The 2003 Medicare Prescription Drug, Improvement and Modernization
Act created a prescription-drug benefit, Medicare Part D,
effective January 1, 2006. For the first time, the federal
government will pay for the prescription medicines used by
American senior citizens. Part D differs from other federal
and state drug programs, which mandate specific price discounts.
Instead, private-sector Pharmacy Benefit Managers (PBMs)
including such well-established firms as Medco, Blue Cross,
and Aetna negotiate with drug companies to set prices
and formularies (lists of covered drugs) for enrolled patients.
Because the prescription drug benefit is projected to cost
hundreds of billions of dollars over the next decade, some
policymakers have called for changing Medicare Part D, to
require federal negotiation of prescription-drug prices. Such
a change would aim to use the purchasing power of the federal
government to force prices below those that would be negotiated
by the private sector.
In addition to cost reductions, however, this policy change
portends other ancillary effects. In particular, this paper
estimates the impact that federal negotiation of prescription
drug prices would have on pharmaceutical research-and-development
(R & D) investment through 2025. It argues that federal
policymakers would have incentives to favor price reductions
at the expense of more-inclusive drug formularies. This greater
willingness of federal officials to exclude drugs from formularies
would lower drug prices below those that otherwise would be
set by the market. This, in turn, would reduce incentives
for the capital market to invest in the research and development
of new medicines.
This report quantifies the results of such a decline in capital
investment. It presents the results of a simulation analysis
that projects pharmaceutical R & D investment, assuming,
under three different sets of parameters, federal price negotiations
for prescription drugs beginning in 2007.
In the baseline case, developed from National Science
Foundation (NSF) data on historical investment trends, the
cumulative decline in research and development investment
would yield a loss of 196 new medicines, or about ten per
Using the same NSF data with a more conservative assumption
about the growth rate of research and development investment,
the loss would be 107 new medicines, or about six per year.
Using historical investment data gathered by the Pharmaceutical
Research and Manufacturers of America, the loss would be 220
new medicines, or twelve per year.
In the short run, federal price negotiations would allow
some consumers to receive medicines at lower prices, or, alternatively,
would yield savings for federal taxpayers. The longer-term
human costs of government price-negotiation, however, are
likely to be large and adverse. This paper estimates that
investment in new drug research and development would decline
by approximately $10 billion per year. It estimates as well
the effect of reduced pharmaceutical R & D investment
on American life expectancies, or expected life-years.
Specifically, this work projects that federal price negotiations
would yield a loss of 5 million expected life-years annually,
an adverse effect that can be valued conservatively at about
$500 billion per year, an amount far in excess of total annual
U.S. spending on pharmaceuticals.
About the Author
Benjamin Zycher, is a Senior Fellow at Manhattan Institute's
Center for Medical Progress and a member of the advisory boards
of the quarterly journal Regulation and Consumer Alert.
During the first two years of the Reagan Administration,
Mr. Zycher was a senior staff economist at the President's
Council of Economic Advisers. He is also a former senior economist
at the RAND Corporation, a former vice president for research
at the Milken Institute and a former member of the Board of
Directors of the Western Economic Association International.
Previously, he was an adjunct professor of economics at the
University of California, Los Angeles and a former editor
of the quarterly public policy journal Jobs & Capital.
He holds a Ph.D. in Economics from the University of California
Los Angeles (1979) and a Master of Public Policy from the
University of California Berkeley (1974).
Mr. Zycher's research focuses on the economic and political
effects of regulation, government spending, taxation and counterterrorism
public expenditures. He has done considerable work on health
care policy and the economics of the pharmaceutical sector
and on energy and environmental policy. Mr. Zycher has also
examined long-term trends in economic performance and military
capability, the use of trade policy in pursuit of foreign
policy goals and measures of burdensharing within alliances.
He is the author of "Defense Economics" and "OPEC"
in The Concise Encyclopedia.
The 2003 Medicare Prescription Drug, Improvement and Modernization
Act (MMA) substantially increased the medical benefits that
the federal government finances for the elderly. Under Part
D of the MMA, the federal government pays a significant portion
of prescription drug costs of seniors covered by Medicare,
beginning in 2006. Previously, only prescription medicines
"incident to" the delivery of physician services
had been covered as a Medicare benefit.
