oversight

NATO: Implications of European Integration for Allies' Defense Spending

Published by the Government Accountability Office on 1999-06-30.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                   United States General Accounting Office

GAO                Report to the Chairman and Ranking
                   Minority Member, Subcommittee on
                   Defense, Committee on Appropriations,
                   U.S. Senate

June 1999
                   NATO

                   Implications of
                   European Integration
                   for Allies’ Defense
                   Spending




GAO/NSIAD-99-185
United States General Accounting Office                                                                  National Security and
Washington, D.C. 20548                                                                            International Affairs Division



                                    B-282890                                                                                         Letter

                                    June 30, 1999

                                    The Honorable Ted Stevens
                                    Chairman
                                    The Honorable Daniel Inouye
                                    Ranking Minority Member
                                    Subcommittee on Defense
                                    Committee on Appropriations
                                    United States Senate

                                    Europe is being affected by a number of changes, including the
                                    enlargement of the North Atlantic Treaty Organization (NATO), the
                                    adoption of a common currency, and the planned enlargement of the
                                    European Union (EU). Concerned about Europe’s ability to share in the
                                    cost of providing a common defense through NATO, you asked us to assess
                                    how European Economic and Monetary Union (EMU) and the enlargement
                                    of the EU may affect U.S. allies’ ability to sustain or increase their defense
                                    budgets. As agreed with your office, this report provides information and
                                    analysis concerning (1) projected defense spending for several European
                                    countries, (2) budgetary effects of EMU implementation and EU
                                    enlargement, and (3) other significant factors that may affect countries’
                                    ability to share in the costs of NATO over the long run.1

                                    To address these issues, we collected and analyzed information from the
                                    U.S. Departments of Defense, State, and the Treasury; and from NATO, the
                                    EU, the International Monetary Fund (IMF), the World Bank, the
                                    Organization for Economic Cooperation and Development (OECD), the
                                    European Central Bank (ECB), and several research organizations. Our
                                    work focused on seven European countries--the four West European
                                    members of NATO that collectively accounted for over 75 percent of total
                                    European NATO defense spending in 1998 (Germany, France, Italy, and the
                                    United Kingdom [U.K.]), and the three newest members of NATO (the
                                    Czech Republic, Hungary, and Poland). We collected and analyzed
                                    information from government officials and private sector analysts in these
                                    countries. We visited each of these countries except France, which is not




                                    1
                                     We have ongoing work reviewing the progress made by our European allies in changing their military
                                    forces to meet the requirements of NATO’s Strategic Concept, and will report its results later this year.




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                      part of NATO’s integrated military command. (See app. IV for a detailed
                      description of our scope and methodology.)



Results in Brief      The United States’ security strategy depends on the ability of its allies to
                      join in military operations. This ability includes being able to train and
                      equip forces to meet certain requirements. Although EMU requirements
                      for additional deficit reduction are likely to mean tighter budgets, NATO’s
                      West European member countries generally plan to maintain their defense
                      budgets at roughly constant levels through 2002. EMU’s budgetary
                      constraints may be offset over time by fiscal benefits and economic
                      growth. A large number of observers are optimistic about EMU’s effects on
                      economic growth, but concerns remain. The costs and budgetary impacts
                      of EU enlargement are not readily identifiable, since several key political
                      decisions regarding the timing and specific requirements of membership
                      have not been made. However, these costs are likely to fall largely on
                      prospective, not current, EU members.

                      Over the long term, defense spending will face increasing pressure as
                      Europe attempts to deal with a number of domestic social issues, in
                      particular escalating entitlement burdens. Spending for public pensions,
                      for example, is already near or above 10 percent of gross domestic product
                      in France, Germany, and Italy—more than twice the U.S. percentage—and
                      is projected to begin to increase sharply in 10-20 years as populations age.
                      Governments’ spending for health care is also expected to rise, increasing
                      the budgetary pressures from coming demographic changes. This budget
                      environment means that member countries are likely to continue to face
                      significant challenges in modernizing their defense forces to meet NATO
                      requirements.

                      Ultimately, the amount of resources allocated to defense is a political
                      decision, driven substantially by views of military threat as well as other
                      competing budget priorities. If EMU’s fiscal constraints require further
                      spending cuts, for example, impacts on defense budgets will clearly depend
                      on policy decisions regarding where those cuts are made. Should EMU and
                      EU enlargement contribute to stronger economic growth in Europe, there
                      will be more budgetary resources to address competing needs. The
                      outcomes from these economic developments and political decisions have
                      important implications for U.S. defense planning.




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Background   The NATO military alliance of 19 European and North American countries
             is supported by its members through several means. First, countries
             contribute to NATO’s three commonly funded budgets, including the civil
             and military budgets and the budget for funding infrastructure
             improvements (about $1.6 billion total in 1999). The United States
             contributes about 28 percent of these commonly funded budgets.
             Countries also support NATO by maintaining forces and assets that they
             pledge to NATO through a defense planning process. NATO does not
             quantify the cost of forces national governments commit to NATO, but one
             way to measure this contribution is through the level of defense spending.

             The EU is a political and economic body of 15 European countries,
             including 11 NATO members. Member states jointly administer the EU
             through three major institutions. The European Union Council of
             Ministers, composed of the governments of the member countries,
             establishes common EU-wide policies. The European Commission
             proposes legislative initiatives and implements policies agreed to by the
             Council of Ministers and the European Parliament. The European
             Parliament, in tandem with the Council of Ministers, must approve most of
             the legislation introduced by the Commission before it goes into effect. 2

             EMU is an effort by EU countries to more closely link their economic
             policies to achieve greater economic cooperation and political integration.
             The most significant and far-reaching aspect of EMU is the adoption of a
             common currency known as the “euro.” On January 1, 1999, 11 EU
             countries, including 8 members of NATO, locked the exchange rates of
             their national currencies to the euro,3 redenominated their national debt
             into euros, surrendered control of monetary policy to the European Central
             Bank, and began using the euro in electronic transactions. 4 (Euro currency
             will not be circulated until 2002.)

             The Maastricht Treaty on European Union, signed in 1992, set forth several
             economic conditions for countries to join the euro area. These included, in
             part, reducing general government deficits to 3 percent of gross domestic
             product (GDP) and showing progress toward lowering general government


             2
              Parliament’s consent is not required for agricultural price reviews.
             3
              There are no procedures for countries to leave the euro area after they have joined.
             4
             EU countries that chose not to adopt the euro are Denmark, Sweden, and the United Kingdom. Greece
             wanted to adopt the euro but could not comply with the economic criteria.




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debt to 60 percent of GDP.5 The 1997 Growth and Stability Pact requires
countries adopting the euro to further reduce their annual budget deficits
and reach the medium-term objective of having budgets close to balance or
in surplus. Countries that do not comply with these requirements are
subject to sanctions, ranging from public rebuke from the European
Council to fines.

In addition to “deepening” European integration through EMU, the EU is
also “widening” to include the countries of Eastern and Central Europe.
The EU believes that enlarging to Central Europe will help cement peace
and stability in the region through developing closer economic and political
links. Countries seeking EU membership concur with this potential
security benefit and also value the intangible seal of approval EU
membership provides.




5
 The Treaty defines “general government” as including Central government, regional or local
government, and social security funds. It also requires countries have low inflation, low interest rates,
stable exchange rates, and independent central banks compatible with the European Central Bank.




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Figure 1: European Members of NATO, the EU, and the Euro Area, and First Wave EU Applicant Countries




                                     Iceland




                                                                                                          Finland

                                                                                     Sweden
                                                                            Norway
    Atlantic
    Ocean
                                                                                                          Estonia




                                                                         Denmark
                                                          United
                                               Ireland    Kingdom


   Netherlands                                                                                   Poland
                                                                           Germany

   Belgium                                                                              Czech
                                                                                        Republic
   Luxembourg
                                                                                       Austria
                                                           France                                   Hungary

                                                                                        Slovenia
                                                                             Italy




                          Portugal
                                         Spain
                                                                                                                         Turkey
          NATO                                                                                                Greece

          EU

           Eurozone

          1st Wave EU Applicant




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                            In December 1997, the European Council determined that the Czech
                            Republic, Hungary, Poland, and three other countries were in the best
                            position to meet the EU’s general economic and political membership
                            criteria.6 The European Council, the European Parliament, all 15 EU
                            member states, and the applicant country must approve a country’s
                            membership before it can enter the EU.



Defense Budget              The four West European members of NATO that we studied plan to
                            maintain their defense spending at roughly constant levels, after
Projections                 adjustments for inflation, through 2002. NATO’s three newest members
                            plan to increase defense spending over the period. NATO countries will
                            generally face substantial challenges in modernizing their defense forces
                            within projected budgets, due to high personnel costs, funding needs of
                            large-scale procurements, and costs of ongoing military operations such as
                            in Kosovo. In addition, such ongoing programs as NATO’s Defense
                            Capabilities Initiative, as well as the evolving European Security and
                            Defense Identity, could have budgetary implications that cannot yet be
                            determined.


West European Defense       Defense spending levels, adjusted for inflation, have begun to level off in
Spending Levels off After   Germany, France, Italy, and the United Kingdom after fairly sharp
                            reductions in the early 1990s. Budget projections of these countries
Post-Cold War Decline       indicate that generally constant defense budgets are planned through 2002,
                            as shown in figure 2. These countries generally could not provide budget
                            projections beyond 2002.

                            NATO uses a standard definition of “defense expenditure” to facilitate
                            comparison between the defense budgets of NATO-member countries,
                            which differs in some cases from definitions in national budgets. For
                            example, some countries do not include payments toward retirement
                            pensions in their defense budgets, while the NATO definition includes
                            contributions to military pensions but not payments to current retirees. In
                            figures 2, 3, 4, and 5, data from 1980 through 1998 are NATO figures based
                            on its definition of defense expenditure. Since NATO defense budget
                            forecasts are classified information, we calculated projected values using


                            6
                             Cyprus, Estonia, and Slovenia were the other three. The Council decided that it was too early to start
                            bilateral negotiations with Bulgaria, Latvia, Lithuania, Romania, and Slovakia and offered Turkey a
                            “European Strategy,” while not including Turkey in the accession process at this time.




