Play the Game - don't let the Game Play You
Biden's EV tax credit is designed to help legacy auto at the expense of Tesla. Industrial policy often misses the mark because companies like Tesla adapt and move faster.
We pick the winners, the ones to thrive,
But the game is rigged, and they'll come to jive,
With subsidies and favors, they'll get ahead,
But in the end, they'll all be dead.
For industrial policy, a fallacy it is,
A notion that we can control the biz.
It's time to step back, and let the market reign,
And watch as our economy grows again.
ChatGPT, 2023
For the first time in decades, the US Federal Government pursues an active industrial policy. On the surface, industrial policy feels like a futile exercise since it rarely accomplishes anything. In this essay, we argue, that Biden’s active industrial policy is crony capitalism in disguise. In particular, we criticize the Biden administration’s attempt to help legacy car manufacturers catch up to Tesla. Biden’s goal is to delay Tesla’s dominance in Electric Vehicle (EV) manufacturing. Never mind that Tesla is single-handedly revitalizing crucial American manufacturing skills and creating tens of thousands of jobs around the country. But this is all happening outside the unions, which happen to be Biden’s largest constituency. Legacy car manufacturers are not able to cope with the rapid innovation Tesla is forcing upon the car industry. While consumers win, the entrenched car lobby is losing out. Our conclusion is that Biden’s misguided attempt will backfire. Tesla is the ultimate antifragile company and will only get stronger when facing adversity. We further discuss the fundamental problem governments face when interfering with private sector enterprises. Governments are too slow to react to changes. Thus, errors compound and render any government action ineffective.
IRS discriminates against Tesla with EV Tax credit
On December 29, 2022, the U.S. Department of Treasury and Internal Revenue Service released further guidance on the Clean Vehicle Tax Credit that is part of the Inflation Reduction Act (IRA). The IRA is a significant investment in clean energy and transportation technologies and includes an array of electric vehicle (EV) incentives. Ironically, the only manufacturer that barely gets any benefit from the EV tax credit is Tesla, even though Tesla is by far the leading pure play EV manufacturer in the US. In fact, if it weren’t for Tesla, there wouldn’t be any electric vehicle industry to talk of. Tesla has created numerous jobs in the emerging fields of battery technology, electric vehicle design, and manufacturing. Tesla is also a leader in applying real world artificial intelligence to the problem of autonomous driving. The company is investing in numerous initiatives to revolutionize transport.
Since taking office in January 2021, the Biden administration has been actively pursuing a policy of fostering technologies to help mitigate climate change and make the US less dependent on fossil fuels. Both of these agendas are of key concern to the Democratic Party base. Despite Tesla’s lead in all these areas, the company has been avoided by the Biden administration. Biden went so far as to invite industry leaders to an EV summit in August 2021 and exclude Tesla. Eighteen months later, the Biden administration showed its real hand when the IRS published the list of eligible car manufacturers for the EV tax credit. Here are some key takeaways:
Under current conditions, the Model Y doesn’t qualify for the EV tax credit. It’s a pure-battery EV with a range of roughly 330 miles on the EPA standard. Surprisingly, the Model Y does not qualify for an EV tax credit since the IRS doesn’t classify the vehicle as an SUV. Even more disturbing is the fact that other manufacturers such as Jeep, Audi, VW, and pretty much every other legacy car brand appear on the EV tax eligibility list, even though their vehicles are far less efficient. Most of them aren’t even real EVs. They are plug-in hybrids with batteries of less than 20 kwh. Even the Model 3 is barely eligible, since the base price of the best-selling Model 3 is slightly above the threshold determined by the IRS.
By excluding Tesla from eligibility for the EV tax credit, the IRS is causing real harm to Tesla. The company will have to react. In the meantime, customers are confused and might hold off on purchases. This puts further strain on demand, which is already struggling due to macroeconomic issues in China and the US.
How will Tesla react?
Sue the Biden administration for discrimination.
Change the trim of Model 3 and Y to be eligible for the full EV tax credit.
