Europe and the IRA: How a Green Subsidy Race Could Both Help and Hurt

On August 16, 2022, US President Joe Biden signed the Inflation Reduction Act (IRA) into law. Although not apparent at first glance, the IRA is a form of industrial policy meant to achieve a number of goals, including the expansion of renewable energies, the rebuilding of energy infrastructure and the production of climate-friendly industrial goods (e.g., electric vehicles).

The United States will be spending $370 billion over a period of 10 years as a result. The country wants to use these investments to catch up in the field of renewable energies and thus generate long-term inflation-reducing effects while driving the transformation towards a green economy.

The IRA has reignited the debate about using subsidies as an industrial policy tool. Especially in Europe, there are concerns that industrial policies such as the IRA implemented by other global players will cause Europe to be left behind as the world economy goes green. Such concerns are being reinforced by the IRA’s protectionist elements.

What is often ignored, however, is that thanks to its Recovery and Resilience Facility (RRF), Europe has also created an industrial policy tool for transforming its economy to make it greener and more digital. At €800 billion – €200 billion of which has been earmarked for transitioning to an ecological economy – the RRF is roughly comparable in size to the IRA.

The European debate is currently focusing on how Europe should respond to the IRA. In light of the Green Deal Industrial Plan presented by the European Commission in February, the discussion is centering on the creation of a European Sovereignty Fund. Exceptions to Europe’s rules on state aid are also being considered that would allow member states to grant subsidies to companies equal to the subsidies available through the IRA in the US.

As a result, it seems we will soon be witnessing a race between Europe and the US to promote climate-friendly investments. In this article, we examine the justifications for implementing subsidies, as well as how subsidies work and the potential impacts they would have. We also look at the positions currently adopted by Europe and the US.

Are government subsidies justifiable from a regulatory point of view?

In terms of regulatory policy, a subsidy is justified if a certain economic activity has a positive externality that the market would not exploit to the desired degree without additional incentives. Is this the case with measures designed to drive the green transition of the economy?

• Negative externalities are primarily present in the area of environmental resources and their use. This suggests that a price, e.g., tax, should be imposed by the state on the relevant activities. The amount of the tax would reflect the difference between the private costs and the costs for society as a whole (i.e., a monetary valuation of the negative externality).
• Environmental protection measures, on the other hand, have positive externalities: If someone plants trees in a forest, the wood generates income for that person when it is later sold. The economic value of the reforestation is determined by the price of the wood. Yet the forest provides other economic benefits, such as recreation (for locals and tourists), food (animals, berries, mushrooms etc.) and ecological advantages (carbon storage, water filtration and the creation of drinking water, cleaner air, erosion prevention, protection of biodiversity etc.). To arrive at an optimal level of activity from an economic perspective, the state would have to pay the forest’s owner a subsidy that reflects the monetary value of the additional societal benefits.

What impacts do government subsidies have?

Government subsidies represent an intervention in the market. Market interventions can target both supply and demand. For the most part, the IRA makes use of supply-side interventions, something that generally also applies to the RRF and other policy measures under discussion in Europe. Instruments such as tax breaks and investment premiums allow companies to produce more cheaply.

This shifts the supply curve downward: Regardless of demand, any amount of output can be offered at a lower price. If there is no change in demand, a new market equilibrium is reached. More goods and services are demanded at a lower equilibrium price. This leads to an increase in production and demand.

If we look at only one country, the outcomes shown above will occur. This makes it possible to increase the supply of and demand for certain climate-friendly goods, such as renewable energy or electric vehicles. In reality, however, many countries compete with each other, which leads to interdependencies when policy measures are enacted. If one country introduces subsidies, its companies can offer their goods at a lower price and thus gain a comparative advantage.

This puts pressure on companies in all the other countries, and they could respond by moving their operations to the country offering the subsidy. The other countries would thus be inclined to follow suit and also introduce subsidies. To ensure its companies can continue to compete globally, each country will offer subsidies similar to those available elsewhere.

If it wants to give its companies a comparative advantage, the country in question will even increase the subsidies. This is where countries become interdependent: If one increases its subsidies, the others will do the same, which leads the first to increase its subsidies yet again. The result is a competition among countries to provide the highest subsidies.

What are the positive impacts of policy measures such as the IRA?

Policy measures like the IRA help accelerate the transition towards a climate-friendly economy. Subsidizing the production of climate-friendly goods can overcome the barrier of high start-up costs, making it possible to generate a critical mass more quickly, along with the attendant lower unit costs. China, in particular, has been able to use this strategy to gain significant market share globally, for example, in the production of solar panels.

