EU’s New Fiscal Rules: Balancing Budgets with Green and Digital Ambitions

The recently enacted EU fiscal framework aims for fiscal prudence but poses challenges for funding the green and digital transition.

9th July 2025

The European Union’s revamped fiscal rules, which took effect on 30 April 2024, mark a significant shift in how member states manage their public finances. This comprehensive reform, the most substantial since the post-financial crisis tightening, seeks to rein in national deficits and debt. However, this renewed emphasis on fiscal consolidation raises crucial questions about the future of public spending, particularly concerning the ambitious green and digital transitions the EU is championing.

While a recent decision to exempt additional defence spending will lead to a more expansionary overall fiscal policy stance, this deficit-financed military expenditure is projected to increase the proportion of government interest payments relative to total tax revenue. Consequently, the anticipated political reluctance towards higher fiscal deficits is likely to exert downward pressure on crucial public investment in the green and digital agendas. This analysis will critically assess the new EU fiscal framework, focusing on its implications for public spending in these vital areas, and discuss potential avenues to enhance fiscal space for the “twin transition” within the constraints of these new regulations.

Key Elements of the New EU Fiscal Rules

The core objective of the new EU fiscal rules is to ensure that member states bring their fiscal deficits below 3 percent of Gross Domestic Product (GDP) and their public-debt-to-GDP ratios below 60 percent of GDP. The revised framework prioritises a medium-term perspective on public finances, shifting away from a purely annual assessment and concentrating on limiting the growth of government expenditures.

Under the new regulations, should a member state breach either the 60 percent debt or 3 percent deficit threshold, the European Commission will propose a “reference trajectory”. This trajectory is designed to guarantee that the public debt ratio follows a “plausibly downward path” by the end of a fiscal adjustment period lasting at least four years. Essentially, the reference trajectory serves as preliminary guidance on the extent of fiscal adjustment each member state must undertake over a multi-year period to ensure the public debt ratio is on a sustainable downward trajectory within 10 years following the adjustment.

Multi-year budget plans, spanning a minimum of four years, will be negotiated between the European Commission and national governments, informed by the reference trajectory and underpinned by a Debt Sustainability Analysis (DSA). The country-specific nature of the fiscal adjustment requirements, based on technical DSA assumptions, represents a significant departure from the previous framework. Safeguard mechanisms will be in place to ensure minimum fiscal adjustment efforts for countries grappling with high deficits and debt levels.

Crucially, member states can commit to a package of investment and reform measures, potentially extending the fiscal adjustment period from 4 to a maximum of 7 years. To qualify for this extension, the package must be growth-enhancing, consistent with debt sustainability, address shared EU priorities (such as the Green Deal, digitalisation, and security), align with country-specific recommendations within the European Semester, and maintain at least the existing national investment level. It is important to note that the reformed framework does not include broad exemptions for public investment at the national level.

The incentives for national governments to submit these investment and reform packages to the European Commission are clear: by doing so, they can lengthen the fiscal adjustment period and reduce the required annual adjustment efforts. These packages should incorporate government spending on shared priorities related to the twin transition. However, member states must convincingly demonstrate that the planned measures are conducive to growth and compatible with maintaining sustainable debt levels. For instance, climate-related spending that is deemed necessary to meet environmental targets but does not demonstrably boost economic growth may not be supported as part of a package aimed at extending the adjustment period. Given the absence of widespread exemptions, if member states wish to increase spending on green and digital initiatives while adhering to the new rules, they will likely need to offset this by reducing expenditure in other areas.

A Critical Assessment of the New Framework

As the EU fiscal framework prioritises the medium-term reduction of public liabilities relative to economic output, it may inadvertently hinder the build-up of public assets through crucial public (infrastructure) investment necessary for the twin transition. An article published by the International Monetary Fund (IMF) suggests that nations with stronger government net worth – calculated by subtracting total public liabilities from total public assets – tend to experience greater economic stability and more robust macroeconomic development. From this perspective, public assets are also vital for ensuring sustainable public finances in the long run. However, the new EU fiscal framework does not explicitly consider government net worth, focusing instead on public liabilities. The green transition, in particular, will necessitate significant investment in replacing and expanding the capital stock over the coming decades.

While the new framework incentivises governments to propose investment and reform plans to the European Commission, the acceptance of such a package does not translate into broad-based exemptions for financing these investments. Instead, it merely extends the fiscal adjustment timeline to a maximum of 7 years, which, while easing annual adjustment pressures, does not fundamentally alter the overall fiscal consolidation requirements.

Maintaining the current level of public investment will likely prove insufficient to achieve ambitious climate targets within the next decade or two. The EU’s overarching goal of achieving climate neutrality by 2050, and thus net-zero greenhouse gas emissions, will demand substantial additional investment in areas such as transport and energy infrastructure, as well as more energy-efficient housing. Worryingly, the multi-year budget plans submitted by EU member states to the European Commission indicate that the nationally financed public investment rate is projected to decline in more than a third of countries. The initial round of plans submitted to the Commission does not adequately reflect the need for increased public investment. Consequently, the Commission’s conclusion that EU countries will maintain or increase investment over the plan horizon appears overstated. Actual reductions in public investment could be even more pronounced as difficult budget choices arise.

The combination of increased defence spending and the pressure for fiscal consolidation on other spending categories from 2025 onwards will likely impede national governments’ ability to sufficiently boost public investment in the twin transition, despite this being essential for meeting climate and digitalisation targets. The following section will explore three potential strategies to expand the fiscal space available for public spending on the twin transition within the constraints of the new EU fiscal rules.

