Wednesday, May 22, 2024

The Perils of the New Industrial Policy


In October 2021, the Biden administration achieved a major milestone when it reached an agreement with nearly 140 countries to establish a global minimum tax. That accord, which imposes a minimum tax rate of 15 percent on corporations, promises to end the damaging international tax competition that has gone on for decades. Under the existing system, large multinational firms have been encouraged to shift their profits to low-tax jurisdictions to avoid taxes worldwide, and countries have sought to undercut one another to attract those companies, engaging in what U.S. Treasury Secretary Janet Yellen described as a “global race to the bottom.” Over time, however, governments around the world recognized that almost no one was winning this race except the corporations themselves and that most countries would be better off if they agreed to end this largely zero-sum game. The new global minimum tax is, in short, a breakthrough in cooperation over competition.

But the Biden administration has also recognized the need for corporate tax incentives to encourage economic activity in certain critical areas. Tax incentives and other kinds of subsidies are now a core part of the U.S. strategy for addressing climate change and the security of supply chains at a time of growing tension with China and Russia. These tools are the primary focus of two landmark bills passed in 2022, the Inflation Reduction Act (IRA) and the CHIPS and Science Act. 

The question now is whether this new industrial policy will set off a counterproductive subsidy race against friends and allies or can instead be implemented cooperatively with them, building on the lessons of the global minimum tax. There is real risk of a new race. In the IRA, the electric vehicle tax credit is contingent on where the parts of the EVs are made and, as enacted, could exclude production in the European Union from much of the subsidy, threatening what the United States’ European allies see as a key industry. And the CHIPS Act, which justifiably seeks to use subsidies to shift semiconductor production away from China and Taiwan, could threaten production in Japan, South Korea, and Europe, too. Without new forms of cooperation or coordination with allies and friends, these U.S. measures could create a damaging contest. Already, leaders in Europe and elsewhere are responding with their own competing subsidies, and amid growing concerns in the West about supply chain disruptions and great-power rivalry, pressure to adopt more such measures will likely increase in the years to come. Even now, there are calls for Washington to enact similar subsidies and other measures in other sectors, from pharmaceuticals to shipbuilding. 

A costly new competition over taxes and subsidies is not inevitable. Significant elements of international cooperation have been built into some of the largest clean energy subsidies in the IRA. From the start, the Biden administration has also rightly focused on the need for global cooperation in trying to implement both the IRA and the CHIPS Act. But Washington will need to employ a variety of tools to ensure that its actions do not instead set off competitive new races among allies and trusted trading partners. And that will likely mean expanding the toolkit beyond subsidies alone.

To build on the Biden administration’s success in launching the multilateral global minimum tax, the United States needs a more sustainable, cooperative model for countering the economic threat posed by China and other global rivals. The task is especially challenging, given that China has aggressively subsidized sectors it deems strategic, including semiconductors, EVs, software, and technological hardware. But failure to adopt such a model could have far-reaching consequences for the United States and its allies and friends around the world. Either they can find new ways to cooperate to achieve their common goals of addressing climate change, securing supply chains, and responding to China, or they can each take on these challenges on their own and in competition with each other, risking a new race to the bottom on tax incentives and subsidies that could end up thwarting those goals.


In an era of rising great-power rivalry and heightened economic insecurity, the 2021 agreement on a global minimum tax provides a striking example of how cooperation can triumph over competition. The rationale for the global minimum tax is powerful. For decades, governments undercut one another’s tax rates to attract corporations and their international capital, diminishing an important and progressive revenue source. Competition from lower-tax jurisdictions encouraged companies that are headquartered in the United States and other major countries to use tax-avoidance strategies to shift their earnings to those jurisdictions—even though they had few or no operations in those havens. 

Yet these problems drew comparatively little scrutiny by policymakers until the 2008 financial crisis. During the global recession that followed, widespread job losses and economic suffering brought new attention to income and wealth inequality and pushed governments to find new sources of revenue. Corporate tax avoidance became a large part of that discussion. Beginning in the fall of 2012, public hearings in both the United Kingdom and the United States revealed that many multinational corporations had been aggressively exploiting the differences in the tax regimes of countries. In the United States, for example, a U.S. Senate committee released a memo showing that Microsoft had avoided paying approximately $6.5 billion in U.S. taxes over a three-year period by routing intellectual property rights through Bermuda, Ireland, and Singapore. In the United Kingdom, meanwhile, a Starbucks executive testified in parliament that Starbucks had been quietly shifting some of its British revenues to a subsidiary in the Netherlands, where it had received a favorable tax arrangement, a disclosure that led to public outrage and boycotts. These hearings were followed by leaks from a major accounting firm showing that Luxembourg helped some 340 companies avoid tax by granting them secret tax rulings, with subsequent investigations showing other European governments doing the same. International taxation had become front-page news.

