The Inflation Reduction Act is a Threat to Freedom Even If It Succeeds in Reducing Inflation
October 2, 2022
The title of this article might surprise the reader. How can the Inflation Reduction Act (IRA) threaten freedom if it reduces the inflation rate? Answer: A high rate of inflation is only one threat to economic freedom, and the IRA includes additional measures that have little or nothing to do with lowering the present high inflation rate. The threat to freedom, however, extends beyond this observation, which is the primary conclusion of this article.
When President Biden signed the IRA into law in August 2022, it represented one of four major pieces of economic legislation enacted during his Presidency. The legislation that serves as the core of President Biden’s economic agenda includes the $1.9 trillion American Rescue Plan enacted in March 2021, the $1.2 trillion Infrastructure Investment and Jobs Act enacted in November 2021, the $280 billion CHIPS and Science Act enacted in August 2022, and the $737 billion Inflation Reduction Act also enacted in August 2022. Although the Biden administration has denied it, many critics have identified the authorization of so much federal stimulus as responsible for the present high inflation rate.
What effect has the Infrastructure Investment and Jobs Act of 2021 had on the inflation rate?
Consider, for example, the $1 trillion Infrastructure Investment and Jobs Act of 2021. Much of the spending is new spending. As Restuccia and Collins (2021) reported, “the infrastructure package includes about $550 billion above projected federal spending on roads, bridges, expanded broadband access and more.” Furthermore, the “remainder of the funding—roughly $120 billion of the $550 billion in new spending—comes in the form of competitive grants. Many of those grants are intended for big-ticket items such as bridge replacements or new rail lines” (Restuccia and Collins 2021). As reported in The Wall Street Journal, “The legislation directs tens of billions of dollars over the next five years or more to repair bridges, redesign intersections, expand rail service and upgrade airports and power lines, representing the largest federal infrastructure investment in more than a decade” (Hufford 2021). There is widespread agreement that America needs to repair and improve its aging physical infrastructure. The question is how the nation can maximize the social benefits associated with this project while minimizing any potential negative consequences that may accompany it.
Businesspeople knew before the legislation was enacted that the likely impact of so much federal spending would include serious complications for the economy. A primary reason for these pessimistic predictions was the supply chain problems that exploded during the pandemic and that have remained with us in modified form to the present day. For example, “[a]t Stellar Industries in Garner, Iowa, President David Zrostlik said he anticipated infrastructure projects funded through the bill will boost orders for his company’s construction-equipment maintenance trucks. He said it would be difficult for Stellar to fill all [] the expected orders in the short term, especially since his company’s backlog is already at eight months” (Hufford 2021). This example reveals how massive government spending programs frequently become inflationary. Any single firm will see some immediate gains as prices rise, but an initial boost in terms of orders and prices for a firm also means higher prices for customers of those firms, especially when the firms cannot expand production due to supply constraints. Moreover, the initial boost to orders and prices in the presence of supply chain disruptions will be accompanied by all the negative side effects that I have discussed elsewhere, which include wage inflation, distortions in the structure of relative prices and wages harming small businesses, and labor strikes as a tight labor market and a wage-price inflationary spiral incentivizes workers to demand periodic wage increases.
The manufacturing sector is one segment of the economy that anticipated rising prices stemming from the huge increase in federal infrastructure investment. For example, “FRP Holdings Inc. owns property in the U.S. that is mined for construction aggregates, like sand and gravel” (Hufford 2021). According to its “Financial chief John Baker III, . . . ‘[a]ny additional demand, like the kind we see should this bill become law, would stretch supply when supply is already stretched pretty thin, which should lead to meaningful price increases’” (Hufford 2021). Also, as The Wall Street Journal reported in early November 2021, “U.S. manufacturers said the new $1 trillion infrastructure bill will support years’ worth of public works projects that will create demand for maintenance equipment and construction supplies, and potentially push prices higher” (Hufford 2021). As Hufford (2021) also noted, “Manufacturers and construction companies are already struggling to meet increased demand this year as labor and part shortages delay output. Total construction spending and consumer purchases of goods both are running significantly higher than before the pandemic, according to federal data.” Indeed, these pressures are precisely the reason the infrastructure law has been one of the major contributors to the present high inflation. Supply chain problems combined with a surge of government spending could only produce higher inflation, especially in the short-term.
Some defenders of the infrastructure law will argue that the increase in federal spending did not occur immediately. As noted by industry executives shortly before the legislation was enacted, “the projects funded by the new bill aren’t likely to get under way for several months or a year. That lag could give companies time to catch up with current backlogs created by supply-chain constraints and tight labor, they said” (Hufford 2021). Similarly, “[s]ome manufacturers said the wait for new demand could be helpful as it’s already difficult to produce enough due to supply chain, labor and logistical constraints” (Hufford 2021). There are two reasons why defenders of the law cannot shift the blame for the present inflation based on the argument that the delay in government spending excludes the spending as the source of the rapid increase in prices. First, the supply chain disruptions have not been resolved and so the delay in spending has not avoided putting upward pressure on prices. Second, as macroeconomists are aware, a boost in expected future inflation leads to higher wage and price demands by sellers of labor and commodities today, which produces higher inflation in the present. As Harrison (2022) explains, “Economists closely follow inflation expectations because they can feed into actual inflation in the future. If workers and businesses expect inflation to accelerate, they will be more likely to ask for higher wages or raise their prices. Likewise, if they expect more moderate inflation they will perhaps accept slower wage and price increases.” In other words, the announcement of an unexpected future growth of the money supply or an unexpected future rise in federal spending can alter inflation expectations and spending patterns in the present. ?
