The US is redefining free trade agreements to justify EV tax credits  

What is a free trade agreement?  

The U.S. Treasury Department and the Internal Revenue Service recently took up this question in providing guidance on electric vehicle (EV) tax credits in the Inflation Reduction Act (IRA). What’s the answer? It’s unclear. Treasury and the IRS see two types: “traditional” free trade agreements, of which the U.S. has few; and critical minerals-specific deals, which largely prevent export bans. 

What’s the point of this exercise? To ensure that China isn’t eligible for the tax credits. 

Easier said than done. Consider the current negotiations between Washington and Brussels over a critical minerals deal. The European Union (EU) sources fully 98 percent of its rare earth elements (REEs) from China. The EU does mine cobalt, but can’t process it because of its own environmental restrictions. A U.S.-EU deal may avert trade tensions caused by the IRA, but it will do little else. 

And at what cost? Brussels, which boasts a lengthy list of traditional free trade agreements, has doubts about the content of a critical minerals deal. Congress has doubts too, not least because the Biden administration has hinted that it wants to implement any U.S.-EU deal by executive order. 

All this for $7,500 in tax credits? 

Here’s the backstory. 

EVs are one of President Joe Biden’s priorities. He wants them to tally for half of all new car sales by 2030. To reach this goal, Tesla would have to build 20 million EVs per year, up from its current production of 500,000. This would require a staggering amount of rare earth elements and other metals. The company would need 40 percent of all the permanent magnets mined globally to make enough motors, and nearly double the cobalt currently available worldwide for its batteries. Tesla would also use 30 percent of the earth’s nickel, and four times more copper per EV than what’s required to make an average non-EV car. 

The inconvenient truth, however, is that nearly all of these REEs and other metals are imported. Roughly 80 percent of REEs are sourced from China, including 80 percent of the world’s neodymium, which is used to make permanent magnets for EV motors. Half the earth’s cobalt for batteries comes from the Democratic Republic of Congo. Even where the U.S. has a trusted source, there are supply chain risks. The U.S. imports aluminum from Canada, for example, but Canada doesn’t mine any of the bauxite used to make aluminum. This exposes the U.S. to a “hold-up” problem upstream. 

The EV tax credits caused a furor with U.S. trade partners because their aim is to incentivize re-shoring. As Janet Yellen, the Treasury secretary, explains, the tax credits are meant to get more consumers in EVs, as well as to create “American manufacturing jobs,” and contribute to the country’s “energy and national security.” 

There are two $3,750 tax credits; one for critical minerals, the other for battery components. Both require an “applicable percentage” of the value of the extraction or processing of these minerals to be done in the U.S., in North America, “or in a country with which the United States has a free trade agreement.” This last allowance was a late addition to the IRA, but it didn’t come with a definition. 

To wit: what is a free trade agreement? 

First, there are deals like the US-Canada-Mexico Agreement which cover “substantially all trade.” This language is from the WTO, and while there’s no definition of what it means, it’s clear that these are what Treasury and the IRS see as “traditional” free trade agreements. 

Second, there can also be deals like the U.S.-Japan Critical Minerals Agreement (CMA) that don’t cover substantially all trade, but do one or several of the following: (A) reduce or eliminate trade barriers on a “preferential basis;” (B) prevent new trade barriers, (C) establish high-standards “in key areas affecting trade,” including labor and environmental standards; and/or (D) ban export restrictions. 

Treasury and the IRS explained that the CMA checks the boxes on (C) and (D). This suggests that a free trade agreement does not have to meet all four criteria. Importantly, (D) is most certainly the key, since (A) has to be included in traditional free trade agreements, or would be WTO-illegal.  

Importantly, the WTO already prohibits export bans, as per (D). The WTO dispute China — Rare Earths gets a lot of attention in this regard. The point of this whole exercise of redefining free trade agreements would thus seem to be to exclude China. That’s not in the cards, since REEs and other metals will continue to be directly or indirectly sourced from China and other non-allied countries. 

Back to the proposed U.S.-EU deal. The definition of a free trade agreement is being twisted to get a deal with the EU, which is even more dependent on China for REEs than the United States. 

Without trade, there’s no future for EVs. Imports of REEs and other metals are the lifeblood of the business. The global rivalry over manufacturing and recycling EVs will test relations among allies and adversaries alike. Beggar-thy-neighbor tax credits will only force countries back to the WTO, just as Treasury and IRS have inadvertently circled back in defining free trade agreements. 

Marc L. Busch is the Karl F. Landegger Professor of International Business Diplomacy at the Walsh School of Foreign Service, Georgetown University, and a Global Fellow at the Wilson Center’s Wahba Institute for Strategic Competition. Follow him on Twitter @marclbusch