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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 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 for climate change investments and about $64 billion 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 over the next ten years.

Tax Incentives for Electric Cars

The debate in Germany and the EU focused above all on the new rules governing subsidies for electric cars. New electric vehicles receive a tax credit of up to $7,500. The benefits only apply to sedans with a sales price of up to $55,000 and SUVs/pickups with a sales price of up to $80,000.

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.
  • In 2023, 40 percent of the critical (explored or processed) 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), or must have been recycled in North America. This quota will increase by ten percent each year until it reaches 80 percent in 2027. In addition, starting in 2025, critical minerals must not come from Russia, China or any other “foreign entity of concern.” If this requirement is met, the buyer will receive a $3,750 tax credit.
  • In 2023, 50 percent (based on cost) of an electric car’s battery components must be manufactured or assembled in North America. That percentage will increase to 100 percent by 2029. Starting in 2024, they also may not come from Russia, China or any other “foreign entity of concern.” Meeting this requirement also results in a $3,750 tax credit.

Both credits taken together add up to a maximum credit of $7,500. The regulations on battery raw materials and components are intended to make the supply chains less dependent on China.

Entirely new under the IRA is a $4,000 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, and heavy-duty vehicles over 14,000 lbs. receive up to $40,000. 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 will flow into the promotion of electric cars over the next few years.

Further Investments in Climate Protection

Other funding under the IRA includes:

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

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 U.S. policy of “friendshoring” and Washington’s push to restructure international value chains along geopolitical challenges.

IRA Task Force to Work Out Solutions

After European and other international partners expressed great concern about the possible implications of the IRA, the U.S. government accommodated some of its close partners. For example, at the end of October 2022, the European Commission and the U.S. administration established an IRA Task Force, which held regular meetings to seek convergence and solutions. The U.S. Treasury Department broadly interpreted the term “free trade agreement” in the electric car tax credit implementation guidelines, creating the possibility of equating the EU, which does not have an FTA with the U.S., with other FTA partners. In order to achieve this equivalence, the EU and the United States are currently negotiating a “critical minerals agreement” that would make it easier for European manufacturers to meet the requirement to use these minerals in new electric vehicles and qualify for at least a portion of the tax credit. These minerals could then also be explored or processed in the EU. Final assembly of the cars in North America will remain a fundamental criterion. Such an outcome would be at least a small negotiating success for the EU. Further concessions by the United States are not to be expected. It should be borne in mind, however, that the EU itself is heavily dependent on imports from third countries for minerals required for battery production, which would be the subject of such an agreement. The necessary raw materials are only mined and processed in the EU to a limited extent.

Some relief for European electric car manufacturers comes in the form of the “commercial clean vehicle tax credit” already mentioned above. This tax credit is available for electric vehicles leased in the United States as company cars. Unlike the subsidy for private vehicles, the tax incentive for commercial vehicles does not depend on the final assembly of the vehicle. The fact that regulations on battery raw materials and components as well as the requirement of final assembly in North America do not apply to this tax credit is possibly unintentional on the part of the legislator and thus represents an accidental loophole for foreign manufacturers.

A Subsidy Race is Not the Solution

It is good that the conflict over the IRA has not yet escalated in the form of tariffs or similar trade policy measures on the part of the EU. “Buy European” rules against the United States – in other words, doing what we have been criticizing not only with regard to 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.

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 over ten years, in relation to the country’s annual GDP, about $25 trillion in 2022. In the EU, there are already numerous funding instruments and initiatives for the green transition. However, it must become much easier for companies in the EU to apply for and receive such 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. The Net Zero Industry Act proposed by the EU in response to the IRA in March 2023 is a step in the right direction. However, there is still room for improvement in some areas.

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.