This benefit is not the only new provision of the MMA. Unlike
previously existing federal and federal/state drug programs
such as those for veterans receiving drugs under
Department of Veterans Affairs programs or Medicaid programs
for low-income patients the new Part D program does
not attempt to reduce prices or spending by mandating specific
price discounts from pharmaceutical producers. Indeed, the
federal government under the MMA is proscribed from negotiating
or imposing such discounts. Instead, such negotiations are
left to private-sector insurers and other buyers
Pharmacy Benefit Managers, or PBMs that negotiate
with the pharmaceutical producers. The PBMs then offer Medicare
enrollees choices of drug benefit plans, with differing
premiums, drug prices, drug formularies (lists of drugs
included in a given program), co-payments, and deductibles.
Under the "noninterference" language of the MMA,
the federal government is prohibited from "interfering"
with those negotiations by mandating price discounts, formularies,
or other central features of the drug benefit plans. This
provision is seen by many as a means of minimizing government
involvement in the market for pharmaceuticals; for example,
Senate Majority Leader Bill Frist argued in 2004 that "competition
is better over time than price fixing."
The new program will be large in terms of the number of
enrollees and newly required federal spending, particularly
with the growing population of baby-boom retirees. This
has led to growing calls for a change in the "noninterference"
provisions of the MMA, which would allow direct federal
negotiation of price discounts for drugs; for example, Senator
John Edwards has argued: "We [should] allow the government
to use its bargaining power to bring down the costs of prescription
drugs for all seniors."
If given such a mandate, Medicare would become the single
largest purchaser of prescription medicines in the U.S., with
powerful incentives for policymakers to use the attendant
purchasing power to obtain large price discounts. Those price
discounts clearly would have an additional effect: They would
reduce the economic returns to investment in the research
and development of new and improved drugs. So one important
concern raised by the possibility of federal price negotiations
for drugs is a decline in that research and development, and
thus in pharmaceutical innovation. Some argue that this effect
would be large; others maintain that it has been exaggerated.
This paper presents findings on the magnitude of that likely
effect under the assumption that the noninterference provisions
of the MMA are removed. The analysis presented below begins
with previously published findings on the effects of growing
government drug purchases on drug prices. Those findings are
applied to historical data from the National Science Foundation
(NSF) on research and development investment trends for pharmaceuticals,
with three different cases a base case and two alternative
cases examined for the range of likely resulting impacts
on that research and development spending over the period
200725. The NSF data are supplemented with additional
public data from the United Nations, the Organisation for
Economic Co-operation and Development (OECD), and the Pharmaceutical
Research and Manufacturers of America (PhRMA). Other published
findings on the cost of drug development, on the effect of
pharmaceuticals on life expectancies, and on the economic
value of life-years are used to estimate the number of new
and improved medicines that would fail to be developed, and
the economic cost of that reduction in pharmaceutical innovation.
The central findings can be summarized as follows:
- For a program of federal price negotiations assumed
to begin in 2007, the average price reduction for drugs for
the period 200725 would be about 21.8 percent, which
can be interpreted as a saving for taxpayers or patients and
as an implicit "tax" on pharmaceutical producers.
- This implicit tax would reduce pharmaceutical research and
development investment annually by $5.611.6 billion,
with the most likely effect at about $10 billion per year.
- This reduction in research and development investment
will result in a loss of between 6 and 12 new medicines
per year, with the most likely reduction at about 10.
- This reduced flow of new and improved medicines will
cost Americans about 5 million life-years annually, which
can be conservatively valued at about $500 billion annually,
a figure far in excess of total annual U.S. spending on
The discussion below proceeds as follows. Section II discusses
differences in the negotiation incentives of the PBMs and
the federal government. Section III offers a summary of
federal pricing policies in other drug programs. Section
IV presents a brief discussion of the simple economics of
investment. Section V follows with a discussion of the methodology
used for the analysis and a detailed presentation of the
analytic findings. Section VI compares these findings with
those in previously published research, and Section VII
presents several conclusions. Appendix A offers a further
discussion of the incentives confronting federal policymakers
pursuing price negotiations with pharmaceutical producers,
as contrasted with those shaping the decisions of the PBMs.
Appendix B presents the data used in the analysis, and Appendix
C presents charts of those data. Finally, Appendix D discusses
briefly a recent report prepared by the Congressional Research
Service on federal price negotiations for drugs.
Crucial Differences between the Federal
Government and the PBMs
The complex adoption and implementation of public policies
inevitably must create winners and losers. Seen in this
context, prices for drugs negotiated by the federal government
in effect impose a tax on pharmaceutical producers in the
form of realized prices lower than otherwise would be the
case; and they generate an implicit revenue stream for current
drug consumers in the form of those same lower prices, or
for the beneficiaries of other government spending programs.