Fight the IRA and try to undo it.
Leave the prices as they are without affecting eligibility, but add more value to the vehicles to make them more enticing to customers. For example, Tesla could include the enhanced autopilot package with the purchase of a Model Y. Other options are to offer free supercharging, offer discounts on insurance, or bundle the Model Y with other energy products.
We are confident that Tesla will solve this problem. But in the meantime, customers are confused. This seems to be exactly what the Biden administration is trying to achieve. Gain time to hurt Tesla’s sales, make the company less appealing to investors, and thus raise the cost of capital. The media-industrial complex is already on Tesla for missing Q4 2022 delivery numbers. In a recent article, the Economist proclaimed Tesla a normal car manufacturer and not a tech company anymore. Not so fast. Tesla still has the leading battery technology globally, the best EV manufacturing, the most advanced real-world AI, and by far the best car software operating system, which allows Tesla to do over the air updates. Teslas are software defined cars. It's depressing to see educated adults with serious jobs (I assume that's what working for legacy media outlets like the Economist entails) act like children when it comes to technologically enabled disruption. They don’t like it because it hurts their finances, and they want it to go away. However, simply because the government and YOU want something to be true does not make it so. It’s funny how alleged liberty advocates like The Economist easily adhere to governmentally imposed industrial policy when it suits their argument. Legacy media is in bed with legacy auto because legacy auto pays for traditional advertising. Tesla doesn’t advertise. I used to work for a conservative newspaper in Switzerland, the NZZ. They are supposed to be libertarians. But when it comes to Tesla, liberty, entrepreneurship, and all that good stuff go by the wayside. I see the same pattern in almost all legacy media outlets. Just to be clear, this applies to both sides of the aisle. The conservative media is outraged when bureaucrats take our freedom in the name of misguided public health policy, but they support bureaucrats starting pointless wars. Like I said, cronyism happens on both sides. Just today, we are exposed to the left wing cool-aid.
When things don’t make sense, just follow the money
Why do legacy journalists have a problem with Tesla? Why do Democrats have a problem with Tesla? Why does the Biden administration have a problem with Tesla? I often think about this. And I don’t have a good answer. So, when things don’t make sense, just follow the money. Let’s do that. Follow the money.
Explaining the anti-Tesla stance of legacy media is easy. Legacy media, from print to TV, is supported by ads. A big chunk of advertising dollars comes from the automotive sector. Legacy media depends on legacy automakers spending billions on ads. By contrast, Tesla is not spending a dime on ads.
Explaining the anti-Tesla sentiment among Democrats and Biden is more complicated. Biden is supported by the autoworkers' union, the UAW. They have strong ties with legacy automakers in the United States. In fact, the UAW was founded in 1935 in Detroit to protect the rights of autoworkers. Since the 1970s, American workers have been slowly disenfranchised, which is partly of their own making and partly a result of increased competition from abroad. The UAW has been driving hourly wages and benefits ever higher and making it uneconomical for US manufacturers to produce in the US. The problem with labor cost increases is that they can only go as far as productivity goes up. In the fight between platitudes and economics, economics always wins. In other words, as much as we’d like to pay blue-collar workers more, we can’t pay them more than what they eventually produce. But that’s exactly what the UAW has been forcing upon US industry. That’s why American manufacturers moved their factories to Mexico, China, and other places around the world. And that’s precisely why innovative companies with a large blue-collar base, such as Tesla, Amazon, Starbucks, or Whole Foods, don’t unionize. American manufacturers don’t have a choice. They have to stay competitive, and the only way to stay competitive is to drive productivity and pay workers according to what they produce. While this empowers workers, it weakens the top brass at the UAW. They lose influence. As a consequence, the UAW has changed course and become much more politically active in other sectors traditionally supported by Democrats, such as Wall Street, health care, and the law. This strategy, however, resulted in further disenfranchisement of the UAW blue color base. They felt like they were stuck between a rock and a hard place. As a consequence, lots of them left the UAW and/or started to support the Republican Party. This development culminated in the election of President Trump. As a response, the Democrats under Biden realized that they needed to connect with the base again to stay relevant. So they did. They promised the UAW concessions if elected. In the meantime, Tesla has been penetrating the US auto sector like a true Silicon Valley disruptor. What began as a harmless experiment with an electric sports car (the Roadster) or a fancy electric sedan (the Model S) became a mass-market phenomenon only a few years later with the introduction of the Model 3 and Model Y. In certain states, such as California, Tesla dominates new car deliveries. This didn’t go unnoticed in Detroit. Tesla is threatening the very base of the UAW, which is the auto industry in Detroit. Even though all Teslas sold in the US are produced domestically, the company is a serious threat to the UAW because Tesla is not unionized. Not being unionized means lots of things. For the workers, it’s actually a good thing. They end up making more money and have better upward mobility. However, for the UAW, this is a nightmare. It’s competition. As a result, they fight it.