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                                               defense budget projections from host countries and applied the projected
                                               growth rates in defense expenditures to NATO’s 1998 spending level for
                                               each country.



Figure 2: Historical and Projected Defense Spending in Four West European Countries, 1980-2002
Billions of 1998 U.S. dollars

60



50



40



30



20



10



 0

      1980      1985    1990    1991   1992   1993   1994     1995    1996      1997   1998     1999    2000    2001 2002
                                         Germany            France           Italy       U.K.


                                               Note 1: Budget projections from 2000-2002 are not available for France; data for 2002 is not available
                                               for the U.K.
                                               Note 2: 1998 figures are NATO estimates. NATO will release actual figures in December 1999.
                                               Source: GAO analysis of data from NATO and national ministries of Defense.


                                               The ratio of defense spending to GDP is one measure of the priority
                                               countries place on spending for defense relative to that for other national
                                               goals. The average defense share of GDP in 1998 was 2.6 percent for all
                                               NATO members and 2.1 percent for European NATO members.7 Using this
                                               measure, defense spending in the West European countries we studied has
                                               generally fallen steadily since the end of the Cold War, as has that of the


                                               7
                                                These figures are calculated using constant 1990 prices and exchange rates.




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                                               United States. Since planned defense spending is roughly constant and real
                                               GDP is projected to grow, defense spending as a percentage of GDP is
                                               expected to continue to decline slightly during 1999-2002 for the West
                                               European countries we studied (see fig. 3).



Figure 3: Historical and Projected Defense Spending as Percent of GDP for Four West European Countries and the United
States, 1980-2002
Percent of GDP

7


6


5


4


3


2


1


0
     1980-   1985-   1990   1991     1992    1993   1994     1995    1996     1997     1998    1999       2000   2001    2002
       84     89


                                   Germany          France            Italy          U.K.          U.S.


                                               Note: Budget projections for 2000-2002 are not available for France; data for 2002 is not available for
                                               the U.K.
                                               Sources: GAO analysis of data from NATO, national ministries of Defense, and Standard and Poor’s
                                               DRI (Lexington, MA).


                                               Defense spending in the West European countries we studied has generally
                                               been lower over time as a percentage of GDP than that of the United States.
                                               This difference, which was particularly significant in the 1980s, continues
                                               over the projected period. This is due to a number of factors, according to
                                               some European officials, such as different spending priorities, threat
                                               perceptions, and views of the determinants of their security. Other officials



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                           noted that whereas the United States has a global military presence and
                           interests, European countries generally have focused on European
                           security.


New NATO Members           The Czech Republic, Hungary, and Poland plan to increase defense
Project Defense Spending   spending during 1999-2003 to modernize their forces and meet NATO
                           requirements. Defense spending declined sharply in these countries as
Increases                  they transitioned from a large Soviet-era defense force to the post-Cold War
                           era,8 but spending began to increase in the mid-1990s as the countries
                           moved closer to NATO membership.

                           Figure 4 shows historical and projected defense spending levels for NATO’s
                           newest members. Poland’s budget shows defense spending in 1999
                           declining 0.01 percent in real terms from 1998 in part because the Polish
                           government removed military health care costs from the 1999 defense
                           budget. The 1999 defense budget would increase about 2.9 percent in real
                           terms if health care costs were included. Similarly, Hungary’s 1999 defense
                           budget includes funding for items that were not included in previous years.
                           When these items are excluded, the budget decreases in real terms
                           between 1998 and 1999, according to the U.S. Department of Defense
                           (DOD).9




                           8
                            For example, Poland’s 1985 defense spending has been estimated to exceed 8 percent of GDP.
                           9
                            U.S. government officials informed us about these changes in the composition of national defense
                           budgets between 1998 and 1999 for Poland and Hungary.




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Figure 4: Historical and Projected Defense Spending in Three Central European
Countries, 1994-2003
Billions of 1998
U.S. dollars

      3.0



      2.5



      2.0



      1.5



      1.0



      0.5




      0.0
             1994    1995    1996    1997   1998   1999   2000   2001    2002   2003

                            Poland          Hungary           Czech Republic

Note: 1998 figures are NATO estimates. NATO will release actual figures in December 1999.
Sources: GAO analysis of data from NATO and national ministries of Defense.


The Czech Republic, Hungary, and Poland have pledged continued defense
spending increases until they reach the NATO-Europe average of defense
spending as a percent of GDP of 2.1 percent.10 While Poland is currently
above that average share, projections show that defense spending will fall
below that share by 2003. In 1998, based on NATO’s definition of defense
spending, the Czech Republic spent an estimated 2 percent of its GDP on




10
  The Czech Republic and Hungary pledged to increase the defense budget’s share of GDP by
0.1 percent each year. Hungary’s intermediate goal is to reach 1.8 percent of GDP by 2001.




Page 10              GAO/NSIAD-99-185 NATO: European Integration and Defense Spending
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                                       defense, Hungary 1.5 percent, and Poland 2.2 percent.11 Figure 5 shows
                                       projected defense spending as a percentage of GDP for the new NATO
                                       members.



Figure 5: New NATO Members’ Defense Spending as a Percentage of GDP, 1994-2003
Percent of GDP

       3




       2




       1




       0
           1994     1995      1996     1997        1998         1999       2000          2001       2002        2003

                                      Poland          Hungary           Czech Republic

                                       Sources: GAO analysis of data from NATO, national ministries of Defense, and PlanEcon
                                       (Washington, D.C.).


                                       While the three new NATO members met their 1999 defense budgetary
                                       commitments, they had some difficulty in doing so as a result of lower than
                                       expected economic growth and other domestic budgetary priorities. In
                                       Poland, officials told us they planned to spend more on defense in 1999 but
                                       could not, in part, due to numerous domestic reforms requiring increased
                                       funding. However, they stated that defense spending in the year 2000 and
                                       beyond would be consistent with their planned funding objectives.
                                       According to Hungarian officials, funding for defense had to be balanced
                                       with social spending priorities to avoid creating social tensions and


                                       11
                                        Figures for 1998 are NATO estimates. NATO will release actual figures in December 1999.




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                          political instability. U.S. embassy and DOD officials were concerned that
                          Hungary’s 1999 defense funding difficulties may continue in later years
                          even though NATO requirements would continue to grow. Given the
                          experiences of 1999, U.S. government officials we interviewed expressed
                          some concern about future defense budgets for these countries. They
                          indicated that to meet NATO’s target force goals and make other needed
                          changes, consistent spending increases are necessary.


New Security Challenges   The international security environment presents a diverse set of challenges
Affect Spending Needs     very different from those of the Cold War. NATO’s new Strategic Concept
                          adopted at the Washington Summit in April 1999 recognizes changes in
                          threats confronting member nations and calls for new military
                          capabilities.12 This concept stresses that NATO members’ military forces
                          need to be more mobile, flexible, interoperable, and sustainable than in the
                          past. According to NATO, this means, for example, developing capabilities
                          for command, control, communications, intelligence, and surveillance.
                          These requirements, and others, were laid out at the Washington Summit,
                          in NATO’s Defense Capabilities Initiative. A NATO steering group has been
                          established to oversee the implementation of the initiative, the budgetary
                          effects of which cannot yet be determined.

                          Some countries have acknowledged these needs in conducting or planning
                          their own defense reviews. Between 1996 and 1998, the United Kingdom
                          and France issued comprehensive defense reviews that reassessed their
                          security interests and defense needs. They concluded that modern,
                          high-quality defense forces can be created without requiring large increases
                          in defense spending by rigorously setting spending priorities and making
                          difficult choices. These include reducing personnel and other support and
                          operating costs, postponing or canceling certain procurement programs
                          and, in the case of the United Kingdom, selling unneeded assets and
                          facilities. Germany has just begun an extensive defense review along
                          similar lines. Some of the same issues have emerged in defense
                          assessments conducted by the three new NATO members as they adapt
                          their forces to Western standards. European officials have stated that
                          improving their defense capabilities is essential for implementing the


                          12
                            NATO’s 1999 Strategic Concept identifies a variety of military and nonmilitary risks that are
                          multi-directional in nature and often difficult to predict. These include: regional instability and the
                          resulting risk of crises; the proliferation of nuclear, biological, and chemical weapons; the spread of
                          potentially dangerous technology; the threat of terrorism, sabotage, and organized crime; and the
                          uncontrolled movement of large numbers of people, due in some cases to armed conflicts.




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                          European Security and Defense Initiative, intended to give European
                          countries the ability to take military action in cases where NATO as a whole
                          is not militarily engaged. They confirmed this position at St. Malo, France,
                          in December 1998 and, in June 1999, the EU member states agreed on the
                          need for capacity for autonomous military action, which requires having a
                          credible force and the readiness to use it.



Competing Needs Present   The countries we studied face considerable challenges as they try to
Challenges for Defense    balance competing needs within defense budgets. DOD officials told us
                          that prioritizing defense needs is one of the key challenges facing NATO
Budgets                   countries as they seek to modernize and restructure their forces. However,
                          shifting priorities within defense budgets can be difficult. For example,
                          personnel costs represent a large portion of defense spending in several
                          countries, such as 60 to 70 percent in Germany, Italy, and Poland, which
                          have traditionally relied on conscription to staff their armed forces. These
                          countries are currently examining the cost, as well as other implications, of
                          reducing their reliance on conscription. In addition, planned procurements
                          of major items such as the West European aircraft, the Eurofighter, can
                          consume large portions of countries’ procurement budgets. Finally,
                          out-of-country deployments, particularly in Bosnia and Kosovo, are
                          requiring significant budgetary resources in the NATO European countries
                          we studied. Combined with the expense of large aircraft purchases and
                          high personnel costs, these operations are affecting the ability of NATO
                          countries to carry out restructuring and modernization, according to
                          foreign officials and U.S. embassy officials. According to DOD and foreign
                          government officials, the efforts of the Czech Republic, Hungary, and
                          Poland to modernize and reorganize their defense structures are made
                          more difficult by limitations in the defense planning and management
                          capabilities needed for effective resource allocations. (See app. I for
                          additional information on defense modernization challenges.)