Considered from the perspective of global climate goals, it would be a very welcome development if countries such as the US, which still produces a significant share of the world’s greenhouse gas emissions, were to use policy measures such as the IRA to accelerate the green transformation of their economies. The US has been widely criticized in the past for its lax environmental policies. Every reduction in greenhouse gas emissions in the US has positive externalities, including for Europe.

The competitive drive unleashed by policies such as the IRA can also give rise to another positive externality: Other parts of the world must make a greater effort to bring about the ecological transformation of their economies. This could lead to an advantageous race to achieve such a transformation through the implementation of smart policy measures. Europe, too, could strengthen and build on its previous efforts in this area.

What are the negative impacts of policy measures such as the IRA?

When subsidies are introduced, there is a risk that companies will no longer be able to hold their own economically if government support is discontinued at some point in the future. It is unrealistic to expect that large-scale subsidies, in particular, can be maintained over the long term.

One potential concern is that companies and even entire sectors could arise that are not viable without subsidies. One negative example is Germany’s photovoltaic industry, which was massively subsidized but no longer competitive once government support was eliminated (and competitors emerged in Asia), after which it collapsed almost completely.

One immediate consequence for Europe arises from the protectionist aspects of the IRA. For example, American consumers only receive a tax credit if they purchase an electric vehicle that was manufactured in North America. Likewise, a large share of the components in the car’s battery must come from the US or a country with which it has a free trade agreement.

This could be an incentive for European companies to invest in the US instead of the EU. This applies in particular to low-margin and highly mobile companies. For the EU, this capital flight would mean reduced domestic value creation and fewer jobs.

Two key factors needed for the green transformation of an economy are innovative capacity and private capital. Yet both are limited globally, something that can give rise to a zero-sum game. Policy measures become more and more generous, but the desired impact – greater output – is no longer achieved. The ratio of subsidy to additional supply is no longer economically optimal.

The US needs capital imports more than the EU does

One rationale underlying the requirements laid out in the IRA might well be a desire to attract more investment to the US from Europe. The US is known to have a relatively low savings rate – compared to domestic investment and to savings rates in the EU. If we look at average values from 2017 to 2021, we see that:

• In the US, the overall savings rate was lower than the overall investment rate. To meet its substantial investment requirements, the country needed net capital imports and, thus increased the current account deficit.
• The savings rate in the EU, on the other hand, exceeded the investment rate. The result was net capital exports and a current account surplus.

Since the EU also wants to drive forward its ecological transformation, it will need high levels of domestic investment as well. At the same time, after Russia’s invasion of Ukraine, more funds are being invested in the production of military equipment.

Both of these factors are tying up financial resources in Europe. This development could prove problematic for the US, since it depends on capital imports from the EU to finance the investments needed for a green transition. To that extent, the US must create incentives that attract the necessary capital imports.

Conclusion: Competition could accelerate the green transformation, and the EU is reasonably well positioned

With the IRA, the US has implemented an extensive series of measures to transform its economy toward climate neutrality. Many of the measures are subsidies designed to promote climate-friendly technologies, production processes and industrial goods. As a result, the EU sees its pioneering role in achieving a future green economy as under threat, a fear that is partially justified in light of the IRA’s protectionist elements. A heated discussion is therefore taking place in Europe on the measures that should be used to counteract this threat. One possible outcome here is a competitive race between the EU and the US to enact subsidies.

Should an industrial policy competition arise between the EU and the US, the transformation to a green economy in both areas could be accelerated by mutualizing start-up costs. At the same time, however, there is a risk of goods and services being subsidized that would not otherwise be economically viable over the long term. It will therefore be necessary to focus on global climate goals as a safeguard against corrosive competition – which existed until recently in the area of corporate tax rates.

The EU is reasonably well positioned as a direct competitor to the US in the area of industrial policy. Thanks to the RRF and other instruments, such as the Important Projects of Common European Interest (IPCEI), Europe’s transformation towards a green economy began some time ago. In terms of funding this transformation, the EU – in contrast to the US – still has room to maneuver when it comes to activating domestic capital for additional investments.

About the authors

Thieß Petersen is Senior Advisor at the Bertelsmann Stiftung, specializing in macro-economic studies and economics. His focus lies on the causes and effects of financial and economic crises as well as the chances and risks of globalization. Among others, he has recently worked on the effects of carbon pricing and the benefits of a potential global climate club.

Thomas Schwab is Project Manager for the Europe’s Future Program at the Bertelsmann Stiftung. He applies a data-driven approach to economic analysis by employing data science and econometric methods.

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