Hence, the marriage between Biden and the UAW. Biden needed support in his fight against Trump, and the UAW needs support in their fight against Tesla and Elon Musk (who also threatens to dominate aerospace manufacturing, another UAW stronghold). Biden got elected, and now he’s doing what he promised. He is fighting against Tesla on behalf of the UAW.
Initially, the Biden administration just ignored Tesla. Examples such as the above-mentioned EV summit summarize the somewhat ridiculous attitude of Washington towards the emerging EV industry. For example, Biden and GM CEO Mary Barra claimed with a straight face that GM is the leader and driving force behind the electrification of transport in the US. Observers weren’t sure whether to pity them for their childish behavior or be concerned. Well, it turns out the latter is more appropriate. Biden is no novice to political power games. His latest move, to exclude Tesla from EV tax credits and confuse customers, is more than just a shot from the hip. It hurts Tesla at a time when the company has to deal with macroeconomic headwinds. Tesla was still able to grow deliveries by 40% in 2022, a year when both the US and Chinese car markets declined by almost 10%. Now Wall Street is concerned about sales in 2023. Add to that the Biden hip shots, and you can see why Tesla stock is down for the year.
Tesla will strengthen its competitive position because Tesla is antifragile
Now, let’s get to the meat of this essay. Tesla will not stand still. The company will react. In fact, any technology company is ultimately defined by the speed of innovation. Business jargon has butchered the word "innovation", but there is a fundamental meaning to it. Innovation is when new ideas get valued in the marketplace. Innovation can be technology-driven; it can also be organizational, political, or social. It has lots of faces. For example, technology-enabled innovation is driving Tesla’s attempt to lower the cost of battery production by introducing the new 4680 architecture. Another technologically enabled innovation is self driving software, which is already dramatically changing the customer experience. But innovation can happen in many areas of the company. Financial innovation is when Tesla bundles insurance with the driving history of customers. There is potential to lower the probability of expensive accidents by tying drivers to the autopilot software. In other words, accidents happen less and/or are less damaging if the computer does most of the driving. Tesla is in a great position to exploit this arbitrage and potentially lower the cost of insuring vehicles. There is a possibility that Tesla drivers overall become less prone to financially damaging accidents because they outsource most of the difficult driving, which is long distances with bad visibility, to the autopilot. Insurance is the ultimate statistics problem. The goal is to find the few types of accidents that cause the most financial damage and instruct the Tesla self-driving computer to avoid those types of accidents. Bingo. You just reduced the cost of insurance and improved everybody’s situation. That’s technologically enabled innovation. Another innovation could be in recruiting. Most blue-chip companies are outsourcing candidate selection to universities. They just hire from the most prestigious academic institutions. While this might actually bring in above average talent, this type of recruitment is very expensive. Your average Ivy League graduate costs more than comparable talent from other universities. Tesla explicitly states that they hire for problem solving rather than prestige. In other words, they focus on what the candidates actually bring to the table and not what academic logos they brag about in their LinkedIn profiles. If an organization grows 50% per year, hiring is a key driver of success. If on average you can improve hiring efficiency by 5% per year, i.e., you hire top candidates from less prestigious schools, you can save 5% on employee compensation and increase productivity by another 5% (people from less prestigious schools might be more excited about working at a place like Tesla and grasp the opportunity versus people from elite universities might feel entitled and not work as hard since they can always get a job elsewhere). Now let's take that 10% improvement in hiring efficiency. Tesla spends about 30% of its costs on employees. Assume 100 billion dollars in sales and a gross margin of 25%, which translates to a cost of goods sold of 75 billion dollars. Let’s assume 30% of that is employee compensation, which is roughly 25 billion dollars. Take 10% off that, and Tesla could reduce its costs by $2.5 billion simply by hiring more efficiently. That’s huge. Let’s be clear here. I am not advocating for Tesla to pay less or squeeze employees. All I am saying is that Tesla could hire a mechanical engineer from UC Davis, pay her above the average she might be making elsewhere, and still save money because the equivalent graduate from Stanford would cost a lot more. At Orange Capital Partners, we are strong advocates of more competition in the academic world. See our essay, "Academia adopts the Language of Cowards."