So many businesspeople identified the problem with the legislation that it is impossible to include all their insights. Even a month before the law was enacted, the supply chain problems were recognized to be a global problem. According to Yap et al. (2021), “Global supply-chain bottlenecks are feeding on one another, with shortages of components and surging prices of critical raw materials squeezing manufacturers around the world.” Furthermore, the global labor shortages were widely perceived to be a challenge to the resumption of economic growth. As Yap et al. (2021) explain, “[G]lobal labor shortages, often the result of people leaving the workforce during the pandemic, [were] throwing further obstacles in the way of producers.” One company president expressed his concern that “supply chain and labor shortages will make it difficult for both manufacturers and construction companies to finish projects on time” (Hufford 2021). As he further noted, “Between supply chain issues and labor shortages, if it takes a year, that’s not necessarily a bad thing” (quoted in Hufford 2021). Imagine a company president prior to the pandemic expressing a willingness to see higher demand for her company’s products postponed for a year.
The timing of the infrastructure law was poorly chosen. The approach appears to have been one of full speed ahead combined with the view that economic conditions should not influence the strategy to address infrastructure concerns. Therefore, the Biden administration needed to focus more on the timing and magnitude of its infrastructure plan. Of course, no one knew for sure what the supply chain situation would be six months to a year after the legislation was enacted. As it turned out, the supply side issues had not diminished sufficiently before the law boosted demand. The impact of an increase in aggregate demand should not be left to chance to this extent. Because that was the tactic chosen, a high rate of inflation is now the result.
Perhaps most troubling is the fact that the Biden administration knew the supply chain problems were an obstacle to the successful implementation of its massive federal infrastructure investment program. One sign of this awareness is reflected in the Biden administration’s prioritization of grants for port infrastructure. As reported in The Wall Street Journal in November 2021, “Earlier this month, the administration said one of its first priorities would be grants for port infrastructure to help deal with a backlogged supply chain. The White House said it would begin accepting applications for $475 million in funding within 90 days” (Restuccia and Collins 2021). This emphasis in the law suggests that the Biden administration recognized the supply chain problem, but even recipients of these grants for port infrastructure investments would be likely to face the same supply chain challenges as everyone else. Transportation officials recognized the imperfect nature of this approach to the problem as some officials “said the package would have limited near-term impact on supply-chain snarls” (Restuccia and Collins 2021). Given the present high rate of inflation, the implication seems to be that whatever measures were included to address this end of the problem were insufficient.
Republicans have identified infrastructure investment as an important policy objective, but their policy recommendations have been very different. For example, in February 2018, President Trump proposed a $200 billion federal infrastructure plan, which included $100 billion to incentivize local and state governments to invest in new infrastructure or to join with private companies to obtain access to federal money for infrastructure spending (Timm 2018). Two aspects of the plan are worth noting. First, the plan was pre-pandemic and so the supply chain problems had not yet exploded. Given the knowledge available at the time, the plan was timed so as not to create any upward pressure on prices since inflation was being kept in check. Second, the public-private partnerships would mean that the plan would cause a much smaller negative impact on the budget deficit than the plan the Democrats proposed. It would also help ensure that the funds were spent more efficiently as private companies focus on the profitability of their investments and state and local communities are more in tune with their own infrastructure needs. Moreover, private companies and state and local governments were expected to put up their own funds, which would help ensure a more careful allocation of federal and state and local government funds. As President Trump explained to the Governors of Wisconsin and Virginia at the time, they know better than anyone else where the money should be invested (Timm 2018).
At the time, House Minority Leader Nancy Pelosi (D-CA) boasted that the Democrats’ $1 trillion infrastructure plan was five times the size of President Trump’s plan (Timm 2018). The Democrats’ plan was five times bigger if one only considers the $200 billion of federal spending and ignores the incentives for private enterprises and state and local governments to invest in infrastructure repair and development, which were the core of Pres. Trump’s plan. Furthermore, we are now seeing the consequences of the “bigger is always better” approach to federal spending, particularly in an era where economic conditions have significantly changed due to supply chain disruptions. Bigger is always better and full speed ahead were the guiding principles, and now Americans are suffering the consequences.
The suggestion that infrastructure investments will produce long-term benefits in the form of reduced transportation costs that ultimately put downward pressure on prices is not one that will save us from a disastrous experience with high inflation. As one business executive noted, “new building projects could eventually reduce transportation costs” (Hufford 2021). Such projects include “[e]verything from the electrical grid, which needs improvement, to ports and roads and bridges” (Hufford 2021). Infrastructure projects take months or even years to complete. Every day that high inflation rates continue, the distortions they introduce into the price structure cause damage to the economy. We should also be very skeptical of any suggestion that a federal spending program that is causing inflation is also the solution to our inflation problem. Americans deserve policymakers who will advocate and implement direct and immediate solutions to economic problems.
