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The Inflation Reduction Act: A big deal for the US economy

Juhi Dhawan, PhD, Macro Strategist
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By 2030, the recently passed Inflation Reduction Act (IRA) could cut US emissions by 40% (relative to 2005 levels), compared with a 27% reduction under current policies.1 But along with this important environmental impact, the IRA is likely to affect the US economy in a variety of ways, including driving up investment spending, driving down the cost of new technologies, and giving productivity a needed boost.

Adding to the US spending spree, with a focus on climate and energy

Like the infrastructure bill passed in August 2021 and the CHIPS Act passed in July 2022, the IRA is consistent with my thesis that we will see higher domestic capital spending in the US over the coming decade. Together, these three bills include roughly US$1 trillion of spending over 10 years. Higher capex should translate into higher productivity and somewhat higher nominal growth, implying higher rates over time. 

The bulk of the spending in the IRA is aimed at energy and climate initiatives, with the key provisions totaling US$387 billion (Figure 1). The bill is expected to boost capex in clean technology by as much as 2.7 times the current projected level (Figure 2). 

Figure 1
Figure 2

Targeting the chief contributors to greenhouse gas emissions

The three largest contributors to greenhouse gas emissions by economic sector are electrical power, industry, and transport. Not surprisingly, then, the key elements of the IRA include the accelerated deployment of clean electricity, the use of carbon capture and storage in industry, and the electrification of transport. I’ll offer some details and observations on each of these areas:

  • Tax credits for alternative power sources (solar panels, wind turbines, batteries, geothermal plants, and advanced nuclear reactors) are extended for 10 years rather than one to two years as has been typical in the past. By some estimates, the coming decade could see wind capacity increase at twice the pace at which it is currently growing and solar capacity increase at five times the current pace. Newer but not yet independently cost-effective technologies also benefit, including hydrogen.

    All this paves the way for better planning by utility companies on their green transition path. According to the REPEAT Project, power will be the single biggest area of emissions reduction, accounting for almost a quarter of the total forecasted improvement. 

  • Technologies aimed at industrial emissions, including carbon capture and storage (CCS) and direct air capture, will benefit from a variety of spending provisions, including grants and loans. According to some independent energy forecasters, we could see carbon capture increase by 13 times its current level over the coming decade, thanks to the new incentives.

  • Incentives aimed at accelerating the adoption of electric vehicles (EVs) include a US$7,500 tax credit for the purchase of new EVs and a US$4,000 credit for used EVs, which are effective until 2032. The bill introduces household income limits on the credits, minimum domestic content provisions (e.g., on batteries and vehicle assembly), and vehicle price caps to ensure that middle-income consumers benefit rather than the wealthy.

    Today, the US has only 2.1 million EVs on the road, versus 5.5 million in Europe and 7.8 million in China. It is not clear how much the new credits will help, since 70% of current EVs would be ineligible based on the domestic content requirements. The vehicle price caps, on the other hand, could help break the trend of ever-rising average transaction prices (ATPs) for new vehicles. Recall that two percentage points of the increase in inflation (CPI) in 2021 came from autos alone, as manufacturers and dealers pushed the most expensive vehicle models to consumers.

Thoughts on policy, politics, and productivity

US climate policy has lagged efforts in Europe and other countries globally, but the IRA provides more predictable funding for renewables in the US and makes the path to net zero credible (read more on US efforts here). Several independent climate experts have touted the sound design of key provisions and the potential for meaningful reduction in emissions. Of course, execution will be key. The mix of federal and state involvement means that even with the IRA funds in hand, the pace of deployment could vary based on local policies. 

From a political perspective, the IRA represents a badly needed win for the Democrats ahead of the upcoming midterm elections, as climate continues to poll as an important policy area for constituents. While it still appears that the Democrats will lose control of the House of Representatives, they may be able to contain losses and keep the Senate, especially as inflation starts to move lower in coming months as I expect (read more on my inflation outlook).

President Biden’s legacy now includes a boost for both physical and climate infrastructure. The passage of two bipartisan bills — the 2021 infrastructure bill and the 2022 CHIPS Act — alongside the Democrat-led IRA will shape the capacity and competitiveness of US industry for the coming decade. The 2010s brought one of the weakest recoveries in US investment spending in post-war history. It is plausible to assume that the 2020s will see a different pattern (Figure 3). With stronger investment spending, as well as a greater policy focus on domestic production (amid the US/China decoupling), we could see improving productivity growth ahead.

Figure 3

Fossil fuels remain important, of course, as energy is chronically undersupplied and (perversely) likely to see strong demand driven by infrastructure changes required to decarbonize the economy. But in the meantime, technological advances continue to drive down the all-in cost of renewables, with onshore wind and solar already lower in price than hydrocarbon-based power — another plus for productivity (Figure 4).

Finally, it is worth noting that the IRA’s focus on investment spending does not come at the cost of more US public debt, as offsets on the revenue side make the tax credits deficit neutral.

Figure 4

1Source: Repeat Project. Other independent forecasters, such as Energy Innovation and Rhodium Group, also suggest similar numbers.

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