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The Inflation Reduction Act: Climate Protection with a Catch

In mid-August 2022, U.S. President Joe Biden signed the Inflation Reduction Act of 2022 (IRA). The act is intended to counter high inflation and promote climate protection in the United States. In the EU, the law has triggered concerns about the future of Europe as an investment location.

After months of wrangling in the United States over the ambitious “Build Back Better Act” legislative package – a core element of the Biden administration’s climate and social policy agenda –, a compromise among Senate Democrats finally ensured that at least some of these ideas could be implemented in the form of the Inflation Reduction Act (IRA).

The IRA is expected to raise an estimated 737 billion U.S. dollars in new budget revenue through a combination of new taxes on businesses, increased tax enforcement and prescription drug pricing reform. At the same time, the law provides about 369 billion U.S. dollars for climate change investments and about 64 billion U.S. dollars for additional spending on mandatory health care (under the Affordable Care Act, dubbed “Obamacare”). The difference between revenues and expenditures is estimated to help reduce the budget deficit by around 300 billion U.S. dollars over the next ten years.

Tax incentives for electric cars

So far, the discussion in Germany and the EU has focused on the new regulations for subsidizing electric vehicles. The IRA modifies previous e-vehicle tax credits and introduces additional ones. New electric vehicles receive a tax credit of up to 7,500 U.S. dollars. The benefits only apply to sedans with a sales price of up to 55,000 U.S. dollars and SUVs/pickups with a sales price of up to 80,000 U.S. dollars.

However, to qualify for these tax benefits (until 2032 initially), e-vehicles must meet the following requirements:

  • Final assembly must take place in North America.
  • Starting in 2023 (i.e., as soon as the U.S. Treasury Department and the Internal Revenue Service, IRS, have issued their guidance), 40 percent of the critical (explored, processed or recycled) battery raw materials used, such as lithium, must come from North America or a country with which the United States has a free trade agreement (FTA). This quota will increase by ten percent each year, from 50 percent in 2024 to 80 percent in 2027. From 2025 onward, the critical minerals will also no longer be allowed to come from Russia, China or any other “foreign entity of concern.” If the critical minerals requirement is met, then a credit of 3,750 U.S. dollars is granted.
  • Starting in 2023 (i.e., as soon as the Treasury and IRS have issued their guidance), 50 percent (based on cost) of an electric car’s battery components must be made in or assembled in North America. This percentage will increase to 100 percent by 2029. Beginning in 2024, they also may not come from Russia, China or any other “foreign entity of concern.” If the battery component requirement is met, then the sale also qualifies for a credit of 3,750 U.S. dollars.

Both parts taken together add up to a maximum credit of 7,500 U.S. dollars. The regulations on battery raw materials and components in particular are intended to make the supply chains less dependent on China.

Entirely new under the IRA is a 4,000 U.S. dollar tax credit for “previously owned clean vehicles” (Internal Revenue Code Section 25E). Also new is a tax credit for “commercial clean vehicles”. Light-duty vehicles under 14,000 lbs. receive a tax credit of up to 7,500 U.S. dollars, and heavy-duty vehicles over 14,000 lbs. receive up to 40,000 U.S. dollars. The requirements to claim the tax credits for “commercial clean vehicles” are less stringent, as no requirements for the final assembly or battery minerals and components apply.

It is estimated that around 7.5 billion U.S dollars will flow into the promotion of electric cars over the next few years.

Further investment in climate protection

Other funding under the IRA includes:

  • 27 billion U.S. dollars for a greenhouse gas emissions reduction fund to finance low- and zero-emission technologies, along with private sector funding;
  • 2 billion U.S. dollars in grants to convert auto plants to produce cleaner vehicles;
  • 10 billion U.S. dollars in tax credits for investments in clean technology production facilities (solar, wind turbines, clean vehicles, etc.);
  • 30 billion U.S. dollars in grant and loan programs for states and electric utilities to increase clean power generation;
  • 3 billion U.S. dollars in grants to reduce air pollution at ports;
  • 500 million U.S. dollars in Defense Production Act support for domestic solar, heat pumps, and electric grid components;
  • Tax credits for carbon storage and sequestration technologies.

Local-content provisions are problematic

For the Biden administration, the IRA is an important element in achieving its climate goals. The act aims to reduce U.S. emissions by 40 percent from the 2005 baseline by 2030. The Biden administration has committed internationally to a 50-52 percent reduction, which will require additional action. However, there is now discussion within the EU about the extent to which the IRA could lead to a shift of investment to the United States at the expense of the EU as a business location. In any case, the United States was already an attractive destination for foreign investors before the IRA was passed, as energy prices have been comparatively low in recent years. Other positive location factors include the size of the domestic market and the availability of skilled workers.

German industry is particularly critical of those aspects of the law that put European and other foreign companies at a disadvantage. These include the criteria for tax credits for electric cars, but also “Buy American” or local-content requirements in other areas. These developments do not send a good signal for transatlantic cooperation and are at odds with the supposed U.S. policy of “friendshoring” and Washington’s push to restructure international value chains along geopolitical challenges.

Transatlantic task force to work out solutions

The EU Commission and the German government are very concerned about possible implications of the IRA. EU Internal Market Commissioner Breton threatened WTO proceedings against the United States, and the chairman of the Trade Committee in the European Parliament, Bernd Lange, also believes that such proceedings would be appropriate. The EU Commission and the U.S. government set up an IRA Task Force between the Commission (von der Leyen’s cabinet) and the White House at the end of October, which has been meeting regularly since then to try to find solutions to keep discrimination against European companies in the IRA to a minimum. With regard to the tax credits for electric cars, for example, there are discussions about putting the EU, which does not have a free trade agreement with the United States, on an equal footing with FTA partners. This might be achieved through the implementation guidelines of the U.S. authorities. The U.S. Treasury Department is responsible for implementing the tax credits. However, it is not expected that there will be any changes to the law itself in the near future. EU Commission President von der Leyen has also announced simpler rules for state aid for clean technologies and a European sovereignty fund as compensatory measures.

From the point of view of German industry, it is important that the implementing guidelines issued by the U.S. authorities to implement the law are now as generous as possible. It is good that a separate task force has been set up for this purpose to negotiate solutions and exemptions for European companies. At the same time, it is essential that the EU and the United States ensure that this dispute does not lead to a trade war. European retaliation in the form of tariffs would further fuel the conflict. “Buy European” rules against the United States – doing what we have been criticizing not only on the IRA but for years – cannot be the solution. The Trump years have taught us that it is always better to talk to each other rather than about each other. Trade wars know no winners. Nor, unfortunately, could a swift and actually effective decision by the WTO be expected in the event of an EU complaint.

EU must carefully weigh its response to the IRA

Overall, the EU should choose a cautious trade policy response to the IRA. A subsidy race would be to the detriment of taxpayers and competition as a whole. First, it is important to put the U.S. subsidy amount for green technologies, 369 billion U.S. dollars over ten years, in relation to the country’s annual GDP, about 23 trillion U.S. dollars. In the EU, there are already numerous funding instruments and initiatives for the green transition, but hardly anyone has a comprehensive overview of these opportunities at the European and nation-state levels. In any case, it must become easier for companies in the EU to apply for and receive funding. Also, the planning and approval procedures in Germany and the EU for new industrial plants, for energy generation plants and for the infrastructures required for them take far too long and represent a high hurdle for the rapid upscaling of alternative technologies.

Fundamentally, we can only meaningfully address climate change if we pull together. Transatlantic cooperation rather than confrontation must remain the guiding principle in the area of climate protection.