Figure 1 in the Appendix shows the annual CPI-U inflation rate from 2016 to 2022. Roughly speaking, the CPI-U inflation rate shows us the percentage change in the prices of goods and services that all urban consumers purchase. Although an econometric analysis would be needed to control for other variables, the assertion that the law has contributed to the present high inflation is consistent with the data. Figure 1 shows the annual inflation rate rising to 5.4% in June 2021 and jumping again to 9.1% by June 2022. Although not conclusive evidence, the first jump in the inflation rate followed the American Rescue Plan enacted in March 2021 with the inflation rate reaching its highest peak in recent memory a little more than a half-year after the enactment of the Infrastructure Investment and Jobs Act. Students of economics know that correlation does not imply causation, but this causal story is firmly rooted in macroeconomic theory. On the other hand, supply chain disruptions can cause prices to rise, but they cannot alone create the kind of sustained inflation that results from an overheating economy. For that result, you need excessive money supply growth and regular injections of that purchasing power into the economy. The Fed and the Biden administration have jointly produced the present high inflation rates by means of the implementation of their expansionary macroeconomic policies. Finally, small dips in the inflation rate since June 2022 do not change the fact that prices continue to rise at an historically rapid pace.
What are the key elements of the Inflation Reduction Act of 2022?
The Inflation Reduction Act (IRA) that President Biden signed into law in August 2022 includes three main elements. The IRA aims “to lower prescription drug prices, boost the renewable energy sector and impose new taxes on large corporations” (Restuccia 2022). This proposed legislation received even less support from Congressional Republicans than the Infrastructure Investment and Jobs Act. As Restuccia (2022) reported in August 2022, “the House and Senate both passed the legislation on party-line votes earlier this month without support from a single Republican lawmaker” (Restuccia 2022). Nevertheless, the bill passed in Congress due to a compromise that was struck “after months of on-and-off negotiations between Sen. Joe Manchin (D., W.Va.) and Senate Majority Leader Chuck Schumer (D., N.Y.) over a crucial piece of President Biden’s agenda” (Omeokwe and Hughes 2022). Contrary to the Build Back Better title that Democrats had applied to the legislation in 2021, Manchin and Schumer named the compromise legislation the “Inflation Reduction Act of 2022” (Duehren et al. 2022). This name change gave the impression that Congressional Democrats were addressing a major economic problem, but oddly, it was one of their own making.
As reported in The Wall Street Journal, “[t]he deal . . . would raise roughly $739 billion, with much of the revenue coming from a 15% corporate minimum tax and enhanced tax enforcement efforts at the Internal Revenue Service, as well as projected savings from allowing Medicare to negotiate some prescription-drug prices” (Duehren et al. 2022). “Of that new revenue, roughly $369 billion would be spent on climate and energy programs, including tax credits for buying electric vehicles, with another $64 billion dedicated to extending healthcare subsidies for three years for some Affordable Care Act users. The bill would dedicate the rest of the new revenue toward reducing the deficit, according to a summary provided by [] Schumer and Manchin” (Duehren et al. 2022). The IRA is thus a mix of contractionary tax increases and tax enforcement efforts, expansionary tax credits and other spending in the pursuit of energy and climate objectives, and the expansionary extension of healthcare subsidies. Clearly, the law will have both contractionary and expansionary effects on the U.S. economy.
Ip (2022) makes the point that Biden and the law’s supporters are treating the Inflation Reduction Act as the “Emissions Reduction Act” because the climate and energy components of the law are so significant. This point supports the contention that the legislation is more about achieving ends that have nothing to do with reducing inflation. The law thus bears a name that can only reasonably be regarded as false advertising. That is, contrary to its name, not everything in the IRA is aimed at reducing the inflation rate, and some components of the law will have the opposite effect.
Even the proponents of the law acknowledge that, at most, only the net effect of the measures on the inflation rate will be negative. As described in The Wall Street Journal, “[t]he deal . . . raises some taxes and limits prescription drug price increases, both of which would help slow inflation, economists said. But it also raises government spending on climate and healthcare programs, which could add more upward pressure on prices. Overall, the agreement reduces the federal deficit by about $300 billion over a decade, according to Senate Democrats” (Harrison 2022). Furthermore, economists report that any tendency to “restrain price increases . . . will be relatively small and won’t show up for several years” (Harrison 2022). To be more specific, “[a]n economic model run by the University of Pennsylvania estimated the framework would shave about 0.25 percentage point from inflation annually by the late 2020s, according to Kent Smetters, who directs the model” (Harrison 2022). With an annual inflation rate exceeding 9% in June 2022, this future impact on the inflation rate amounts to almost nothing. In any case, we have no time to waste.
What are the likely effects of the climate measures that are part of the IRA?
The IRA includes spending of “roughly $369 billion on climate and energy programs, including tax credits for buying electric and hydrogen vehicles and making energy-efficient home improvements. Mr. Manchin said the proposed legislation would invest in technologies needed for cleaner production and use of fuel types including hydrogen, nuclear, renewables and fossil fuels” (Omeokwe and Hughes 2022). Restuccia (2022) adds that “[t]he package includes hundreds of billions of dollars in subsidies for investing in renewable-energy projects and producing energy from renewable sources—and includes credits to help factories retool to turn out electric vehicles or other products needed in a low-carbon economy. It also includes tax credits to help homeowners upgrade their homes with more energy-efficient products. It gives a $7,500 tax credit for purchasing electric vehicles, although with conditions that could make it hard to qualify.”