                          In addition to the costs of military operations, addressing regional
                          instabilities is expected to have other budgetary effects for EU member
                          countries. In particular, they have committed to funding the major portion
                          of the costs of reconstruction operations in the Balkans, although the
                          specifics regarding funding levels and sources have not yet been
                          established.




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Consequences of EMU              EMU and EU enlargement’s impacts on defense spending depend on both
                                 direct effects on national budgets and how these institutional changes will
and EU Enlargement               affect the European economy over the long run. The EMU’s requirement
for Defense Spending             for countries to limit deficits and debt will continue to constrain
                                 government spending options. At the same time, the enhanced integration
                                 brought about by the euro can have positive effects on economic growth
                                 that may offset fiscal constraints and provide greater budget flexibility over
                                 the longer term. While EU membership may bring economic benefits to
                                 new entrants, meeting membership criteria will impose significant costs.
                                 The magnitude of these costs and thus their budgetary impact depends on
                                 several key political decisions that have not yet been made, such as the
                                 timing and specific requirements of membership. Applicant countries are
                                 likely to bear most of these costs.


EMU’s Implications for           EMU has no direct effect on defense spending, but it can affect the
Defense Spending Remain          availability of national resources for defense spending depending on how
                                 the euro and its related requirements influence budgets and economic
Uncertain                        growth. Adopting the euro constrains national spending, because countries
                                 are required to attain roughly balanced budgets in the next few years. The
                                 degree to which this will require cuts in government spending depends in
                                 part on economic growth in euro area countries. EMU’s impact on
                                 economic growth remains uncertain. A key determinant will be how
                                 national economies restructure in reaction to the enhanced competitive
                                 pressures from EMU.

Significant Deficit Reductions   The fiscal requirements associated with EMU have resulted in significantly
Achieved, but Further Cuts       lower budget deficits throughout the EU and will require further reductions
Required                         among those countries that have adopted the euro. Since the early 1990s,
                                 countries have significantly reduced their national deficits through a
                                 combination of spending cuts and tax increases. (See fig. 6.) For example,
                                 between 1994 and 1997, Italy reduced its deficit from 9.2 percent to
                                 2.7 percent of GDP.




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Figure 6: Annual General Government Deficits for Four West European Countries as Percent of GDP, 1990-98
Percent of GDP

      12



      10



       8



       6



       4



       2



       0
           1990     1991      1992       1993        1994      1995         1996          1997    1998

                               Germany            France            Italy          U.K.
                                           Source: European Commission.


                                           Countries can achieve required deficit- and debt-to-GDP ratios by cutting
                                           spending, raising taxes, or as a result of increases in GDP. According to the
                                           OECD, countries have so far achieved compliance with EMU requirements
                                           largely through raising taxes; cutting investment spending and subsidies;
                                           and implementing a series of one-time measures that included Italy’s
                                           euro-tax, and, in some countries, the postponement of certain expenditures
                                           1 week into 1998. In the case of Italy, significant spending reductions have
                                           also been achieved through decreased debt service payments due largely to
                                           lower interest rates.13 Table 1 shows the combination of spending cuts and
                                           revenue increases used to meet deficit criteria for several countries.




                                           13
                                             Italy’s long-term yield on government bonds, a measure of the cost of government borrowing, dropped
                                           from 11.88 percent in 1992 to 6.85 percent in 1997.




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Table 1: Sources of Deficit Reductions in Four West European Countries as a
Percent of GDP, 1990-97

Country                                    Changes in spending                  Changes in revenue
Germany                                                          -0.3                                2.0
France                                                            1.7                                2.5
Italy                                                            -5.0                                4.8
United Kingdom                                                   -2.0                               -0.1
Note: The OECD data calculates changes in various spending and revenue categories as a
percentage of the country’s potential GDP over the 1990-97 period. Spending includes government
transfers as well as other types of spending. The OECD did not specify the breakdown of government
spending cuts across functional categories.
Source: GAO analysis based on OECD data.


Countries within the euro area must make additional reductions in both
debt and deficit levels over the next few years to comply with the
provisions of the 1997 Growth and Stability Pact. Although 1998 debt levels
in France, Germany, and the United Kingdom were near or below the
required 60 percent of GDP, Italy’s debt was 118 percent of GDP. While this
represents progress from the peak debt level of 125 percent of GDP
attained in 1994, Italy must continue to show progress in reducing
government debt to 60 percent of GDP to remain in compliance with EMU
requirements.14 In addition, as table 2 shows, all four EU countries studied
plan to continue to cut deficits to comply with Stability Pact deficit
requirements, although three of the four countries plan to cut deficits at a
slower rate over the next 4 years than was achieved from 1994 to 1998.




14
  The relationship between deficit- and debt-to-GDP ratios is complex and depends on factors such as
GDP growth rates, inflation, and interest rates on outstanding debt. In general, high-debt countries will
face greater fiscal constraints than low-debt countries. For example, to bring debt below 100 percent of
GDP by 2003, Italy plans to have general government revenue exceed general government expenditures,
except for debt service payments, by 5.5 percent of GDP.




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Table 2: General Government Deficit for Four West European Countries, Selected
Years, as a Percent of GDP

Country                                 1994 deficit     1998 deficit            Planned 2002 deficit
Germany                                           2.4              2.1                            1.0
France                                            5.8              2.9                      0.8 to 1.2
Italy                                             9.2              2.6                           1.0a
United Kingdomb                                   6.8              0.8                            0.2
a
    Italy’s plans are for 2001.
b
    The United Kingdom chooses to abide by the euro area’s fiscal constraints.
Source: European Commission.


Achieving further deficit reduction over the medium term may prove
difficult for some euro area countries. Countries have made limited
progress in reducing deficits since 1997, and budget plans promise little
improvement in the near term, according to the IMF. OECD officials told us
that many European governments were suffering “fiscal fatigue” from the
effort to meet euro area deficit requirements and did not continue to cut
spending in 1998 to reduce deficits. In March 1999, the European Central
Bank issued a report criticizing governments for this slowdown in deficit
reduction and for assuming that sustained economic growth and low
interest rates would bring compliance with EMU requirements without
further cuts in government spending. The European Central Bank, the
OECD, the IMF, and the European Commission have expressed concern
that, in the event of a severe or prolonged slowdown in economic growth,
government deficits could fail to meet Stability Pact requirements or could
even exceed the 3-percent deficit limit. According to European officials,
this would reflect badly on the credibility of EMU and could trigger a
political crisis if countries were required to pay the fines for
non-compliance spelled out in the Treaty on European Union.

While discussion of EMU’s fiscal requirements focuses on constraining
government spending, the requirements also have beneficial economic and
fiscal effects. European Central Bank officials have stated that the lower
deficits and debt brought about by EMU will create a more stable economic
environment and contribute to greater economic growth in the future. We
have also reported on the potential benefits to economic growth of lower




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                              deficits.15 In addition, as Italy’s case shows, reducing deficits can also lead
                              to lower interest rates on sovereign debt and thus reduced government
                              spending on debt service. Moreover, reductions in debt levels over time
                              also directly lower debt service costs. Lower interest payments and levels
                              of debt will increase budgetary flexibility making resources available for
                              other policy priorities.

                              If EMU’s deficit requirements require further spending cuts, impacts on
                              defense budgets will clearly depend on policy decisions of individual
                              governments regarding where those cuts are made. We heard a range of
                              views from officials and analysts regarding the potential impact of further
                              budget tightening under EMU. Several officials told us that defense
                              budgets had already been affected by deficit reduction measures to date in
                              several countries. Other officials stated that because current defense
                              spending levels are low by recent historical standards, they are unlikely to
                              be cut further. Many officials and analysts stressed that it is hard to
                              develop a causal link between deficit reduction requirements and changes
                              in a particular category of spending, since a number of factors are involved,
                              including political priorities and rates of economic growth. For example,
                              during the 1990s, Italy cut its general government deficit the most and its
                              defense spending the least, among the countries we studied.

EMU Should Benefit Economic   EMU has broad and important effects on several aspects of European
Growth, but Concerns Remain   economies, including competitiveness, structural reforms, and the ability
                              of national governments to react to economic downturns. The impact of
                              EMU on economic growth in Europe depends on how EMU affects these
                              and other economic factors. On balance, analysts are guardedly optimistic
                              about the implications of EMU for Europe. However, concerns remain
                              about how EMU will affect the ability of national governments to adjust to
                              economic downturns and derive political consensus to pursue structural
                              reforms. Officials at the IMF, the EU, and the OECD told us they believe
                              that EMU will ultimately boost economic growth in Europe but have not
                              quantified this expected impact.

                              Optimists believe that, in addition to providing economic benefits from
                              lower deficits, EMU will tie the countries of Europe closer together,


                              15
                                Economic growth requires investment, which over the longer term, depends on savings. Government
                              deficits represent dissavings since they use funds that otherwise could be used for investment. For
                              examples of our work in this area see Budget Issues: Analysis of Long-Term Fiscal Outlook
                              (GAO/AIMD/OCE-98-19, October 22, 1997) and Budgetary Policy: Prompt Action Necessary to Avert
                              Long-Term Damage to the Economy (GAO/OCG-92-2, June 5, 1992).




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increase their prosperity, and ultimately improve security through the
beneficial effects of integration. Since national governments will no longer
be able to adjust to downturns through monetary or exchange rate policy,
and the use of fiscal policy will be constrained, they will have to rely on
structural reforms, such as revising their policies to increase labor mobility,
to address economic problems. Economic efficiency and growth will
increase because countries in the euro area will have no choice but to allow
increased flexibility in labor, capital, and goods and services markets to
stay economically competitive.