For decades, governments undercut one another’s tax rates to attract capital.

A growing mass of statistics also documented the long-term cost of tax competition. Among countries in the Organization for Economic Cooperation and Development, for example, the average corporate rate was 32 percent in 2000. Twenty years later, it had fallen to just 23 percent. The downward pressure on rates was even more apparent over a longer time horizon: in the 1980s, the OECD average was rarely less than 45 percent—nearly twice the level of 2020. The pressure to lower corporate taxes was particularly costly for the United States. It has been estimated that a cut of just one percent in the corporate rate will, over ten years, reduce federal government revenues by $100 billion. Yet in large part because of global tax competition, the United States reduced its corporate rate from 35 percent to 21 percent in 2017 and only partially paid for that tax cut by broadening the tax base. As the owners of capital profited from their lower taxes, their gains threatened to come at the expense of ordinary workers and others who would have to pay for these corporate tax cuts through either higher taxes or less government investment and fewer government services.

These facts drove the Biden administration to revitalize global efforts to end the race to the bottom in corporate taxes. The result was the landmark global minimum tax agreement in 2021, which provides for a floor tax rate of 15 percent on the earnings of large multinational businesses. Countries that had served as tax havens saw that major economies around the world were committed to addressing this problem and signed on to avoid the potential lost revenue and reputational consequences of being left out; even major U.S. rivals such as China saw it in their interest to work multilaterally with the rest of the globe. If fully implemented, the agreement will eliminate the costly effects of the existing situation, increasing global tax revenues on corporate income by approximately $220 billion, or an additional nine percent.

Despite the Biden administration’s role in shaping the agreement, however, the United States has not yet changed its own tax code to comply with it. During the drafting of the IRA, Senator Joe Manchin, a Democrat from West Virginia, insisted that measures in the bill that would have implemented the global minimum tax be removed from the final legislation, expressing concerns that by approving the tax before other countries, Washington would be putting U.S. corporations at a disadvantage. Although the United States has failed to act, however, many countries—including all member states of the EU—have taken important steps to implement the global minimum tax by the end of 2023. In fact, the tax is undergirded by a strong enforcement rule that allows countries that implement it to increase taxes on corporations based in countries that have not yet implemented it and are not paying the 15 percent minimum rate in every country in which they’re operating. Because of this rule, it truly doesn’t pay for a country to stand outside the deal, since its corporations will still pay taxes at the 15 percent rate to countries that implement the agreement.

Nevertheless, the lack of U.S. participation could increase tensions with EU members and other countries over trade and economic policy. Foreign governments, for example, could seek to enforce the deal against U.S. companies, and a future U.S. administration could threaten them with retaliation for doing so. Those tensions can be avoided if Congress takes action. In fact, in 2025, when key elements of the 2017 Trump tax cuts expire, Congress will have the opportunity to bring the U.S. tax code into compliance with the agreement and raise revenue in the process. The question now is whether Congress and the administration in office in 2025 will act to collect revenue that would otherwise be taken by countries implementing the agreement rather than try to fight an agreement that is in Washington’s own interest.


There’s some irony that, at a time of historic global cooperation to raise corporate taxes, a vigorous new contest has emerged between countries over corporate subsidies. Much like the old tax regime, these subsidies are aimed at getting corporations to shift their activities to a more favorable jurisdiction. This contest has been heightened by the IRA and the CHIPS Act.

Both pieces of legislation are aimed at addressing critical challenges. The IRA will provide almost $400 billion in government support for clean energy and green technologies over the next decade, with around three-quarters of that in the form of tax credits, and it is the main hope for progress on climate policy in the United States. One analysis found that the package could result in U.S. greenhouse gas emissions falling between 32 and 42 percent below 2005 levels by 2030—seven to 10 percentage points higher than without it. The CHIPS Act provides more than $60 billion in subsidies for companies to build “fabs”—chip manufacturing facilities—in the United States and to try to diversify the supply chain, especially away from China and Taiwan. About $24 billion is in the form of an investment tax credit, and the remainder is in the form of grants and subsidized loans.