Such negotiated prices may seem analogous to the price
discounts familiar to patrons of large pharmacy chains or
insurers that negotiate with drug producers or with various
middlemen, but three crucial differences between such negotiators
and the federal government are clear. First, it is likely
that the federal government would enjoy greater market power
in price negotiations than a given "large" private-sector
purchaser could exercise; note that the Medicaid program
before the implementation of the Medicare drug benefit was
the largest single purchaser of prescription drugs, accounting
for over 19 percent of national prescription drug expenditures
in 2004. The CMS
projects that federal government drug purchases will be
over 40 percent of the national total by 2010.
As a monopsonistic purchaser of pharmaceuticals, government
can be predicted to attempt to lower both the prices it
pays and the quantities purchased; the latter effect is
the deeper implication of the more restrictive formularies
likely to be observed in the context of federal price negotiations,
as discussed in more detail below.
Second, unlike private-sector purchasers serving customers
seeking both low prices and formularies that contain the
drugs that they demand, the federal government does not
have "customers" as such.
Instead, it has individual voters and collective interest
groups, the demands of which are registered in infrequent
elections driven by perceived voter/interest group preferences
on numerous issues of varying political importance. It is
by definition the case that negotiations between drug producers
and retailers (or their market proxies) hinge on the prices
at which both parties are willing to include given drugs
in formularies; profit-seeking firms are driven by the demands
of their customers to pursue some balance between the benefits
of low prices and the benefits of formularies that are more,
rather than less, inclusive. For the federal government,
on the other hand that is, for federal policymakers
lower prices offer budget relief, that is, greater
potential spending on other budget categories, while less
inclusive formularies offer even more such budget benefits.
The beneficiaries of drug use cannot take their business
elsewhere without moving to some other country or by simply
buying retail. While it is likely to be the case that more
inclusive formularies yield some political benefits, particularly
for specific medicines demanded by organized or visible
patient groups, the latter are offset partially or wholly
by the political benefits of higher spending on other budget
categories. In short, the substitution of federally determined
formularies in place of those determined under market competition
deprives consumers of the right to opt for more favorable
alternatives. Thus do the negotiation incentives of federal
policymakers differ substantially from those of large private-sector
buyers ultimately serving retail customers.
Third, the more powerful partial incentive of large private
buyers to satisfy their customers (i.e., patients) with
larger formularies has the long-term effect of preserving
economic incentives for research and development investment
greater than is the likely case for prices and formulary
restrictions determined in negotiations with the federal
effect is separate from the market incentives of the pharmaceutical
research (branded) industry to maintain research
and development programs; those market incentives are independent
of whether the buyer across the negotiation table is an
insurer or the federal government.
But the weaker incentive of the latter to include given
drugs in formularies automatically yields greater downward
pressure on negotiated prices drugs excluded from
formularies are rewarded with a price of zero, and the federal
government can be predicted to favor less inclusive formularies
and thus a reduction in expected returns to research
This problem of reduced long-term incentives for research
and development investment inherent even (or particularly)
in federal price negotiations is one dimension of the short
time horizon confronting federal policymakers. Those policymakers
have no claim, whether political or pecuniary, on the future
benefits from ongoing investment; after all, many future
patients are unavailable to vote today, and many of those
who are available do not know that they will endure the
future adverse effects engendered by the current investments
the future medicines that are forgone.
Prices under Current Federal Drug Programs
Unlike the case for the new Medicare Part D, the government
purchases drugs or establishes drug prices for Medicaid,
Medicare Part B, the Department of Veterans Affairs pharmacy
program, and for various programs under the Public Health
Service Act (PHS). Each obtains drugs at discounted prices,
but the computation and magnitudes of the respective discounts
Medicaid drug spending in 2004 (federal and state) was
about $36.6 billion (in then-year dollars), accounting for
over 19 percent of total U.S. spending on drugs that year,
having grown at about 9 percent per year since 2000, even
after adjusting for inflation. Medicaid requires drug producers
to participate in a national rebate (essentially, a price
discount) program in order for their respective drugs to
be included in the Medicaid formulary for a given state.
The rebate is determined by the average manufacturers
price (AMP) and by the manufacturer's "best" price
paid by retail pharmacies and other large private-sector
buyers. For brand-name drugs, the rebate is the greater
of: (a) 15.1 percent of the AMP; or (b) the difference between
the AMP and the best price.
(For generic drugs, the rebate is 11 percent of the AMP.)