Options to Increase Fiscal Space for the Twin Transition

Given the restrictive nature of the new EU fiscal rules, policymakers must explore innovative solutions to ensure adequate funding for the green and digital transitions. Three potential options warrant consideration:

1) Changing Technical Assumptions in the Substructure of New EU Fiscal Rules

While debt sustainability forms the cornerstone of the new regulatory framework, studies of the European Commission’s Debt Sustainability Analysis reveal that relatively minor adjustments to a few technical assumptions can significantly alter fiscal consolidation requirements. Therefore, modifying the DSA assumptions could lead to a reduction in the DSA-based fiscal adjustment demands.

The European Commission’s current DSA framework does not account for the potential positive economic growth effects stemming from public investment and reforms. A potential way forward could involve revising the technical assumptions to explicitly incorporate the anticipated benefits of increased investment and structural reforms. Higher projected growth rates would result in more favourable simulations of public debt ratio trajectories over time, thereby lessening the need for stringent fiscal adjustments. Importantly, this could be achieved without necessitating further legislative reform, as the relevant technical assumptions are not explicitly regulated by the legislative texts.

2) Increasing National Co-financing of EU Funded Programmes

When assessing member states’ compliance with their fiscal plans under the new framework, the European Commission will exclude national spending on the co-financing of EU-funded programmes from government expenditure calculations. Consequently, an increase in the fiscal deficit resulting from higher-than-planned co-financing of EU programmes will not be considered a breach of the rules’ expenditure ceilings.

In the short term, this may not have a substantial impact, as the majority of national co-financing is linked to spending on EU regional funds. However, in the future, a greater reliance on national co-financing could enable governments to meet fiscal targets more readily and to better align their spending with EU policy objectives, including efforts related to the green and digital transitions. The potential for co-financing will depend on the nature and scope of future EU programmes and the level of national co-financing they require or permit. Therefore, the next Multiannual Financial Framework (MFF, 2028-2034) will be of critical importance in this regard.

The European Commission has proposed making the MFF significantly more flexible, moving away from fixed programmes towards a general budget pool designed to address broadly defined EU objectives. This would allow individual member states to set their own priorities within these overarching EU goals. Consequently, EU funds could be leveraged more easily than before and could also be combined more effectively with the ex-post exemption of national co-financing from EU fiscal rules.

3) Introducing an EU Investment Fund for Climate and Digitalisation

Another option to facilitate a substantial increase in public investment is the establishment of a dedicated investment fund for climate and digitalisation at the EU level. Key features of such a fund could draw upon the experience of the Recovery and Resilience Facility (RRF). The RRF was established during the Covid-19 crisis to support the economic recovery of EU member states while simultaneously promoting investments and reforms aimed at achieving climate and digital objectives. However, the RRF’s current size is insufficient to fully address the investment demands, and its grant component is scheduled to conclude in 2026.

Following the RRF model, the European Commission could issue bonds on behalf of the EU to raise capital in financial markets for a new EU investment fund specifically targeted at fostering the green and digital transition. Investments financed by such a fund could prioritise genuinely European public goods projects in areas such as the transformation of energy and transport systems, as well as digital infrastructure, thereby generating clear EU added value.

For example, investments could be channelled into a European high-speed train network, which would contribute to long-term reductions in carbon dioxide emissions within the transport sector. Furthermore, in the energy and decarbonisation domain, policymakers could support the development of an integrated electricity grid for the transmission of renewable energy and promote complementary battery and green hydrogen projects. In the realm of digital infrastructure, truly EU-wide projects could focus on delivering significant cross-border benefits for multiple member states, aligning with the EU’s overarching digital strategy and promoting EU integration in the digital sphere. Examples include a high-speed, ultra-broadband network connecting all EU regions, an EU-wide 5G network, EU cloud infrastructure, cross-border digital identification systems, or a European digital health infrastructure.

Conclusions

Major fiscal consolidation will be necessary in several large EU countries in the coming years to comply with the reformed EU fiscal rules. However, the temporary exemptions granted for additional defence spending will result in a more expansionary overall fiscal stance across the EU than would otherwise have been the case. There is currently a political emphasis within the EU on industrialisation through re-armament. Nevertheless, the pressure to finance additional defence spending through deficits will eventually increase the proportion of government interest payments relative to total tax revenue, and the anticipated political aversion to higher fiscal deficits is likely to exert downward pressure on public spending dedicated to the green and digital transitions.

To meet ambitious policy goals, policymakers must identify new long-term financing solutions for the green and digital transition. As argued above, options to expand the fiscal space for additional public expenditure in these crucial areas, within the context of the new EU fiscal rules, include:

1) Modifications to key technical assumptions underpinning the new rules, which could lead to an overall reduction in fiscal adjustment requirements.

2) An expansion of national co-financing for EU programmes, as this spending is not counted when assessing compliance with the reformed fiscal rules.

3) The establishment of a permanent EU investment fund for climate and digitalisation to provide funding at the European level, focusing on genuinely European projects that deliver clear EU added value, such as investments in an integrated electricity grid, high-speed rail networks across the EU, an EU-wide 5G network, or a European cloud infrastructure.

Author Profile
Philipp Heimberger

Philipp Heimberger is an economist at the Vienna Institute for International Economic Studies (wiiw) and the Institute for Comprehensive Analysis of the Economy (Johannes Kepler University Linz).

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