Skeptics fear that EMU will create longer, deeper recessions in parts of
Europe and possibly increase political tensions between countries if
workers and firms move across national boundaries. They believe EMU
will ultimately not work because national governments will lack the
political support to maintain balanced budgets and undertake unpopular
economic structural reforms, such as making it easier for businesses to fire
workers. (See app. II for a further discussion of the mechanisms through
which EMU can affect economic growth.)

The link between increased economic growth and countries’ defense
budgets is, of course, an indirect one. In general, stronger growth leads to
more resources for all spending needs, including defense, and weaker
growth can squeeze many budgetary categories. However, changes in the
level of defense spending over time solely due to changes in economic
growth can be relatively small. For example, holding assumptions about
military threat and political support for defense spending constant, if GDP
growth increased (decreased) by 1 percentage point per year relative to
baseline projections, it would take about 5 years for real defense spending
to increase (decrease) by 5 percent.16

EMU’s impact on economic growth within the euro area also has important
economic consequences for the newest NATO members. For example,
exchange rates of the Polish and Hungarian currencies are determined by
the values of “currency baskets” that include the euro. In addition, the
Polish, Hungarian, and Czech economies depend heavily on trade with the
countries in the EU.




16
  This assumes the defense share of GDP declines slightly over the period, based on existing defense
budget projections for the countries we studied.




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EU Enlargement’s               EU enlargement’s effect on resources available for defense spending
Budgetary Impact               depends on how enlargement affects economic growth and on the
                               budgetary costs of meeting enlargement criteria. Both of these impacts are
Uncertain, but Effects on      likely to be greater for countries joining the EU than for current members.
New Member Countries           While applicants expect membership to improve their economies over the
Likely to Be Greatest          long run, meeting EU requirements is likely to be costly in some areas,
                               although the magnitude of costs depends on timetables and specific
                               requirements that have not been established. Current EU members plan to
                               provide financial support for enlargement primarily through the EU
                               common budget. The EU financial framework for 2000-2006 limits
                               assistance to applicant countries to 11 percent of total spending over the
                               period, which is slightly above 0.1 percent of total EU gross national
                               product (GNP).17 Most of these funds will not be available until countries
                               actually join the EU, which is likely to be several more years.

EU Membership Should Benefit   EU applicants, whose average per capita GDP in 1997 was about 32 percent
New Members’ Economic          of that of current members, expect to derive broad economic benefits from
Growth                         membership. Benefits are expected to flow from several factors:
                               expanded trade due to reduced trade barriers between entrants and current
                               members, increased foreign investment due to lower risks and reduced
                               barriers, and overall institutional reforms associated with joining the EU.
                               Although the requirements of EU membership often coincide with steps
                               toward general economic development in applicant countries, the prospect
                               of membership adds an important motivation for countries to carry out
                               needed reforms. In addition, because the accession process itself increases
                               investor confidence, some of the economic benefits should accrue before
                               formal membership. Finally, applicant countries expect to benefit through
                               financial assistance from the EU although, as we discuss later, the EU’s
                               current budget limits the commitment to assistance for applicant countries
                               and new members.

Enlargement Requires Reforms   The EU requires that new members have
by Applicant Countries
                               • stable government institutions guaranteeing democracy, rule of law, and
                                 human rights;
                               • a “functioning market economy” that can withstand competitive
                                 pressure and market forces within the EU; and

                               17
                                 GNP differs from GDP—the total market value of all the final goods and services produced within an
                               economy in a given year—in that it includes earnings abroad by a country’s firms and residents and
                               excludes income earned in that country by foreign firms and residents.




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                             • the ability to take on EU membership obligations, including the
                               adoption, implementation, and enforcement of the EU’s entire body of
                               laws, known as the “acquis communautaire.”

                             Some of these criteria are quite general and open to interpretation. For
                             example, having a functioning market economy can be demonstrated
                             through showing sustained economic growth with growing private sector
                             participation. This in turn requires changes across the spectrum of
                             economic institutions. For example, countries’ legal systems need to
                             include the regulation of property rights so contracts can be enforced.

                             Adopting and implementing the full spectrum of EU law, however, requires
                             a number of specific actions. Adopting the acquis is a massive undertaking
                             for accession countries. The acquis comprises 80,000 pages of
                             requirements, which the European Commission has divided into 31
                             categories, or chapters, for the purpose of carrying out negotiations with
                             applicants. (See app. III for a complete listing of these chapters.) Some
                             requirements of adopting the aquis can be met with simple, technical
                             changes, while others will require large investments. Meeting EU
                             standards for the environment and for infrastructure are most likely to
                             constitute the greatest challenges and costs for the three accession
                             countries we visited.

Enlargement Not Likely for   The first accessions to the EU from the current enlargement process are
Several Years                not likely to take place for several years, most likely not until 2004-06,
                             according to U.S. and foreign officials with whom we met. Applicant
                             countries’ own official timetables remain somewhat shorter—2002 or
                             2003—as does the timetable officially assumed in the recently adopted EU
                             budget. Enlargement cannot occur until (1) applicant countries make
                             sufficient progress in satisfying EU membership criteria and (2) the EU
                             agrees to reforms in its decision-making processes and possibly changes in
                             its budget.

                             The timing of accession is ultimately a political decision on the part of
                             current EU members. According to several EU and government officials,
                             while current members have made a political commitment to the idea of
                             enlargement, they have not made a political commitment to the timing or
                             conditions under which it will take place. The degree of support for EU
                             enlargement among current member populations is mixed. According to a
                             1998 survey conducted on behalf of the EU, 42 percent of respondents
                             favored enlargement, with support ranging from a high of 63 percent in
                             Sweden to a low of 28 percent in Belgium.



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In its report on applicants’ progress in meeting EU membership criteria,
issued in late 1998, the European Commission indicated that while
candidates were “broadly on track,” countries still had a long way to go in
meeting membership criteria. According to the Commission, among the
Czech Republic, Hungary, and Poland, Hungary has made the most
progress and the Czech Republic the least. The Commission reports that
all the candidate countries lack the administrative and judicial capacity to
implement the acquis. According to Commission officials, it is not realistic
to expect that all the requirements of the acquis will be met prior to
negotiation. The accession process does provide for transition periods—
periods after membership during which some requirements can be
implemented. Views on how extensively transition periods will be granted
varied among the officials with whom we talked. Transition periods are
generally expected in some cases, however, particularly in the area of
meeting environmental standards.

The need to make politically difficult changes in EU policies could impede
EU enlargement, according to officials from the EU as well as member and
applicant countries. These include several issues with respect to EU
decision-making structures and procedures in the Council and
Commission, and potentially the EU budget—including the allocation of
funds to support agriculture.

EU and member-country officials stated that reforms of the EU
decision-making process are necessary prior to enlargement. These
reforms include reducing the number of members of the Commission to
one per country to accommodate an increasing number of countries (the
largest countries now have two members); reweighting the voting power of
members in the Council to offset the loss of commissioners; and increasing
the use of majority voting in the Council to replace the current system of
consensus decision-making. A State Department official characterized the
prospect for agreement on these reforms in the near-term as “dim.”

The EU financial framework for 2000-2006 (discussed later) reflects most
of the reforms that the Commission had determined would be necessary for
an expanded EU except with respect to agriculture policy, the area of
greatest contention. 18 This has led to the views of some officials that
elements of the budgetary framework will have to be revisited prior to


18
 The European Commission laid out in a 1997 document, Agenda 2000, specific changes to EU policies
needed before enlargement.




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                                 enlargement. In presenting the financial framework, the Council
                                 acknowledged that further changes in agriculture assistance payments to
                                 current members may be necessary. However, EU countries receiving the
                                 largest amounts of agricultural subsidies could potentially use their votes
                                 on enlargement to maintain their net level of assistance from the EU at the
                                 expense of new members.19

Future Budgetary Impacts         The budgetary implications of EU membership for applicant countries
Depend on Specific Enlargement   depend on the outcome of ongoing membership negotiations with the EU.
Terms                            At this point, total cost estimates have not been developed. While there is
                                 general agreement that meeting EU membership requirements will entail
                                 significant expenditures by applicant countries, quantifying these costs
                                 remains difficult. For example, neither the EU nor the World Bank, which
                                 have both worked with applicants to develop accession strategies, has
                                 developed broad estimates of accession costs.

                                 EU requirements with respect to environmental standards and
                                 transportation infrastructure are expected to be among the costliest for
                                 applicant countries to meet. The most comprehensive sector-specific
                                 estimates are for environmental reforms, where the World Bank has
                                 recently completed analyses of what Poland, Hungary, and the Czech
                                 Republic must do to meet EU environmental standards. The World Bank
                                 has estimated that Poland’s public sector costs of meeting EU requirements
                                 could be $5 billion to $11 billion dollars per year for 20 years to cover
                                 investment, operation, and maintenance. 20 This represents about
                                 3.4 percent to 7.5 percent of Poland’s 1998 GDP and 1.7 percent to
                                 3.7 percent of Poland’s projected GDP in 2015. The World Bank estimates
                                 Hungary’s annual costs of environmental reforms as ranging from
                                 2.1 percent to 5.5 percent of 1997 GDP, and annual costs for the Czech
                                 Republic ranging from 2.5 percent to 3.7 percent of 1997 GDP. The
                                 difference between the high and low ends of the cost ranges are due to
                                 different assumptions about what the specific requirements will be and the
                                 details of the compliance plan these countries and the EU agree to.



                                 19
                                   Currently, about half of all EU appropriations are for agricultural price supports and direct payments
                                 to farmers. Between 1993 and 1997, France was the leading recipient of EU agricultural support
                                 payments, followed by Germany, Spain, and Italy. Extending these payments to new entrants, whose
                                 economies are, on average, about four times as reliant on agriculture as current members, would
                                 increase expenditures considerably.
                                 20
                                   These calculations assume investments are spread over their expected life and discounted to reflect
                                 the time value of money. They also exclude what private industry must spend to meet EU standards.