To summarize the climate and energy components of the IRA, subsidies and tax credits for investing in renewable energy projects, are part of the plan to reduce inflation. How does that work? The immediate impact is the opposite. The only possible way in which these measures can reduce inflation is by eventually reducing the cost of energy, but it adds to the problem before it addresses it. America cannot wait for these measures to work their magic. Again, the law contains objectives that are being presented as inflation-reduction measures but that do no nothing to reduce the inflation rate and instead worsen the problem. Framing the legislation as a set of inflation-reduction measures is thus very misleading. ?
The impact of the IRA on global emissions by 2030 will be small and not enough to stop the planet from warming. According to Ip (2022), “[t]he incremental reduction in emissions from the IRA is 6% to 10%, according to the research firm Rhodium Group, or 15%, according to Princeton University’s Zero Lab. This translates to roughly 1% to 3% of expected global emissions in 2030: a start, but not enough to move the needle on temperature.” The legislation might affect the adoption of new technologies, which could have a great impact, Ip (2022) states. As Ip (2022) puts it, “Where the bill could be truly consequential is in planting the seeds for technology adoption that drives emissions lower beyond 2030. Recent history shows that climate policies such as taxes, subsidies and mandates matter most by catalyzing a virtuous cycle of higher demand that leads to more innovation, learning-by-doing and economies of scale that lower costs and further boost demand” (Ip 2022). On the other hand, these benefits are, at best, long-term benefits that will not be felt for at least a decade, Ip (2022) argues.
Inflation is an immediate problem that requires immediate solutions. The connection between renewable energy subsidies and tax credits, on the one hand, and inflation reduction, on the other hand, is very weak. New productive technologies do expand supplies, which puts downward pressure on prices, but any such impact is so far down the road that the damage to the economy in the interim must not be ignored.
What are the likely effects of the healthcare measures that are part of the IRA?
The healthcare measures that are part of the IRA are like the energy and climate components in terms of their potential to have no impact on, or even to contribute to, rather than combat, the present high inflation rate. The IRA includes an extension of the subsidies under the Affordable Care Act (ACA). Specifically, the “deal will dedicate $64 billion to extending for three years the Affordable Care Act subsidies that first kicked in under the 2021 American Rescue Plan” (Omeokwe and Hughes 2022). This component of the law is interesting. The objective is to lower health insurance premiums for millions of Americans, but while the subsidies may lower the price of health insurance for some Americans, they do not reduce spending on healthcare overall because the subsidies make up for what the covered Americans do not pay. Additionally, we are talking about a change that is unlikely to affect inflation generally. By what mechanism would such a reduction occur in the general price level? On what grounds can this component of the law be regarded as an inflation-fighting measure? The government cannot reduce the inflation rate by targeting a few specific prices for reduction. ???
The IRA contains a couple items related to the pricing of prescription drugs that are especially controversial. Walker (2022) notes that one of “[t]he most contentious aspects of the drug-pricing provisions [is] those requiring Medicare to directly negotiate prices for certain drugs starting in 2026[.]” As Walker (2022) reported in The Wall Street Journal, “Starting in 2026, Medicare will negotiate prices for 10 drugs in Part D from a list of 50 drugs with the highest program spending that have been on the market for nine or 13 years and lack generic competition. Additional drugs would be added each year afterward. In 2028, Medicare will start negotiating prices for high-spending drugs in the Part B program, which covers outpatient medical care such as drugs that are administered by healthcare professionals.” The IRA will “allow Medicare to negotiate the cost of some prescription drugs with pharmaceutical companies, a longtime goal of many Democrats that has been opposed by the drug industry, which says it would stifle innovation” (Omeokwe and Hughes 2022). For sure, this measure enhances monopsony power in the market for prescription drugs, which depresses prices and reduces production below the levels that would exist in a competitive market. Hence, the market outcome is less efficient than it would otherwise be. Also, pharmaceutical companies use profits to finance research and development, so if prices are held artificially down, then it will cut into profits and stifle innovation. The stifling of innovation in the industry means improvements to existing prescription drugs and the development of new drugs will be less likely. The tragic side effect of such government policies then is that by destroying the willingness to innovate (i.e., the profit incentive), they undermine the ability to innovate (i.e., profits as a major source of financing).
From a policymaker’s perspective, the high prices of some prescription drugs are a mixed bag. High prices make prescription drugs less affordable, but they also ensure the profitability to develop and improve them. Patent protection is essential even in a free-market economy because otherwise competitors would have virtually unlimited opportunities to appropriate the benefits of their competitors’ efforts and investments. Patent protection grants short-term monopoly power to firms holding patents precisely so that competitors will not be allowed to engage in such behavior. Once the period of patent protection expires, competitors will be allowed to produce similar products, which will put downward pressure on prices. The mixed bag of high prices for some prescription drugs is not something we should seek to throw away. High prices in the industry are important for a period of years until the benefits from competition outweigh the benefits from protecting innovators. Therefore, if a policymaker thinks that the price of a prescription drug is too high, then the debate should focus on the length of the patent protection period, or when competition in the production of that drug should be allowed to begin. The suggestion that the government should enter the market as a large buyer or as a monopsony buyer of the drug is to recommend more market power rather than less in the industry.??