Under the first formula, the Medicaid rebate amounts to
a straightforward excise tax of 15.1 percent of the AMP
applied to Medicaid sales; note that the AMP, while not
defined uniformly, is an average across several markets,
so that it is, in some crude sense, a market price. Under
the second formula, state Medicaid programs receive the
best prices negotiated by large private-sector buyers, so
that in effect, the rebate serves as an implicit tax on
price discounts negotiated outside Medicaid because discounts
offered to large private-sector buyers must be offered to
the Medicaid programs as well.
Medicare Part B reimburses physicians and other medical
providers for drugs used for such outpatient services as
dialysis treatment and for drugs given to patients "incident
to" physician services. Most are cancer and antinausea
drugs taken orally, inhalation therapies, and oral immunosuppressives.
Medicare payments for Part B drugs over time have been based
on a series of shifting computations: the physician's "acquisition"
cost, varying percentages (at various times, 85100
percent) of average wholesale price (AWP), and the lower
of estimated acquisition cost and some percentage of AWP.
These differing methods of computing payments for the providers
have been implemented at various times because Part B reimbursements
often have been found to exceed the actual prices at which
the medical providers were able to obtain the drugs, yielding
Because of this perceived problem, the MMA established a
new payment system for Part B based upon a drug producer's
average sales prices (ASP), thus presumably reflecting market
prices. But because the ASP includes price discounts negotiated
with various buyers, the requirement that Part B prices
reflect ASP in effect imposes a tax on such discounts negotiated
with other buyers, as in the case of Medicaid discussed
It is commonly reported that the Department of Veterans
Affairs "negotiates" the prices that it pays for
pharmaceuticals. That is a misconception: Under the 1992
Veterans Health Care Act, two price constraints are imposed.
First, there is a minimum 24 percent discount from the AMP,
often called the Federal Ceiling Price (FCP); in addition
to the VA, this price is available to the Defense Department,
the Indian Health Service, and the Coast Guard. Second,
there is a Federal Supply Schedule (FSS) requirement that
the pharmaceutical producers sell drugs to the VA at the
"best price" offered private-sector buyers. These
FSS "best prices" must be offered as well to many
health-care programs receiving federal funding; thus does
the FSS "best price" requirement allow the federal
government and many others to receive the benefits of private-sector
negotiations without undertaking any negotiations themselves.
The VA is entitled under the law to receive the lower of
the FCP and FSS prices. The 24 percent discount under the
FCP is explicitly a tax on drug prices; and the FSS best-price
requirement, as in the case of both Medicaid and Medicare
Part B, is a tax on negotiated prices.
Drug producers refusing to sell at these prices would be
precluded from selling their products both to the VA through
the FSS system and to Medicaid, thus shutting themselves
out of 1015 percent of their sales. For most pharmaceuticals,
production costs per pill (or dose) are small, so that a
loss of so significant a portion of sales combined
with a fixed period of patent protection can wreak
havoc with sales and pricing strategies designed to recoup
large research and development costs. This is one manifestation
of federal pricing power, the central implication of which
is that the implicit tax, whether large or small, would
be difficult to avoid.
The Public Health Service Act implements drug price discounts
for such programs as Community Health Centers, Ryan White
program grantees, and AIDS Drug Assistance Programs. Drug
producers selling to such programs are required to offer
discounts at least as large as the AMP discounts under Medicaid.
Similarly, these prices implicitly impose a tax on market
Some Simple Economics of Investment
This experience with other federal drug programs demonstrates
that the mandated price discounts, as they are defined and
implemented, analytically are taxes not only on the prices
paid for the drugs sold for the specific programs, but under
some conditions also on the prices negotiated with large
private-sector buyers for sales outside the federal programs.
As such, the discounts incontrovertibly must reduce the
perceived economic returns to research and development investment
in the creation of new and improved drugs. This effect would
be strengthened by federal price negotiations under Medicare;
the central issue to be addressed is the magnitude of that
Any investment is "efficient" (that is, expected
to be profitable) as long as the anticipated future rate
of return or stream of profits from the investment, adjusted
for risk and other factors, is equal to or greater than
the market rate of interest. This should be intuitively
obvious: If the rate of return from an investment is expected
to fall below the "cost of money," the investment
should not be made. That future rate of return is determined
in substantial part by the net price that the future products
are likely to command; accordingly, taxes on that price,
whether explicit or implicit, must reduce that future return
by some amount.
So the tax will reduce investment, even if the lower rate
of return remains at or above the market rate of interest.
But if the tax reduces the future rate of return below the
market rate of interest, investment will fall to zero because
no part of the investment remains efficient.
