US pharmaceutical R&D driven partly by tax incentives, CBO report concludes

Pharmaceutical spending on research and development (R&D) in the US has increased substantially in recent decades, with changes driven by numerous factors, including R&D tax incentives. However, how the US’s 2017 tax reform will affect R&D investment is uncertain, according to a Congressional Budget Office (CBO) review of R&D in the pharmaceutical industry published in April.

The pharmaceutical industry spent $83 billion on R&D in 2019, ten times what it spent in the 1980s (adjusted for inflation), the CBO review reports.

Some of that increase was driven by market considerations relating to factors like expected demand, anticipated price, and risk of failure. Government policies, including tax incentives, were responsible for another part of that increase.

Tax incentives in the pharmaceutical industry include both the general R&D tax credit and R&D tax deductions, available to companies in other industries, as well as an additional credit available for companies developing treatments for uncommon diseases, provided for in 1983 in the Orphan Drug Act.

These tax incentives generally encourage more pharmaceutical R&D by decreasing the costs of undertaking such R&D. However, the 2017 Tax Cuts and Jobs Act included changes that are likely to discourage R&D investment as well as some that are likely to encourage it.

Some changes enacted in 2017 directly decrease the value of R&D incentives. One such change is the new requirement beginning in 2022 for companies to amortize R&D costs over five years, rather than allowing companies to benefit from the full tax deduction in the year the expenses are incurred.

“That discourages investment in R&D because the value of that deduction will decline,” the report states.

In addition, the 2017 tax changes also reduced the Orphan Drug Act tax credit for the development of treatments for uncommon diseases from 50% to 25% of the cost of clinical trials.

As far as encouragement, the CBO report stated that the reduction in the corporate tax rate from 35% to 21% should encourage more investment in R&D to the extent that it increases the earnings that the drug companies get to keep on the products of their R&D.

However, the reduction of the corporate tax rate is also a double-edged sword when it comes to incentivizing R&D. While the lower tax rate increases profit returns on drugs, it also decreases the relative value of the R&D tax incentives.

For instance, the report states, the 25% reduction in the Orphan Drug Act “[w]hen combined with the lower tax rate … will reduce the first-year tax benefits for R&D spending on orphan drugs by about 40 percent.”

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