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America’s Potential Subsidy Race with Europe

“It should be a race against time, not a race against each other. It should be a race to the top, not a race to the bottom.” These were the words uttered by European Commission President Ursula von der Leyen in response to the American Inflation Reduction Act (IRA). While maintaining diplomatic poise, the E.U. President was clearly irked by the new American Act and how it leaves the European Union exposed to unfair competition and discriminatory rules for American protectionism. Her response? “We need to give our answer, our European IRA.”

Her ire may seem a little heated for a piece of legislation in another continent, but is in response to the genuine threat American policies have in undermining the European economy by luring away some of their best companies. To understand how we got to this point, let’s break down the issues with the IRA and why it has upset the European Union.

For an act with “reduction” in the name, there are a lot of increases involved, but these increases are beneficial towards increasing economic growth in the direction of combating climate change. The Act includes a massive amount of revenue generation in the form of $739 billion from corporate taxes and pharmaceutical pricing reform, and $369 billion in investment in climate security. The overall goal is to increase the productivity of strategically important sectors, such as semiconductors, in America with these incentives. Not only do they encourage the creation of more firms in the U.S. but they also tempt established companies in other countries to come here, because the taxes are cheaper and the American government is literally offering money. The CHIPS Act (which is another major American act aimed at increasing the production of semiconductor chips) comes with its own $52.7 billion price tag. But there’s a catch: a made-in-America clause with a geopolitical target, namely American reliance on Chinese manufacturing for certain goods, and the weakness of American productivity in critical sectors.

The goal of the IRA and the CHIPS Act is to move the production of vital industries away from China and into the U.S., but you can’t just tell companies to do this. When a government wants to nudge industries and companies into doing something, they have to offer an incentive, which in this case is money. The multi-billion-dollar price tags of these acts come in the form of tax cuts and subsidies aimed at giving companies good reason to move production from China (with its unique ability to produce goods cheaply) to the U.S., where wages are high and regulatory realities mean manufacturing is expensive. The issue for the Europeans is that these incentives that help companies shift from China to the U.S. are also tempting enough to potentially move companies from Europe to the U.S. as well.

Now to be fair to the U.S. government, discriminating against production in a specific country is hard without being … well, discriminatory. If you want to stop companies from working in China you have to give them a reason to work somewhere else. Countries do this by providing tax breaks and offering investment into specific industries, but these incentives all cost money to the taxpayer, who wants to see something for that cost. They are not interested in using their own money to push production from China to anywhere other than the U.S., even if you wrap these acts in lingo that espouses geopolitical security. Because how does that help them?

What the American government is trying to do is incentivize these companies to come to the U.S. so that they can provide jobs for American taxpayers who are footing the bill for these incentives. The logic for this is fairly clear: the American taxpayer is not particularly interested in funding job growth in France even if doing so would let them sleep easier about supply chains. Job creation does interest Americans, but specifically American job creation—and to achieve that these acts have to include a made-in-America clause for companies that want access to U.S. government funding. This clause means that certain portions of production need to be done either in the United States or in some instances a country with which the U.S. has a free trade agreement—the latter of which is not available to the European Union.

The E.U. is unhappy with the situation for a good reason: it appears to have been cut out of the loop with a major ally, and it might end up being the loser in a competition between China and America. America has put up these subsidies and incentives that make it harder for European nations to compete, which has also meant that there is not a level playing field in the competition for companies on the international market. If American firms can operate with certain portions of their costs being paid for by the U.S. government, it makes it harder for firms in other countries to compete if they do not have access to that same funding, which is the desired effect of these subsidies. This likely does not mean we will see a mass exodus of European firms to the United States—the incentives are simply not that good enough yet. But even still, if there is a larger incentive to have your company work in America, over time then European firms may very well leave.

The European Union has tried to respond to the IRA and the CHIPS Act, but its efforts have been found wanting by companies and legislators alike. In February 2022 it proposed its own €43 billion European Chips Act, but it was criticized for mainly relying on funding from member states rather than the Union itself, and the €3 billion portion that does come from the Union is being seized from other existing E.U. initiatives. In response to the IRA, it also introduced the Green Deal Industrial Plan in February this year, which has a bill of €270 billion redirected from pandemic recovery plans and proposals to relax state rules surrounding manufacturing and provide tax breaks. However, it was also the subject of the very same criticism that dogged the European Chips Act.