Innovation is what defines a technology company. Technologically enabled innovation is engineering with value. In other words, innovation requires engineering talent and tinkering around technical problems as much as business acumen to actually monetize those technologies. Value creation enabled by technology is fundamentally an iterative process that necessitates humility and risk tolerance. Elon Musk has been beating this drum for decades. Here is a statement that summarizes his approach and Tesla’s innovation culture: "I think it's very important to have a future-oriented perspective and to be willing to take bold moves and be unafraid." Now contrast that with the government. It’s the exact opposite. Bureaucrats move slowly because they are afraid, and they’d rather be slow than wrong. Tesla’s culture is orthogonal to the way the government acts. Tesla’s motto is "better be right than consistent." Of course, this approach entails risk and volatility. But eventually it wins. The government cannot influence the outcome of economic activity because it is too slow to react. This applies to the Biden apparatchiks as much as it did to the Soviet apparatchiks. Here is a short fictional story to illustrate this point. Some parts of the story are based on real events, others are not. I leave it up to the reader’s imagination to determine which is which.
Biden's industrial boomerang pierces the heart
President Biden proudly signs the Inflation Reduction Act, a massively misleading piece of legislation passed in 2022. Naturally, the government is never in the business of lowering inflation. It’s the opposite. This bill is no different. It’s a blank check for Biden cronies and bureaucrats to spend money on politically motivated pork barrels. It’s appalling. Just as a side note for all the political strategists in Washington who make a living identifying geopolitical threats to the USA. The single most dangerous threat to our democracy is the government's shameless spending on partisan policies. It happens on both sides of the aisle. Just this time, Biden is taking it to the next level. But let’s get back on topic. So, Biden passes this piece of legislation and gives a speech about how a subsection of the bill is designed to promote electric vehicles. According to Biden, the bill will further strengthen the US leadership in electric vehicle technology, battery technology, and charging technology, all areas in which American companies such as GM, according to Biden, are already leaders. Biden also praises American involvement in battery technology with initiatives such as GM’s "Ultium" platform. Biden doesn’t even mention the actual global leader in EV technology, which is Tesla. Tesla is the leader in EV technology, with the highest-quality and best-selling EVs in its lineup. In fact, the Tesla Model Y is on track to become the best-selling vehicle in the world, not just in the EV segment. Tesla is also setting new milestones in battery technology with its 4680 battery architecture. The Tesla 4680 battery cell is a high-energy-density lithium-ion battery cell that was announced in September 2020. The key objective of the Tesla 4680 battery cell is to increase the range and reduce the cost of electric vehicles (EVs) while also improving their performance. The 4680 cell has a significantly larger capacity than Tesla's previous battery cells, which allows EVs to travel further on a single charge. It also has a lower cost per kilowatt-hour (kWh) than Tesla's previous battery cells, which should help reduce the overall cost of EVs. In addition, the 4680 cell has been designed to be more energy-dense, which means it can store more energy in a smaller space, which should help improve the performance of EVs by allowing them to be more responsive and accelerate more quickly.
