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Optimal Fiscal Policy Under Endogenous Disaster Risk: How to Avoid Wars?

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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.

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  • Vytautas Valaitis & Alessandro Villa, 2025. "Optimal Fiscal Policy Under Endogenous Disaster Risk: How to Avoid Wars?," Working Paper Series WP 2025-13, Federal Reserve Bank of Chicago.
    • Handle: RePEc:fip:fedhwp:101716
    DOI: 10.21033/wp-2025-13
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    JEL classification:

    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • E60 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - General

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