The paper says the case for the first major review since 1998 is compelling
Members of the armed forces who risk their lives in war should get a written guarantee of proper care, the Liberal Democrats have said.
The party is calling for the first strategic and security review of UK defence capability in 10 years.
A paper by former Lib Dem leader Sir Menzies Campbell warns the military covenant - between the armed forces and society - could be broken irreparably.
The government said it wanted to give veterans "the best support possible".
His paper, No Choice but Change, argues that the Strategic Defence Review of 1998 did not predict the costs of fighting in Iraq and Afghanistan.
Sir Menzies said: "Our military has been 'running hot' for years; its budget is in crisis and there are huge deficiencies in the quality, quantity and utility of the military equipment available for operations.
"Our armed forces are qualitatively second to none in the world. They do a phenomenal job for our country every day, without challenging the wisdom of their deployment, but there are now tough choices to be made.
"We have come to a point where there is no choice but change. Either our armed forces should do less and differently, or we need increases in the defence budget which will be difficult to justify to taxpayers."
Sir Menzies' paper contains an estimate from the Royal United Services Institute which suggests that the Ministry of Defence's procurement plans for new equipment are now underfunded by up to £15bn over a 10-year period.
He told BBC Radio 4's Today programme the military covenant was at risk, saying: "In a sense they give up the kind of employment rights that people like you and I would regard as being fundamental.
"But when you impose upon them [armed forces] operational strain to the extent that we have seen in recent years, then my view is you are in breach of that covenant, but in addition you are severely damaging your effectiveness."
BBC defence correspondent Caroline Wyatt said the paper was a plea not so much for more money for upgrading military accommodation, or buying more helicopters for Afghanistan, but for an urgent public debate.
According to Sir Menzies, this should focus on the role the UK wants its armed forces to play at home and abroad - and to fund that role properly.
His paper describes the military as "overstretched" and the defence budget as being in crisis, risking real problems in the future in generating, deploying and sustaining Britain's fighting power.
A Ministry of Defence spokesman said: "We recognise that we are currently asking a lot of our armed forces.
"As a government we have a duty to provide them with the best support possible - for them, their families and for our veterans."
He added that the government's Service Personnel Command Paper was "already delivering improvements such as increased boarding school places for the children of service families and better access for state school children to cadet organisations".
The spokesman said the current defence budget would ensure that military capability for current and future operations was "maintained and improved".