Despite all these efforts, the Biden administration is not even mentioning Tesla. In our opinion, Tesla’s rapid pace of innovation is precisely the reason why Biden is pushing for an EV tax credit. He wants to slow Tesla down and give GM, Ford, and other legacy car manufacturers time to catch up. Why would Biden do that? It's because his main constituency is the UAW, which is entrenched among DC Democrats. It’s a shame that Republicans aren’t voicing more opposition to this shameless pork barrel. Tesla is not unionized and therefore threatens the established hierarchy in what is left of American manufacturing. It’s even more shameful if you consider that Tesla’s rapid innovation in R&D and manufacturing is actually bringing high-quality manufacturing jobs back to the US. But Biden doesn’t care about jobs; he is only interested in votes. Votes are won by pleasing powerful constituencies, and the UAW is at the top of that list. So, Biden supports the UAW top brass at the expense of high quality manufacturing jobs created by Tesla. As a consequence of that, the EV tax credit is designed in such a way that the best-selling Tesla Model Y doesn’t get any tax credit. The problem is the price. The IRS states in their preliminary list that the Model Y is not an SUV and thus must be below 55,000 US dollars to qualify for a tax credit. Never mind the fact that many competitive models, which aren’t even pure battery EVs but plug-in hybrids with batteries much smaller than the Model Y, are qualifying. That’s proof that Biden is actively trying to hurt Tesla.
When the game is rigged, don’t play the game; change the game
What is Tesla going to do? Management calls in for an offsite at the Half Moon Bay Ritz Carlton, where they discuss future actions while strolling along stunning California coastal trails. One manager suggests keeping the Model Y at $65,000 but providing free FSD. Another idea is to reduce the price to $60,000 and include enhanced Autopilot. Lisa Myers, an executive in the Tesla finance department, is frustrated with the whole situation. "We can’t just fight them with their own weapons. If we lower the price, they’ll figure out another way to hurt us. When the game is rigged, don’t play the game; change the game," she adds with stoic conviction. Paul, a manufacturing manager based in Austin, chimes in. "Yeah, I hear you, but what does that actually mean—change the game?" "We change the way we price the car." Instead of selling it the traditional way with a high sticker price, we sell a subscription, something like per mile or per month. It’s like Netflix or a yoga gym. Most people don’t buy a car because they want to own one. It’s because they want transport. Why don’t we sell them transportation on tap, like transportation as a service, like cloud computing? Consider what the cloud has done to the cost of compute and storage. The same will happen to the transportation industry with TAS. "All the cost, the car, the electricity, licensing, insurance, etc., can be bundled into, let’s say, 50 cents per mile driven or 1200 bucks per month." Paul let’s that sink in. Lee, an executive out of Shanghai, waves his right hand. "We could add FSD to the package." "Yes, pricing per month would allow us to monetize many more services, and we’d overcome the hurdle of high price tags," adds Lisa.
Two months later, Tesla starts a pilot in Australia. They offer a subscription to a Model Y for the equivalent of 1,250 dollars per month. There is no deposit, no credit check, and no other requirements. All the cost of ownership are included. The subscription ends after three years and is good for up to 70,000 miles. You just get the car and pay a monthly subscription fee. Everything is included: free supercharging, insurance, service, tire replacement, everything. You can add several software updates, such as enhanced Autopilot or FSD, for additional fees. Tesla even allows you to unbundle some features and pay for self parking, summon, or certain gaming features. Initially, consumers are somewhat reluctant to change their behavior. A few months later, the Tesla mobile app team launches the Tesla subscription through the app, which turns out to be a breakthrough. Customers can now subscribe to a Model Y with any desired software package by tapping a few options on their phone. "It's literally like subscribing to a yoga package," says one customer in a survey. The introduction of the app accelerates orders, and within three months, Tesla commands a 10% market share of new car deliveries in Australia. Six months later Tesla commands 30% market share of new car deliveries and is listing roughly 40k vehicles per month. Lisa is overwhelmed by the success of the Australian pilot. Thankfully, the Shanghai production facility was able to keep up with demand. Now the big question is whether this pilot should be rolled out in other, larger markets. The Tesla forums on the internet are screaming with requests. But how can this be done? If Tesla gains the market share that Lisa anticipates, their production capacity will be quickly depleted. After revamping the Fremont and Austin production facility to 1.5 million cars each, Tesla finally launches the subscription service in the US. Needless to say, the demand is overwhelming, and it only takes Tesla a few months to command a 30% market share of new car deliveries in the US, which equates to roughly 350,000 cars per month. As a result, Tesla is accelerating the development of new factories in Mexico, Oklahoma, and Georgia in order to meet the increased demand in North America.