The disagreements around the European Union and its acts are mainly structural in that it is a bloc of different countries which are not strictly under the control of the Union. The main fact that you have to get your head around to understand the E.U.’s functional differences from the U.S. is that the E.U. is not a federal government—it is a union over multiple nation-states with sovereignty, so its income stream is comprised of duties, Value Added Tax (VAT), fixed Gross National Income (GNI) contributions by member states (which they do not like), and other smaller methods of revenue collection. These are all hard to increase without repercussions on trade, which the Union wishes to avoid, and it is only allowed to alter the budget every seven years by unanimous agreement in parliament. Perhaps most importantly, the Union is not allowed to run a deficit—it cannot borrow to fund expenditures with the exception of emergencies like COVID-19.

While the American federal government is debating on whether or not the debt ceiling should be increased, the European Union is not allowed to have a debt ceiling at all. This means the European Union’s capability to fund its own initiatives is limited, and with agendas like the Green Deal Industrial Plan, it has to rely on nations to employ their own tax increases or spending contributions. While the E.U. has historically been strict on state rules around these issues, they have begun to relax those in the face of initiatives like the IRA, but becoming less rigid has brought issues for the Union as well.

Certain countries like Germany and France have larger coffers and less debt than other nations like Italy, which allows them to contribute more money to initiatives. They can pick up the financial slack that the E.U. does not inherently possess, but this also means those countries will have a competitive advantage over others in setting the E.U.’s agenda. Germany and France made up nearly 80% of state aid approved under emergency subsidy rules; while this might be the result of economic reality and limitations of the E.U. system, it hardly bodes well for the nationless ideal the Union is striving for. These issues are also continued in the realm of specific taxes: because the Union inherently operates over sovereign nations, it cannot quickly enact tax breaks to spur industry development. One of the main constraining factors for the E.U.’s economy is that it is a single market in which goods can be transacted freely without too much interference. Its job as a governing body is to ensure that there is a level playing field for all member countries, and to allow individual nations to set their own tax breaks and subsidies (as they would need to do to remain competitive in the international market for investment) is detrimental to that agenda.

Now could the United States win this subsidy race if it really came to one? Against the European Union, absolutely. It’s not even a question. As stated earlier, the E.U. simply cannot enact legislation on the same scale and with the same direction as the United States federal government. But is it really beneficial for America to compete with a bloc that is aligned with it politically?

The downside of subsidy races is that they can devolve into a tit-for-tat scenario, in which countries are aggressively employing subsidies and other incentives such as tax breaks to try and lure companies to their shores. With this dynamic there quickly emerges one winner: companies. Citizens across multiple countries are paying their taxes for the right to have a company operate on their home soil with all of those benefits, but there comes a point where those benefits are not worth the payments of those citizens. What started out as a policy aimed at genuinely aiding the average citizen devolves into an unsavory market in which companies go shopping for the best deal of incentives for themselves, and the taxpayer is left holding the bill for an unimproved situation.

Subsidies also run the risk of having only a rhetorical impact while flying in the face of economic reality. It might seem appealing to have your country produce everything it needs on its own soil, but in the United States, the consumer has been well-trained by low prices to not want the high prices associated with domestically produced goods. The number of manufacturing firms in the United States has declined by 25% since 1997, which is a hard trend to turn around. Subsidies may incentivize companies to manufacture in America at prices that are tolerable to the American consumer, but they still pay for that outcome, just with their tax form instead of their wallet at the till. While the goal of producing in-house is commendable, it simply is not sensible for the United States. But there are good alternatives.

A subsidy race between the U.S. and the E.U. doesn’t help anybody and runs the risk of alienating historical allies, but there is hope. While President von de Leyen was unhappy with the IRA in her speech, she also made it clear she does not believe that the E.U. will benefit from simply being belligerent, arguing that “we have to work with the United States.” She understands the limitations of the European Union as well as anyone and that a zero-sum game leaves everyone unhappy and only opens a door to China. The European Union wants to work with the United States on subsidies—what the American government needs to do is pick up the phone.

Featured Image: The Atlantic

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