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                             The World Bank’s studies do not determine what portion of estimated costs
                             will be borne directly by national governments. The national budgetary
                             impact of these and other requirements depends on a number of factors,
                             including the degree to which costs are passed on to consumers—through
                             higher utility bills, for example--and the types of financing available.
                             According to these studies, much of the costs would be affordable to
                             households under the low-cost scenario but not under the high-cost
                             scenario. Moreover, since these studies focus only on the costs of meeting
                             enlargement criteria in these areas, they do not attempt to present net
                             assessments of the criteria’s economic costs and benefits.

                              The World Bank emphasizes that these countries will make many of the
                             required improvements whether they join the EU or not. A common theme
                             we heard from officials in accession countries is that there is substantial
                             overlap between their national development goals and EU requirements in
                             areas such as the environment. However, EU requirements can affect the
                             timing of reforms and thus the relative impact of their costs. For example,
                             Hungarian officials pointed out that, while commercial vehicles in Hungary
                             will eventually satisfy EU emission control requirements, membership
                             criteria will force these requirements to be met by a certain date. This will
                             compress the period of time over which adjustments take place, thus
                             increasing annual expenses.


New EU Financial             EU members plan to support enlargement of the Union primarily through
Framework Limits             the EU budget, not their national budgets. According to the financial
                             framework adopted in March 1999, the EU will appropriate about
Expenditures of Current EU   11 percent of its spending during 2000-2006, about $80 billion dollars, to
Members for Enlargement      applicant and new member countries. This is slightly above 0.1 percent of
                             current member GNP.21

                             As illustrated in figure 7, the financial framework reflects some increase in
                             total spending, since members’ GNP is assumed to grow over the period,
                             and revenues are limited to a percentage of GNP. The framework shows
                             only a slight decrease in agriculture and regional development payments to
                             current members. It assumes some new members would join in 2002, and
                             then receive a portion of agriculture and regional development payments.


                             21
                               Financing for the EU budget comes from GNP-based contributions, value-added taxes, and
                             agricultural levies and customs revenues. Member contributions are limited to a percentage of total EU
                             GNP, which is 1.27 percent in the newly adopted budget.




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                                              The framework reflects the decision to set an explicit cap on the amount of
                                              funds that new members will receive over the period. According to the EU,
                                              there are budgetary walls between the funding for current and new
                                              members. Thus, if enlargement takes place after 2002, current EU
                                              members would not get the funds earmarked for new members for that
                                              year.



Figure 7: Planned EU Spending for Current and Applicant Members, 2000-2006
Billions of 1999
U.S. dollars

120



100



 80



 60



 40



 20



  0
         2000         2001         2002         2003           2004        2005          2006

        Current members      New members (before joining EU)    New members (after joining EU)

                                              Source: European Council.


                                              Most of the financial assistance, 68 percent, given to new members will be
                                              for regional development. The amount of assistance earmarked for new
                                              members is not sufficient to support new members at the same level as
                                              current members. EU officials have stated that the EU’s greatest
                                              contribution to the economic development of applicant countries is not
                                              financial assistance, but rather fostering an environment conducive to



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                              increased trade and influxes of private capital. However, a State
                              Department official stated that this budgetary framework may have to be
                              modified before enlargement can take place.



Defense Budgets Face          Defense budgets face strong and increasing pressures from demands for
                              domestic spending in both West and Central European countries.
Strong and Increasing         Pensions, in particular, are placing pressure on national budgets and
Pressure From                 expenditures will increase dramatically as populations age, unless difficult
                              reforms are made. Health care costs are also expected to rise. In the long
Domestic Spending             run, the pressure from rising entitlement costs may have a greater effect on
                              countries’ defense budgets than EMU or EU enlargement. Recent
                              budgetary debates in both West and Central European countries have
                              highlighted the tradeoffs facing decisionmakers as they try to satisfy
                              demands for social spending within a budgetary environment characterized
                              by lower economic growth and fiscal constraints.



Social Spending Is a Large    The countries we reviewed have historically spent a large portion of their
Portion of National Budgets   GDP and government budgets on social programs such as pensions, health,
                              and welfare. For example, according to OECD figures, in 1995—the latest
                              year for which comparable data are available—France, Germany, Italy, and
                              the United Kingdom spent an average of 26 percent of GDP on social
                              programs, compared with 16 percent in the United States. 22 Public
                              pensions and health programs are the largest component of government
                              spending for social programs in these countries, averaging about
                              80 percent of the total. Central European governments also devote a
                              significant portion of GDP to social programs. According to IMF data,
                              using a slightly different measure than the OECD, the Czech Republic,
                              Hungary, and Poland spent about 22 percent of GDP in 1997 on social
                              programs (including pensions, welfare, and health).

                              The cost of public pension programs has been placing increasing pressure
                              on government budgets in some countries. Payroll taxes in several
                              countries, although considered high, do not cover the annual costs of
                              current pension programs, requiring sometimes large and growing portions



                              22
                                According to OECD figures, about half of total government spending in the United States is for social
                              programs, about the same as in Western Europe. However, government spending in Europe is a larger
                              portion of GDP than in the United States.




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of the national budget to fill the gap.23 For example, in Germany, transfers
to pension funds increased from 16 percent to 22 percent of federal
government spending between 1994 and 1998. 24 In Italy, government
contributions to the state pension system increased from 2.3 percent of
GDP in 1997 to 2.7 percent in November 1998. In 1998, the Czech
Republic’s pension system required payments from the national budget to
finance the gap between payroll taxes and pension expenditures equivalent
to roughly 1.1 percent of GDP. Officials there told us that without serious
change in the current system, these deficits would continue.

However, reforming pension programs can increase costs in the short term.
For example, in 1998, Hungary launched an ambitious reform of its
pay-as-you-go pension program. Although the move to add mandatory
individual savings accounts enhanced the long-term viability of the system,
Hungary’s short-term budgetary costs will require payment for two parallel
pension systems over the next several years, reflecting these transition
costs.

The growing pressures for spending for domestic needs such as addressing
unemployment and improving education are reflected in the 1999 budget
debates for all the countries we studied. Germany, for example, increased
spending for education and to reduce youth unemployment while
continuing to spend large sums related to the integration of the eastern
region. France’s budget also increased funding directed at lowering
unemployment and improving education, and Italy spent more for social
and regional development. In the United Kingdom, half of all planned
budgetary increases are in education and health. In Central Europe, Poland
is implementing costly pension, health care, industrial, and local
government reform programs. The Czech Republic’s mildly expansionary
budget is geared to spur growth. And Hungary’s budget shows increased
spending for pensions and education, as the new government attempts to
satisfy campaign promises while limiting deficit spending.




23
  Most countries we studied have multiple public pension programs, and the complex funding and
benefit details of these programs differ from country to country. Governments collect payroll taxes to
support the current year’s public pension outlays. This is known as a “pay-as-you-go” funding scheme.
General government budgets are used to cover any gaps. Pay-as-you-go schemes are not generally
designed to accumulate and set aside funds to pay for future liabilities.
24
  National budget figures cannot be compared across countries, due to significant differences in
definitions; spending categories; and distinctions between national, regional, and local government
responsibilities.




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Aging Populations Present   Demographic trends present a huge budgetary challenge for the countries
Budgetary Challenge         we studied, although the budgetary consequences for the United Kingdom
                            are much less negative than those for the other countries.25 According to
                            studies by the OECD, the World Bank, and national governments, in the
                            absence of substantive public pension reform efforts, budgetary stability
                            will come under significant strain in the next century. German Central
                            bank officials, for example, described the projected fiscal consequences of
                            Germany’s demographic problems as catastrophic.

                            The share of retired elderly (people over 65) in most developed countries,
                            which grew slowly over the last 25 years, will begin to rise dramatically
                            after 2010 as the baby boom generation moves into retirement and other
                            demographic forces play out. These changes will generally be greater in
                            European countries than in the United States, as shown in figure 8.




                            25
                              The U.K.’s population is aging less rapidly and its pension system is less generous than in France,
                            Germany, and Italy. The United Kingdom has also undertaken a series of reforms, including partial
                            privatization of its pension system, reducing the fiscal burden on the national government.




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Figure 8: Share of Population Over 65 in Four West European Countries and the
United States, 1960-2030
Percent of population

           30


           25


           20


           15


           10


            5


            0

                1960          1990        2000          2010         2020           2030


                            Italy     Germany        U.K.       France       U.S.

Source: OECD.


The projected impact on public pension expenditures of these
demographic trends for France, Germany, Italy, the United Kingdom, and
the United States is shown in figure 9.




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Figure 9: Pension Expenditures as Percent of GDP in Four West European Countries
and the United States, 1995-2050
Percent of GDP

        25



        20



        15



        10



          5



          0

              1995       2000          2010         2020          2030          2040          2050

                           Italy       Germany             U.K.       France           U.S.

Source: OECD.


Figure 9 shows that, using projections based on current trends and policies,
public pension costs in France, Germany, and Italy will consume growing
proportions of total GDP. Predicted costs for the United Kingdom are
lower in part due to reforms that have included lower benefits. By several
measures, based on current policies, the future budgetary consequences of
the trends in France, Germany, and Italy are very serious. For example, the
OECD has estimated that current pension policies will drive the national
debts of Germany and Italy over 200 percent of GDP by 2030. To maintain
their respective national debts at current levels, the OECD estimates that
Italy and Germany will need to maintain unrealistically high budget
surpluses of 7 percent of GDP or greater per year by 2030.26




26
  A 1997 OECD study estimated the net present value of long-term financing shortfalls of government
pension programs for a number of countries. Expressed as a percent of a country’s 1994 GDP,
estimated shortfalls were 24 percent for the United Kingdom, 60 percent for Italy, 62 percent for
Germany, and 102 percent for France.




