The US Inflation Reduction Act’s potential, and polarising impacts

Key takeaways

• The US Inflation Reduction Act, a USD 391 billion package of subsidies and tax credits, is aimed at driving the country’s transition to clean energy and its infrastructure
• The Act is expected to create a ‘multiplier impact’ from private investment, depending on monetary conditions
• It has attracted concerns from the EU and some Asian trade partners on the impact of industrial subsidies on international competition
• Firms active in the electric vehicle sector, railways, wind and solar energy, battery storage, carbon capture, hydrogen, and public services including water, should all benefit.

The US Inflation Reduction Act (IRA) is less about taming inflation and more a package of industrial subsidies and tax cuts. The five-year programme creates incentives to boost US growth and offer its industry a competitive advantage as it transitions to cleaner technologies. It may accelerate the green energy revolution, creating new winners and legacy losers globally that investors must monitor.

The package, signed into law in August 2022 and worth USD 391 billion in tax credits and subsidies for energy and climate-related spending plus another USD 108 billion for healthcare, is designed to provoke the US economy into clean energy leadership and secure reforms in healthcare insurance and drug pricing.

The Act includes both spending on green infrastructure and cost efficiency measures in the government’s budget to ensure that the overall impact is a net surplus over 10 years. Most of the attention it has received focusses on incentives to move the US economy towards the green transition that in turn will help to drive the wider global revolution in sustainability. Support depends on firms engaging in production and investment activities in the US that allow them to earn tax credits, and consumers buying American-made electric vehicles. It includes a tax on methane emissions by the oil and gas industries. After the CHIPS and Science Act, and the Bipartisan Infrastructure Law (BIL), which spends on electric grid modernisation, electric vehicle charging stations and infrastructure resilience, the IRA adds an annual pipeline spending worth up to USD 40 billion to the country’s green investment over the next decade.

The Act started out as a USD 3.5 trillion ‘Build Back Better’ package, but got no backing from Republicans in Congress. One element, ten-year tax corporate credits, has met with business support that makes them unlikely to be politically challenged, especially if they boost investments in areas important for Republicans. In its final form, the IRA still offers substantial support, including a USD 15 billion programme targeting electric vehicles, designed to improve the country’s charging infrastructure and offer consumers a USD 7,500 tax credit to buy new electric cars, subject to income and retail price caps. It also aims to reinvigorate the US’s ageing infrastructure, as well as reboot the country’s declining regions that were historically reliant on heavy industries such as mining and manufacturing.

While the CHIPS and Science Act directs funding to climate-related research and the BIL caps the amount to be invested in green infrastructure, the IRA offers uncapped tax credits for domestic clean energy production and investment. The macroeconomic multiplier effect from government spending or revenue is still being debated among economists, especially if aggressive monetary policy tightening offsets the positive impact of fiscal policy. Industry analysts are hoping for a much higher multiplier effect than usual as they believe that public funding of R&D will have a significant “crowding-in” impact on private capital looking for long-term investment opportunities.

Global side effects

There have been polarised responses to the US plan. On the one hand, a shift in policy that moves the world’s largest economy closer to meeting its climate change targets is welcome. Some have argued that the Act is not a “zero-sum” game in favour of the US economy to the detriment of its allies and competitors. Its incentives, the IRA’s defenders say, will push a global decline in greenhouse gas emissions and encourage cleaner sources of energy by cutting the costs of both technologies and their installations.

There are, nevertheless, potential side effects. The US’s unapologetic incentives to American production and to foreign businesses installed in the US may trigger a race, among those who can afford them, to provide industrial subsidies. In theory, a climate strategy that is centred on unilateral subsidies and tax credits may be less effective than a simpler – if politically difficult – global carbon price.

The underlying approach of the IRA has already created tensions with the European Commission and some Asian trading partners; any response at the national level from, say, Germany or France to support carmakers, railways or pharmaceutical industries, would fall foul of anti-competition regulations. Europe is already debating how to respond to the IRA due to competitiveness concerns for its own climate-related industries. There are reports that Germany plans to propose Europe’s own version of the IRA that would purchase renewable output under state guarantees and replicate the US’s tax credits as offered to the solar and wind sectors. The EU’s existing 2020 ‘Next Generation EU’ fiscal stimulus programmes, the region’s pandemic response package that includes green initiatives, are worth EUR 807 billion in loans and grants, funded through debt issued by the European Commission. On 1 February, the EC announced its “Green Deal Industrial Plan”, which includes proposals for a simplified regulatory environment, easier funding, enhancing skills and open trade to bolster supply chains. The Commission is expected to finalise the plan before the next EU summit on 24-25 March.

Another consequence may be to push the world further from the globalisation of manufacturing and supply chains, and away from the multilateral competition and subsidy rules developed to prevent national protectionism. It is also likely to intensify the post-pandemic trend toward ‘friend-shoring,’ or diverting production facilities and infrastructure investment away from economies such as China. Interestingly, the IRA does not ban the sourcing of electric vehicle battery materials from countries that are friendly to the US, so enshrining the trend to friend-shoring.