Cronyism is for losers
It’s been five years since Lisa and her colleagues strolled down the coastal trails of Half Moon Bay discussing strategic responses to Biden’s attack on the company. Lisa’s idea of charging a monthly subscription unleashed a wave of new demand that she couldn’t have expected in her wildest dreams. Tesla Chairman Elon Musk recently upped the company’s annual volume growth target to approximately 70%. Today, Tesla is not only dominating the EV market segment; the company is the market leader in all new cars delivered globally. As a consequence of this massive disruption, legacy OEMs in the US, Europe, and Asia have dramatically scaled down their ICE and plug-in hybrid production. Their problem is not only that they are still producing ICE cars but that they have refused to switch to the cloud-based TAS (Transport as a Service) model pioneered by Tesla. Recent data shows that the annual TAS volumes of light vehicles in the US exceeded 75% of all new vehicles delivered in the US. Tesla alone delivered over six million cars in the US. Their market share in EVs is roughly 50%. Tesla’s market share in China is roughly 30% of total vehicles delivered. Unlike the US and Europe, China quickly adopted the TAS model for car deliveries, which drove demand for EVs even higher. Tesla kept a steady market share in a fiercely competitive market.
At a recent industry conference, Lisa was asked about the Biden EV tax credit and how it affected Tesla. She said: "Initially, we looked at Biden’s EV tax credit as a threat to the company. But, as has happened many times before in Tesla's history, the constraint forced us to innovate. And oh, boy, did we innovate. The idea for a monthly subscription was born on a cloudy January afternoon in Half Moon Bay. I recall the surf being so high that local surfers referred to it as the swell of the decade. Well, we had our brainstorm of the decade. Some of my colleagues first thought the monthly subscription would be too much of a novelty. We went with it anyway. Our pilot took place in Australia. You might remember those headlines six months later, when ships full of Teslas had to be diverted to serve the massive increase in demand in Australia. We clearly underestimated the psychological effect a new pricing regime would have on customers. All of a sudden, young people didn’t see owning a car as a lifetime decision anymore. It became just another subscription, like their yoga studio or the nutrition service they were already using. Our market share of new car deliveries in Australia grew from 3% to 30% in three months. And that was just the beginning. So, to answer your question, yes, Mr. Biden. Thank you for forcing us to innovate. It was your attack that inspired us to innovate and move even faster with our mission "to accelerate the advent of sustainable transport by bringing compelling mass-market electric cars to market as soon as possible."
Conclusion
Failure of Industrial policy is typically caused by two main factors. First, the government, even if well-intentioned, often misses the mark because it’s too slow to react to changes. Second, industrial policy inevitably creates unintended consequences. Ironically, the very competitors that are supposed to be hurt by government intervention are the ones that react the fastest and carve out novel niches for themselves. Eventually, they get stronger, not weaker. Industrial policy in the US has traditionally been passive, which means the government focused on setting the right incentives and general conditions for private enterprise. Under President Biden, this attitude has changed, and the White House is trying to do more active industrial policy with the goal of influencing outcomes. In this essay, we argue that active industrial policy doesn’t work and often results in unintended consequences that weaken the very companies it is intended to support.