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              Central European governments face similar budgetary problems due to
              demographic trends. Polish officials have projected they will reach
              unsustainable levels of spending in 10 to 15 years. Likewise, Czech officials
              reported being in the same situation. Long-term projections for Hungary
              are somewhat more optimistic, given recent reforms, although long-term
              funding shortfalls are still projected.

              Aging populations are also expected to increase health care costs in these
              countries, although less dramatically. Public spending on health, which
              throughout the 1980s equaled approximately 6 percent of GDP in the EU
              countries we studied, began to rise early in the 1990s. According to one
              study, this spending is projected to increase to approximately 9.5 percent
              of GDP in 2050, under current trends and policies. Expenditures on health
              care for the elderly account for nearly all of this projected increase.
              According to the OECD, such estimates are highly dependent on the future
              cost of medical technology and the outcome of reforms aimed at improving
              efficiency.

              Although the dramatic budgetary consequences of aging populations
              appear to be a number of years away, significant political and budgetary
              impacts will be felt sooner, according to a number of officials and analysts.
              The longer pension system reforms are delayed, for example, the more
              stringent they will have to be. Officials told us that achieving the political
              consensus to carry out reforms to temper the budgetary consequences of
              aging populations will be difficult. They also told us that the hardest and
              potentially most effective choices, such as raising the retirement age or
              reducing benefits, are not yet being seriously addressed. The political
              challenges are compounded by the fact that some long-term reforms can
              have negative budgetary consequences in the short to medium term.



Conclusions   While neither EMU nor EU enlargement affect defense spending decisions
              directly, they can affect the flexibility of governments to allocate resources
              to various needs. The impacts of EMU and EU enlargement on overall
              government budgets remain difficult to predict. The estimated costs of
              meeting some EU membership requirements are quite high. But just how
              high these costs will be, who will pay them, and over what period of time
              they will be incurred remain to be determined. Clearly, however, EU
              membership is a priority of many Central European countries, and support
              for it could fare well as budgetary decisions are made. Over the next
              several years, EMU requires additional cuts in deficits in participating
              countries. While these cuts are not large relative to the deficit reductions



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                      already made, they are not easily achieved, particularly in countries that
                      are experiencing slow growth. Since defense is a relatively small portion of
                      the budget, it can arguably be protected from cuts. However, if the political
                      support for defense spending is low, it may be a more attractive target than
                      other spending. Pressures for increased spending on pensions and also
                      health care due to aging populations will strain future budgets in many
                      European countries. Strong economic growth is clearly a key to
                      governments having any flexibility for meeting competing needs for
                      resources.



Agency Comments and   The Defense Department provided written comments on a draft of this
                      report and concurred with our findings (see app.V). The Department of
Our Evaluation        State provided oral comments on a draft of this report and concurred with
                      our findings. DOD and the Department of State also provided technical
                      comments, which we incorporated where appropriate. In oral comments
                      on a draft of this report, the Department of the Treasury, the European
                      Union, the World Bank, and NATO provided technical comments, which we
                      incorporated where appropriate.


                      As agreed with your office, unless you publicly announce its contents
                      earlier, we plan no further distribution of this report until 15 days from its
                      issuance date. At that time, we will provide copies of this report to other
                      appropriate congressional Committees; the Honorable William Cohen, the
                      Secretary of Defense; the Honorable Madeleine Albright, the Secretary of
                      State; and the Honorable Lawrence Summers, the Secretary of the
                      Treasury. We will also make copies available to others upon request.

                      If you or your staff have any questions about this report, please contact me
                      at (202) 512-4128. Other GAO contacts and staff acknowledgments are
                      listed in appendix VI.




                      Benjamin F. Nelson, Director
                      International Relations and Trade Issues




                      Page 32          GAO/NSIAD-99-185 NATO: European Integration and Defense Spending
Page 33   GAO/NSIAD-99-185 NATO: European Integration and Defense Spending
Contents



Letter                                                                                           1


Appendix I                                                                                      38
Composition of
Defense Spending in
Selected European
Countries

Appendix II                                                                                     44
Possible Effects of
European Economic
and Monetary Union on
National Economic
Growth

Appendix III                                                                                    46
Topics of Negotiation
for EU Accession

Appendix IV                                                                                     48
Objectives, Scope, and
Methodology

Appendix V                                                                                      51
Comments From the
Department of Defense




                         Page 34   GAO/NSIAD-99-185 NATO: European Integration and Defense Spending
                   Contents




Appendix VI                                                                                    52
GAO Contacts and
Staff
Acknowledgements

Tables             Table 1: Sources of Deficit Reductions in Four West European
                     Countries as a Percent of GDP, 1990-97                                    16
                   Table 2: General Government Deficit for Four West European
                     Countries, Selected Years, as a Percent of GDP                            17
                   Table II.1: Ways in Which EMU Could Benefit Economic Growth                 44
                   Table II.2: Ways in Which EMU Could Hurt Economic Growth                    45


Figures            Figure 1: European Members of NATO, the EU, and the Euro Area,
                     and First Wave EU Applicant Countries                                      5
                   Figure 2: Historical and Projected Defense Spending in Four West
                     European Countries, 1980-2002                                              7
                   Figure 3: Historical and Projected Defense Spending as Percent of
                     GDP for Four West European Countries and the United States,
                     1980-2002                                                                  8
                   Figure 4: Historical and Projected Defense Spending in Three Central
                     European Countries, 1994-2003                                             10
                   Figure 5: New NATO Members’ Defense Spending as a Percentage of
                     GDP, 1994-2003                                                            11
                   Figure 6: Annual General Government Deficits for Four West
                     European Countries as Percent of GDP, 1990-98                             15
                   Figure 7: Planned EU Spending for Current and Applicant Members,
                     2000-2006                                                                 25
                   Figure 8: Share of Population Over 65 in Four West European
                     Countries and the United States, 1960-2030                                29
                   Figure 9: Pension Expenditures as Percent of GDP in Four West
                     European Countries and the United States, 1995-2050                       30
                   Figure I.1: Trends in Composition of Defense Spending in Three West
                     European Countries, 1980-2002, 2003                                       39
                   Figure I.2: Trends in Composition of Defense Spending in Three
                     Central European Countries, 1996-2003                                     42




                   Page 35        GAO/NSIAD-99-185 NATO: European Integration and Defense Spending
Contents




Abbreviations

DOD        Department of Defense
EMU        Economic and Monetary Union
ECB        European Central Bank
EU         European Union
GDP        gross domestic product
GNP        gross national product
IMF        International Monetary Fund
NATO       North Atlantic Treaty Organization
OECD       Organization for Economic Cooperation and Development



Page 36         GAO/NSIAD-99-185 NATO: European Integration and Defense Spending
Page 37   GAO/NSIAD-99-185 NATO: European Integration and Defense Spending
Appendix I

Composition of Defense Spending in Selected
European Countries                                                                                Appenx
                                                                                                       Idi




                 The defense budget challenges of the West and Central European countries
                 we studied arise in part from large personnel costs, large procurement
                 projects, and deployments. Officials have identified the need to prioritize
                 defense requirements as key to effectively addressing new security
                 challenges.



Western Europe   Personnel expenses for the countries we studied in Western Europe
                 generally constitute a large portion of their defense budgets—60 to 70
                 percent in some cases—and have affected the ability of these countries to
                 appropriate additional funding for defense modernization. In Germany and
                 Italy, in particular, personnel expenses, as a share of overall expenses, have
                 been rising in the Cold War and post-Cold War periods, as shown in figure
                 I.1. While these countries expect personnel expenses to fall in the future,
                 this may be complicated by sensitive political and social issues associated
                 with the elimination of conscription and the reduction in personnel
                 strength. In the United Kingdom, with its all-volunteer force, personnel
                 expenses have decreased relative to other expenses since the end of the
                 Cold War.




                 Page 38         GAO/NSIAD-99-185 NATO: European Integration and Defense Spending
               Appendix I
               Composition of Defense Spending in Selected
               European Countries




               Figure I.1: Trends in Composition of Defense Spending in Three West European
               Countries, 1980-2002, 2003
                                   United Kingdom                                                                     Germany
                                                                                        100%
                100%
                                                                                        80%
                 80%

                                                                                        60%
                 60%

                                                                                        40%
                 40%

                                                                                        20%
                 20%


                  0%                                                                     0%




                                                                                                                              1995

                                                                                                                                     1998

                                                                                                                                            2000

                                                                                                                                                   2002
                                                                                                1980-84

                                                                                                          1985-89

                                                                                                                    1990-94
                                                           1995

                                                                   1998
                         1980-84

                                      1985-89

                                                 1990-94




                                                 Italy

               100%


                80%


                60%


                40%

                                                                                               Other
                20%
                                                                                               Equipment

                 0%                                                                            Personnel
                                                                                 2002
                                                            1995

                                                                   1998

                                                                          2000
                       1980-84

                                    1985-89

                                                1990-94




               Note 1: Comparable data for France are not available. Breakout of future defense spending for the
               United Kingdom is not available.
               Note 2: “Other” primarily includes spending for operations, maintenance, and infrastructure.
               Sources: GAO analysis of data from North Atlantic Treaty Organization (NATO) and national ministries
               of Defense.




Conscription   Compulsory military service, known as conscription, has been a
               fundamental element of defense planning for France, Germany, and Italy
               since the end of World War II. It has both integrated the professional core
               of the military into society and, in some cases, provided a source of
               employment for youth. While conscription may have been effective during



               Page 39                                      GAO/NSIAD-99-185 NATO: European Integration and Defense Spending
                       Appendix I
                       Composition of Defense Spending in Selected
                       European Countries




                       the Cold War for staffing large territorial armies, the restrictions attached
                       to it pose problems for post-Cold War security conflicts, according to
                       officials with whom we met. For example, conscripts in Italy cannot be
                       deployed to an overseas conflict or crisis except on a volunteer basis.
                       When they do volunteer, it can be a costly deployment for the country
                       because Italy’s laws require that the volunteers be paid at a higher rate
                       when on an overseas deployment.