In fact, subsidies for designated industries, such as those in the IRA and the CHIPS Act, largely fall outside the purview of the global minimum tax. By design, the 15 percent tax floor is primarily focused on preventing the largest corporate profits (often related to the ownership of valuable intellectual property rights) from migrating to lower tax jurisdictions. But it does little to address a different kind of competition, in which governments seek to woo industry by subsidizing corporate investments in tangible capital—plants and equipment, for example—through direct grants, tax credits, and other forms of subsidies. Although such subsidies need to be structured in specific ways to avoid counting as tax cuts, these requirements are not insurmountable, and most of the new U.S. subsidies should meet them.


U.S. President Joe Biden examining semiconductor equipment in Durham, North Carolina, March 2023

Jonathan Ernst / Reuters

But the introduction of subsidies does not necessarily result in a new race to the bottom. In some cases, a country may be able to subsidize a particular industry, such as clean energy generation, without creating a net cost to other countries. In fact, such a targeted subsidy may benefit other countries by helping address climate change and supporting new technologies from which they, too, can benefit. And that is how major parts of the IRA are structured. For instance, most of the legislation’s clean energy production and investment tax credits are available to U.S. producers regardless of where they get the technology they use. Companies receive a ten percent bonus for using domestic content in their facilities, but most of the production and investment tax credits aren’t contingent on using domestic content. In this way, the IRA enhances cooperation rather than competition.

Some of the new measures, however, are focused on moving critical industries to, or retaining them in, the United States, even at the potential expense of close allies and partners. The subsidies in the CHIPS Act are only available to semiconductor fabs located in the United States. In the IRA, the $7,500 EV tax credit is only available to buyers of cars that are assembled in North America and whose batteries meet content requirements. Half the credit is contingent on the critical minerals for those batteries being extracted or processed in a country with which the United States has a free trade agreement or that are recycled in North America, and the other half requires that increasing percentages of the batteries over time be manufactured or assembled in North America.

Of course, there are good reasons to subsidize the creation or strengthening of supply chains in critical industries. To start with, the United States’ reliance on foreign sources that are vulnerable to global rivals for semiconductors and other critical goods carries significant national security risks. Since Taiwan produces an overwhelming portion of the world’s semiconductors—including over 90 percent of the most advanced semiconductors—any move by China to restrict Taiwan’s access to world markets could seriously threaten the U.S. economy. The consequences could be especially devastating given that it would take considerable lead time to build production capacity elsewhere. Moreover, experience shows that the U.S. private sector has been unable on its own to develop a viable alternative to Taiwanese chips. In other words, under existing practices, the production of key goods has become overly concentrated in China or in countries that are vulnerable to Chinese influence, and intervention by the U.S. and other governments through countervailing subsidies may be required to correct that imbalance.

Other rationales for these kinds of subsidies include the broader goals of revitalizing industrial production in the United States, pushing higher wages for American workers, and protecting the domestic economy against major supply chain disruptions. Those are the right aims, but in seeking to draw industrial jobs to the United States alone, the government may do more harm than good. And by concentrating solely on domestic production capacity, rather than working in concert with allies and partners, the government may incur significantly higher costs. This in turn can reduce living standards for workers because they are consumers, too.


Already, many U.S. allies and partners have perceived Washington’s new chips and green energy incentives as a new form of competition that may come at a cost to their own economies. In December 2022, South Korea enacted an initial round of new semiconductor subsidies, and its Finance Ministry almost immediately called for even larger ones, which are now under serious consideration in the South Korean legislature. In February 2023, Japan approved another round of subsidies for its own semiconductor industry. Meanwhile, the EU is considering new subsidies for semiconductor manufacturing in response to the U.S. legislation. And Taiwan has enacted semiconductor tax credits aimed at trying to keep the most advanced semiconductor manufacturing in Taiwan—which, of course, runs exactly counter to the aims of the United States and other governments. 

