Climate ActionEuropeGlobal EconomyThought

How the EU can counterbalance the US

The Inflation Reduction Act (IRA) of 2022, signed into law by US President Joe Biden, represents a landmark legislation in the US with the dual goals of curbing inflation and reducing the national deficit. A significant portion of the IRA is dedicated to energy security and climate change, with an allocation of $391 billion in tax provisions aimed at advancing clean energy usage and domestic energy production.

The introduction of the IRA has triggered a wave of concern within the EU regarding the potential economic repercussions. The crux of these concerns revolves around the IRA’s generous tax credits and fiscal incentives that focus on renewable energy, electric vehicle incentives, home energy efficiency upgrades, and advanced manufacturing processes.

Critics argue that such measures may catalyse a shift in investment and production from the EU to the US, thereby impacting the competitiveness of European industries, particularly those involved in green technology and sustainable practices.

Prior economic analyses, such as those in Attinasi et al (2023), suggest that the IRA’s impact on the EU’s production would be unambiguously negative and non-negligible in magnitude for affected industries in the EU.

Nonetheless, these studies do not incorporate the concurrent availability of EU support measures for environmental and climate-related activities. Funds from the EU’s Multiannual Financial Framework and NextGenerationEU programme provide significant resources for climate policies, and neglecting these in impact assessments could lead to an overestimation of the IRA’s negative effects on the EU economy.

The EU’s current Multiannual Financial Framework (MFF) and the NextGenerationEU package provide financing for over €2 trillion for 2021-2027. Of this amount, at least 30% will be spent to fight climate change. We consider the EU funding supporting climate objectives, whereas funding supporting other environmental objectives only (eg. circular economy, pollution reduction, biodiversity, water management) is not taken into account.

In addition, we do not take into account funding from national sources in EU member states. Thus, country-specific figures on the availability of funding in the EU for the environmental sector as a whole are underestimates. In fact, as also pointed out in Rusch et al (2023), compared to available funds at the European level, the amount of IRA funding for climate policies appears rather modest.

We use the Joint Research Centre’s CORTAX multi-country, general equilibrium model to provide estimates of the potential impact of the IRA on the main macroeconomic aggregates for the green industries in the EU and the US, including the capital stock, employment and output.

One distinctive advantage of CORTAX is that it models in detail the provision of the corporate income tax system and accounts for their impact on cross-border direct investment and on the economy as a whole. See Álvarez-Martínez et al (2016) and Bratta et al (2023) for details on the model, incl. functional specifications, individual optimization problems, details about market closures, and the empirical calibration.

We consider two scenarios: one in which only the IRA is implemented in the US, and another one in which we consider the potential impact of the EU’s long-term budget and the NextGenerationEU programme whereby the EU provides financial support for climate objectives via different programmes, notably the Recovery and Resilience Facility (RRF). By design, CORTAX is a one-sector economy, ie. it does not distinguish between different industries and activities of the economy.

Therefore, in order to back out the specific macroeconomic impacts for the subset of activities mostly concerned by the IRA, we adjust the economy-wide results by considering the EU-wide share of employment in the environmental goods and services sector (EGSS) in total employment. The number of employees in the EGSS sector in the EU is directly available from Eurostat (2.71% in 2020). Georgeson and Maslin (2019) estimate that the share in the US is 4.2%, as of 2016.

Our analysis suggests that the impact of IRA on the EU economy and, in particular, on its attractiveness for green investments should be largely mitigated by the availability of the NextGenerationEU and other related programmes, resulting in a positive net impact for the EU’s green sectors and the EU economy as whole

The Inflation Reduction Act is integrated into the CORTAX model using inflation-adjusted estimates from the Congressional Budget Office (CBO) and the Tax Policy Center. These estimates suggest an increase in net tax expenditure of $241 billion over ten years for investment and green energy, leading to a 0.13% rise in the annual US government deficit relative to GDP by 2031.

This increase is simulated as a reduction in the US corporate tax base, achieved by enhancing corporate income tax deductibilities. For the calibration of EU climate funding impact, the methodology from Pfeiffer et al (2021) is employed, assuming that additional EU funding under the current financial frameworks will result in increased permanent factor productivity due to technological innovations. See Pfeiffer et al (2021), and in particular Section 3.6 therein on the calibration of changes to factor productivity.

These productivity enhancements are country-specific and correlate with the exact EU funding received. The additional EU climate funds are expected to lead to higher government debt levels since they need long-term refinancing.

In this simulation, we focus on EU-level support programmes and do not take into account other public funding supporting climate objectives, eg. additional funding at the national level. Furthermore, the model does not incorporate the inter-institutional agreement which stipulates that the NGEU programme should be refinanced by new own resources.

