Is the U.S. Inflation Reduction Act Hurting the German Economy?

Prof. Dr. Michael Hüther, Director and Member of the Executive Board of the German Economic Institute (IW), and Jürgen Matthes, Head of IW’s Global and Regional Markets Cluster, assess the impact of the U.S. Inflation Reduction Act (IRA), which took effect on January 1, 2023, on German and European businesses.

By Michael Hüther and Jürgen Matthes

In Europe, the U.S. Inflation Reduction Act (IRA) has caused a stir in the media and startled politicians. Many see it as an attack on Germany as an industrial location, and some observers see it as a continuation of Trump’s protectionism with other instruments. Upon closer inspection, however, the criticism and alarm appear to be both self-righteous and exaggerated – self-righteous because the U.S. is now taking climate protection seriously and wants to restructure the industrial sector using legitimate means and exaggerated because there is never just one factor that causes industrial locations to erode. Most importantly, we are the ones who are responsible for our local economic conditions. Similarly, we can try to improve transatlantic trade relations through the Trade and Technology Council and the G7’s Climate Club. Those who are now complaining about the IRA should also be complaining about the failure of TTIP.

However, the climate policy subsidies developed by Joe Biden and his administration do have considerable leverage, especially since further programs have already been launched and individual U.S. states are not twiddling their thumbs either. With the Inflation Reduction Act, considerable efforts are being made to reduce the U.S.’s carbon footprint. The IRA includes $369 billion in funding over ten years for climate change mitigation and energy security (U.S. Senate, 2022). However, these figures, as estimated by the Congressional Budget Office (CBO), are only a rough guide, primarily because the extensive tax credits for climate-friendly investments and projects included in the IRA are not capped. Thus, they could either not be met or exceeded. Moreover, the Biden administration has also made smaller amounts of climate-related funding from other fiscal packages available (Kunath et al., 2022).

The outcry in Germany over the IRA is due to the U.S. pursuing climate policy primarily through extensive subsidies and the fact that some of these subsidy programs are likely to be accessible to European companies only to a limited extent, due to the protectionist elements of the IRA. For example, so-called local content requirements are imposed, which stipulate that essential inputs must be manufactured in the U.S. and can thus not be imported from Europe. The discussion in Germany is primarily focused on perceived disadvantages for the German automotive industry. New electric vehicle tax credits for passenger cars (Mayer-Brown, 2022; RGIT, 2022; VDA, 2022) only apply to those vehicles with a final assembly in the U.S., i.e., not to German car exports. There are also other restrictions, such as price and income caps, and very strict regulations regarding the production and supply of electric car batteries. Most importantly, after 2027, at least 80 percent of critical minerals for such batteries must come from the U.S. or from countries that have a free trade agreement with the U.S., which the EU currently does not have. Even cars (and batteries) manufactured in the U.S. by U.S. subsidiaries of German parent companies are unlikely to be eligible for these tax credits due to the IRA’s critical minerals requirements, as well as the price and income limits.

At first glance, the U.S. approach seems problematic and downright protectionist. Moreover, a great deal of disappointment with the Biden administration’s approach to trade policy rings through in the heated media debate. But how should the IRA and the EU’s climate policy approach really be assessed? How problematic is the U.S. approach for the German economy? To what extent are German exporters discriminated against and is the IRA act really a game changer when it comes to dislocation of investments?

In any case, the effects of the IRA should be analyzed in more detail before the European side also turns to protectionism. Only then can we pose the question of how Europe should respond. And independently of this, Europe should consider what new trade policy perspectives it would like to open with the U.S. and what the EU itself needs to do to become a more attractive manufacturing location. On the other hand, opening the gates for industrial policy (counter)subsidies runs the risk of wasting taxpayer money in a subsidy race.

1. Subsidies Are a Legitimate Approach to Climate Policy

For global climate policy, the new U.S. approach is a big deal. The Biden administration is turning over a new leaf after the setbacks during the Trump administration. The fact that the U.S. is relying primarily on subsidies instead of carbon pricing has a lot to do with domestic politics. In the polarized political debate in the United States, placing a higher burden on consumers and businesses is unlikely to be enforceable, especially since parts of the Republican party are still questioning or denying the existence of man-made climate change.