The European reaction to the new U.S. subsidies for clean energy and particularly EVs has been especially heated. “You’re hurting my country,” French President Emmanuel Macron told Senator Manchin in January 2023. In March, the European Commission announced that it aims to ensure that 40 percent of clean energy technology is made in the EU by 2030 and it has set a similar goal for the critical minerals needed for EV battery production and other industries. When it comes to subsidies, Brussels is waiving its normal state aid rules—which are meant to prevent subsidy races—and allowing countries to adopt “matching aid” to compete with countries outside the EU. The only requirement is that such measures are introduced in response to those other countries’ subsidies. Whether these moves will result in a counterproductive subsidy contest with the United States now depends on the actions of the EU countries themselves.

A new race to the bottom over subsidies could undercut the very objectives these tools are designed to achieve. The danger is that rather than helping governments develop green technology and diversify their supply chains, more of the subsidies will be consumed in higher after-tax corporate profits and higher costs of production, with little or no benefit for workers overall. Take semiconductors. Only a few corporations have the necessary know-how and resources to make expensive investments in new fabs, and these require major economies of scale and scope. The largest of these companies can play governments against each other. Japan, South Korea, the United States, and the EU could end up drawing business away not just from China and Taiwan but from one another as well. The winners in this race will be these outsize corporate players, not the competing governments, consumers, or the companies’ own workers.

Coordinated tariffs can help countries become less vulnerable to China.

Another consequence of a subsidies race would be to push up costs for the technology in question. For example, some of the subsidies in the IRA do not just reward companies that produce low-carbon technologies but also require that production to be located in the United States or in a few select countries. (For the ten percent bonus on the production and investment tax credits, the domestic content requirements focus on the United States alone. For the EV credit, certain stages of production, such as final assembly, must take place in North America, and critical minerals must be mined and processed in North America or in countries with free trade agreements with the United States—for example, Australia and South Korea but not the EU.) Companies would otherwise tend to allocate their production among a variety of countries in ways that minimize costs. This means that some share of the subsidy will be devoted to offsetting the higher costs of producing technology in the United States alone.

In fact, there is little national security or economic advantage to producing clean energy technology in the United States instead of in allied and partner countries. Although a U.S.-centric approach may increase the number of clean energy jobs in the United States, it comes with associated costs. Those workers would likely come from other productive jobs in the U.S. economy, and the cost of producing clean energy technologies will be higher because the government is subsidizing businesses based on their location in the United States rather than on where those technologies can most efficiently be made. In some cases, it may be significantly more expensive to produce certain kinds of clean energy technologies in the United States than to buy them from allies and friends and then use them to generate energy. The consequence would be both higher energy bills for consumers and less clean energy use overall, undermining two critical objectives. Of course, subsidies should not be entirely neutral with respect to where clean technology is made, and Western governments are right to be concerned about an overreliance on China. But they should keep the subsidies as focused as possible on the real risks to their global supply chains rather than on promoting domestic production over all alternatives, including production in friendly or allied countries that could help lower costs for everyone.

Amid the war on the European continent and growing tensions with China, the potential of U.S. subsidy policies to create economic rifts with close allies and friends also comes with diplomatic costs. Washington relies on its partners to help defend against autocracies and other global menaces, and economic cooperation with the EU and other partners has been essential in standing up to Putin’s assault on Ukraine. Cooperative trade in critical technologies such as semiconductors and clean energy can help countries become less vulnerable to Chinese pressure and more amenable to the goals of the United States. By taking a “go it alone” approach, however, Washington will find it harder to maintain that unity and may have to rely more heavily on other tools, such as military power, to try to bring its allies and partners together.


To avoid a counterproductive competition with allies and partners, the Biden administration will need to embrace new forms of international cooperation. Fortunately, some of the tools needed for such an approach are already at hand. In March 2023, during a visit by European Commission President Ursula von der Leyen to the White House, the United States and the EU announced the start of negotiations for a free trade agreement for critical minerals needed for EV batteries. If a deal can be reached, it would extend at least half the administration’s new EV subsidies to cars with batteries that use minerals sourced from the EU, although final assembly of the cars would still have to happen in North America. That expansion would be a step forward. The announcement also shows the potential for negotiating targeted free trade agreements with other friendly countries.

Yet there are preliminary signs that political opposition in Washington could pose obstacles to such an agreement. Although the administration is pursuing the deal as an executive agreement, which does not require congressional approval, the chair of the Senate Finance Committee, Ron Wyden, a Democrat from Oregon, has asserted the need for the White House to work with Congress on any such deals. And opposition from Congress would make the politics tricky. Manchin, for one, has previously criticized the administration’s efforts to extend its clean energy incentives to more U.S. allies, going so far as to vote against Biden’s nominee for IRS Commissioner for supporting such efforts.