Figure 1 summarises the main effects, separately for the (entire) EU and for the US. Panel A covers the counter-factual scenario, in which the US would have unilaterally adopted the IRA energy subsidies, absent any policy reaction from the EU. Our results suggest that the IRA provisions would have indeed boosted investment in this country at the expense of investments in the EU.

In this counter-factual scenario, investment in US green sectors would have increased substantially (+21.5%) thanks to the increase in the after-tax return of capital in the US vis-à-vis third countries. Given the inflow of capital, wages and output in these sectors would experience significant increases (+8.1% and +6.5%, respectively).

As a result of the unilateral US policy, and not taking into account ongoing and future EU-level support programmes for green activities in the EU, business investment and output in EU green sectors would indeed fall by 2.5% and 0.5%, respectively, in the longer run. Wages in that sector of activities would decline by 1.1% driven by the fall in capital stocks.

Given the overall size of the IRA-supported industries, the impact on total US GDP would remain more contained (+0.3%) according to our simulation results. For the EU economy as a whole, the effects would have been minor with a fall in GDP of -0.01%.

Notes: The figure displays the impact of the adoption of the IRA in the US on the environmental goods and services sector (EGSS), separately for the EU and the US. In Panel (A) we do not consider the planned support for climate objectives provided through EU funding facilities under the long-term budget and the NextGenerationEU programme. In Panel (B) we assume full absorption of such funds.

Source: the Joint Research Centre’s CORTAX model.

In Panel B, we consider the case in which not only the US implements the IRA but also EU member states fully access the planned support for climate objectives provided through EU funding facilities under the long-term budget and the NextGenerationEU programme.

In this case, equilibrium wages (+8.0%) and employment (+5.2%) in EU green activities both respond strongly to additional funding. The capital stock increases as it partially complements higher employment levels (+3.7%). As production, read GDP, is a function of capital and labour, it rises strongly (+12.0%) for the EU’s environmental goods and services sectors. At the same time, the effect would be slightly smaller in the US than under a unilateral adoption (Panel A), albeit still strongly positive.

Our analysis suggests that under a unilateral adoption of IRA provisions, the boost to investment in the US would be indeed detrimental to green investments in the EU. However, in practice, the use of EU funding facilities for supporting EU green sectors significantly increases investment in the EU, even in the case of the IRA adoption.

As a result, the capital stock and production level of the EU green sectors would experience significant rises, leading to pronounced increases in wages and employment in these activities.

The expected positive effect of the IRA in the US would be slightly smaller compared to the scenario where the US would implement such reform unilaterally and without considering the EU funding in support of climate objectives.

Our analysis therefore suggests that the impact of IRA on the EU economy and, in particular, on its attractiveness for green investments should be largely mitigated by the availability of the NextGenerationEU and other related programmes, resulting in a positive net impact for the EU’s green sectors and the EU economy as whole.

However, the degree of implementation of the NextGenerationEU programme remains a key aspect for this positive outcome to materialise, since the expected productivity impact depends directly on the country-specific absorption of EU funding facilities. In fact, the magnitude of the results for the EU would be considerably smaller when taking into account that countries typically do not fully absorb the available EU funding.

References

Álvarez-Martínez, MT, S Barrios, L Bettendorf, M Gesualdo, D d’Andria, S Loretz, P Pontikakis and J Pycroft (2016),”‘A New Calibration for CORTAX: A computable general equilibrium model for simulating corporate tax reforms”, JRC Working Papers on Taxation and Structural Reforms No 09/2016.

Attinasi, MG, L Boeckelmann and B Meunier (2023, “Unfriendly Friends: Trade and Relocation Effects of the US Inflation Reduction Act”, VoxEU.org, 3 July.

Barrios, S, J Pycroft, AL Stasio and D Stoehlker (2023), “The Macroeconomic Impact of the Energy and Climate Provisions of the US Inflation Reduction Act: Evidence for the EU”, European Commission, JRC135642.

Bratta, B, J Pycroft and D Stoehlker (2023), “CORTAX 2019: Updated calibration and baseline results”, JRC Working Papers on Taxation and Structural Reforms No 07/2023.

Georgeson, L and M Maslin (2019), “Estimating the Scale of the US Green Economy within the Global Context”, Palgrave Commun 5: 121.

Pfeiffer, P, J Varga and J in’ t Velt (2021), “Quantifying Spillovers of Next Generation EU Investment”, European Economy Discussion Papers No. 144.

Rusch, J, M Carceller del Arco, E Vording, B Heerma van Voss and K Mavromatis (2023), “Macroeconomic Effects of the Inflation Reduction Act”, DNB Analysis.

Author’s note: This column reflects the opinions of the authors and not necessarily those of the European Commission. This article was originally published on VoxEU.org.