Advocates of requiring the government to directly negotiate the prices of prescription drugs that are made available through the Medicare program are not seeing the importance of maintaining the mixed bag of high prescription drug prices. As Walker (2022) reports, “The [Medicare] program hasn’t worked well for patented medicines that are protected from competition, advocates of the government negotiation say. Changes in the new legislation will help check prescription-drug costs, some advocates say.” But protection from competition is precisely the purpose of patent protection! The IRA requires the government to work against itself by using the government’s power of negotiation to push the prices of prescription drugs down even as the government offers patent protection to the producers of those drugs. Patent protection is about more than simply preventing competitors from producing and selling the patented product. Patent protection is also about allowing the owners of the innovative firm that developed the product to benefit from their investment in research and development that created the product in the first place. Those benefits derive from the higher price charged during the patent period. We would all like something to come from nothing (that is, a free lunch), but this principle can never serve as a rational basis of economic organization.
A second controversial item related to prescription drug pricing in the IRA that Walker (2022) discusses pertains to a requirement that drug companies pay rebates to the government. As Walker (2022) explains, the IRA will require “drugmakers next year to pay rebates to the government for revenue they make from price increases above the inflation rate.” Most economists would consider this method of preventing inflation to be a classic example of what not to do. Such rebates function as the effective equivalent of price ceilings. Consider what happens when the demand is high for a product and the product is in short supply. Sellers will raise prices, which is the market’s way of coping with a shortage. Price ceilings establish a legal maximum on prices so that sellers cannot engage in this rationing activity.
The IRA does not impose legal maximum prices for prescription drugs but instead requires drug companies to hand over to the government the revenue they receive from price increases that exceed the inflation rate. This requirement has the same effect as a price ceiling. Figure 2 in the Appendix shows a supply and demand diagram where a prescription drug is in short supply and the market is experiencing a shortage. Competition in a free market would push the price up to its equilibrium level. A price ceiling that establishes a legal maximum price would lead to a persistent shortage in the market. What will happen because of the IRA’s government rebates? The revenue earned at the initial low price of P1 is represented by the box abcd. Now suppose the drug companies increase the price of the drug to P2. Assume this price increase is a price increase above the inflation rate. Then the revenue will grow to aefg. Because the IRA requires the government to appropriate any revenue earned above this amount, it will take the difference in revenue, which is the shaded portion in Figure 2. Even if the firm leaves its price at P1, it will not earn enough revenue to cover the additional cost of producing more. Therefore, drug companies faced with this situation would never choose to increase production above the quantity d because the firms’ production costs will rise, and the revenue earned will not be enough to cover the additional cost. With production and price held down to d and P1, respectively, the government rebate requirement has the same effect as a price ceiling, which produces a persistent shortage.
The pharmaceutical companies have opposed both measures in the IRA. That is, “[t]he pharmaceutical industry opposes the negotiation and inflation-cap measures, which it said would give the government too much power to set prices and impinge on the development of new drugs” (Walker 2022). Regarding the inflation caps, specifically, the CEO of Amgen Inc. explained that the “bill will impose price controls, and price controls will stymie innovation” (Walker 2022). Price ceilings failed to stop the high rates of inflation that the American economy experienced in the 1970s. We should expect nothing different from their functional equivalent in the form of the IRA’s requirement that drug companies pay rebates to the government for price increases that exceed the rate of inflation.
There is one final point that should be made regarding the IRA’s requirement that drug companies pay rebates to the government for revenue earned from price increases that exceed the inflation rate. The measure suggests that the only justified price increases are those that are lower than, or in line with, the inflation rate. The fallacy in this thinking should be clear. Relative prices change in the economy due to shifts in the supplies and demands for goods and services. Although distortions arising from variable inflation do occur, if a price rises more quickly than the rate of inflation in a free market, typically it means that the price increase reflects a change in the underlying conditions of supply and demand. By implementing a policy that prevents such price increases in the market for prescription drugs, the IRA further distorts an already distorted price structure. That is, the government’s inflationary spending programs are causing a variable inflation that is distorting the structure of wages and prices. Now the government’s effort to fight this inflation by interfering with relative price adjustments in the market for prescription drugs will further distort the structure of prices. Each time the government adopts such measures, the information reflected in market prices becomes less reliable and less meaningful.
What are the primary tax provisions in the IRA and what are their likely economic consequences?
The IRA also includes some important tax provisions, which are contractionary by nature. That is, tax increases reduce aggregate demand and take pressure off prices. Specifically, “the agreement calls for a 15% minimum corporate tax rate and higher taxes on certain forms of income. It also includes money to beef up tax enforcement at the Internal Revenue Service. By reducing the amount of money people and businesses have available, the plan would lower overall demand in the economy, which, in theory, should relieve some price pressure” (Harrison 2022). The plan also includes a tax on stock buybacks, which adds to the contractionary effect of the legislation. As Francis (2022) explains, “[t]he 1% excise tax on buybacks, along with a 15% minimum tax on large company profits, would help raise revenue for government spending on climate and health programs” (Francis 2022). Beyond raising funds for these spending programs, the tax measures are intended to offset the expansionary effects of the climate and healthcare components of the law. In fact, for the law to have an overall contractionary effect and thus reduce the inflation rate, these tax hikes must have a relatively greater impact on the economy than the measures that increase government spending.
