliament would cost an additional £20bn a year on top. 

Three ways to pay for the increase in defence spending

Reallocating spend from elsewhere

The government has already done reallocated spend to fund the initial step to 2.5%. This was done by transferring around £6bn from the overseas aid budget to defence spending. However, that leaves the remaining aid budget at about £8bn, not enough to cover even half of the additional £20bn required. Given most government departments outside of health and defence are already set to have budgets squeezed, freeing up the required budget through small cuts to other departments seems impossible. The only areas of spending large enough to generate savings of that size would be health and social care, where spending is forecast to rise by £22.6bn over the next two years alone and welfare spending which is set to rise by £81.4bn by the end of the decade. Either of those would be a tough political choice.

Rising taxes to fund higher spending

There is a strong argument that a permanent increase in defence spending should be funded by a permanent increase in taxation. However, the tax burden is already set to rise to its highest level since World War II. Adding another 0.5% of GDP onto that tax burden would be politically difficult and potentially economically damaging. Admittedly, this is still not especially high by European standards. But there is also the issue of which taxes to raise. Raising employer National Insurance Contributions is arguably one of the worst - from an economic point of view - ways of raising revenue. An increase in taxation of this scale would probably have to come from higher incomes taxes or higher VAT. Indeed, France is reportedly thinking about increases taxes on the wealthy to fund an increase in defence spending to over 3% of GDP. 

Increase borrowing

At face value increasing borrowing is tricky. Given the recent rise in gilt yields and economic underperformance the government has probably already wiped out its meagre headroom against its fiscal rules. A significant and sustained increase in borrowing would therefore require altering fiscal rules. One option would be to follow Germany’s lead and exempt defence and security spending from the fiscal rules altogether. In addition, participating in a “rearmament bank” or other multilateral institution could potentially lessen the headline impact on the fiscal deficit.

Ultimately, the UK and EU is going to have to significantly increase defence spending. Some of this will come in the form of higher borrowing, and that is why we have seen the yield on 10-year German government debt jump by 10 basis points this week. However, it’s doubtful that all of the necessary increase in spending could, or should, be funded through additional debt. European governments are facing some tough choices around tax and spend.

Impact on the economy

The impact on the economy depends in part on how the increase in spending is funded and how it is spent. Shifting spending from other government departments to defence is unlikely to have a significant impact on the overall economy. But increases in tax to fund higher defence spending could have a small stimulatory impact on the economy if done in an efficient way as the economic multiplier on tax increases tends to be smaller than the multiplier on defence spending.

The biggest impact would come from higher borrowing. This would represent a direct stimulus to the economy, although at the cost of even higher debt interest. What’s more, the UK manufacturing sector has been especially weak recently. Manufacturing output has been stagnant at best compared to growth in the whole economy of a little over 4%. It looks like there is plenty of excess manufacturing capacity that could be put to work, which would reduce any inflationary concerns associated with a big increase in spending. Indeed, one idea gaining momentum is that increased defence spending is one way to offset job losses in Europe’s struggling car manufacturing sector. Output in the UK manufacturing sector was about £224bn in 2023 according to Make UK so an increase in defence spending of almost £30bn a year (relative to 2023) would represent a potential huge 10% plus boost to the sector. What’s more, defence spending is spread around the country with almost 70% of defence spending going to outside London and the South East according to the government.

However, only 4% of defence spending currently goes to UK SMEs, partly this will be because of the highly complex nature of modern defence equipment and security needs, but improving the Uks defensive capabilities also means building out a UK based supply chain that is able to meet the needs of the defence industry. Admittedly, the government has launched new SME spending targets and a ‘support hub’ but this will need to be followed up with consistent long term plans to give UK manufactures the confidence to make the necessary investments.

While the details are yet to be worked out, the direction of travel is clear, Europe and the UK will be spending hundreds of billions of euros more on defence over the next few years. But in order to generate the technological gains and spill over effects to other industries that can boost productivity as well as to capture the growth impact of higher spending, governments will need to focus on increasing domestic supply chains. Simply importing arms from abroad will not provide any economic benefits. That represents a golden opportunity to revive a withering manufacturing industry in the UK and on the continent.