Case Study 2 — The Inflation Reduction Act: Green Industrial Policy as Climate Strategy

On August 16, 2022, President Biden signed the Inflation Reduction Act (IRA) into law. Despite its name, the IRA's primary significance is as climate legislation — the largest climate investment in U.S. history. The law allocates approximately $370 billion (and potentially much more, depending on take-up of tax credits) in clean energy subsidies, tax credits, and incentives over a decade.

The IRA is a case study in what happens when the "first-best" policy (a carbon tax) is politically impossible and the government turns instead to a "second-best" approach (subsidies for clean alternatives). This case study evaluates the IRA through the externality framework from Chapter 11 and the political economy framework from this chapter.

What the IRA does

The IRA's climate provisions include:

For consumers: - Up to $7,500 tax credit for new electric vehicles (with domestic manufacturing requirements) - Up to $4,000 tax credit for used EVs - Tax credits for heat pumps, solar panels, insulation, and other home energy efficiency upgrades - Rebates for low-income households making energy-efficient improvements

For businesses: - Production tax credits for wind and solar electricity (extended through 2032) - Investment tax credits for clean energy facilities - Tax credits for manufacturing clean-energy components (batteries, solar cells, wind turbines) in the U.S. - Tax credits for clean hydrogen production - Tax credits for carbon capture and storage

For the energy sector: - Bonus credits for projects in low-income or energy communities (including former coal towns) - Methane emissions reduction program (with fees for excess methane leaks from oil and gas operations) - A program allowing Medicare to negotiate prices on some prescription drugs (not climate-related but included in the bill)

The total estimated cost ranges from $370 billion (the CBO's initial score) to over $1 trillion (some private estimates that assume higher-than-expected take-up of the uncapped tax credits).

The economic logic

Why subsidies instead of a carbon tax?

In the externality framework from Chapter 11, the efficient response to a negative externality is to tax the externality (a Pigouvian tax). A carbon tax would have been more efficient than subsidies because it directly prices the externality and lets the market find the cheapest reductions.

So why didn't the U.S. enact a carbon tax?

Political infeasibility. A carbon tax was proposed multiple times (the Baker-Shultz Carbon Dividends Plan, various Democratic proposals) and failed every time. The word "tax" is politically toxic in the U.S. Fossil fuel companies, energy-intensive manufacturers, and many Republican legislators oppose carbon taxes. Many Democratic legislators in fossil-fuel-producing states also oppose them. The votes were never there.

The subsidy alternative. Subsidies are politically easier because they reward rather than punish. An EV tax credit makes a specific purchase cheaper — a visible, tangible benefit. A carbon tax makes energy more expensive — a visible, tangible cost. The political math favors carrots over sticks, even when the economics favors sticks.

The IRA passed the Senate 51–50 (with Vice President Harris casting the tiebreaking vote) and the House 220–207. Not a single Republican voted for it. A carbon tax at any level would not have gotten 50 votes.

Is the subsidy approach efficient?

In theory, no. Subsidies for clean energy don't directly price the externality. They lower the cost of the clean alternative without raising the cost of the dirty one. This means the dirty alternative is still underpriced relative to its social cost. Some emissions that a carbon tax would have eliminated will continue because the fossil fuel is still cheaper than the clean alternative in some applications.

In practice, the efficiency loss may be smaller than it sounds, for several reasons:

1. The subsidies are very large. At $370B+ over a decade, the IRA shifts the economics of clean energy substantially. Solar and wind were already cheaper than coal in most of the U.S.; the IRA makes them cheaper than natural gas in many applications. The subsidy doesn't need to be as efficient as a tax if it's large enough to drive the transition anyway.

2. Technological learning curves. The IRA's subsidies for manufacturing (batteries, solar cells, wind turbines) are designed to drive down costs through scale — the same mechanism that has already reduced solar panel costs by 90% since 2010. If the subsidies accelerate the learning curve, the long-run cost of clean energy falls faster, making future climate action cheaper.

3. Industrial policy has strategic benefits. By subsidizing domestic clean-energy manufacturing, the IRA aims to build a U.S. industrial base in the sectors that will dominate the 21st-century energy economy. This is a strategic bet — similar to the semiconductor subsidies in the CHIPS Act — that has benefits beyond the climate externality.

4. Political durability. Subsidies create constituencies (solar installers, EV manufacturers, battery factories in red states) that have an interest in maintaining the policy. A carbon tax, if enacted, could be repealed by the next administration. Subsidies that have created thousands of jobs in specific Congressional districts are harder to repeal. The IRA's design — spreading clean-energy investment across red and blue states — is a deliberate strategy for political durability.