From an environmental economics perspective, subsidies for climate protection are a legitimate approach because the environmental externalities of economic activities can be internalized through pricing, subsidies, or regulation. The aim is to bring the social costs of climate change into the calculations of private sector companies. The EU is approaching this mostly through pricing and regulation. Thus, the U.S. and EU approaches collide, and in some sectors, a subsidy race is emerging.

To the extent that U.S. subsidies roughly correspond to internalizing costs of climate-damaging negative externalities, they would be justifiable in environmental economic terms. To be sure, U.S. subsidies are not explicitly oriented on a one-to-one basis toward reducing carbon dioxide emissions, as would make sense in theory. However, the subsidies are clearly aimed at more climate protection. Only if it can be proven that the subsidy volume would significantly exceed the value of climate-damaging negative externalities could the U.S. be accused of an unfair approach with overly generous subsidies. If this is not the case, climate policy and competition policy collide in an unfortunate way.

2. Germany Benefits from Previous U.S. Fiscal Packages

The Biden administration has already launched several comprehensive fiscal packages in its first two years (Kunath et al., 2022): the short-term American Rescue Plan (ARP), $1.7 trillion spending bill intended to counter the negative effects of the COVID pandemic in March 2021, and the medium- to long-term Infrastructure Investment and Jobs Act (IIJA), which provides $550 billion over the next ten years.

The U.S. economy has received a major boost, particularly from the ARP, which has also benefited the German economy. It is estimated that the ARP has boosted U.S. economic output by almost 7 percent in 2021 alone and, through a higher demand for German exports, has increased German economic output by more than 1 percent (vbw, 2022). This represents a significant positive spillover effect. The same applies to the IIJA, albeit to a lesser extent, however with a longer-term impact.

Partly due to these fiscal packages, German exports to the U.S. have been booming recently. As a result, the U.S. has been able to significantly expand its role as the most important export partner for Germany. In the first three quarters of 2022, German exports of goods to the U.S: grew by more than 29 percent, almost twice as fast as overall goods exports did, at around 15 percent. The share of German exports to the U.S. in total exports to the rest of the world subsequently increased to almost 10 percent. A similarly high ratio was last recorded 20 years ago.

3. The European Automotive Industry Is Only Partially Discriminated Against

At first glance, the IRA support for electric vehicles (i.e., regulations regarding the final assembly in the U.S., on battery production, and the supply chain) appears to strongly discriminate against the German automotive industry and German auto exporters especially. A closer look, however, shows that a differentiation must be made here. One has to bear in mind that the German automotive industry already produces some models locally in the U.S. and in North America. In addition, exports of electric vehicles are still quite low, although this is likely to change in the future.

Let’s put this into perspective: tax credits for electric vehicles, with an envisaged volume of around $7.5 billion, represent only a small part of IRA spending. In addition, price and income caps must be considered. This is because mainly higher-priced cars are exported from Germany to the U.S.: The German Association of the Automotive Industry assumes that many mid-range vehicles will be ineligible for U.S. subsidies for this very reason (VDA, 2022). Thus, while the tax credits do not apply in this case, there is also no trade discrimination since IRA funds are not available for similarly priced U.S. competitor models either. To be sure: the requirements to quickly ban mainly Chinese inputs from the battery supply chain, remain challenging and are unlikely to be met in the allocated timeframe. However, European automakers share this issue with their American counterparts.

The Biden administration is expected to respond to European concerns. After in-depth discussions in a dedicated task force and at the highest level, it appears that Washington is prepared to address European concerns regarding the IRA. According to media reports, EU cars (including exported ones) that are leased in the U.S. as company cars could be classified as commercial vehicles, to which the aforementioned requirements do not apply (Fasse et al., 2022). A significant proportion of German (exported) electric vehicles should be able to benefit from IRA funding through such a “leasing solution”. Experts estimate that about half of the German electric vehicles registered in the U.S. are leased.

Such exemptions would not apply to the probably moderate share of German electric vehicles on U.S. roads that are not leased but owned privately and that meet the price and income limits. To benefit from IRA funding, battery production and supply chain requirements remain relevant in these cases, and thus constitute discrimination against EU vehicles. However, here, too, relief might be coming. According to media reports (Fasse et al., 2022), the U.S. is said to be willing to prevent discrimination against the EU vis-à-vis free trade partners in the sourcing of critical minerals by concluding a commodity partnership between the U.S. and the EU and considering it equivalent. Because many questions and issues remain regarding the implementation of the IRA, the U.S. Department of the Treasury has postponed the publication of guidelines for battery production-related regulations until March 2023 (U.S. Department of the Treasury, 2022).