                       France, Germany, and Italy acknowledge the lack of flexibility inherent in
                       conscription, as well as the expense of maintaining large numbers of these
                       forces, and are in various stages of making or considering changes. A shift
                       to a professional, volunteer force can initially result in higher personnel
                       costs, although costs can be lower over time as the size of the force is
                       decreased, according to U.S. and foreign officials. In addition, ending
                       conscription can exacerbate countries’ unemployment and associated
                       problems, according to military personnel specialists. In 1996, the French
                       government presented a plan for downsizing and professionalizing the
                       French military, including a massive reduction of conscripts within the
                       French armed forces, to be accomplished by 2002. Italy has also begun to
                       professionalize its military forces but is proceeding at a slower pace than
                       France. The Italian government believes a gradual transition is necessary
                       because Italy has never had a professional military, and also because
                       conscription forces have provided volunteer labor that is relied on by both
                       the military and the outside community. As a result of this gradual
                       transition, however, personnel costs, as a percent of total defense
                       spending, increased from 67 percent to nearly 73 percent between 1995 and
                       1998 to accommodate professionalization and maintain conscription. In
                       May 1999, Germany launched the first comprehensive study of the
                       structure of its armed forces in almost 30 years. This review, which will
                       look out to the 2010 time frame, will include an examination of
                       conscription policies.


Procurement of Large   The expense of developing and procuring large military systems
Systems                significantly limits flexibility in defense budgets in many European
                       countries, according to U.S. and European officials. While participation in
                       such projects can serve national interests, through increasing employment,
                       enhancing technology, and boosting international prestige, it can also limit
                       the ability of countries to buy other needed systems and equipment for
                       modernization programs. The prime example of this is the EF-2000
                       “Eurofighter.” Of the countries we reviewed, three are participating in this
                       project--Germany, Italy, and the United Kingdom. Our analysis shows that



                       Page 40            GAO/NSIAD-99-185 NATO: European Integration and Defense Spending
                 Appendix I
                 Composition of Defense Spending in Selected
                 European Countries




                 Eurofighter procurement is accounting for a growing portion of the
                 procurement budgets in each of these three countries. Germany, for
                 example, is procuring 180 Eurofighters, which represents approximately
                 28 percent of the costs of its major combat equipment purchases in 1999.
                 This is an increase from 24 percent in 1998. According to U.S. embassy
                 officials in Bonn, Eurofighter procurement, in combination with current
                 overseas deployments, has had a depressing effect on the funding available
                 for other defense programs. They stated that many German defense
                 procurement programs have been delayed or are awaiting a decision
                 whether or not to go forward, as a result of funding uncertainty.

                 The Eurofighter is also important to the Italian government because it
                 supports Italian industry and jobs and provides international prestige. To
                 fund such a large program, the Italian government is relying in part on
                 financing sources outside the defense budget, such as the Ministry of Trade
                 and Industry. Because of this funding arrangement, assessing the
                 Eurofighter’s impact on other defense programs is difficult. However,
                 military analysts both inside and outside of Italy have expressed concerns
                 regarding Italy’s ability to fund the Eurofighter as well as other needed
                 systems and equipment, particularly given costly military deployments
                 such as Kosovo and expenses involved in moving to a professional military
                 force.

                 The United Kingdom is procuring 232 Eurofighter aircraft--the largest
                 number among participating countries. U.S. embassy officials in London
                 stated that expensive procurement programs such as the Eurofighter must
                 necessarily affect other programs, particularly when the defense budget is
                 not growing. Moreover, recent U.K. government reports indicate high cost
                 overruns from large weapon system purchases, with the Eurofighter
                 accounting for nearly half of the total cost overruns.



Central Europe   Personnel costs also constitute a large portion of the defense budgets for
                 Poland, Hungary, and the Czech Republic—between 49 and 61 percent in
                 1998. Operational and personnel costs combined equal nearly 80 to
                 90 percent of the defense budgets, leaving 10 percent or less for major
                 equipment. According to U.S. embassy and European government officials,
                 a major challenge for these nations has been reducing the large, top-heavy,
                 military personnel structures—a holdover from their membership in the
                 Warsaw Pact. Conscription is a political and economic issue for these
                 Central European countries, as it is in the West, and affects these countries’
                 ability to reduce their military force numbers. Projections indicate that



                 Page 41            GAO/NSIAD-99-185 NATO: European Integration and Defense Spending
Appendix I
Composition of Defense Spending in Selected
European Countries




personnel expenses, as a share of overall expenses, will decline slightly in
the next 5 years but will still remain a large percent of the overall defense
budget (figure I.2 shows the composition of defense spending in the Czech
Republic, Hungary, and Poland).



Figure I.2: Trends in Composition of Defense Spending in Three Central European
Countries, 1996-2003
                      Poland                                              Hungary

 100%                                       10 0 %



   80%                                       80 %



   60%                                       60 %



   40%                                       40 %



                                             20 %
   20%


    0%                                        0%
          1996    1998      2000    2003              199 6      19 9 8    200 0    20 0 3



            Czech Republic

10 0 %



 80 %



 60 %



 40 %



 20 %
                                                     Other
                                                     Equipment
  0%
         1996    19 9 8    2000    20 0 3            Personnel


Note: “Other” primarily includes spending for operations, maintenance, and infrastructure.
Sources: GAO analysis of data from NATO and national ministries of Defense.


Achieving defense reform and modernization goals depends on the ability
of these countries to balance competing elements of defense spending.
Undertaking certain high-cost modernization programs could prevent these
Central European nations from meeting their NATO force goal
commitments if the purchases are not carefully planned and budgeted,




Page 42                   GAO/NSIAD-99-185 NATO: European Integration and Defense Spending
                       Appendix I
                       Composition of Defense Spending in Selected
                       European Countries




                       according to U.S. Department of Defense (DOD) officials. In recognition of
                       its budgetary limitations, Hungary has deferred purchase of new fighter
                       aircraft until after 2001 and will continue to use MIG-Soviet-built aircraft.
                       The Czech Republic has also deferred purchasing new fighter aircraft but is
                       proceeding with the procurement of subsonic multirole jets (the Aero
                       Vodochody L-159). Poland has decided to move ahead now with new
                       multirole fighter aircraft but has not decided whether to lease or buy the
                       new systems. U.S. government officials stated that these aircraft purchases
                       are feasible for Poland if the country meets GDP-growth projections of at
                       least 4.2 percent and spends defense budget increases` primarily on
                       procurement.



Funding Requirements   In our discussions with U.S. and foreign government officials, nearly all of
                       them identified the increasing number of out of country deployments,
of Peace Support       particularly in the Balkans, as a growing drain on their defense resources.
Operations             Combined with large aircraft purchases and high personnel costs, these
                       operations are affecting the ability of the NATO countries we studied to
                       carry out restructuring and modernization, according to these officials.
                       The expense of the current operation in Kosovo is requiring some
                       European countries to draw on other government funds or, in the case of
                       Germany, appropriate supplemental funds for defense. Defense officials
                       from France and the United Kingdom told us that requests for additional
                       funding from their treasuries may be made later this year. Funding the
                       Kosovo operation has been particularly difficult for the new NATO
                       members because of their ongoing defense and economic reforms,
                       according to U.S. government officials. The Czech Republic, for example,
                       plans to increase its budget deficit in order to fund humanitarian aid. In
                       Poland, contributions are being funded from budget “reserves,” as a
                       spending contingency fund was quickly exhausted. According to U.S.
                       embassy officials, the Polish Defense Minister has frequently complained
                       to the press that the overall budget reserve for emergencies will also be
                       quickly depleted.




            Lte
              rt       Page 43            GAO/NSIAD-99-185 NATO: European Integration and Defense Spending
Appendix II

Possible Effects of European Economic and
Monetary Union on National Economic
Growth                                                                                       Appe
                                                                                                nIx
                                                                                                  Idi




              European Economic and Monetary Union (EMU), particularly the adoption
              of a common currency, can affect economic growth in participating
              countries through several mechanisms. Overall growth effects depend
              both on how these mechanisms individually affect growth, and on how they
              interact. Both are subject to considerable uncertainty. Table II.1
              summarizes the ways EMU could benefit economic growth. Table II.2
              summarizes the ways EMU could harm economic growth.



              Table II.1: Ways in Which EMU Could Benefit Economic Growth

               • Governments will be forced to undertake structural reforms,
                 especially in improving the flexibility of labor markets. This will
                 allow economies to adjust more easily to economic downturns, and
                 therefore benefit long-term growth.
               • Maintaining low budget deficits, which EMU requires, helps establish
                 the foundations for stronger economic growth by limiting the
                 government sector’s absorption of national savings.
               • Exchange rate variability among euro area countries is eliminated.
                 Consumers and businesses will no longer incur currency conversion
                 costs, and the macro economy will be spared the impacts of large
                 fluctuations in currency values that harmed European economies in
                 the early 1990s.
               • The European Central Bank is required to keep prices stable, which
                 should contribute to lower interest rates.
               • A common currency allows consumers to easily compare prices
                 across borders, spurring economic competition and eventually
                 boosting efficiency and productivity.




              Page 44         GAO/NSIAD-99-185 NATO: European Integration and Defense Spending
Appendix II
Possible Effects of European Economic and
Monetary Union on National Economic
Growth




Table II.2: Ways in Which EMU Could Hurt Economic Growth

 • Common economic policies, particularly monetary policies, may not
   be well-suited to the needs of various countries that are at different
   stages of the business cycle. For example, a single interest rate set by
   the European Central Bank for 11 different economies could possibly
   lead to stagnation in some countries and overheating in others.
 • National leaders will no longer be able to use monetary or exchange
   rate policy to cope with economic downturns. Without these tools,
   some countries may suffer additional pain from economic shocks that
   do relatively little harm to the rest of the euro area.
 • The limitations on government spending will constrain national
   efforts to increase social spending during times of recession.
 • Countries may be unwilling to continue to comply with EMU’s
   requirements or adopt politically difficult structural reforms,
   especially in the labor market. A series of national decisions at
   cross-purposes could place tremendous strain on the ability of EMU
   to hold together politically.