Early evidence (2023–2025)

In the first two years after the IRA's passage:

• Clean-energy investment surged. Over $300 billion in new clean-energy manufacturing investments have been announced in the U.S. since the IRA was signed. Battery factories, solar panel plants, EV assembly lines, and wind-turbine component facilities are under construction in multiple states.

• EV sales accelerated. EV sales in the U.S. rose from about 5.8% of new-car sales in 2022 to about 10% in 2024, partly driven by the IRA's tax credits.

• Emissions projections improved. The Rhodium Group estimates that the IRA will reduce U.S. greenhouse gas emissions by 32–42% below 2005 levels by 2030 — roughly double what would have happened without it. This is still short of the 50–52% reduction the U.S. pledged under the Paris Agreement, but it's a significant improvement.

• Clean-energy jobs grew. The clean-energy sector added about 300,000 jobs in 2023, spread across construction, manufacturing, installation, and engineering. Many of these jobs are in states that historically depended on fossil fuels.

• The cost to government is higher than expected. Take-up of the uncapped tax credits has been higher than CBO estimated. Some analysts now project the IRA's total cost at $800 billion–$1.2 trillion over a decade, roughly double the initial $370 billion estimate. Whether this is a problem (expensive!) or a feature (high take-up means it's working!) depends on your framing.

What the IRA doesn't do

It doesn't price carbon. The largest gap. Without a carbon price, the U.S. is still underpricing fossil fuels relative to their social cost. Emissions that would be eliminated by a $190/ton carbon tax will continue under the IRA because the subsidy approach doesn't directly penalize emissions.

It doesn't address international emissions. The IRA is a domestic policy. It does nothing about emissions from China (the world's largest emitter), India, or other developing countries. The IRA's domestic manufacturing requirements may even shift some emissions to countries with weaker environmental standards (if U.S. consumers buy domestically manufactured clean goods but the mining and processing of inputs happens in countries with dirty energy).

It doesn't address adaptation. The IRA is focused on mitigation (reducing emissions). It does almost nothing for adaptation (preparing for the climate change that is already locked in — sea-level rise infrastructure, drought-resistant agriculture, extreme-weather preparedness). Adaptation is a complement to mitigation, not a substitute, and the U.S. has underinvested in it.

It doesn't solve the political economy problem. The IRA passed on a party-line vote. Its political durability depends on whether the clean-energy jobs and investments it creates become popular enough to survive potential repeal by a future administration. This is a live question as of 2026.

What this case study illustrates

Lesson 1 — Second-best policy can be very effective. The IRA is not the carbon tax that most economists would prefer. But it is having large effects on investment, emissions, and technology development. The "perfect" policy (carbon tax) that can't pass is worse than the "imperfect" policy (subsidies) that can.

Lesson 2 — Political feasibility is a real constraint. The economic analysis says a carbon tax is more efficient. The political analysis says a carbon tax is impossible. The IRA is what you get when you take the political constraint seriously. Economists who insist on carbon-tax-or-nothing will get nothing.

Lesson 3 — The cost of subsidies can be higher than expected. The IRA's uncapped tax credits have been more expensive than projected, raising concerns about fiscal sustainability. This is a real cost of the subsidy approach: when you offer an open-ended incentive, take-up can exceed your estimate.

Lesson 4 — Strategic benefits go beyond the externality. The IRA is partly climate policy, partly industrial policy, partly trade policy (domestic manufacturing requirements), and partly regional development policy (clean-energy jobs in fossil-fuel communities). The multiple objectives make evaluation complex — the IRA may be inefficient as pure climate policy but efficient as a package that achieves several goals simultaneously.

Lesson 5 — The debate about "enough" continues. The IRA improves the U.S. emissions trajectory but does not achieve the Paris Agreement target. Whether additional policy is needed — and what form it should take — is the next chapter of the U.S. climate debate.

Discussion questions

1. The IRA uses subsidies instead of a carbon tax because subsidies are politically feasible and a tax isn't. Is "second-best" policy that passes better than "first-best" policy that doesn't? Always? Sometimes?

2. The IRA's cost is turning out to be higher than expected because take-up of tax credits has been high. Is this a success (the policy is working) or a failure (the policy is too expensive)?

3. The IRA spreads clean-energy investment across red and blue states. Is this good policy design (creates bipartisan constituencies for durability) or wasteful pork-barrel spending?

4. Could a carbon tax have been designed to be politically feasible if the revenue were returned to citizens as a "carbon dividend"? What evidence exists for or against this approach?

5. The IRA addresses mitigation but not adaptation. Should climate policy spend more on adaptation? How would you decide the right balance?