The impact of these tax measures on the government budget deficit and their implications for the inflation rate are examined in the next section. This section considers some direct effects of the IRA’s tax provisions. First, proponents of higher corporate taxes seem to think that such taxes only harm wealthy corporate shareholders. However, the employees of the corporations that are subject to the higher taxes are not spared. The increase in a corporation’s tax liability is as likely to affect workers negatively as a rise in any other cost to the firm. As Omeokwe and Hughes (2022) note, the “corporate tax won’t raise taxes directly on middle-class households on their individual returns. But higher taxes typically add costs elsewhere and those can affect individuals. That can include smaller profits for shareholders or lower wages paid to workers.” Essentially, the corporate tax increases are likely to trickle down, negatively affecting wages.
The IRA also aims to raise revenue from a 1% excise tax on stock buybacks. That is, “[t]he legislation [will] tax publicly traded companies that repurchase their shares starting Jan. 1, at 1% of the fair market value of the shares repurchased” (Francis 2022). To clarify the way it works, “[t]he tax is on net buybacks—total shares repurchased offset by the number of shares issued during the year[]” (Francis 2022). “Excise taxes are imposed by the government on activities, goods or services, as opposed to income. The taxes would be paid by public companies, not individual investors” (Francis 2022). The reader should note that the corporation is not being taxed on any income received when it is subjected to the stock buyback tax. Instead, the corporation subjected to the stock buyback tax is taxed for its activity–that is, for making payments to investors and so in addition to making a payment to an investor when it repurchases its stock, it must pay the excise tax to the government. Furthermore, the stock buyback tax is unusual as far as excise taxes go. Excise taxes are usually applied to goods like tobacco, alcohol, and gasoline. Economics professors often use examples of excise taxes to demonstrate how a business will shift part of a tax to consumers in the form of a price increase. We have no reason to expect stock buyback excise taxes to function differently. A portion of these taxes is likely to be shifted to consumers in the form of higher prices. Therefore, when such taxes on corporate activity are implemented, one should remember the likely consequences for both consumers and workers.
The subject of stock buybacks has received much attention recently because of their increasing importance. For example, “S&P 500 companies bought back an estimated $281 billion in shares in the first quarter [of 2022]—likely a record” (Francis 2022). Furthermore, “[o]ver the past 10 years, S&P 500 companies have bought back about $6.2 trillion in shares” (Francis 2022). Due to the large volume of stock buybacks and their perception that firms should not be returning funds to investors, Democratic lawmakers have now succeeded in taxing this activity. The stock buyback tax is expected to raise “[j]ust over $70 billion over 10 years, according to Senate Majority Leader Chuck Schumer (D., N.Y.), who hammered out the legislation with Sen. Joe Manchin (D., W.Va.)” (Francis 2022). These lawmakers view the stock buyback tax as way to punish and discourage undesirable behavior while also raising revenue, much like excise taxes imposed on the consumption of alcohol or tobacco. As Francis (2022) notes, “Buybacks have drawn fire since at least the aftermath of the financial crisis, as some lawmakers criticized companies for returning cash to shareholders instead of reinvesting it or raising wages. Some also argue that buybacks can help boost executive pay.” Is there anything to these criticisms?
Contrary to the views of the critics of stock buybacks, stock buybacks serve an important purpose. Finding stock buybacks to be in the best interest of their businesses, “[m]any public companies repurchase, or buy back, their own shares in the market. The move reduces the number of shares outstanding, can offset the shares issued to employees as compensation and improve the per-share earnings that companies report and investors watch closely” (Francis 2022). The management of earnings per share through stock buybacks helps firms acquire additional funds for investment. Without this option, earnings per share might decline and prevent even a profitable company from attracting additional investment funds. Of course, corporations should not be required to justify their decisions about resource allocation to non-owners. In other words, corporations and other business entities should be allowed to use their assets as they see fit. Only owners have a right to demand that corporate managers defend their business decisions.
The alternative approach that involves discouraging stock buybacks through oppressive taxes or the most extreme approach of prohibiting them altogether would have disastrous economic consequences. An efficient allocation of capital throughout the economy requires a functioning capital market. If the government insists that any funds a firm has available to it must be reinvested in that firm, then the government has ensured that resources will be employed inefficiently. For this very reason, “[t]he U.S. Chamber of Commerce said it was opposed to the buyback tax, saying it would ‘distort the efficient movement of capital to where it can be put to best use and will diminish the value of Americans’ retirement savings’” (Francis 2022). Corporate managers will always be in a far better position than government officials, who are far removed from the situation, to evaluate where the capital under their control may be most efficiently employed.
By contrast, consider Senator Schumer’s negative opinion about stock buybacks: “’I hate stock buybacks,’ Sen. Schumer said at a Friday press conference on the legislation. ‘I think they’re one of the most self-serving things that Corporate America does instead of investing in workers and in training and in research and in equipment’” (Francis 2022). Sen. Schumer’s remark that stock buybacks are self-serving is correct. Their self-serving character is what ensures that the capital is allocated in a way that maximizes the benefits to society. We want the investment funds to go where the marginal product per dollar of investment capital is greatest. If the government imposes a rule that prohibits capital from flowing to its most productive uses, then the government denies the most productive workers in the economy wages, and it denies consumers the products and services that make the most efficient use of society's resources. The government thus guarantees that capital will remain where it will be inefficiently employed. How is this strategy a recipe for economic success?
Sen. Schumer thinks the money used for stock buybacks should be used to pay wages for workers instead of to repurchase shares from investors. Are the Democrats planning to use the revenue collected from the buyback tax to increase the wages of the workers at those firms? Absolutely not. According to the proponents of the IRA, the tax revenues collected under the Act will be used for healthcare subsidies, tax credits, and a variety of other policy priorities, including deficit reduction.?
