The Political Economy And Worldwide Implications Of The Inflation Reduction Act In The US

By Simon Wren-Lewis, February 28, 2023

In May last year I wrote about a new book by Eric Lonergan and Corinne Sawers called Supercharge Me. The book argued, in essence, that economists should stop thinking about carbon taxes as the way to tackle climate change, what we could call the big stick, and instead think about carrots in the form of subsidies and public investment designed to get green industries to a scale where their rapid growth would be inevitable.

The Inflation Reduction Act (IRA) is essentially a climate bill passed in the US that does exactly that. It is full of carrots, sometimes open ended carrots, designed to promote greener industries, financed not with carbon taxes but higher corporate taxes and lower drug prices for medicare. As I largely agreed with the central idea behind Supercharge Me, I thought it would be interesting to see how that strategy had proved successful in one of the most difficult countries to convince to go green.

The IRA started as Build Back Better, which was a massive programme of infrastructure spending with a large green component and welfare spending. Some of that was diverted into the Infrastructure Investment and Jobs Act, which was passed into law in November 2021, but the climate part became stuck because one Democratic Senator, Joe Manchin from the Coal and Gas state of West Virginia, refused to support it. (The Republican party was of course united in opposition.)

It looked as if once again the US Congress would block effective green action in the US. But then, to the surprise of many and with a name change the IRA was passed in August 2022. So why did Manchin change his mind, and what was lost as a result? What follows leans very heavily on this excellent talk and discussion, so if you want to know more than I can write here have a look.

A key idea from Supercharge Me is to use the story of solar power as a model for how to green large parts (not all) of the economy. Solar power started off as a relatively expensive form of energy that also required large capital costs to install. However, partly as a result of what the book calls Extreme Positive Incentives, costs came down, more solar power was installed which allowed costs to come down even further, until now solar is one of the cheapest forms of energy.

Electric Vehicles (EVs) are another example of where strong incentives or regulations could produce similar effects. In the UK at the moment not many people buy EVs because they cost more to buy and the charging network is far from ideal. However if the government provides incentives for people to buy EVs their costs will fall, and if they ensure the charging network is substantially improved more people will want to buy them. The IRA includes incentives to buy EVs (which are already working), heat pumps and a lot more besides.

So what made Senator Manchin decide to finally support this bill? The answer is complex, and there are certainly some changes in the bill that he insisted on which are far from progressive. One example is that green incentives no longer require union labour. No one is suggesting the IRA is everything those supporting a Green New Deal would want. But something is better than nothing, so it is interesting to see why Manchin changed his mind, and why Big Oil did not fight against the IRA.

One answer is the invasion of Ukraine. As I have already noted, green energy is now cheap energy, and that is intensified when the price of carbon based energy suddenly shoots up. That is one reason for the change of name to IRA. But perhaps more importantly, with US energy producers getting huge profits and exporting large amounts of gas to Europe, green energy seemed less of an existential threat to Big Oil. Republicans pleaded with oil companies to fight the IRA, and they refused.

There are some signs that the IRA may also be robust enough to survive a Republican Congress. There is a new ‘battery belt’ in the US in a similar position to the old bible belt: southern red states which will be reluctant to give up the subsidies the IRA has created.

The other factor that helped get the IRA passed in the Senate was China. Once you see Green Energy as at least part of the future, then most politicians will want their own country to be part of that. As with IT, there was a common concern that China was becoming too successful in providing key parts of the green revolution, and so the IRA is actually a very protectionist measure. Trump’s Make America Great Again has become an insistence that green goods should be Made in America. Again this aspect of the IRA may be far from ideal, but the link between greening the US and protection is not one I would have guessed beforehand. It has also created difficulties for the EU in how to respond.

Hopefully the Ukraine war will also accelerate the global move towards renewable energy. For any significant movement in the UK we will have to wait for a Labour government, which has pledged a substantial programme of green investment, including a publicly owned renewable energy company. The main threat to this happening on the scale required to avoid harmful global warming, both in the UK and elsewhere, is an obsession with the government’s deficit and public debt.

The IRA is fully financed by higher taxes, and that was the only political option Biden had. But whether we are talking about conventional public investment, or incentives to encourage private investment in green energy, using borrowing rather than taxes makes a lot more sense from an economic and political point of view. This is, after all, temporary government spending to spur investment with future benefits, so its costs should be spread over generations. There are strong economic arguments for higher carbon taxes because the polluter should pay, but the political constraints on achieving this seem high. In the UK at least there is a strong argument that permanent revenue from higher taxes should be used to fund permanent increases in current public spending to allow our public sector to recover from 15 years of Conservative governance.

So how do we avoid deficit targets slowing down the transition to a green economy? Once again I need to stress that in an ideal world this would not be a problem. I have argued many times that targets for the total deficit or for falling debt to GDP make no sense, because public investment should not be constrained by fiscal rules. If public investment yields a good social return then it should happen, whatever the implications are for public debt. But unfortunately we are not in that ideal world, and so we need to start thinking about more imaginative ways to get around the obsession with public debt.

One of these has recently been proposed in an interesting article by Peter Bofinger. He makes the case for funding public missions through increases in public debt, which is a kind of ‘project based golden rule’. (This idea of missions for government has recently been championed by Mariana Mazzucato, but it goes back further than this.) In the UK context this would allow the debt to GDP ratio to increase only to the extent that it represented spending to undertake a mission, in this case to green the economy. This generalises an idea I put forward in my post on Supercharge Me, which was to create a ‘green account’ that was outside normal fiscal rules. As I noted there, it would also require monitoring by the OBR to ensure mission spending was clearly defined.

As the IRA illustrates, the obstacles to fighting climate change can with compromise and imagination be overcome. It is a mistake to prevent such compromise when the ideal is not politically possible. Providing incentives for greener energy is politically easier than making the polluter pay. While in an ideal world fiscal rules would not get in the way of such incentives, we live in a world that is obsessed by public debt. This too requires imagination and compromise to ensure this obsession does not get in the way of tackling climate change.