On Sunday, August 7, along strictly partisan lines, the Senate passed the Biden administration’s misnamed Inflation Reduction Act (IRA), with Vice President Kamala Harris casting the tiebreaking vote. The bill avoided a filibuster after the Senate parliamentarian held that the energy and drug provisions were budgetary matters that satisfied the reconciliation procedure under the Byrd Rule. Some strategic concessions won over the two Democrat holdouts, senators Joe Manchin of West Virginia and Kyrsten Sinema of Arizona. As matters now stand, the IRA cobbles together a number of disparate programs whose common thread is taxing a wide range of activities to supply handsome subsidies, largely for health care ($64 billion) and climate and renewable energy programs ($369 billion).
The overall legislation is notable for its relentless ad hoc–ery and last-minute amendments. On the taxation side, there is a 15 percent book minimum tax, that is, income that companies report to their investors, free of the odd quirks found in the Internal Revenue Code. The IRA now tinkers with the carried-interest exception by extending the long-term capital gain treatment waiting period from three to five years, but only for people whose adjusted gross income exceeds $400,000. In the IRA, there is also a stiff excise tax on drug manufacturers and drug companies with the temerity to refuse supplying the government with prescription drugs at bargain prices under Medicare Part D. And the ARA allocates $80 billion to increased IRS enforcement over the next ten years. In its most recent analysis, published on August 2, the Tax Foundation concluded that the bill is much ado about nothing, estimating that it will generate about $304 billion over the next ten years, with only tiny changes in both GDP growth wages of -0.1 percent, and a loss of some 30,000 jobs over that period. Following Senator Sinema’s changes, at least one Democratic official maintained the IRA would still generate close to $300 billion.
There is thus a striking disconnect between the huge political battle over the legislation and these modest estimates of its supposed consequences. Unsurprisingly, professional economists are deeply divided over the impact of the legislation. On the one side stand critics of the IRA, who fear its provisions are down payments on a much larger programs to come; on the other are defenders of the program, such as Alan Blinder, who tend to say that opposition to the program is overblown, if only because “damage done through higher corporate rates would be offset by job-creating provisions.”
Unfortunately, this one sentence reveals the dangerous mindset that permeates the entire Democratic Party program. Why believe that these promised offsets will ever take place in this overheated political environment? At present, there are no available, let alone credible, estimates as to the size of these effects, which is par for the course. But matters only get worse because no estimate, however sophisticated, can anticipate how future regulations and ultimate enforcement policies will shape the economic effects. Elect a Republican president in 2024 and we have one kind of tax regime; elect a Democrat and there is quite another. Economists like Blinder then compound their original error when they insist that “higher taxes on capital distort corporate decision-making, but in the direction of using more labor, not less.” But, a priori, a distortion for labor is neither better nor worse than one for capital. Reduce capital, and the result may be diminished investments that in turn lead to fewer jobs.
The same critique applies to every one of the IRA’s provisions. Sure, it sounds good to talk about increased tax enforcement to collect what the government is owed. However, that optimistic scenario ignores possible wayward actions by the IRS. For instance, evangelical tax collectors could try to extort revenues from taxpayers who don’t owe any additional tax, drive out of business firms that need certain tax breaks in one area to offset overtaxation under the tax code under another, or perhaps do nothing much at all. Further, the enforcement could end up primarily targeting lower- and middle-income taxpayers. Pushing down prices on pharmaceuticals may well smother innovation by reducing available capital, which will move to other sectors that promise a higher rate of return. The consequent fewer new drugs and devices will translate into higher health care costs and inferior health care outcomes.
It seems painfully clear that, taken as a whole, this extensive tinkering with a new set of taxes here and a new set of giveaways there will do nothing to cool down today’s overheated rate of inflation. The cash infusions will offset the taxes, so that the anticipated shrinkage in the size of the economic pie will keep inflation on its current course, no matter how many times the White House releases grandiose pronouncements that the bill is all gain and no pain.
The sad truth of the system is that we need to develop a more coherent approach to tax reform that raises needed revenues without imposing undue costs on the economy. The basic prescription is diametrically opposed to the current approach. First, we must, as best we can, determine the optimal structure of the tax system and then adjust only the rates, but never the structure, in order to meet revenue requirements. On the first point, the general sources of tax revenue should be imposed on a broad base of productive activities, preferably by flat rate, which can then rise or fall with revenue needs. What is crucial is that this structural commitment avoids the endless struggles over the particular objects of taxation—which currently characterize tax policy arguments—rather than its proper scale.
To be sure, there are many remaining problems. Policing the line between capital gains and ordinary income is always difficult, which is why the case for a consumption tax is so strong. Such a regime makes it unnecessary to look to the source of income to determine how it is taxed, and the long-standing carried-interest debate just disappears. All income is treated the same way, so that wealth tucked away in a lockbox avoids taxation until it is withdrawn for a current use. In the short run, that solution is not available, so the key point is to settle the structural issue on carried interest in a permanent manner. Since the entrepreneur gets both deferred compensation for his labor and capital appreciation from his original sweat equity, the best solution might be to settle on a fifty-fifty split of gain through good times and bad. But the worst way to deal with this knotty problem is to tie retention of this gain to the willingness to impose a terrible special tax—one that, in the current case of a stock buyback tax increase, discourages the redeployment of capital to venture capitalists, who can make better use of it that corporate CEOs flush with idle cash.
The situation of energy subsidies programs is even worse. But here the problem is less with the tax system and more with the overconfident assessment that huge expenditures, direct or indirect, should be made to curb net carbon dioxide emissions. The proposed shift away from fossil fuels is bound to fail in both the short and the long run. Today, our pressing need is to increase fossil fuel production to make up for shortages at home and abroad. Russia’s war on Ukraine has given rise to an extensive energy shortage throughout Western Europe.
But the prevailing compromise in American energy policy is a mishmash of special subsidies targeted to carbon dioxide capture on the one side and hydrogen production on the other, along with special benefits for solar and wind. We thus drift ever further from the only sensible solution, that is, to contain negative externalities like noise and emissions without subsidizing some rival technology that may or may not prove better. Driving net carbon dioxide emissions to record lows is not necessary to save the world, especially given the serious weaknesses of both wind and solar energy.
In all cases, moreover, the relevant calculations have to be made at the margin. Without question, there have been massive improvements in the extraction and use of fossil fuels, which affect the amount and types of carbon dioxide emissions. There is much to fear from violent swings by invoking a deep decarbonization policy that moves too fast, thereby putting millions of people at risk of grave energy shortages. [DH1] [RAE2] We have already witnessed the debacle that has taken place in Sri Lanka from its reckless shift to organic farming . With soaring energy prices threatening to wreak havoc in Great Britain and Western Europe, it is irresponsible to follow John Kerry’s long-standing advice to not let Ukraine (or anything else) to stand in the path of his alarmist energy agenda. Unfortunately, the Senate Democrats appear to have thrown caution to the wind and are recklessly careening ahead with the inclusion of their energy subsidies program in the IRA, which aligns with Kerry’s position.
And so, by making a few fatal blunders, the proposed IRA is likely to fail on two counts. It will make a mess of the taxation system while creating serious energy dislocations at home and abroad.