Breaking Down the Inflation Reduction Act’s Green Energy Tax Credits

The Inflation Reduction Act created numerous tax subsidy programs intended to accelerate the transition to a greener economy.

The justification for climate change action is strong, but there are two possible approaches to take which we might colloquially call carrots and sticks. Carrots are subsidies designed to reduce emissions—think tax credits for green energy or carbon capture technology. Sticks, such as carbon taxes, penalize emissions.

Both approaches employ the same theoretical mechanism—they change the relative prices of different activities based on how much carbon they emit. A tax subsidy for wind production makes a wind farm a more attractive energy source than a coal plant; a tax on carbon emissions makes the coal plant a less attractive energy source than the wind farm.

Most evidence suggests the stick approach of a carbon tax is more efficient. The tax allows the market to choose the best approaches to lowering emissions, while subsidies usually involve the government picking specific technologies to support. From a tax perspective, a carbon tax raises revenue that can then be used to reduce other, more economically harmful taxes, creating a double dividend of both economic growth and reduced harm from climate change. Meanwhile, subsidies require tax increases elsewhere in the economy that reduce growth.

The Inflation Reduction Act mostly chooses the carrot approach over the sticks, financing green energy tax credits with poorly designed tax increases. While these policies are not ideal, we can consider whether the subsidies are reasonably well-designed.

Carbon emissions are often classified by sector (e.g., electric power generation, transportation, industrial, commercial and residential, and agricultural). Most of the tax policies focus on reducing electric power, transportation, and commercial and residential emissions.

There are several policies included in the green energy package that are more oriented around supporting U.S. manufacturing rather than directly reducing industrial sector emissions.

Progress Towards Emissions Reduction

The bill should achieve its main policy goal of at least somewhat reducing emissions. Most proponents and news articles point to three independent studies showing around a 40 percent reduction in U.S. emissions a decade from now. However, this figure may be confusing. The 40 percent reduction in emissions is relative to 2005 baseline levels, not today’s emission levels, which have already fallen significantly since 2005 (and were projected to continue falling without the Inflation Reduction Act). Nonetheless, the estimates still show the act reducing emissions by a respectable amount.

The Inflation Reduction Act’s impact on foreign emissions is uncertain. As Holman Jenkins of The Wall Street Journal has argued, promoting clean energy in the United States and prompting Americans to switch away from fossil fuels should lower fossil fuel prices globally, which would then spur additional consumption of fossil fuels in foreign markets. This would increase emissions and partly cancel out the benefits of reduced domestic emissions.

Alternatively, investment in green technology could drive what is known as negative leakage—if policies end up spurring faster development in low-emissions technology domestically, these technologies may become cost-effective in other countries without subsidies, thus leading to an additional reduction in total emissions.

The Inflation Reduction Act takes some steps towards a more technology-neutral approach to reducing carbon emissions. For example, before the law, nuclear energy received low government support relative to other low-emission power sources. The law provides a credit for nuclear energy production that should keep more nuclear power plants online, preventing them from being predominantly replaced by more emissions-intensive energy sources.

Similarly, the Inflation Reduction Act converts existing tax breaks for clean energy investment and production on the power generation side into two technology-neutral tax credits. Starting in 2025, the production and investment tax credits will both be available to any electric generation facility that produces zero, or fewer, carbon emissions—although taxpayers must choose between using one over the other. While a carbon tax would be better from the perspective of technology neutrality (as, for example, the technology-neutral credit does not increase incentives to replace existing coal plants with significantly lower-emission natural gas operations), it is an improvement over the status quo.

While the law introduces some technology-neutral credits, it also includes subsidies for specific technologies, such as $7.9 billion for clean hydrogen technology. Low-to-no-emission hydrogen technology does not exist yet. That does not necessarily mean it will never exist, or that government should never support investment in pre-viable technologies. However, it would be better to have broad incentives for R&D and low-to-no-emission technology, the latter ideally in the form of a carbon tax. With those incentives in place, markets can better allocate capital towards the most promising technologies.

In addition to this broader design problem, these tax credits also feature other provisions that detract from their climate focus. For instance, taxpayers will only be able to fully benefit from several new credits if they meet a handful of requirements around apprenticeships, prevailing wage rates, domestic content usage, and location. Domestic content and prevailing wage requirements have slowed down and raised the cost of American infrastructure investment; including them in tax credits could make those tax credits less effective.

Many of the credits are temporary, providing unstable investment incentives. Frequent changes in environmental policy can make investors less likely to pursue new projects. On the other hand, while many of these credits are temporary, they are more durable than extenders—tax provisions that must be renewed every year. 

The main uncertainty, though, comes from permitting and other regulatory hurdles. For clean energy tax credits to translate into a shift towards renewable energy in the broader economy, several different levels of government need to let companies build power plants, among other things. Permitting has been a major impediment to low- or no-emission energy facilities, from offshore wind to hydropower to solar to nuclear.

The Inflation Reduction Act does not include permitting reform, but its passage came with assurances that a major permitting reform bill would follow. Without significant efforts to cut red tape, new green energy projects could ironically fall victim to regulations, and even activist groups, originally designed to protect the environment.