Even if the Democrats returned every penny collected from the stock buyback tax to the workers at the firms where the stock buybacks occurred, we should not lose sight of the fact that the government would be reaching into someone’s pocket and using the money to pay workers more. How is that different from directing Sen. Schumer to pay the workers more using funds from his personal bank account? Is it different because the workers already work for the employer? Why does that matter? At least the employer has already paid the workers something. What has Sen. Schumer paid them? Think of it this way: The employer thinks she is paying a worker a value equivalent to what is received. If forced to pay more, now she expects to receive nothing for the difference. How is that different from asking someone else like Sen. Schumer to pay the worker for nothing at all?
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A critic of this view might counter that the worker is worth more than the employer is currently paying, but that assertion places us in the realm of total fantasy. The only person who can comment on the value of the transaction with any real authority is the person who makes the decision to enter the transaction. No one else can speak on the subject except the person who has skin in the game. Marxism offers the most extreme rejection of this principle. With one broad stroke and without any skin in the game, it declares every purchase and sale of labor-power in a free market economy (past, present, and future) to be one where the employer ultimately will gain more than the worker will receive. It overrules the judgment and autonomy of every pair of individuals who have ever entered, and who will ever enter, a transaction involving the sale and purchase of the capacity to work for a given period.
Of course, even the employer might turn out to be wrong in her estimation of the value of the labor received, but that employer has earned the right to make this assertion and when the contract period or the pay period is over, she is entitled to make a new assertion. Of course, the employee is entitled to his own assertion because he has skin in the game too. If they agree, then their voluntary assertions about the value of the transaction have led to a cooperative conclusion that they believe will benefit each. The only alternative is to force people to interact on terms that at least one party to the transaction rejects, rendering it logically impossible that both parties will expect to benefit. We all want the world to be a better place, but we will not achieve it by imposing our vision and stomping all over others’ abilities to make independent decisions.
How will the IRA help reduce the federal budget deficit and to what end?
The IRA has the potential to reduce the budget deficit. As The Wall Street Journal reports, “[t]he initial measure, according to numbers released by Senate Democrats, would raise a total of $739 billion in revenue, and spend a total of $433 billion. It would reduce the budget deficit by roughly $300 billion over a decade” (Omeokwe and Hughes 2022). According to a more recent estimate, the Congressional Budget Office (CBO) has estimated that the IRA will achieve $238 billion in deficit reduction over a decade (CRFB 2022). Therefore, the law has some potential to reduce the deficit over a decade.
Government budget deficits are widely regarded as expansionary in terms of their macroeconomic effect. Conversely, budget deficit reductions are considered contractionary. As Harrison (2022) noted regarding the proposed IRA, “the overall reduction in the federal deficit in the proposal would have a similar effect of curbing the country’s total demand for goods and services.” Additionally, “[s]ome economists have said the package would help ease inflation, but modestly and likely over time. A group of more than 100 economists sent a letter to congressional leaders expressing support for the measure, saying the proposal ‘addresses some of the country’s biggest challenges at a significant scale. And because it is deficit-reducing, it does so while putting downward pressure on inflation’” (Omeokwe and Hughes 2022). Therefore, if the IRA reduces the federal budget deficit and such reductions are contractionary, then the IRA could have a small or modest impact on inflation over time.
First, as macroeconomists know, fiscal policy measures are a much less effective method of fighting inflation than monetary policy changes. Part of the reason is the length of time required to alter the inflation rate, which in this case will take years. Second, the economists who expressed support for the IRA in a letter to congressional leaders argued that “because it is deficit-reducing, [the IRA proposal puts] downward pressure on inflation” (CNN 2022). However, an easily overlooked argument about the macroeconomic impact of a budget deficit reduction is that will not necessarily be contractionary in its effect on aggregate demand. Why not? Under the IRA, taxes are projected to rise more quickly than federal spending, which will reduce the deficit. However, the impact of the deficit reduction on aggregate demand depends on the relative magnitudes of the changes in taxes and government spending since the government expenditures multiplier and the tax multiplier are different.
For readers not familiar with these multiplier concepts, a rise in government spending will have a magnified impact on total spending in the economy because the recipients of that income will spend a portion of it, creating income for the recipients of that income, and so on. The total positive effect on the economy is a multiple of the initial rise in government spending. By contrast, when taxes increase, the immediate impact is that households spend less, but their spending reduction is less than the full amount of the collected taxes because they would have saved a portion of it had it not been paid as taxes. Even so, their spending reduction does trigger additional spending reductions by thwarted recipients of that income, and so the total negative effect on the economy is a multiple of the initial rise in taxes. However, the multiplier effect of the tax increase is smaller than the multiplier effect of the government spending increase since total spending in the first round of spending rises by the full amount of the government spending in contrast with the partial impact on total spending in the first round of spending following a tax increase.