This case of zero investment may seem extreme, but it is
highly plausible under a broad set of conditions. Consider
a market in which pharmaceutical research and development
investments earn competitive returns (as contrasted with
above-competitive returns); this outcome can obtain for
two reasons. First, pharmaceutical products can be direct
and indirect competitors; when finally approved for sale,
their prices may yield only competitive rates of return.
Second, pharmaceutical producers invest in a portfolio of
potential new products and drugs; it is efficient for such
investments to be made until the last invested dollar is
expected to yield only the market rate of return.
But in any given year, not all such investments will yield
returns greater than or equal to the market rate of interest;
some will prove to be losers. Some years will be relatively
profitable in terms of research and development success
and the market prices received for drugs, and other years
will be afflicted with relatively heavy losses; investment
outcomes over time are subject to random influences, so
that the statistical distribution of returns over time has
an average equal to the market rate of interest adjusted
for perceived risk.
But the implicit federal price-discount tax would not be
imposed randomly; it is the drugs that finally are approved
for sale that would be subjected to the tax. So large-scale
federal price negotiation of drug prices would create a
bias in the returns earned by pharmaceutical producers:
Upside potential for the investments yielding approved drugs
would be reduced, while downside potential for losing investments
would remain unaffected. This means that average returns
must decline. If the average expected return in the absence
of federally mandated price discounts is at the market rate
of interest, the introduction of discounts must yield a
reduction in investment, and perhaps zero (or near zero)
only way for a producer to avoid this outcome is to reduce
or eliminate investment in new drugs either riskier or prospectively
less profitable, a market adjustment with highly adverse
upshot of this adjustment process is a market with less
research and development investment and fewer new
medicines than otherwise would be the case.
Quantitative Analysis of Research and
Development Investment under a Federal Price Negotiation
There is no dispute in the economics literature with respect
to the downward effect of mandated price discounts upon
research and development investment. The analytic issue
to be addressed is the likely magnitude of that impact were
the noninterference provisions of the MMA to be repealed.
We proceed as follows. We examine the published literature
for empirical findings on the effect of federal drug purchases
on the growth of drug prices. Those findings are applied
to historical data on research and development investment
trends for pharmaceuticals, in order to estimate the resulting
future downward effect upon that investment. The period
for which the projections are made is 200725. Other
published findings are used to estimate the number of new
drugs that would fail to be developed as a result of the
reduction in research and development investment, the effect
of pharmaceuticals on life expectancies, and the resulting
economic cost created by federal price negotiations for
drugs and the resulting decline in pharmaceutical innovation.
Because the other federal and state drug programs already
in operation impose downward price pressures of varying
kinds, empirical literature is available that links those
price effects with government spending on drugs. In particular,
a recent paper by Santerre et al. presents empirical analysis
of the historical price effects of increases in the governmental
share of total pharmaceutical spending.
That paper reports a decline in the growth of real pharmaceutical
prices from 1962 through 2001, yielding reduced research
and development investment and fewer new medicines.
In brief, the statistical analysis presented in Santerre
et al. finds an annual reduction of 1.2 percent in the growth
of real drug prices attendant upon each 10 percent increase
in the government share of drug spending before 1992, and
an annual reduction in drug prices of 5.3 percent for each
10 percent increase in the spending share after 1992.
Note that these are annual reductions in the growth rate
of drug prices and thus would compound over time.
Santerre et al. use those econometric findings to estimate
the research and development investments forgone because
of the rising share of government pharmaceutical spending,
and then use Lichtenberg's empirical findings on the effect
of pharmaceutical research and development investment on
life expectancies in the U.S. to derive an estimate of the
life-years lost because of the price effects of the growing
governmental share of drug spending.
Santerre et al. estimate that for 1962 through 2001, forgone
research and development investment was $251256.3
billion. Given Lichtenberg's estimate that an additional
life-year is obtained from a research and development investment
of $1,345, the estimated loss in terms of life-years over
the period is between 186.6 million and 190.5 million, or
roughly 4.7 million per year. Using a range of $50,000150,000
for the assumed value of a life-year lost, Santerre et al.
conclude that the adverse effect of growing government drug
purchases and attendant price impacts for the 40-year period
is in the range of $9.328.6 trillion.
For the analysis reported here, U.S. pharmaceutical and
biotechnological research and development investment data
for 1985 through 2003, converted to year 2005 dollars, were
obtained from datasets constructed by the National Science
Foundation, and then compared or supplemented with data
from the United Nations Industrial Development Organization,
the Organisation for Economic Co-operation and Development,
and the Pharmaceutical Research and Manufacturers of America.
