Productivity Commission offers alternative view of the IRA

Almost 12 months since it was passed by the US Congress, the landmark Inflation Reduction Act (IRA) has sent shockwaves globally and in turn prompted debate on how Australia should respond. Of note in public commentary was the latest Trade and Assistance Review, released last month by the Productivity Commission which argues that an attempt by Australia to adopt countervailing policy responses would be a step in the wrong direction. We take a closer look into the Productivity Commission's views on how Australia should be responding to the IRA.  

Recap of the Inflation Reduction Act

As described in one of our previous articles , the title ‘Inflation Reduction’ Act is a bit of a misnomer. Although an EU report notes that it aims to curb inflation by ‘withdrawing excess purchasing power from the economy by way of increased taxation,’ at its core the IRA provides significant federal funding towards climate efforts. In total, the Act puts an estimated US$394 billion (A$589 billion) towards America’s energy transition in the name of fighting climate change and is the largest funding allocation in US history for this.

Most of the $394 billion directed to energy climate funding comes in the form of tax credits and tax reductions, although there are also grant and loan guarantee schemes in the mix. With its heavy focus on incentive-based changes, some commentators have described the  Act as ‘all carrot, no stick’.  

Figure 1: Selected tax credit modifications in the Inflation Reduction Act

Source: McKinsey & Company

Despite this, the IRA represents a significant step in the United States’ climate ambition. As indicated by the graphs below, the Rhodium group estimates that ‘that the IRA can accelerate emissions reductions to a 32% cut below 2005 levels in 2030, compared to 24% under current policy.’ Given the Biden Administration has stated that its goal of an 50-52% reduction on 2005 levels by 2030, commentators will be closely watching their next steps.

Figure 2: US greenhouse gas emissions

Source: Rhodium Group

Figure 3: US emissions in 2030 under the Inflation Reduction Act, compared to current policy

Source: Rhodium Group

International Response

The international response to the Inflation Reduction Act has been decidedly mixed. While the scope and breadth of the IRA’s climate ambitions have been praised, the ‘Buy American’ provisions within its fine print has led to criticism from some international actors. Indeed, world leaders from Brussels to Seoul have all criticised the bill as amounting to ‘Green Protectionism’, pointing to the tax breaks that only apply to electric vehicle parts and renewable energy products if they are produced in North America. These economic concessions are designed to draw investment and skills away from other countries to the US, leading some commenters to go as far to say that the IRA is the starting gun to a ‘clean-energy arms race.’

Indeed, other international actors have begun to respond in turn. In February of this year, the European Union announced their own Green Deal Industrial Plan, a suite of measures aimed at countering the investment pull from the IRA. The Plan commits $272 billion to the green transition and aims to scale up the EU’s own manufacturing capacity for net-zero technologies and products. Japan’s green transformation bill passed their parliament in May, which likewise funds green transition investments, debt-financed to the tune of US$150 billion. Other countries such as the UK have likewise hinted that they will undertake action of their own.

Figure 4: Comparison of the Inflation Reduction Act and Green Deal Industrial Plan

Source: The Internet Economy Foundation

Australian viewpoints

Naturally, the question of how Australia should respond to the Inflation Reduction Act and other industrial policy developments globally has become a source of debate domestically. As Australian policymakers at Federal and State levels have stated a broad desire for the nation to become a ‘clean energy superpower’, there is concern that these large-scale climate policies from the US and elsewhere may draw the required skills and capital elsewhere.

For example, Professor Ross Garnaut from the University of Melbourne, argues that the ‘IRA will be distracting and destructive’ and that its ‘protectionist character’ may ‘threaten Australia’s zero carbon opportunity’.

The Clean Energy Council notes that the IRA has clearly put us on the backfoot when it comes to this ‘clean-energy arms race.’

Likewise, the Climate Council states that ‘through the IRA, the US has offered a tremendous opportunity to Australia, but one that requires us to respond with similar vision and commitment.’

Finally, as noted in our previous article on the subject, various local business leaders have also argued that Australia needs to act.

The Productivity Commission, however, appears to take a markedly different view.

Productivity Commission Analysis

Released last month, the Productivity Commission’s Trade and Assistance Review includes a considerable amount of commentary on the Inflation Reduction Act and other noted expansions of industrial policy from both the US and EU.

The Productivity Commission cautions that any attempt to emulate or counter the IRA would not be beneficial for a small open economy such as Australia. Indeed, to do so would likely result in a ‘net negative’ for Australia. In explaining why, the Review considers a number of important international trade principles in their analysis, such as Comparative Advantage.   

As the Productivity Commission notes, the ‘primary force behind rising living standards over the post-war period’ has come about as a result of countries focussing on the production of goods and services, they have a comparative advantage in while trading their surplus in these things for goods and services more efficiently produced by other countries.  Common examples include the export-led growth strategies of Asian nations.

Much like other forms of protectionism such as ‘at the border’ tariff protections, ‘behind the border’ industry assistance such as that provided by the IRA potentially has a perverse impact on global and national income gains. While industry assistance might initially result in an initial reduction of market prices for a particular good or service, the rest of the economy indirectly and ultimately, bears the cost of these subsidies for little long-term gain.

According to the Review, should Australia implement industry assistance polices that seek to counter the IRA as some commentators have called for, this would only have the result of ‘distorting Australian production patterns away from our competitive advantage.’ Indeed, given the size of the Australian economy, any attempt to create domestic industries that could compete with those subsidised by the IRA would likely be futile and at great cost to the rest of the Australian economy. Moreover, the Review notes that if Australia goes down this path, it could have the unintended effect of encouraging other small open economies to have a similar response. This would only further the ‘erosion of the rules-based global trading system’ and in turn ‘lower the collective gains from international trade.’

Therefore, when thinking about any potential Australian responses to the Inflation Reduction Act, the Productivity Commission writes that it is worth returning to the notion that ‘that all countries should focus where they fit best within global production patterns’ even if they are ‘are distorted by major economy industry policy.’ Australia, in this case, has existing comparative advantages in the supply of natural resources and the production of high-skill services which stand to benefit from the IRA. Australia’s mining and critical mineral processing sectors, for instance, are well positioned to become more internationally competitive due to increased US demand for critical minerals. Moreover, the IRA and similar forms of major economy industry policy, if successful, would create larger manufacturing sectors in the US and EU which would allocate ‘resources away from their services sector’. This could likewise boost demand for Australian services.

While the IRA might be detrimental to Australia’s ambitions in developing clean energy technologies locally, benefits will nonetheless flow into other sectors where Australia has competitive advantage. If, as the review notes, Australia’s ambitions for a domestic energy sector were purely premised on environmental concerns, then the IRA ‘would advance those same goals at a global level, at no direct cost to Australia.’