No. 45
February 8, 2000
Sally C. Pipes and Naomi Lopez*

What do you get when you cross Washington politics with an agenda for government-controlled health care? Extortion, D.C. Style. Some politicians are threatening to institute government-determined price controls on pharmaceuticals if the industry does not line up behind a prescription drug benefit plan for Medicare. The pharmaceutical industry can choose any color as long as it is black: support the drug benefit plan, risking government-imposed price controls on drugs, or face government-imposed price controls on drugs.

The emerging political battle centers on the industry’s opposition to a proposal to include a prescription drug benefit in the federal Medicare program, the federal health program primarily serving seniors. The Pharmaceutical Research and Manufacturers of America (PhRMA) would enthusiastically support government picking up the tab for drugs, but they vehemently oppose approaches that include government-control over the industry, such as establishing price controls on drugs and limiting available drugs that will be covered.

But apparently, pressure by the Clinton administration and Democrats in Congress is working. Earlier this month, industry representatives took a more conciliatory tone to stave off an all-out frontal assault that Clinton would have likely launched in the January 27 State of the Union address. Instead having the cooperation of the industry, Clinton was able to victoriously promise seniors a prescription drug benefit. Amgen chairman Gordon M. Binder, who also serves as PhRMA chairman, and Merck chairman Raymond V. Gilmartin have said that the industry will work with the Administration to establish prescription drug insurance as part of Medicare.

One recent coercion tactic came from the Democratic minority of the U.S. Joint Economic Committee, a committee composed of both Republican and Democrat members of the Senate and House. The Democratic minority of the Committee requested the Congressional Research Service, the research organization for the U.S. Congress, to prepare an analysis which subsequently reported the U.S. pharmaceutical industry pays relatively low taxes and earns high profits, compared to other major industries.

According to the analysis, "the drug industry realized significant tax savings from five tax provisions" and that the "drug industry was taxed relatively lightly between 1990 and 1996, despite earning relatively high rates of return on shareholder equity."

As soon as the analysis was released, Congressman Pete Stark (D-CA), who is the ranking minority member of the committee, was quick to claim that "Drug companies charge U.S. consumers more for their products than anywhere else." He also said, "Twelve Fortune 500 drug companies pulled in over $26 billion in 1998…Retail prices for new brand-name drugs have never been higher. Yet PhRMA is asking the American public to swallow the fiction that adding a drug benefit to Medicare will kill research and development, and will drive the industry into bankruptcy."

The White House is not above twisting a few arms, either. Referring to high drug prices, strong profits, and low taxes among pharmaceutical companies, associate director of the Office of Management and Budget Daniel N. Mendelson stated that "If we don’t do something about that now, by expanding access and availability to insurance, price controls are an inevitable outcome."

But what they failed to discuss was that Congress is responsible for the industry’s relatively low taxes. The federal government "helps" certain selected businesses and industries through the corporate tax code. Essentially, companies get tax breaks for certain activities, one example being research and development in new drugs. Not surprisingly, there is no shortage of companies taking advantage of these opportunities to reduce their tax burdens.

For example, Section 936 of the federal tax code (Puerto Rico and possession tax credit) provides a substantial tax credit on taxable income and investment income for drug firms with a significant manufacturing presence in Puerto Rico and other U.S. territories. While this tax credit is being phased-out, it did encourage many companies to set up operations there.

Section 41 (credit for increasing research activities) of the tax code provides a 20 percent tax credit for certain research expenses and payments that exceed a specified amount. Section 174 (research and experimental (R&E) expenditures) of the tax code allows tax deductions for certain research and experimental expenses. These, and several other, preferential tax rules are responsible for much of the lower tax rates the industry currently enjoys.

While the drug industry does have a lower tax liability than many other major industries as a result of these tax breaks, it is also paying proportionately higher taxes than in years past. For example, in 1993, the drug industry’s tax bill was only 39% of its tax bill before tax credits. However, in 1996, the industry’s tax bill was 53% of its tax bill before tax credits, according to data included in the Congressional Research Service study.

The pharmaceutical industry argues that these tax breaks spur innovation. Economic theory predicts that companies will divert additional resources to activities they may not otherwise engage in absent the tax break and that they will spend enormous resources working to maintain and expand these benefits through lobbying efforts. In fact, they will be willing to spend up to the amount of their potential gain.

According to the Center for Responsive Politics, a Washington, D.C.-based political research group, the pharmaceutical industry spent almost $74 million on lobbying efforts in 1998. While not all of these dollars are spent for seeking preferential tax treatment, it does demonstrate a political system that is encouraging companies to divert resources from business activities to political activities—and puts the pharmaceutical industry in the precarious position of being held hostage by a corporate welfare devil of its own making. Some lawmakers are persuasively arguing that, because the tax system subsidizes the industry, the government should be able to exert control over it.

Before pharmaceutical companies reluctantly line up behind proposals that could change the nature of their industry, they should consider a new approach: support the phase-out of tax credits and oppose any further government intrusion into the industry, no matter what incarnation it takes—corporate welfare or price controls.

Apparently, there will be no thinly-veiled threats in this war. The ultimatum has been issued: Support a prescription drug benefit plan for Medicare or else. The U.S. pharmaceutical industry is being coerced into supporting a Medicare drug benefit proposal. The questions are: How will the industry respond? Will it survive this battle? Or will it become a casualty of a big-government expansion?

While this government power-grab may score big political points, it is the wrong prescription for health care. Keeping big government out of our medicine cabinets will preserve the incredible drug innovations and treatments that benefit all Americans and people around the world.

* Sally C. Pipes is president and CEO and Naomi Lopez is director of the Center for Enterprise and Opportunity of the California-based Pacific Research Institute. For additional information, contact Naomi Lopez at (415) 989-0833.