Four Reasons the Inflation Reduction Act Might Be Better at Fighting Inflation than Projected
August 2, 2022
By Mike Konczal
Addressing current high inflation requires an all-of-government approach. Bringing down inflation cannot simply be the responsibility of the Federal Reserve, whose sole tool, adjusting interest rates, risks destabilizing the current strong labor market and tipping the economy into a recession. Instead, our recent analysis shows the need for a comprehensive administrative and legislative response to tackling the inflationary pressures of demand, supply, and market power. The proposed Inflation Reduction Act (IRA), reconciliation legislation being considered by Senate Democrats, is an important step in this direction.
All of the major components of this bill would reduce inflation, contrary to conservative claims. From expanding the supply of energy and addressing the skyrocketing costs of prescription drugs to reducing demand through taxing the rich.
Despite finding that the IRA wouldn’t contribute to inflation, some economic models, like Penn Wharton’s and Moody’s, are skeptical of the IRA’s ability to fight inflation in the near term.
We should be skeptical about that skepticism. The impact on inflation will likely be greater than currently envisioned in those models, for four main reasons:
- Progressive taxation will collect more money than the models project;
- Public financing can bring more energy investment than projected;
- Efforts in the 2010s to address health-care costs reduced inflation; and
- Strong policy can set forward-looking expectations.
Progressive Taxation Will Collect More Money than the Models Project
The IRA uses progressive taxation to address spending, allowing for a more targeted intervention than just relying on the blunt tool of interest rate hikes. As another entry in this series will show, the IRA restores a better balance of equity and justice to the tax code, which has been a major contributor to inequality. The bill also closes the carried interest loophole, a long-standing priority for the Democrats, which could raise up to $14 billion over the next 10 years.
But there’s another reason the IRA’s tax components could reduce inflation: It’s likely that they will raise even more revenue than predicted.
One of the key components of this bill is that it will step up IRS enforcement, which has been lacking in recent decades due to disinvestment. And that will raise significantly more money than the Congressional Budget Office (CBO) and others estimate. Right now, the CBO believes it will net approximately $120 billion. But that analysis fails to consider how a reinvigorated IRS will impact taxpayer behavior and compliance, and almost certainly understates how much the specific focus of resources on the top tier of earners will net. Larry Summers and others have argued that revenue from the bill could therefore be more on the scale of $1 trillion over the next decade. Beyond the tax justice of the rich paying their fair share, that would reduce demand—and thus inflation—more than is being assumed.
Public Financing Can Bring More Energy Investment than Projected
Energy has become one of the central drivers of inflation, contributing 3.9 percent to the 11.1 percent annualized headline inflation in 2022. As our work has emphasized, public investments in the domestic production of clean energy goods will help the economy transition away from inherently volatile fossil fuel prices.
This bill delivers consumer-facing incentives that will make clean energy consumption more lucrative to households. By making electric vehicles, solar panels, heat pumps, and other forms of home electrification cheaper for consumers, these rebates and tax credits will save households up to $1,800 a year.
Other key elements of the bill, such as the $27 billion National Green Bank and $250 billion in loans and guarantees from the Department of Energy, are designed to leverage maximal impact from public dollars and will bring the total clean energy investment higher than the bill’s reported top-line dollar amount over the long term. Studies find $3.70 for every green bank dollar in total investment.
Further, investments in the IRA intended to build out the clean energy supply chain from manufacturing to installation will create the infrastructure and viability for further private investment, similar to the impact of the 2010 stimulus. This means there’s more room for investments than inflation modeling might be capturing.
Efforts in the 2010s to Address Health Care Costs Reduced Inflation
The IRA directly addresses skyrocketing costs in prescription drugs and health care, a big pocketbook issue for families and increasingly a source of inflationary pressures.
Extending the subsidies under the American Rescue Plan that were set to expire by the end of this year will decrease insurance premium costs for millions of American households. Roughly 2 million Americans were eligible for free or cheap insurance coverage as a result of this expansion in 2021. According to the Kaiser Family Foundation and CBO, the proposed bill would reduce the deficit by $288 billion over the next 10 years, and being able to negotiate drug prices would save Medicare $102 billion.
Based on what we’ve experienced in similar measures during the 2010s, we know that reductions in health-care spending can have an impact on measured inflation. Jeffrey Clemens, Joshua D. Gottlieb, and Adam Hale Shapiro, writing at the Federal Reserve Bank of San Francisco, found in 2014 that “the full effect of the Medicare payment cuts from the 2011 Budget Control Act resulted in a decline of 0.24 percentage point in the overall personal consumption expenditures price index” with important private-sector spillovers. The payment cuts to Medicare in the BCA that reduced inflation were estimated by CBO at around $123 billion over 10 years, a similar range to the amount of savings from negotiating drug prices. It’s unlikely the economic modelers are following this dynamic.
Strong Policy Can Set Forward-Looking Expectations
One macroeconomic insight from recent decades is that firms and people don’t set prices just by looking backward, but also by looking forward. However, this is generally taken to absurd extremes in economic modeling and has a conservative bent in public economic discussions, with people fearing anything that could disturb the tea leaves of inflation “expectations.”
But the idea of expectations can also tell a progressive story. By setting guideposts for how to bring down carbon emissions, for example, private industry can move faster and work within a framework to invest in less volatile energy sources. The wealthy, who will pay a fairer share of their taxes, will adjust their spending right away, not just by the year-to-year increased taxes they pay. Health-care and pharma companies will start adjusting their prices now, knowing that bigger interventions are coming later. The expectations of these adjustments can help coordinate price-declining action quickly, faster than when the individual components go into law.
Even if inflation were not high, the Inflation Reduction Act would be worth passing: Addressing health-care costs, the climate crisis, and our inequitable system of taxation are major, popular goals that Democrats should deliver on. But inflation makes passage an even more urgent priority. Since the impact of the IRA on inflation is codetermined between policy and the Federal Reserve, it will be hard to measure. But if this bill helps the Federal Reserve avoid another rate hike, that will benefit everyone. And while each of its individual investments and regulations, under conventional assumptions, might not do much, taken together they will make a real dent in our inflation challenges.