The Inflation Reduction Act Will Bring Some Manufacturing Back To The U.S.

I’ve always been a bit skeptical on how much manufacturing could return to American shores after the last two decades of offshoring. While supply chain challenges over the last three years have given companies the motivation to move production back home or at least closer to market, a manufacturer still has to overcome higher costs if moving production back to the U.S. What’s changing my mind is a new wave of industrial policy incentives that started with the Infrastructure Investment and Jobs Act (IIJA) and the Inflation Reduction Act (IRA). Let’s start with the economics of offshoring, next what I see as two different types of policy incentives, and finally why my thinking on reshoring is shifting.

The economics of offshoring

Let’s start with what drove offshoring in the first place. The first thing to consider is tradability, to what extent can a product be produced far away from where it is sold. This is usually driven by transportation cost and product lifecycle or perishability. Products that are heavy and of relatively low in value are not tradable because the cost of transporting them over long distancse becomes too great a proportion of the overall value. Similarly, if a product spoils quickly, it’s usually not very tradable unless there is some way to extend its life. Most manufactured goods are tradable, and the growth of low-cost container shipping and international air cargo in the late 1990s and 2000s vastly expanded the range of goods that fit these conditions.

The next thing to consider is labor content and labor cost differentials. Back in the early 2000s at the beginning of the offshoring boom, the labor cost in China might be as little as one tenth or less that of the U.S. For example, a product that used to cost me maybe $90 to assemble in the U.S. cost around $38 to assemble in Japan, and less than $2.50 in China. Then it might have cost $1.00 to ship the finished product back to the U.S. That meant I could hire 10 times the number of factory workers in China and still be ahead of the game (actually, more than that). Of course, going into China meant setting up a factory, hiring and training workers, and setting up the supply chain, but the costs were paid for by the savings in product cost. The payback period could be as short as a year, so it was a compelling proposition. This was the magic of labor arbitrage, the movement of jobs to produce goods or services from high-cost regions to low-cost regions. As we know, a lot of firms took advantage of this. By the early 2000s as much as 70% of the merchandise in one of the top big box discount stores came from China, and this was a big part of what kept inflation in check – until recently.

Moving from a high-cost region like the U.S. to a low-cost region like China was an economic no-brainer. It paid for itself quickly. But moving production from a low-cost region like China to a high-cost region like the U.S. is not as easy, because who or what is going to pay for the move? Certainly not cost savings on the product. On top of that, the higher labor costs mean you either must have much higher labor productivity in your domestic factory, or you need a product where the labor cost doesn’t matter. Higher labor productivity can be a result of using automation or innovative new manufacturing processes. Labor costs won’t matter if they are a small percentage of the overall product cost, or because the product has such high differentiation and value that labor costs don’t really matter. Think Hermès products handmade in France, or GE Aviation jet engines assembled in North Carlolina. In those cases, production never moved in the first place.

For all these reasons, I have been skeptical that a lot of manufacturing for things like household goods or electronics could move out of China back to the U.S. Granted wages in China have risen dramatically, but that means Vietnam, Malaysia, Thailand, Mexico, or Eastern Europe would be more logical destinations to transfer production to. As long as American shoppers buy on price, economics rule. That was until recently.

Government incentives

Government incentives are changing the game, and my mind as well. We only need to look at the IIJA and IRA and new factory announcements. These acts provided a wide range of incentives: everything from tax credits for the purchase of new or previously owned clean vehicles, to grants for charging and fueling infrastructure. A critical aspect is domestic or North American content rules that must be met to qualify for the various credits. For example the IRA Section 45X MPTC Advanced Manufacturing Tax Credit applies to components for wind, solar, and battery projects manufactured in the U.S., and significantly the credits are tradable, which means they can be transferred (i.e., sold) to an unrelated party. What all this means is that it does not matter if it costs more to manufacture qualifying products in the U.S., because the tax credits and grants offset the higher cost of domestic production. Plus tradable credits can be taken into the earnings line, and don’t have to be shown below the EBITDA line. In theory the manufacturers can then build economies of scale and lower their costs before the credits end.

This has led to a boom in the construction of new manufacturing facilities. First SolarFSLR
announced a big expansion, and there have since been a string of new battery and EV factories announced. According to Atlas Public Policy’s EV Hub, at the end of 2020 the U.S. had $51 billion in announced domestic EV and battery factories, lagging the $115 billion announced for China at the time. But thanks to the IIJA and IRA, that number jumped to $210 billion by January of this year, putting the U.S. at the head of the pack globally for new battery factories.

The heavy hitters inside the IRA and IIJA are what I call demand side incentives. They make products – like EVs – more attractive to consumers by lowering the cost of purchasing them. Some, like the Section 13502 Advanced Manufacturing Production Credit of $35 per kilowatt hour of battery manufacturing capacity and $10 per kilowatt hour of battery module capacity also effectively lower costs, but these are what I call supply side incentives. These subsidize the cost of building and running factories to make batteries. There’s over $30 billion allocated to Section 13502, which is a really big number.

Generally, I like demand side better than supply side incentives. That’s because they create market pull by incenting purchasers, and they preserve market competition among firms who vie to sell their products. The buyer receives the incentives and choses the best products on offer. Supply side incentives, which hopefully would involve competition for grants, means picking winners among competing producers, and that’s very hard for governments to do better than the market.

Thus my thinking on reshoring is changing. In sectors where as a country we are willing to commit the huge amount of funding as we have done with the IIJA and IRA, we will see a renaissance of American manufacturing. One sure sign is complaints from the European Union (EU) and others, who are fretting that the size of the incentives is causing companies to redirect investments from the EU to North America. Swedish EV battery maker Northvolt AB has already put this on the table, which has caused some level of angst across the pond. Of course another factor was high European energy prices, another area where the U.S. has a distinct advantage. But new industrial policies are changing the tradability equation in sectors they target. We should not be surprised if other countries and regions take notice and follow suit with their own industrial policies.