4. The Economic Impact of Local Content Requirements Is Limited

Some subsidy programs are subject to local content requirements (which vary slightly from program to program), i.e., they stipulate that relevant inputs must be manufactured in the U.S., if the full subsidy is to be granted. To the extent that these rules apply, intermediate goods exports from Germany are excluded from IRA funding.

The Biden administration is using the discriminatory rules (including the rules on final assembly in North America and battery production) to strengthen the weakened industrial production base in the U.S., especially in the heavily politically contested Rust Belt, as part of its Made in America-initiative (Kunath et al., 2022). While this goal is certainly understandable, the discriminatory IRA rules are problematic since they might violate WTO law (European Commission, 2022). The EU does not use such restrictions. Germany, for example, makes its subsidy program for electric vehicles available to foreign manufacturers without any restrictions.

However, when considering the extent to which local content requirements actually act as an export barrier to inputs from Germany, various qualitative arguments suggest that the discriminatory effects are likely to be limited:

• Local content requirements do not apply to all IRA programs. For German U.S. subsidiaries, which usually have a high local value-added share (vbw, 2022), those requirements are much less relevant, if at all.

• If such requirements do apply, they relate only to a limited amount of potential subsidies, depending on the program. Other IRA-funding elements, some significantly more relevant in scope, are tied to other more easily implemented conditions, such as requirements for pay and training or for the establishing of firms in certain U.S. regions.

• If only a limited portion of IRA subsidies are accessible through compliance with local content requirements, it is questionable whether it is worthwhile for firms located in the U.S. to reorganize their supply chain so that inputs from Germany are no longer used. Supply chains are optimized and adjusting them is costly as well as time-consuming. It is therefore not a foregone conclusion that German exporters of intermediate goods will lose their customers because of the IRA.

• Local content regulations generally leave room for foreign supplies because they do not require 100 percent domestic inputs in most areas. Even if there is formally no room for European supplies within the set limits, there are possibilities for exceptions, so-called waivers, if no suitable inputs are available in the U.S., or if this results in significant cost increases (e.g., of more than 25 percent for some programs). Particularly in the case of capital goods, German exports are sometimes without serious U.S. competition, so these exceptions are likely to apply at a wider range. This would allow German intermediate exports to continue despite local content regulations.

5. IRA Overall Rather Positive for Sales in the U.S.

If the impact of the discriminatory elements of the IRA remains limited, there is much to suggest that the demand for climate protection-related goods boosted by IRA spending is likely to have positive effects on German sales opportunities and exports to the U.S. Figuratively speaking, the pie gets bigger. Even if some parts of it should not be accessible due to discriminatory elements, the share for Germany should get bigger in absolute terms. Overall, the German economy is thus likely to benefit. This is likely to apply particularly to capital goods manufacturers, which also benefit from the IIJA infrastructure package.

However, there are fears that the high IRA subsidy and the protectionist elements in it could be a strong incentive for European companies to relocate production and investment to the U.S. in order to benefit from the generous subsidies there. Such investment diversion may occur in individual cases. In fact, there are media reports of a few company decisions in which investments planned in Germany were cancelled or postponed, for example regarding battery plants. Moreover, IRA funding interacts with tax incentives in the U.S. at the state level as well (i.e., with elements of international tax competition.) Nevertheless, caution is warranted in generalizing from individual examples and anecdotal evidence.

The following arguments call into question whether the IRA is indeed a crucial factor when it comes to relocation decisions:

• It is not out of the question that a possible Republican president after 2024 would significantly cut IRA funding. This is because parts of the Republican party are skeptical about climate change and oppose extensive subsidies and government control. Much will depend on whether the constituents of (potential) Republican or Democratic members of Congress benefit from such funding. Since U.S. Democrats have an interest in channeling funding to their own constituents, a cut to IRA funding might therefore be not very likely to hurt Republicans too much.

• Companies generally do not make location decisions based on limited (and possibly non-permanent) subsidy programmes, but rather, they consider a variety of indicators (or they should, at least.)