Research and development investment spending during 19932003
grew at an annual compound rate of almost 8 percent; that
rate was used in the analysis reported below to project
annual investment data to the year 2025.
Just as annual investment in plant and equipment over time
yields a "stock" of plant and equipment
the sum of the annual investments minus annual depreciation
the data on annual investment in pharmaceutical research
and development allow a calculation of the U.S. pharmaceutical
research and development capital stock. This capital stock
can be thought of as the plant, equipment, intellectual
advances, and other assets created with the annual investments,
minus depreciation. At the outset of 1985, the pharmaceutical
research and development capital stock is assumed to be
six times 1985 investment; this is a standard investment/capital
assumption used in a number of published economic analyses.
Annual depreciation is assumed at 8 percent, so that for
each year, the capital stock is that remaining from the
previous year, plus new investment.
The annual data and projections are shown in Table
B1 of Appendix B. Table
1 presents the data and projections for both investment
and the capital stock at five-year intervals in the assumed
absence of federal price negotiations for Medicare Part
D. Annual investment is projected to grow from $13.5 billion
in 2000 to $95.7 billion in 2025; the respective figures
for the capital stock are $87.9 billion and $645.4 billion.
Data from the CMS show an increase in the federal spending
share for drugs, from 9.4 percent in 1992 to 16.9 percent
in 2004, rising to a projected 39.7 percent in 2006 and
43.4 percent in 2015.
Almost all this increase after 2004 is due to the effect
of the MMA on Medicare drug spending, which is projected
in 2015 to be almost 70 percent of all federal drug spending.
The empirical analysis presented by Santerre et al., summarized
above, implies strongly that downward pressure on drug prices
will intensify as the public-sector share of total drug
spending increases. Using the lower estimate of that effect
reported by Santerre et al., together with the CMS projection
of the federal and total government spending share for drugs,
we can estimate the resulting percent downward effect
the implicit tax on drug prices.
presents those projections of the federal and total government
shares of national drug spending and the adjusted downward
price effects (compound tax rates) implied by
the Santerre et al. analysis as applied to the increasing
federal share after 2005. The implicit tax estimates are
adjusted by: (1) assuming a 5 percent implicit price tax
as an effect of all government drug purchases before 2006;
(2) holding constant for all subsequent years the 2006 federal
government spending share; and (3) assuming a marginal implicit
price tax of 1.2 percent per 10 percent increase in the
federal share of total drug spending, compounded annually.
We adopt these conservative assumptions because it is appropriate
to estimate a lower bound on the research and development
effects of federal price negotiations and because some downward
pressure on prices can be expected as a result of negotiations
between the pharmaceutical producers and the Medicare Part
D PBMs even in the absence of negotiations by the federal
government. The major increase in the federal drug spending
share projected by the CMS is in 200506, from 17.2
percent to 39.7 percent. Under the assumptions described
above, the implicit tax on pharmaceutical prices would rise
from 5 percent in 2005 to 13.1 percent in 2010 to over 35
percent in 2025. For 200725, the average implicit
tax is 21.8 percent.
This prediction is moderately lower than the 27.5 percent
price differential estimated by Santerre et al. for 196282,
and lower than the 2838 percent figure for 19922001
estimated as a consequence of market purchases by all levels
of government. Note that their analysis did not include
federal purchases for Medicare. Moreover, the sheer size
of the Medicare drug program can be predicted to strengthen
the monopsony (purchaser) pricing power of the federal government,
an effect likely to be increased further by any threat to
exclude given drugs not only from Medicare formularies but
from Medicaid and other public formularies as well. Accordingly,
the available empirical evidence suggests that a price reduction
of 1.2 percent per 10 percent spending share, compounded
annually, represents a conservative assumption a
lower bound for the likely price effect for pharmaceuticals
attendant upon federal negotiations over Medicare drugs.
A downward price effect imposed in the short or medium
term will affect current investor behavior, since the research
and development (and regulatory approval) process for new
drugs is about ten years or longer. From the viewpoint of
a pharmaceutical producer considering a particular investment
in research and development, the implicit tax affects the
present (discounted) value of the expected future revenue
stream. As intuition
suggests, simple analytics show that, as a first approximation,
a compounded price effect of a given percent would reduce
the present value of the net revenue stream by that same
It is possible that pharmaceutical research and development
investment is so profitable that this implicit tax would
have little effect. Were that true, we would expect to observe
substantial new entry into the market. As discussed above,
it is possible as well that a zero investment outcome would
be observed, as the tax might reduce expected returns below
the market rate of interest. A conservative assumption for
purposes of developing projections is proportionality: The
implicit annual compound 1.2 percent tax imposed by federal
price negotiations would reduce research and development
investment by that percentage, also compounded annually.
presents projections analogous to those in Table
1 under the assumption that the implicit tax is imposed
beginning in 2007.
