THE EFFECT OF MILITARY SPENDING EXEMPTIONS FROM FISCAL RULES ON PUBLIC DEBT IN THE EUROPEAN UNION

Purpose- The research fills a serious policy gap by quantitative empirically determining the macro-fiscal effect of the exemption of military spending by the Stability and Growth Pact (SGP) rules of the European Union on the sustainability of public debt. The study is driven by the political argument of the year 2022 on whether defense expenditure or fiscal prudence should be given priority. Methodology- The study is done using a balanced panel data of 27 EU member countries between the years 2000 and 2023. This methodology is quite stringent with the start of the diagnostic tests, the Pesaran CD test of cross-sectional dependence, and the Westerlund Cointegration Test, which proved the existence of a long-run equilibrium relationship between the variables. The primary model is a Fixed- Effects (FE) estimator to adjust to unobserved heterogeneity that the final results would be based on Driscoll-Kraay (1998) robust standard errors to address the documented cross-sectional dependence and serial correlation. The fundamental component of the model is an interaction term (Military Expenditure times Exemption Dummy) that aims at capturing the impact of the institutional change. Findings- The empirical findings are very convincing in terms of their support to the hypothesis of the study. The interaction term is positive and quite significant (p < 0.01), which indicates that the process of exempting military expenditure on the SGP rules causes its effect on the accumulation of public debt to be significant. Although the baseline FE model proved to be fragile in certain control variables (e.g., GDP growth), the strong Driscoll-Kraay estimates prove that the impact of the institutional change is statistically dependable. Moreover, the control variables are also analyzed, which proves that both the government spending and the role of inflation as a debt-reducing factor have a very strong positive impact. Conclusions: The paper comes to the conclusion that the policy option of bending the rules to spend on defense is not a fiscally neutral option, but has a quantifiable price in the form of sustaining debts. The results send a very strong signal to the SGP, with its credibility under attack, and it urges policymakers in the EU to focus on other methods of financing transparency, including common EU defense funds, rather than exemptions in an ad-hoc fashion. This study adds a well-timed, methodologically sound study to the current argument about the security necessity versus the fiscal stability of the Eurozone in the long term.