• Energy price differentials are a much more important factor for energy-intensive companies. Relocation considerations by German firms in these industries, which have been reported in the media, are therefore unlikely to be caused by the IRA. After all, around 8 percent of the industrial companies surveyed by the German Chamber of Commerce and Industry (2022) in the fall of 2022 are considering relocating production due to high energy costs. In addition, the European Union’s increasingly strict climate policies represent additional incentives to relocate production that is harmful to the climate.

• For some products, factors such as transport costs play an important and sometimes even decisive role in the site selection decision. For example, the production and assembly of wind turbines and their essential parts usually takes place in the country of installation because the transportation of towers and blades is very complex and expensive. However, this is not true for other major components. If the construction of wind turbines in the U.S. is strongly supported with the IRA, the export of more easily transportable components from Germany should continue to be possible even with local content rules in place.

• The EU could ultimately benefit from a strong promotion of hydrogen production in the U.S. because Germany and Europe will be dependent on imports of cheap hydrogen in the future. German companies are also likely to benefit from the construction and maintenance of hydrogen production plants in the U.S:. Besides, this also applies to the construction of battery factories.

• The attractiveness of the U.S: as an investment location could be better. Persistent infrastructure deficits and a grave shortage of skilled workers are likely to be more important – especially for less energy-intensive companies – than energy price advantages. Moreover, given low unemployment levels and a tight labor market, U.S: labor costs have risen significantly in recent years and will likely continue to do so.

• German direct investment flows to the U.S., which are an indicator of attractiveness as an investment location, have been uneven in recent years. After reaching a high of more than EUR 30 billion in 2019, according to Deutsche Bundesbank data, in 2021, just under EUR 13 billion in additional investments by German parent companies in the U.S. were recorded. The first three quarters 2022 saw a similar level of investments. Greenfield investments in the U.S. from foreign investors have also declined recently (Evenett, 2022).

6. The Biden Administration Is Cooperative in Many Areas

Compared with the previous administration, the Biden administration has managed to return the U.S. to transatlantic cooperation. Under the current administration, several trade conflicts with the EU have been substantially defused, albeit not finally resolved (Matthes, 2022). This is true of the conflict over U.S. tariffs on steel and aluminum imports, as well as on the subsidies for Boeing and Airbus, where reciprocal tariffs have been cut or not imposed. Working groups are moving to resolve these conflicts – a difficult task since both fields are impacted by China’s distortion of competition.

There can be no doubt that the Biden administration is aiming to foster transatlantic cooperation. In the geopolitical conflict with China, Democrats are seeking joint action with like-minded partners. The Trade and Technology Council exemplifies this as well, even if no major breakthroughs have been reached so far.

However, the resulting channels of discussion have helped to partially smooth over concerns about the IRA from the point of view of European and German automakers. Washington apparently underestimated the potentially negative effects on the EU as a transatlantic partner and is looking to implement remedial measures. The U.S. Deputy Secretary of the Treasury, whose department is responsible for IRA implementation, has clearly signaled that they are aware of European concerns and are interested in a Europe with a strong manufacturing base (Brüggmann/Heide, 2022).

All in all, the criticism of the Biden administration on the IRA issue seems to be overblown. Critics seem to suggest that the U.S. is in general no longer a reliable partner. Despite all the uncertainties concerning Washington’s future geopolitical focus, the global power competition requires the strengthening of transatlantic relations wherever possible. Anything else would be geopolitically highly counterproductive, especially since the EU and the U.S. share many common interests, for example when it comes to shaping and stabilizing the world order so that China and other autocracies can undermine it as little as possible.

7. Beware of a Trade War and Excessive Sectoral Industrial Policy

In the heated debate over the IRA, there have been repeated calls for trade retaliation against this supposedly egregious U.S. protectionism and demands that the EU should raise its own trade barriers against the United States. However, we strongly advise against such steps. First, such an escalation does not seem justified in light of the arguments presented here. Second, such steps are likely to be counterproductive for transatlantic cooperation and could even provoke a trade war. Third, this debate distracts from what Europe itself can do regarding trade and industrial location policy.

A more nuanced question is whether the EU should initiate WTO proceedings regarding the local content requirements in the IRA. In principle, this step would be understandable because the U.S. is, at least in spirit and possibly de jure, disregarding fundamental WTO trade rules. This could be emulated by other countries, eroding WTO rules across the board. However, a WTO lawsuit would be counterproductive from a geostrategic perspective. This is because such a step would put a strain on cooperation in the Trade and Technology Council and make the already very domestically focused U.S. Congress more skeptical of the EU. China, on the other hand, could exploit a trade dispute fought before the WTO for its own ends. In addition, it could be argued that a WTO lawsuit is a bargaining chip for negotiations with the U.S. on the flexible implementation of the IRA.

