The Pharmaceutical Industry's R&D Investment

Background

In the attack du jour on the pharmaceutical industry, critics have charged that the annual estimates of R&D expenditures compiled by the Pharmaceutical Research and Manufacturers of America (PhRMA) are inflated. The charge appears to be based on the erroneous assumption that amounts claimed under the R&D tax credit represent total R&D expenditures.

The R&D Tax Credit

In fact, the R&D tax credit is based on incremental, or added, spending on a limited category of expenses. Its purpose is to spur companies to increase investment in R&D; it was never meant to include all R&D spending. Moreover, the IRS rules defining expenses eligible for this credit are extremely restrictive. Many expenditures that qualify as research and development expenses under generally accepted accounting principles are excluded. Ineligible expenses include:

• all R&D equipment costs (including the cost of equipping state-of-the-art laboratories with such expensive tools as screening robotics, high-speed computers, laser capture microscopes and others);
• fringe benefits paid to employees engaged in R&D;
• salaries and benefits of many employees supporting and supervising R&D activities;
• a percentage of the expenses of research conducted on a contract basis, and
• expenses for R&D paid by a U.S. company for R&D conducted outside the U.S.

IRS data show that, as a result of the above restrictions, only about 55 percent of total R&D expenses are qualified expenses for the purposes of the R&D tax credit.

The TACD Analysis

The Transatlantic Consumer Dialogue (TACD), an organization affiliated with Ralph Nader's Public Citizen, attempted to estimate total pharmaceutical industry R&D expenditures based on the R&D tax credit used by taxpayers to reduce tax liability. While the TACD analysis attempts to take into account the fact that the credit is only for incremental, or added, R&D expenditures, it arbitrarily assumes a base of 50 percent. In other words, it assumes that current year R&D is double the average of the previous four years' R&D expenditures. This is unrealistic. Only start-up companies and other very rapidly growing companies have such a low base. For more mature companies, a base of 80 to 90 percent is more realistic. This means that mature companies increase R&D by 5 to 15 percent each year. In fact, the PhRMA Survey for calendar year 2000 estimates an increase in industry R&D spending of 10.1% over 1999. By assuming a universally low base, the TACD analysis seriously underestimates R&D expenditures.

Finally, the TACD analysis assumed all taxpayers received a 20 percent credit for incremental qualified expenditures. In fact, a number of taxpayers choose an alternative 13 percent credit to avoid an R&D deduction disallowance that is required if the 20 percent credit is claimed.

PhRMA's Annual Surveys

Every year, PhRMA surveys its member companies - the country's leading pharmaceutical and biotechnology companies - on their individual R&D expenditures. These expenditures are defined as the total costs incurred for all pharmaceutical research and development activity, including salaries of employees who conduct, support or supervise R&D; supplies and equipment used in R&D; a fair share of overhead; contract research expenditures; the costs of synthesis and extraction of compounds; the costs of laboratory testing (pre-clinical); expenditures involved in formulating the dosage and testing the stability of compounds; the expenditures incurred in three-stage, FDA-supervised clinical trials; the costs of post-marketing studies, and bioavailability studies.

The most recent survey found projected R&D expenditures for 2000 of $26.4 billion. This figure represents a 10.1 percent increase over 1999 R&D expenditures of $24 billion.

Other Government Data Sources

The National Science Foundation collects and publishes annual R&D expenditures by industries. That data, when adjusted to take into account the different categories between PhRMA surveys and the NSF survey, is consistent with the R&D expenditure figures published by PhRMA.

For 1996, NSF data show $9.8 billion for domestic research performed by pharmaceutical companies, plus an additional $2.1 billion of pharmaceutical industry domestic contract research. The PhRMA survey includes all biomedical research, including biotech, some of which is included in a larger NSF category for "Research, Development and Testing." The amount in that NSF category is $5.9 billion, a substantial portion of which relates to biomedical research.

The Fruits of R&D

Anyone who questions the fact that pharmaceutical companies are investing heavily in R&D should look at the results of that investment - "the proof of the pudding." Last year alone, pharmaceutical companies added 40 new treatments to the nation's medicine chest. The new medicines target 36 diseases with a total patient population of 545 million and a total annual cost of $600 billion. In the last decade of the 20th century, companies made a total of 370 new medicines available - up from 239 in the previous decade.

The medicines of the 1990s included breakthrough medicines for AIDS, cancer, stroke, depression, schizophrenia, arthritis and many other diseases.

The Rising Cost of R&D

According to the Boston Consulting Group, the average cost of development a new drug is about $500 million, including the cost of research failures as well as interest costs over the period of investment. Drug development costs are increasing due to a number or reasons, including more clinical trials, usually involving more patients and more procedures, and the fact that companies are attacking more and more difficult diseases.

Prices vs. Expenditures

Critics of the pharmaceutical industry tend to confuse "drug prices" with total "drug expenditures." Total expenditures for pharmaceuticals increased by 15.7 percent in 1998. But, according to IMS Health, the average cost of a prescription Medicine increased by a modest 3.2 percent. In other words, because more patients got more and better medicines, even if there were no price increases, total expenditures would have increased by 12.5 percent.

Rising drug expenditures represent a sea change that is occurring in health care. Prescription drugs are an increasingly important treatment option, which can often keep people out of hospitals, nursing homes and surgical suites. They are the most cost-effective, least invasive form of health care. The share of total health care expenditures represented by outpatient prescription drugs is only in the single digits, currently 7.9 percent. That figure is inching up every year because patients, physicians and insurers are increasingly turning to prescription drugs. Still, it should be noted that since outpatient drugs account for only 7.9 percent of health care expenditures, even a 15.7 percent increase in total drug expenditures is a good investment in effective and cost-effective treatment of patients.

Coverage is Key

The fact that prescription drugs are the most cost-effective and least invasive health care treatments means that prescription drug coverage is increasingly important. This is especially true for seniors, who use more prescription medicines than younger Americans. Medicare's lack of coverage of prescription drugs is truly an anachronism. That's why PhRMA supports enhancing drug coverage for seniors. We want to do this in a way that provides quality health care for seniors while preserving the incentives to invest in pharmaceutical R&D.

2/1/00

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