The data and projections presented in Table
B1, as summarized in Table
3, yield conservative estimates of the investment effects
of the implicit tax inherent in federal price negotiations
for pharmaceuticals. The cumulative decline in research
and development investment for 200725 is predicted
to be $196 billion in year 2005 dollars, or $10.3 billion
per year. The predicted decline in 2025 in the pharmaceutical
research and development capital stock is $133.1 billion.
If we assume a marginal investment cost of $1 billion per
new drug, the decline in research and development investment
implies the loss of about 196 new medicines over the simulation
time period, or roughly ten new medicines per year.
Santerre et al. estimate a cumulative reduction in pharmaceutical
investment of about $261 billion (in year 2005 dollars)
for 19622001, or about $6.5 billion per year on average.
As described above, that estimate flows from a conceptual
experiment similar to that reported here, with somewhat
different estimation methodologies applied. More important,
that analysis examines price behavior in the absence of
federal price negotiations under Medicare, a condition that
largely explains the increased investment effect reported
here, an outcome of the projected price effects of the sharp
increase in the 2006 federal spending share for pharmaceuticals,
assumed constant after 2006.
The findings of empirical research are often heavily affected
by certain underlying assumptions, sometimes in subtle ways,
so it is useful to change those assumptions to see the degree
to which the findings are "sensitive" to those
changes. One parameter discussed above is the use of the
historical growth rate during 19932003 for pharmaceutical
research and development investment almost 8 percent
per year as the growth rate assumed for the period
through 2025 in the absence of federal price negotiations.
Smaller assumed growth rates would reduce the projected
effect of the implicit negotiation tax, while larger assumed
future investment would increase that effect.
presents a first sensitivity case, in which research and
development investment in the absence of a federal negotiation
effect is assumed to grow at 4 percent per year, half the
rate (almost 8 percent) observed in the NSF data for 19932003.
This sensitivity case is a bit arbitrary why half?
but a 50 percent reduction in the growth rate is
a useful compromise between a drastic reduction
in assumed investment and only a small reduction that would
not make much difference. Under this assumption, cumulative
research and development investment between 2007 and 2025
is projected to decline $107.1 billion, or about $5.6 billion
per year as a result of federal price negotiations. The
decline in the projected capital stock in 2025 is $68.4
billion. Under this lower investment growth assumption,
the decline in projected investment attendant upon federal
price negotiations implies the loss of 107 new medicines
over the simulation period, or about six new medicines per
presents a second sensitivity case, in which the historical
research and development investment data from PhRMA are
used to project investment with and without federal negotiation
effects on prices.
The assumed annual compound growth rate for investment in
the absence of the tax is 4 percent, as in the first sensitivity
case, but the levels of investment are higher than in the
NSF data, particularly after 1990. The cumulative investment
decline through 2025 is projected to be $220.4 billion,
or about $11.6 billion per year. The predicted decline in
the research and development capital stock is $140.8 billion;
the projected decline in investment for this case implies
a loss of about 220 new medicines, or about 12 per year.
summarizes the projected decline in the development of new
drugs for the three cases.
These estimates of the future reduction in the flow of
new and improved medicines can be used to project resulting
effects on lost life-years for Americans. Lichtenberg estimates
that between 1960 and 1997, each pharmaceutical research
and development investment of $1,345 yielded an expected
gain of one life-year.
If we assume, crudely, that figure to be $2,000 in year
2005 dollars, the investment decline, projected in the base
case at about $10 billion annually as a consequence of federal
price negotiations, would result in 5 million life-years
lost each year. At an assumed $100,000 per life-year,
the economic cost of this effect would be about $500 billion
per year, far in excess of total annual U.S. spending on
pharmaceuticals. As discussed above,
the assumptions underlying the base-case investment projections
are highly conservative;
accordingly, the effects summarized as the base case in
and then expressed in terms of lost life-years and economic
costs can reasonably be viewed as a lower bound on the prospective
effects of federal price negotiations for pharmaceuticals.
Another approach is to ask how the projected annual decline
in the number of new medicines compares with the annual
number of new drug approvals by the FDA over the last several
7 presents those data. For 19952005, there were
on average 98 new drug approvals annually. Our base-case
projection of annual new medicines lost is about 10 percent
of that figure. For 200005, new drug approvals averaged
62 annually; our base-case projection is about 16 percent
of that figure.