Channels of discussion with the U.S. administration should be used to their full extent in order to achieve effective facilitation in the implementation of the IRA. In addition, the Trade and Technology Council should focus also on creating common standards for climate-friendly products and technologies as soon as possible. That is because unequal standards would be non-tariff barriers to trade that act as important obstacles for exporters.

In addition to trade policy options, there are calls for greater use of industrial policy and subsidies. Behind this is a concern about relocation of production and the realization that the European Green Deal, with its pricing approach to reduce climate-damaging activities, conflicts with the U.S. subsidy approach. Competitive disadvantages for European companies, which are already imminent, are thus in danger of being further aggravated. A carbon border adjustment mechanism, which the EU recently agreed to in principle, can probably only partially offset these disadvantages for a few sectors.

France and Germany are calling for a softening of European state subsidy rules for climate-friendly projects – and the European Commission is moving forward on this issue. In addition, there are calls for so-called matching clauses – i.e., rules that make it possible to counter U.S: subsidies with equivalent European subsidies to prevent relocation. If such demands were implemented, a wave of industrial subsidies at the expense of European taxpayers would be imminent. Companies would engage in massive lobbying efforts to obtain subsidies for themselves. And on the political side, bureaucrats would get excited. Some business development departments of economic ministries have been waiting a long time for the European subsidy shackles to be loosened.

Isolated industrial policy interventions may be appropriate, but not across the board. A close examination is needed of where IRA subsidies (and not other causes) would be decisive for production relocations. In battery production, moreover, there are already new subsidy options and exemptions from EU state aid rules. Here, however, the problems lie more in the slow implementation of the European subsidy projects. In this respect, the EU has its own homework to do when it comes to safeguarding the quality of this location, particularly with a view to streamlining bureaucratic procedures.

The European Commission’s proposal to create a sovereignty fund with a further possibility for the EU to take on debt for industrial policy subsidies is problematic. Entering a subsidy race with other states that may be lost in the end, would be a bad investment of European debts.

There is also a link between a significant relaxation of state aid rules and a European fund for subsidy financing. This is because a relaxation of state aid rules would raise the argument that financially strong countries could outcompete financially weaker countries in the EU with high subsidies – and push the argument for a sovereignty fund. For this reason, too, the relaxation of state aid rules should be handled with caution. A relaxation with a view to a limited compensation of excessive electricity and gas prices for energy-intensive European companies would be more important than allowing counter-subsidies against the IRA on a broad scale.

Regarding the calls for an EU sovereignty fund, reference should also be made to the European Recovery and Resilience Facility (RRF), which is of considerable size compared to the IRA. Italy, with a nominal GDP of EUR 1.7 trillion, receives around EUR 190 billion over a good five years. Relative to GDP, this is more than ten times as much per year as in the U.S. with the IRA volume of around $370 billion over a span of about ten years, as the US GDP amounts to more than $23 trillion. Even if one considers the fact that not all funding in Italy is used for climate protection (just under 40 percent), the RRF support is still five times as much as the U.S. has made available.

In addition, it is generally advisable for all EU countries to reallocate Recovery and Resilience Facility funds to make even more money available for renewable energy development, also to accelerate independence from Russian energy. The RePowerEU initiative is a step in the right direction. Reallocations of Recovery and Resilience Facility funds are also conceivable at the national level to address concrete risks of relocation that are clearly attributable to IRA subsidies, but only in a targeted and limited manner. Since substantial funds in the Recovery and Resilience Facility remain unused, especially when it comes to affordable credit opportunities, this source should be tapped first before calling for a new EU fund.

Above all, however, the debate surrounding the Inflation Reduction Act makes clear that policy makers in Europe and Germany should urgently do their homework. On the one hand, this means a clarification of trade policy perspectives, claims, and expectations. On the other hand, it involves a new and comprehensive supply-side program to strengthen economic locations in international competition with tax breaks, progress in digitization, infrastructure investment and, fundamentally, a consistent acceleration of permits and licensing procedures. Europe should remember its goal of being the most successful knowledge-based economy in the world and focus all its ambitions accordingly.

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