What this discussion of the government spending and (lump sum) tax multipliers implies in this context of the IRA is that to have an overall negative impact on aggregate demand and thus to put downward pressure on the price level, the increase in taxes must not only be larger than the increase in government spending (which will reduce the deficit), but the rise in taxes must be so much larger that the negative impact on aggregate demand of the higher taxes offsets the positive impact on aggregate demand of the higher government spending. In other words, a deficit reduction is not enough to reduce aggregate demand and put downward pressure on prices. Tax collections must rise enough relative to government spending that aggregate demand falls overall, putting downward pressure on prices. The implication is that for the Biden administration to reduce the inflation rate, it needs to raise taxes a lot in absolute and relative terms. Not just any deficit reduction will suffice. It must be large. Of course, a careful empirical study is necessary to determine whether the Biden policy is likely to achieve the desired outcome, which is obviously beyond the scope of this article.
How important was deficit reduction to the supporters of the IRA? “The lawmakers said in a joint statement that the bill will ‘make a historic down payment on deficit reduction’ to fight inflation, while also investing in domestic energy production and reducing carbon emissions” (Duehren et al. 2022). Nevertheless, Congressional Democrats had another reason to support deficit reduction. Duehren et al. (2022) explain this additional motivation:
Democrats had been aiming to pass a narrower bill in the coming weeks focused on reducing prescription drug prices and extending healthcare subsidies. Now, instead of focusing on just those two topics, they are again setting their sights wider. Democrats are hoping to use special fast-track budget rules to advance their priorities without needing Republican votes. Under the reconciliation process, bills tied to the budget can pass with a simple majority, rather than the 60 votes typically required in the Senate. Legislation passed through the reconciliation process must also comply with a series of special restrictions and Democrats will need to ensure the policies comply with those rules. (Duehren et al. 2022)
Arguably then, the budget deficit reduction component of the IRA was about getting the other parts of the proposed law approved by the Senate with only a simple majority. This suggests that even the most deficit-reducing aspect of the bill was more of a tactic to win approval for the other parts of the bill.
In their popular economics textbook, McConnell, et al. (2008) describe two very different ways to manage the booms and busts of the economy using fiscal policy. During periods of recession, the government might increase government spending to promote economic recovery. Once the economy recovers and begins rapidly to expand, the government might then increase taxes to prevent inflation rates from rising or to reduce high inflation rates. Over time, this approach will cause the growth of government expenditure and taxes. The consequence will be a larger government and a relative contraction of the private sector. By contrast, the government might reduce government spending during periods of inflation to prevent inflation rates from rising or to reduce inflation rates. Once the economy enters a recession, however, the government may reduce taxes to encourage consumer spending and investment spending. Over time, this latter approach will cause a reduction in government expenditures and taxes. The consequence will be a smaller government and a relative expansion of the private sector.
The approach that Pres. Biden and Congressional Democrats have adopted is clearly the big government approach to managing the business cycle using fiscal policy. In fact, the IRA goes even further in this direction than what McConnell, Brue, and Flynn describe by raising both government spending and taxes during a period of overheating and high inflation rates. With both government spending and taxes rising, the legislation leads to an expansion of the government sector.
Finally, we should consider the possibility, however unlikely, that the measures included in the IRA succeed in eventually reducing the inflation rate in a significant way. Even if the law helps tame inflation, that success will only encourage more spending and more taxes. Taming inflation is important, but it is not the only economic objective; in fact, there is a more fundamental economic objective–indeed, the most fundamental economic objective–defending the freedom of the American people to pursue their own objectives–their own happiness. Taming inflation is necessary but not sufficient to ensure the fulfillment of this fundamental economic objective. Inflation might be brought under control, but if government objectives increasingly displace the objectives of the American people, then freedom will die a slow death. Taming inflation is only important because of its contribution to the protection of individual liberties. Unfortunately, the taming of inflation may be used for the opposite end–that is, to defeat opposition to the growth of government and the suppression of liberty. Therefore, even if Pres. Biden’s Inflation Reduction Act by some miracle reduces the inflation rate, that success would only be used to expand government programs and to raise taxes further. Reducing inflation is not the end that we seek but a means to the end of safeguarding our freedoms. For this reason, we cannot adopt the position of waiting to see what happens with the inflation rate because of the Inflation Reduction Act. A high inflation rate is a threat to freedom but a greater threat to freedom is a reduction in the inflation rate combined with plans further to expand the role of government in the economy. Put simply, we face the broader problem of a law that threatens freedom even if it reduces inflation.
Conclusion
At the root of the debate between Democrats and Republicans is a fundamental disagreement about the value of human freedom. Democrats appear to operate on the assumption that because it is intangible, freedom should be a lower priority for policymakers, whereas material wealth, because it is tangible, should be the primary focus of lawmakers. That is, lawmakers should focus on the existing distribution of income and wealth and the potential for its redistribution as a method of societal improvement. The truth is the complete opposite. All our income and wealth flows from the exercise of freedom. Freedom is not one priority in the list of priorities. Freedom is the priority. The day we resolve this disagreement is the day everything will change in America.
[Author's Note: Because I have sufficiently made my transition to a new political perspective, I have decided to restore my middle initial in all my authored work.]
?Appendix
Figure 1: The Twelve-Month Percentage Change in the CPI-U, 2016-2022 (all items in U.S. city average, all urban consumers, not seasonally adjusted), base period 1982-1984 = 100. U.S. Bureau of Labor Statistics. Retrieved on September 28, 2022. Web.
Figure 2: The Impact of Government Rebates in the Market for Prescription Drugs (author-created)
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Photo: Larkin, Bill. “Balloon Inflations.” July 29, 2005. Attribution-NonCommercial-NoDerivatives 4.0 International (CC BY-NC-ND 4.0). flickr.com.