Page 45           GAO/NSIAD-99-185 NATO: European Integration and Defense Spending
Appendix III

Topics of Negotiation for EU Accession                                                                                                         AppeInx
                                                                                                                                                     Idi




                                               Table III.1 presents the 31 chapters of the acquis communautaire, or the
                                               European Union’s body of laws, for the EU’s negotiations with EU
                                               applicant countries regarding those countries’ adoption of the acquis. Also
                                               shown are examples of topics included in each chapter.


Chapter                                             Examples
1. Free movement of goods                          Export procedures; elimination of trade barriers.
2. Freedom of movement of people                   Right of residence for employees, self-employed persons, and students.
3. Freedom to provide services                     Service activities including insurance, banking, and stock exchanges.
4. Free movement of capital                        Relations between financial institutions and consumers.
5. Company law                                     Formation, mergers, and division of public limited liability companies.
6. Competition policy                              Competition principles; intra-EU dumping practices: and national trading monopolies.
7. Agriculture                                     Processing and marketing of agricultural products; agricultural research; and setting of
                                                   compensatory amounts.
8. Fisheries                                       Catch quotas and management of stock; agreements with nonmember countries.
9. Transport policy                                Ground transport safety conditions; shipping vessel registration; and air route
                                                   distribution.
10. Taxation                                       Income and corporate taxes; excise duties; and prevention of tax evasion and tax
                                                   avoidance.
11. Economic and monetary union                    Limitations on government deficits; harmonized indexes of consumer prices; and
                                                   provisions for the introduction of the euro.
12. Statistics                                     Collection of statistical information on tourism; statistics on distribution of earnings.
13. Social policy and employment                   Working conditions; wages; and employment incentives.
14. Energy                                         Coal rates; nuclear energy safeguards; and oil and gas supplies and stocks.
15. Industrial policy                              Research and technological development; competitive pricing and other sale
                                                   conditions.
16. Small- and medium-sized enterprises            Interest subsidies for loans; taxation; and technological innovation.
17. Science and research                           General principles and research sectors.
18. Education and training                         Mutual recognition of diplomas, certificates, and other evidence of formal
                                                   qualifications.
19. Telecommunications and information             Policy on data processing; directive on competition in the markets for
     technologies                                  telecommunications services.
20. Culture and audiovisual policy                 Resolution on electronic publishing and libraries.
21. Regional policy and coordination of structural Monitoring and coordination of regional state aid; aid for stricken regions; and
    instruments                                    community loans.
22. Environment                                    Nuclear safety and radioactive waste; water protection and management; monitoring
                                                   of atmospheric pollution; prevention of noise pollution; and chemicals, industrial risk,
                                                   and biotechnology.
23. Consumers and health protection                Consumer information; protection of economic interests; and protection of animals.
24. Cooperation in the fields of justice and home EU extradition procedures; cooperation to combat international organized crime.
    affairs
25. Customs union                                  Tariff types, quotas, and ceilings.
                                                                                                                                     (continued)



                                               Page 46               GAO/NSIAD-99-185 NATO Defense Spending and European Integration
                                         Appendix III
                                         Topics of Negotiation for EU Accession




Chapter                                      Examples
26. External relations                      European political cooperation; multilateral relations; and commercial policy.
27. Common foreign and security policy      Regulation on the reduction of economic relations with the Federal Republic of
                                            Yugoslavia.
28. Financial control                       Decision conferring powers to carry out measures of control regarding EU revenue
                                            and expenditure.
29. Financial and budgetary provisions      Impact on the EU budget of the accession. Arrangements for the collection of own
                                            resources.
30. Institutions                            Principles, objectives, and tasks of treaties.
31. Othera                                  None identified as of June 1, 1999.
                                         a
                                           The EU set aside chapter 31 to cover any major issues that arise during negotiations that were not
                                         covered in the preceding chapters.
                                         Source: European Commission.




                                         Page 47                GAO/NSIAD-99-185 NATO Defense Spending and European Integration
Appendix IV

Objectives, Scope, and Methodology                                                           Appenx
                                                                                                  IV
                                                                                                   di




              The Chairman and the Ranking Minority Member of the Subcommittee on
              Defense, Senate Committee on Appropriations, asked us to assess how the
              implementation of European EMU and the enlargement of the EU may
              affect our European allies’ ability to sustain or increase their defense
              budgets. To address this issue, we collected and analyzed information on
              (1) projected defense spending for several European countries, (2)
              budgetary effects of EMU implementation and EU enlargement, and (3)
              other significant factors that may affect countries’ ability to share in the
              costs of NATO over the long run.

              Our work focused on seven European countries: the four members of
              NATO with the largest defense budgets in Europe (Germany, France, Italy,
              and the United Kingdom) and the three newest members of NATO (Poland,
              Hungary, and the Czech Republic). We chose these countries because
              (1) collectively they accounted for over 75 percent of the total gross
              domestic product (GDP) and defense spending by all European NATO
              members and (2) because they included all three newest members of
              NATO. We visited all of these countries except France, which is not part of
              NATO’s integrated military command. We also contacted officials at DOD,
              State, and Treasury. We also obtained access to the World Bank and
              International Monetary Fund (IMF) officials and analytical studies through
              the staffs of the U.S. members of their Boards of Executive Directors. The
              European governments in our study provided us access to reports and staff
              from a variety of ministries.

              To determine levels and composition of defense spending in Europe, we
              interviewed and obtained data from officials in the U.S. government, NATO,
              EU applicant countries, current EU member countries, and academic and
              private sector institutions. During our visits to NATO countries, we
              discussed planned defense spending trends with officials from the
              ministries of defense, finance, and treasury; parliaments; national audit
              offices; U.S. embassies; and defense research institutes such as the
              International Institute for Strategic Studies in London, the Center for the
              Study of International Politics in Rome, and the Government Center for
              Strategic Studies in Warsaw. We also collected defense budget data and
              interviewed officials from the Central Intelligence Agency, the Defense
              Intelligence Agency, the National Defense University, and the Council on
              Foreign Relations. To determine past and present defense spending trends
              (1980-98) for the figures used in the report, we relied exclusively on NATO
              data and its definition of “defense expenditure.” NATO defense budget
              forecasts for NATO member countries are classified. To present
              unclassified information on future defense spending levels, we obtained



              Page 48         GAO/NSIAD-99-185 NATO: European Integration and Defense Spending
Appendix IV
Objectives, Scope, and Methodology




defense budget projections from the host countries, calculated yearly
growth rates, and applied these growth rates to NATO’s 1998 spending level
for each country. Similarly, for the composition of defense budgets and the
breakout of these budgets into “personnel,” “equipment,” and “other,” we
relied on NATO data for 1980-98. For future trends, we relied on budget
projections from the countries. We applied growth rates for each of these
categories, derived from the countries’ budgets, to NATO’s 1998 breakouts.
We discussed our methodology with DOD officials, and they concurred
with the logic of our approach.

To assess the consequences of EMU on defense spending, we collected and
analyzed information on EMU’s effects on national budgets and economic
growth from the U.S. Department of the Treasury, the Department of State,
and the Department of Defense; the EU; the European Central Bank; EMU
member countries; the World Bank; the IMF; and academic and private
sector organizations. We met with officials from Germany and Italy to
discuss how meeting EMU membership criteria has affected their national
budgets. Within these countries, we obtained information and met with
officials from the Central banks, the finance ministries, U.S. embassy staff,
and academic institutions.

To examine the consequences of prospective EU enlargement on defense
spending, we assessed how enlargement could affect national budgets and
economic growth. We collected and analyzed information and interviewed
officials from the U.S. government, the EU, applicant governments, current
EU member governments, multilateral institutions, and academic
institutions. We discussed the objectives and total costs of EU enlargement
with officials at the Department of State, the World Bank, and the EU’s
Council, Commission, and Parliament. To identify the potential impact of
meeting EU membership criteria on the respective national budgets of
current and applicant members, we interviewed officials and obtained
information from ministries of finance and foreign affairs. In the applicant
countries, we also met with officials from the national parliaments, EU
integration offices, U.S. embassies, and local academic institutions.

To identify primary nondefense domestic budgetary trends and pressures,
we met with officials from the U.S. government, current EU member
countries, applicant member countries, multilateral organizations, and
academic and private sector organizations. We obtained data and
analytical studies and interviewed officials from the Organization for
Economic Cooperation and Development, the World Bank, the IMF, and
economic institutes, including PlanEcon. In the countries we visited, we



Page 49           GAO/NSIAD-99-185 NATO: European Integration and Defense Spending
Appendix IV
Objectives, Scope, and Methodology




discussed the major areas of the domestic budget with officials from the
Central banks and the ministries of finance, industry and trade, and labor
and social affairs; U.S. embassies; and local academic institutions.

The information in this report concerning foreign laws and regulations
does not reflect our independent legal analysis, but is based on interviews
and secondary sources.

We performed our review from April 1998 to June 1999 in accordance with
generally accepted government auditing standards.




Page 50           GAO/NSIAD-99-185 NATO: European Integration and Defense Spending
Appendix V

Comments From the Department of Defense                                               Appe
                                                                                         nx
                                                                                          Vdi




             Page 51   GAO/NSIAD-99-185 NATO: European Integration and Defense Spending
Appendix VI

GAO Contacts and Staff Acknowledgements                                                                Appenx
                                                                                                            V
                                                                                                            diI




GAO Contacts         Harold J. Johnson, (202) 512-4128
                     Celia Thomas, (202) 512-8987



Acknowledgements     In addition to those named above, Dave Maurer, Elizabeth Guran, Arturo
                     Holguin, Christian Hougen, Bruce Kutnick, and Jane Li made significant
                     contributions to this report.




(711325)      Lte
                rt   Page 52         GAO/NSIAD-99-185 NATO Defense Spending and European Integration
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