An important issue in this debate is the likely impact of initiatives of this sort on the commercial development of new medicines. Some initiatives would entail significant changes in one or more of the federal policies affecting new drug development. As will be seen, the federal tax code affects the incentive to invest in new drug development in several ways. The report begins with an examination of the distinguishing traits of the drug industry, then identifies the tax provisions that have the biggest impact on the industry's return on investment, and concludes with an assessment of the effects of federal taxation of the industry on the incentives to invest in new drug development. The information presented here may be of use to the 111 th Congress as it weighs the advantages and disadvantages of proposals to modify how health care is financed and delivered in the United States. Firms that develop new innovative medicines seem especially inclined to invest heavily in advertising. Federal Tax Burden on the Drug Industry and Major U.S. Industries from 2000 to 2006

Generally, the federal tax burden on an industry refers to how the tax code affects its return on past investment. A widely used measure of an industry's federal tax burden is its average effective tax rate, which is the ratio of its federal income tax liability after credits to its taxable income, expressed as a percentage. In addition, average effective tax rates do not provide a comprehensive measure of the federal tax burden for an industry because they cannot capture the influence of provisions in the tax code that accelerate the timing of tax deductions or delay the recognition of income for tax purposes. Table 3 shows the average effective federal tax rates for the drug industry and all major U.S. industries from 2001 to 2006. As noted above, the rates compare the industries' federal income tax liability after all credits except the foreign tax credit with their worldwide taxable income (as reported on their federal income tax returns). The data in the table indicate that the drug industry's federal tax burden in 2001 to 2006 was similar to the average tax burden for all industries. This is because the effects of some tax preferences that tend to benefit drug firms more than other firms are not fully reflected in average effective tax rates. Three tax preferences in particular are likely to yield significant tax savings for U.S.-based drug firms and thus warrant further examination: (1) the deferral of federal income taxes on net income retained by foreign subsidiaries of U.S.-based corporations; (2) the expensing (or deduction as a current cost) of qualified research spending; and (3) the expensing of advertising and promotional costs. But this might not be the case. As a firm's user cost of capital declines, the number of investment projects it can profitably undertake increases, all other things being equal. An indicator of the effect of tax policy on new drug development is the drug industry's federal tax burden, as measured by average effective tax rates. Among the key ones are the opportunities for novel drug compounds opened up through advances in basic research, the regulatory requirements for the drug approval process, the competitive strategies of drug firms, and the potential earnings from investing in the development of new drugs.
A key issue in congressional debates over expanding consumer access to prescription drugs is the impact of proposed initiatives on the development of new medicines. Some of the initiatives entail significant changes in one or more of the federal policies affecting new drug development. One such policy is federal taxation of firms that invest in this development.
This report examines the impact of federal taxation on the incentive to invest in new drug development. More specifically, it looks at the provisions in current tax law that affect the performance of the drug industry, compares the industry's federal tax burden with that of other major industries, and assesses the effect of federal taxation on the incentive to invest in new drug development. This information may be useful to the 111th Congress as it considers the pros and cons of proposed changes in the U.S. health care system. The report will be updated as necessary.
An industry's federal tax burden refers to the effects of federal taxation on its return on investment through statutory provisions that define taxable income, make adjustments to this income, and establish tax rates and credits against tax liability. Economists generally measure an industry's federal tax burden as its average effective tax rate, which is the ratio of its federal tax liability after all credits (except the foreign tax credit) to its taxable income, expressed as a percentage. This measure has some limitations, such as the inability of average effective rates to capture the effects of tax provisions that accelerate the timing of deductions or delay the recognition of income.
A comparison of average effective federal tax rates for the drug industry and major U.S. industries indicates that the share of the drug industry's worldwide net income paid as federal taxes was similar to the average share for all industries from 2000 through 2006. This has not always been the case. For much of the 1990s, the drug industry's tax burden was significantly lower than the average tax burden for all industries. But starting in the late 1990s, the drug industry's federal tax burden began to rise as the U.S. possessions tax credit was phased out. Drug firms were major beneficiaries of this credit. They also appear to benefit substantially, if not disproportionately, from three tax preferences whose combined effect is not fully reflected in average tax rates: (1) the deferral of federal income tax on the retained earnings of foreign subsidiaries of U.S.-based corporations, (2) the expensing of research outlays, and (3) the expensing of advertising outlays.
Available evidence suggests that current federal tax law bolsters the incentive to invest in new drug development for some firms but not for others. The most powerful drivers of this investment seem to be the quest by certain drug firms for sustained competitive advantage and profit growth and the available technological opportunities for developing new, safe, and effective medicines. Still, all other things being equal, a substantial increase in the industry's tax burden might slow growth in this investment by raising the industry's cost of capital and reducing its cash flow.