A recent Penn Wharton Budget Model (PWBM) study has been used by opponents to claim the Inflation Reduction Act (IRA) would increase rather than reduce inflation. In reality, the study finds the legislation would have essentially no effect on inflation in the near term and would reduce inflation modestly over time. We believe the actual deflationary effects of the bill will be more significant on both fronts for several reasons. Specifically, the IRA’s deficit reduction is likely to be higher than estimated by PWBM, accompanying regulatory and permitting reforms will help reduce inflationary pressures, and the microeconomic effects of the bill – by lowering observed prices for households and businesses – will likely help combat persistent inflation.
Ultimately, we expect the IRA to very modestly reduce inflationary pressures in the near term while lowering the risk of persistent inflation over time and thus make it easier for the Federal Reserve to reduce inflation without causing a recession. Policymakers should follow the IRA with further inflation-reducing actions and should especially avoid policies that would worsen inflation and make the Federal Reserve’s job harder.
How Will the Inflation Reduction Act Fight Inflation?
Using its macro-economic “impulse response” model, PWBM finds the IRA would increase price levels by a statistically and economically insignificant 5 basis points in 2024 – the equivalent of a 0.025 percentage point boost in inflation in the first two years. By the late 2020s, PWBM finds the plan would reduce price levels by 25 basis points (0.25 percentage points).
In our view, the IRA would actually reduce the inflation rate somewhat in the near term and do more to reduce medium-term inflation than PWBM estimates. There are at least three reasons to expect it will reduce inflation more substantially:
1. Deficit Reduction Will Be Larger. PWBM estimates the IRA will reduce deficits by less than $250 billion over a decade and increase deficits by $30 billion in the first two years. Yet based on official tax estimates and other information, the IRA is likely to score as reducing deficits by over $300 billion – and we believe it could include roughly $30 billion of deficit reduction in the first two years.1 Near-term deficit reduction should mean near-term inflation reduction as well. If the legislation saves $30 billion in the first two years instead of costing $30 billion, it is likely to reduce inflation rather than increasing it. Even if near-term deficit reduction is less than we expect, higher near-term revenue should reduce any inflationary effects from higher spending.
2. Regulatory and Permitting Reforms Will Be Deflationary. As part of the agreement to pass the IRA, President Biden, Senate Majority Leader Chuck Schumer (D-NY), and Speaker of the House Nancy Pelosi (D-CA) apparently agreed to a number of energy-related regulatory reforms. According to Senator Joe Manchin (D-WV), this will include “a suite of commonsense permitting reforms this fall that will ensure all energy infrastructure, from transmission to pipelines and export facilities, can be efficiently and responsibly built to deliver energy safely around the country and to our allies.” The Administration may also soon greenlight several other drilling and pipeline projects in conjunction with the IRA’s passage. These policies should all put downward pressure on inflation, beyond the direct effects of the IRA, by increasing energy supply and reducing the prices of energy and oil.
3. The IRA Includes Deflationary Microeconomic Effects. The inflationary or deflationary impact of a given policy is driven primarily by its macroeconomic effect in changing aggregate supply or aggregate demand. However, the microeconomic effect of a policy on the prices faced directly by households and businesses can also matter, especially as inflation may be increasingly driven by wage-price spirals, changes in inflation expectations, and other factors that can cause inflation persistence even as supply and demand converge. For example, workers facing higher prices for goods and services may demand higher wages, while businesses facing higher input prices may pass those onto consumers. Many of the policies in the IRA reduce prices at the microeconomic level, whether by lowering the price of prescription drugs, health care premiums, or renewable energy.2 In combination with the macroeconomic effects of the bill, these microeconomic effects will likely help to hold down inflation.
The Microeconomic and Macroeconomic Effects of the Inflation Reduction Act on Inflation
|Policy||Microeconomic Effect||Macroeconomic Effect||Full Effect|
|Drug Pricing Reform||Deflationary||Deflationary||Very Deflationary|
|Corporate Minimum Tax||Slightly Inflationary||Somewhat Deflationary||Slightly Deflationary|
|ACA Subsidy Expansions||Somewhat Deflationary||Inflationary||Somewhat Inflationary|
|Energy & Climate Reforms^||Deflationary||Inflationary||Unknown|
|Net Effect||Deflationary||Somewhat Deflationary||Deflationary|
Source: Committee for a Responsible Federal Budget.
^Including permitting & regulatory changes. and assumes stricter regulations absent new tax credits and spending measures.
Given the deficit reduction, accompanying regulatory reforms, and microeconomic effects of the IRA, we fully expect the bill – as advertised – would reduce inflation.
However, the effects are likely to be modest, especially in the near term. The IRA can assist the Federal Reserve in fighting inflation by making its job easier, but it will by no means replace the need for action from the Fed. To further support the Fed’s efforts, lawmakers should build on the IRA with further deficit-reducing and health-care-cost-lowering legislation and actions. And they should especially avoid measures that would worsen inflation, such as extending the student debt repayment pause.
The IRA isn’t going to fix inflation on its own, but having fiscal and monetary policy row in the same direction is an important step forward.
1 The largest difference is in the score of the corporate minimum tax, which the Joint Committee on Taxation estimates will raise $97 billion in the first two years, compared to PWBM’s $61 billion estimate.
2 In general, we expect macroeconomic effects to overwhelm microeconomics effects, particularly when inflation is primarily driven by very high demand or broadly constrained supply. However, microeconomic effects can be helpful to reduce the risk that inflation persists through wage-price and expectations channels, especially if the policy as a whole is not worsening macroeconomic inflationary pressures or substantially increasing pre-subsidy prices as a result of the subsidy itself. For this reason, we expect clear deflationary effects from drug pricing, ambiguous effects from energy and climate changes, and a somewhat inflationary effect from the ACA subsidy expansion.