The importance of research and development (R&D) spending in the pharmaceutical industry and the innovations that result from it is clearer than ever as millions of people are being vaccinated against COVID-19. In a new report, the Congressional Budget Office (CBO) analyzes federal policies that influence R&D spending in the pharmaceutical industry. The report highlights how taxes affect R&D investment incentives and the importance of structuring the tax code so that it is not biased against investment.
Before looking into tax policies that affect drug R&D spending, it’s a good idea to review some background information. Developing new drugs is expensive and risky. On average, a new drug takes 10 years to develop, and the average cost per drug ranges from under $ 1 billion to over $ 2 billion. Ultimately, only about 12 percent of drugs that enter the clinical trial phase are FDA approved for launch.
On average, pharmaceutical companies spend about a quarter of their revenue on research and development, a larger proportion than other knowledge-based industries like semiconductor manufacturing and software developers, according to the CBO. In 2019, the industry spent $ 83 billion on research and development.
Determinants of pharmaceutical R&D spending include the expected cost of drug development, the expected revenue from a new drug, and the policies that affect drug supply and demand, including regulations, health programs, direct purchases or subsidies – and Taxes.
Taxes can affect both the demand for prescription drugs and the supply of prescription drugs.
Tax policy affects the demand for prescription drugs primarily through an income tax exclusion for employer-sponsored health insurance plans. This tax break costs approximately $ 170 billion per year, making it the largest persistent individual income tax expense in tax law.
Employer contributions to employee health insurance are not counted as employee taxable income, which reduces health insurance costs. This, in turn, translates into more generous health insurance coverage, which indirectly stimulates pharmaceutical research and development spending. The exclusion also has other effects, e.g. B. the distortion of employers’ wage decisions and likely the widening of differences in wage equalization payments.
Tax policy affects drug supply by changing the expected post-tax return for a new drug by adding deductions, credits, and the tax rate as an expense.
The tax code currently allows companies to fully and instantly deduct the cost of their R&D investments rather than depreciating them over time. The full allowance ensures that the tax base is not primarily biased against investment. Corporations pay the reasonable amount of tax on their net income compared to late deductions for R&D costs that would overestimate profits due to inflation and the time value of money.
In addition, the tax code provides credits that can be used to reduce taxes that companies owe to incentivize R&D spending. The R&D tax credit is based on a company’s additional R&D expenses and the orphan drug credit is based on the cost of clinical trials for orphan drugs.
Many companies use a mix of different credits and full expense deductions, but cannot claim multiple tax preferences for the same expense. Ultimately, any policy tends to increase the expected after-tax return on a new drug (in other words, to lower the after-tax R&D cost), thereby creating incentives for higher spending and supply of new drugs.
Changes to credits, exemptions, deductions, and tax rates can change the incentives to invest in research and development. For example, the 2017 Tax Reform Act included changes that both increased and decreased R&D incentives.
The CBO report found that the net impact of the Tax Act of 2017 on R&D investment is unclear. The lower corporate tax rate from 35 percent to 21 percent increased the incentive to invest in research and development by increasing the expected after-tax return. However, the 2017 law cut orphan drug credit by half. Starting in 2022, companies will have to deduct R&D spending over a five-year period rather than immediately – both changes that reduce R&D incentives.
Investing in research and development is central to driving long-term technological change and innovation. As the pandemic comes to an end and the economy begins to recover, neither a higher corporate tax rate, as proposed by the Biden government, nor amortization for research and development should be a headwind for R&D activities. Instead, the legislature should examine how tax legislation can be made more conducive to innovation in general, ie across industries and activities.
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