Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/324852 
Year of Publication: 
2025
Series/Report no.: 
Working Paper No. WP 2025-13
Publisher: 
Federal Reserve Bank of Chicago, Chicago, IL
Abstract: 
We examine the role of government investment in defense capital as a deterrence tool. Using an optimal fiscal policy framework with endogenous disaster risk, we allow for an endogenous determination of geopolitical risk and defense capacity, which we discipline using the Geopolitical Risk Index. We show both analytically and quantitatively that financing defense primarily through debt, rather than taxation, is optimal. Debt issuance mitigates present tax distortions but exacerbates them in the future, especially in wartime. However, since additional defense capital deters future wars, the expected tax distortions decline as well, making debt financing a welfare-improving strategy. Quantitatively, the optimal defense financing in the presence of heightened risk involves a twice higher share of debt and backloading of tax distortions compared to other types of government spending.
Subjects: 
Optimal Fiscal Policy
Incomplete Markets
Endogenous Disaster Risk
JEL: 
E62
D52
E60
Persistent Identifier of the first edition: 
Document Type: 
Working Paper

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