Accordingly, it is reasonable to observe that the tax effects
projected here are not trivial. In particular, the adverse
investment effects are likely to be concentrated on drug
research that otherwise would serve smaller populations,
riskier treatments, and drugs expected to prove relatively
Related Research Findings
Other research findings are available and can be compared
with those presented here. Using data for the 15 largest
pharmaceutical producers, Vernon estimates that implementation
of European-type price regulation by the federal government
would yield a decline in research and development investment
of 3648 percent.
Golec et al. estimate that the mere proposal of pharmaceutical
price restraints in the Health Security Act by the Clinton
administration in 1993 reduced research and development
spending by $1 billion despite the fact that the proposal
was never enacted into law. That figure is $1.24 billion
in 2005 dollars and was 15 percent of pharmaceutical research
and development spending that year.
Abbott and Vernon estimate that small price reductions of
about 5 percent would yield declines in research and development
investment of 5 percent but that price reductions of 4045
percent would drive research and development spending down
by 5060 percent.
Santerre et al. find an annual reduction of 1.2 percent
in the growth of real drug prices attendant upon each 10
percent increase in the government share of drug spending
before 1992, and an annual reduction in drug prices of 5.3
percent for each 10 percent increase in the spending share
The International Trade Administration of the U.S. Department
of Commerce estimates that the pharmaceutical price controls
imposed by some members of the OECD, if extrapolated to
the OECD more broadly,would reduce sales revenues by 2538
percent and research and development investment by 1116
et al. find a 6 percent change in research and development
spending attendant upon a 10 percent change in the growth
of real drug prices.
The implicit tax estimated above (Table
2) attendant upon a federal spending share of 39.7 percent
is 35.3 percent in 2025; the Giaccotto et al. estimate would
have been about 24 percent using the same methodology. Vernon
finds that regulation of U.S. pharmaceutical prices yielding
profits equal to those observed on average in non-U.S. markets
would reduce research and development investment by 23.432.7
Vernon et al. find that a reduction in drug prices of 10
percent would engender a reduction in research and development
spending of 5.83 percent.
summarizes these comparative findings. Notwithstanding differences
in conceptual experiments and methodologies, the findings
presented here are broadly consistent with those reported
elsewhere in the published literature.
Federal price negotiations for drugs under Medicare Part
D would reduce costs for taxpayers and perhaps patients,
but those effects can be achieved only at the cost of reduced
pharmaceutical innovation, projected in this research to
be substantial. While the average effect across the population
in terms of life expectancy may or may not be small,
depending on somewhat subjective perspectives on the value
of lost days, months, or even years, the effects are likely
to be large by any definition for particular patient groups.
That the reduced flow of new medicines, summarized above
in Table 6,
clearly will not be trivial underscores the stakes for individuals
suffering from such specific conditions as cancer, diabetes,
or Alzheimers disease.
One crude measure of the value of pharmaceutical technology
is total spending on medicines. As noted above, a conservative
estimate of the average annual future economic loss
in terms of forgone life-years caused by reduced
pharmaceutical research and development investment is $500
billion, an amount far greater than total U.S. spending
on drugs both now and in the future, as projected by the
CMS. This suggests that the short-term gains would be outweighed
greatly by the longer-term losses; that those losses will
be inflicted disproportionately upon patient groups cannot
be a source of indifference.
The federal government, of course, buys many things, and
the results here do not suggest that the U.S. economy writ
large would benefit from the absence of federal negotiations
over prices in any market. In most other contexts, the federal
government is both the price negotiator and the consumer
and so has some interest in preserving both the availability
of given goods and technological advances; the latter may
be particularly true in the context of national security
capital demanded by a permanent bureaucracy. In many contexts,
both the federal government and the given producer have
market power, so that negotiation over price may yield outcomes
closer to those that would emerge under competitive conditions.
This bilateral monopoly condition is unlikely
to characterize negotiations over prices for drugs that
are not unique within a given class.
Most important, most goods do not exhibit the combination
of large fixed costs and low marginal production costs that
characterize most pharmaceuticals. The upshot of this almost
unique condition is the opportunity to drive very hard price
bargains without harming availability in the short term.
But the longer term is the problem, the adverse effects
upon which federal policymakers have relatively weak incentives
The fiscal crisis inherent in Medicare is far greater than
the short-term savings that federal price negotiations might
yield, but the resulting longer-term costs caused by reduced
pharmaceutical innovation are large. So once again, we are
confronted with a stark choice: Cheap drugs in the here
and now would prove expensive indeed tomorrow.