Business & Economics

The Inflation Reduction Act Is All Smoke and Mirrors

Despite the proposed legislation’s name, it will likely neither lower inflation nor meaningfully reduce the deficit

Optical illusion. Contrary to its name, the Inflation Reduction Act won’t lower inflation or reduce debt. Image Credit: Mubariz Khan/Getty Images

In a shocking reversal, Sen. Joe Manchin (D-W.V.) has announced that he will agree to more spending and taxes in the name of fighting inflation. If it weren’t so sad, it would be fascinating to ponder the question of how someone can say the opposite of what he has been saying for over a year after he was proven right all along. Sen. Kyrsten Sinema (D-Ariz.), who has also been a wise legislator this past year, has signaled that she could lend her support to new legislation after Senate Democrats agreed to drop the proposal for taxing hedge fund managers’ profits as income (at a higher rate) rather than as capital gains.

After surging inflation doused progressives’ hopes of passing a multitrillion-dollar spending bill, congressional Democrats have seemingly convinced moderates within their ranks to support a slimmed-down version of the Build Back Better legislation.

Advocates of the proposed legislation, rebranded as the Inflation Reduction Act, say that it makes “a historic down payment on deficit reduction to fight inflation.” Sen. Manchin claimed that the proposed legislation would “begin paying down our $30 trillion national debt.”

But the name of a proposed statute doesn’t guarantee results. In this case, a closer look at the proposal, its rosy assumptions and its use of budget gimmicks reveals that it is unlikely to reduce inflation at all, let alone meaningfully reduce the deficit in any significant way.

What’s at Stake

What will it take to both tame inflation and reduce the national debt? During the pandemic, the Federal Reserve bought $2.7 trillion in Treasurys and over $1.3 trillion in mortgage-backed securities, and Congress spent over $5 trillion in a seriously supply-constrained economy. Under these conditions, it is stunning that so few people saw inflation coming.

To tame inflation, then, the Fed needs to raise interest rates to soak up all the money that the Fed’s and Congress’ expansionary policies injected into the economy. But the fiscal authorities need to do their part, too, by seriously tightening Uncle Sam’s belt through fiscal consolidation. We can’t stress enough how much this matters. If Congress fails to do its part, Americans may experience the harsh reality of stagflation.

As John Cochrane reminds us: “In 1970 and 1974, the Fed raised interest rates more promptly and more sharply than now, from 4% to 9% in 1970, and from 3.5% to 13% in 1974. Each rise produced a bruising recession. Each lowered inflation. Each time, inflation roared back.”

With these principles in mind, it becomes apparent that the skinny Build Back Better bill is just another spending splurge, funded with tax hikes that will damage the economy at a time when the U.S. is on the verge of entering a recession.

The Real Costs of the Proposal

Early cost estimates of the proposed legislation by the Penn Wharton budget model find that, as written, the bill would reduce the 10-year cumulative deficit by $248 billion. Making a realistic assumption that the Affordable Care Act subsidy provisions will not sunset in 2025, the Penn Wharton budget model finds that the deficit would be reduced by just $89 billion—a measly 0.6%.

No earnest economist would consider this level of deficit reduction a serious “down payment” to tackle out-of-control budget deficits, which are forecast to total $15.74 trillion over the coming decade. What’s more, the Penn Wharton analysis found that the impact of the “Deficit Reduction Act” on inflation would be statistically indistinguishable from zero.

Some economists have nevertheless championed the proposed legislation, arguing that although it raises inflation marginally in the near term, it actually reduces inflation in the longer run. In other words, they argue that it isn’t a problem if the legislation raises our current inflation rate of 9% today, so long as the bill marginally reduces inflation in the late 2020s, when inflation is forecast to be around 2% anyway.

Another problem with the cost estimates presented by the Senate proposal is that some of the estimates from the Joint Committee on Taxation don’t use dynamic scoring. Put another way, these cost estimates do not account for the negative effects of legislation on GDP—these effects tend to result in less revenue than nondynamic estimates report.

For example, the proposal estimates that $313 billion in revenue will be raised from implementing the 15% corporate minimum tax. However, dynamic cost estimates of this proposal find that it would raise somewhere between $100 billion and $200 billion in new revenues over a decade. Taking these differences into account, this legislation might actually make budget deficits larger.

The idea that raising the corporate tax burden to fund new spending can reduce inflation is an old Keynesian theory that we thought had died in the 1970s. Up till then, Keynesian theory placed great emphasis on the deflationary effects of tax hikes on consumer spending. However, tax hikes, especially on corporations, depress investment and productivity and further suppress the struggling supply side of the economy. Economists have known this since the emergence of supply-side economics in the 1970s and ’80s.

Economic Effects of the Inflation Reduction Act

Then there is the issue of who will feel the effect of this tax burden. The Tax Foundation estimates that the largest burden will fall on the U.S. manufacturing industry, which would have to shoulder over $73 billion in new taxes. An additional $32 billion tax hike would fall on the transportation and warehousing industry, which has struggled for the past two years to keep up with excess demand. With the supply side of the economy already struggling to keep up with excess demand, the last thing we need is to increase the tax burden on businesses.

The bill also includes billions of dollars in corporate welfare, much of which is included under the guise of climate change provisions. For example, the $7,500 tax credit for electric vehicle (EV) purchases will be passed on to EV companies such as Tesla in the form of increased vehicle sales. Meanwhile, legislators twisted Sen. Manchin’s arm by promising to fast-track the construction of natural gas pipelines in his home state of West Virginia—this after the administration spent two years opposing the construction of new oil and gas pipelines.

Proposed prescription drug price reforms in the Inflation Reduction Act give the government the power to set drug prices irrespective of market forces and apply a punitive tax to drug manufacturers if they balk. In a world that already suffers from the healthcare market being fatally distorted by government interventions, this proposal adds yet another distortion. What these drug price reforms would achieve is enabling Congress to credit itself with saving money. In sum, it’s bad policy that will only result in reduced access to drugs for those who need them most.

If policymakers are serious about deficit reduction, then they should be proposing reductions in spending, which this legislation doesn’t do. Instead, the Inflation Reduction Act imposes tax increases, market-distorting federal subsidies and price controls on an ailing American economy—all while failing to reduce surging inflation or curb our multitrillion-dollar budget deficits. Don’t fall for the headline; the Inflation Reduction Act won’t live up to its name.

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