Industrial policy was once so out of fashion that it was jokingly called “the policy that shall not be named.” Now it’s back in a big way. On issues ranging from clean energy to semiconductors to Covid-19, governments are trying to improve the performance of key business sectors. Can they manage to do so without subverting competition and subsidizing special interests?

This article is part of ProMarket‘s series on industrial policy. Stay tuned as we publish an article each week this quarter on the topic.

Love him or loathe him, you can say one thing for President Biden: he’s gone large on industrial policy. The Inflation Reduction Act (IRA) is America’s biggest ever piece of legislation to combat climate change. It contains $400 billion in subsidies for solar, wind, electric vehicles, and other green activities. 

The IRA is a major achievement in politics as well as policy—it seemed dead in the water even days before it passed. Every Republican senator opposed it, and Democrat Joe Manchin only made a volte face at the last moment. After years of debate and near-misses—including cap-and-trade proposals like the Waxman-Markey bill of 2009—the U.S. is finally getting serious about climate policy. 

But it’s doing so using industrial policy, not carbon pricing, which economists believe to be the single best way to limit greenhouse gas emissions. With a carbon price, polluters pay the true social cost of carbon, and people—rather than the government—choose how to adapt. Unfortunately, there is massive political opposition to the high levels of taxation this would entail, not just in gas guzzling America, but also in Europe, as the French Yellow Vest movement amply demonstrated.

It’s tempting then to see the choice of subsidies over market mechanisms as a purely political move, without any economic backing. But that’s a mistake. The transition to net-zero emissions is about more than taxes and regulation: it is fundamentally a growth story where we seize opportunities to speed up the adoption of clean technologies and boost green innovation. And, over and above the need to build political coalitions, there are good theoretical reasons why technological subsidies should be part of the policy mix. Green industrial policy makes sense on the merits.

The many market failures of climate change     

The reason why climate change policy is so hard is that global warming is the mother of all market failures. The cost of greenhouse gas emissions isn’t captured in prices, and so markets can’t address them. That’s the massive failing that carbon prices are designed to solve. But there are other market failures in play as well. 

In the international arena, there’s a free rider problem: Every country has a strong incentive to free-ride off the efforts of other countries, and even “binding” international agreements such as the Paris Agreement are devilishly hard to enforce. Countries see the need to lower emissions, but each one wants the other to act first. As St. Augustine said, “Please God, make me virtuous, but not just yet.”

Finally, the transition to clean energy is a technology problem and there are significant market failures involved there, too. The natural course of events is that new ideas build upon old ideas. Since humanity has a big stock of fossil fuel knowledge this makes dirty innovation easier than clean innovation. Shifting the technological trajectory is like changing the direction of a supertanker. Carbon prices help re-direct the ship, but only slowly as consumption patterns change. Green R&D incentives can complement carbon taxes to make the change much more quickly. 

The rationale for industrial policy

Although industrial policy used to be disparaged by economists, well-designed interventions can help an economy grow. When there are market failures due to learning by doing, technology spillovers, and financial constraints, government subsidies can help—think of China’s solar industry or South Korea’s phenomenal growth. Similarly, having more resilience in the face of supply chain disruptions from pandemics and autocratic regimes is also desirable.

And if investing in green industries helps a nation build up the new industries of the future, this can help overcome this global free rider problem. 

Ironically, the “race to win the technology war” narrative generates an unlikely political bond between conservative national security hawks and liberal tree-huggers. There are strong benefits of a single country’s taxpayers subsidizing green innovation both for global growth and for tackling climate change: knowledge flows across international boundaries, just like pollution. But the conflict narrative helps stimulate local people to cough up their tax dollars.

Don’t ignore the risks

The potential downsides from industrial policy should not be ignored. Managerial attention can shift from competing for customers to competing for state handouts. Furthermore, it stimulates protectionism. The “Buy American” provisions of the IRA mean, for example, that the full value of electric vehicle tax credits can only be claimed when a car is built in North America. The aim is to stimulate more demand for U.S. based production and jobs. Understandably, this is to help cement a political coalition. However, the increased demand from subsidies would lift American output even without tough domestic content requirements. And such requirements have two big drawbacks. First, if consumers were allowed to source their products from wherever they could be produced more efficiently, prices and taxpayer costs would be lower. Second, the IRA creates disputes by reshuffling investments from one country to another. Subsidies always have both a scale and substitution effect. The real benefits of the IRA come from increasing the overall scale of clean technologies, it is not accomplishing so much if it simply substitutes activity from Europe to America.  

Sure enough, the IRA’s domestic content requirements have not gone down well in other countries. For example, on February 1, 2023, the EU responded with its own plan to support green industry, trying to redirect $272 billion. The Commission has much less fiscal firepower than the U.S. federal government. So instead it may make it easier for big countries like France and Germany to go large on green subsidies. 

A subsidy war between the U.S. and other countries can lead to more distortions. Beggar-thy-neighbor policies can mean production being diverted to who pays the biggest subsidies, rather to where it is most efficient. The raison d’etre of the rules-based international trade system (e.g. the much-maligned World Trade Organization) is to reduce government-imposed barriers and distortions to trade and investment. 

There is a better way. The IRA already expands the definition of domestic content to include Canada and Mexico in many of its provisions. Moving to “friendshoring” instead of “onshoring” is a good middle way of maintaining a political coalition and enacting green subsidies. Europe and other liberal democracies could also be embraced in this, even if countries like China are left out. 

The broader picture

The Biden administration is not just applying this strategy to climate policy—it hopes to use industrial policy to accelerate science and raise productivity across the U.S. economy. In addition to the IRA, the Infrastructure Act invests $1.2 trillion and the Chips and Science Act a further $280 billion. This new spending broadly aligns with my Hamilton and Aspen proposals on innovation policy. 

This is welcome for three reasons. First, there is an emphasis on the importance of technology as the critical way of reviving productivity growth. Whether it’s broadband infrastructure in the Infrastructure Act, green tax incentives in the IRA, or semiconductors in the CHIPS Act, these are all ways to raise productivity. 

Second, the “science” part of CHIPS has authorized $174 billion for non-semiconductor tech—NASA, climate research, NSF, ARPE-E, etc. This wide-ranging, basic research potentially creates larger spillovers. 

Third, there are provisions to share benefits with strong labor standards and efforts to include under-represented groups and left-behind areas. For example, to get more people from all backgrounds participating in invention (countering the “Lost Einstein” effect), CHIPS authorizes expanded investments in STEM education and training.

One problem with these support packages is the risk of the government getting it very wrong in which technologies and firms to support. The more “horizontal” approaches such as general public R&D funding and a more generous R&D tax credit have less of this industrial policy risk. But these provisions are smaller (e.g. more generous start-up R&D tax credits). There needs to be much more funding for these horizontal innovation policies.

The IRA is a historic achievement in a polarized country and the climate change benefits could be immense. This fact should not be lost in the brouhaha over cross-country subsidy races. But by making some smart adjustments it could be a lot better in helping tackle the twin global problems of low productivity growth and climate change.