But the administration has other ways to further cooperation in critical industries. For example, in December 2022, despite European concerns about Biden’s U.S.-oriented industrial policies, the United States and the EU announced that they will coordinate their chip subsidies, and the U.S. Commerce Department has said that it intends to engage in such coordination more broadly with allies and partners. It is possible that a coalition of willing governments could agree to not bid against each other where they have discretion—although such efforts will be challenging given that the enacted incentives focus on production in their jurisdictions only. Moreover, the CHIPS Act may not be Washington’s last word on semiconductors. Industry observers are already concerned that these subsidies may be insufficient to shift production of the most advanced semiconductors to the United States at the scale the country needs. In addition to working with allies and friends to block technologies from going to China, the United States will need to do more to coordinate its efforts to diversify production away from China and Taiwan without creating an open-ended competition for subsidies.


Von der Leyen announcing an EU industrial plan, Brussels, February 2023

Yves Herman / Reuters

To achieve these long-term goals, the United States will need to expand its economic toolkit beyond the current subsidies—and in areas that go beyond chips and clean energy. In late March 2023, a report from the Senate Committee on Homeland Security and Governmental Affairs identified U.S. reliance on China and India for the manufacture of critical medicines as a national security and health threat. It cited, for instance, data from the Administration for Strategic Preparedness and Response showing that 90 to 95 percent of the generic sterile injectable drugs that are used for critical acute care in the United States rely on materials from those two countries alone. Health experts such as Ezekiel Emanuel have also called attention to the growing risks of sourcing critical drugs from China. To address this problem, Emanuel has called for a tax subsidy to bring pharmaceutical production back to the United States, and the Financial Times has reported that the main pharmaceutical industry lobbying group is making the case for such tax breaks. As with the Biden administration incentives for U.S.-made chips and EVs, however, such subsidies could threaten yet another race to the bottom. 

To avoid that scenario, there are several strategies the United States and its partners could pursue. For example, if several leading countries agreed that sourcing pharmaceuticals was a key national security and health priority, they could offer coordinated subsidies for production in any of their countries, provided that domestic regulators can achieve appropriate oversight. In this way, vulnerable supply chains could be secured without creating new competition. Such an approach may be hard to achieve, even if it is attractive in theory, given that it may be difficult to persuade members of Congress that U.S. subsidies should be available for pharmaceuticals produced in Europe or other countries. Alternatively, Washington could pursue coordinated tariffs, which might be more politically palatable. In cooperation, friendly countries and the United States could impose tariffs on critical products whose manufacture relies heavily on China—or any other country that appears to pose a national security concern. With enough lead time, that production could diversify and shift to friendly jurisdictions.

Of course, any of these options would entail risks of their own. Subsidies must be paid for with additional taxes; tariffs will raise prices. But the result would be a stronger, more secure supply chain—giving the U.S. and its partners a cushion against future disruptions and, potentially, a way to avoid a very dangerous outcome if imports from China were suddenly frozen. Still, these kinds of measures should be deployed only in industries where there is a good case for shifting the location of existing production and where the benefits of such a shift would exceed the costs. Although many industries will seek to qualify for such preferential treatment, only a small number of critical sectors will merit it.

Such coordinated actions would be a way to avoid a subsidy race and foster the kind of cooperation that the Biden administration has called for in implementing the IRA and the CHIPS Act—but may not achieve. They could create a strong foundation for what Yellen has labeled “friend shoring,” or the pursuit of trade with countries that have shared values rather than trade with the entire world. In essence, this approach involves balancing the immediate economic efficiencies of broader global integration with the long-term benefits of blocking undue influence or leverage from rival states, as well as the future economic costs that that influence could impose. Friend shoring achieves that balance by maintaining global integration but focusing that integration on the economies of allies and friends.

The United States and its allies now face a critical choice. In successfully reaching the global minimum tax agreement, they showed that countries can cooperate to address one of the great challenges of globalization—big corporations playing countries off one another, not in pursuit of greater productivity but simply to maximize profits. The question now is whether Washington can find an analogous solution with its friends and allies to address the location of industries deemed crucial to national security and to the fight against climate change. If it instead helps drive a new race to the bottom over subsidies, the United States and its workers will bear the costs, and the barriers to achieving secure supply chains and a green energy transition will be even higher.