Federal Taxation of the Pharmaceutical Industry: Effects on New Drug Development and Legislative Initiatives in the 109th Congress
Prepared for Members and Committees of Congress
An important consideration in the debate in Congress over expanding consumer access to
prescription drugs is the forces shaping the domestic climate for the discovery and development
of new medicines. One such force is federal policy. This report examines a small slice of the
assortment of federal policies that affect the incentive to invest in pharmaceutical innovation: the
federal tax burden on the pharmaceutical industry and legislative initiatives to modify the burden. th
It will be updated to reflect more recent data or significant legislative activity in the 109
Generally, an industry’s federal tax burden refers to how the federal income tax affects its return
on total investment through such critical elements as the definition of taxable income,
adjustments to this income, tax rates, and adjustments to tax liability. Economists typically
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 pre-tax income, expressed
as a percentage. This measure is not without shortcomings. A principal problem is that average
effective rates do not fully capture the influence 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 drug industry’s federal tax burden was significantly less than the
average burden for all industries from 1996 through 1998, but that in the next three years, it rose
to the point that it was nearly identical to the average for all industries in 2000 and 2001. This
upward shift was due mainly to a phase-out of the possessions tax credit that commenced in 1997
and is to come to fruition in 2005. Pharmaceutical firms have been major beneficiaries of this
credit. As corporate income tax return data for years after 2001 become available, it would not be
surprising if the pharmaceutical industry’s tax burden were to remain near the average for all
industries. Pharmaceutical firms also appear to benefit substantially (and perhaps more than many
other firms) from two tax preferences whose combined influence 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, and (2) the expensing of R&D and advertising outlays.
Available evidence suggests that current federal tax law has little influence on the pharmaceutical
industry’s incentive to invest in R&D. This is because R&D investment in the industry is driven
to a far greater extent by the competitive strategies of pharmaceutical firms. Nonetheless, a
substantial increase in the industry’s tax burden would be likely to affect the industry’s ability to
invest in innovation.
At least one bill that would alter the tax treatment of many pharmaceutical firms has been th
introduced in the 109 Congress. H.R. 575 would deny a tax deduction for any amount spent by a
business taxpayer on direct-to-consumer advertising.
Distinguishing Characteristics of the Pharmaceutical Industry Relevant to Its Federal Tax
Burden ......................................................................................................................... ................. 2
Heavy Investment in R&D........................................................................................................2
Heavy Investment in Advertising and Product Promotion........................................................3
Dependence on Patent Protection..............................................................................................4
Extensive Foreign Operations...................................................................................................5
Federal Income Taxes Paid by the Pharmaceutical Industry Between 1990 and 2001...................6
Foreign Tax Credit....................................................................................................................7
Possessions and Puerto Rican Economic Activity Tax Credit...................................................8
General Business Credit............................................................................................................9
Research Tax Credit..........................................................................................................10
Orphan Drug Credit..........................................................................................................10
Federal Tax Burden on the Drug Industry and Major U.S. Industries from 1996 to 2001.............11
Deferral of Federal Income Taxes on Foreign-Source Income...............................................13
Temporary Dividends Received Deduction Under IRC Section 965................................15
Expensing of R&D Spending..................................................................................................15
Expensing of Advertising Spending........................................................................................16
Federal Tax Policy and Pharmaceutical R&D...............................................................................17
Legislation in the 108th Congress to Modify the Tax Treatment of Pharmaceutical Firms...........19
Legislation in the 109th Congress to Modify the Tax Treatment of Pharmaceutical Firms...........20
Table 1. Federal Income Tax Liability for the Pharmaceutical Industry, 1990 to 2001...................7
Table 2. Main Federal Tax Credits Claimed by the Drug Industry from 1990 to 2001...................8
Table 3. Average Effective Tax Rates for the Drug Industry and Major U.S. Industries
from 1996 to 2001 (%)...............................................................................................................13
Author Contact Information..........................................................................................................20
t times, it seems as though the pharmaceutical industry thrives on controversy. On the one
hand, firms that develop, produce, and sell brand-name or patented drugs have been
lauded for their large and rising investments in the development of safer or more effective A
versions of existing medicines and new medicines that advance the treatment of a host of serious 1
illnesses. On the other hand, the same firms have been excoriated for pricing policies that result
in U.S. customers paying considerably more for the same branded drugs than many customers in
other developed countries in Europe and Asia, their efforts to thwart or delay competition from
cheaper generic drugs, their relatively high rates of return on investment, and their substantial and 2
rapidly rising outlays for advertising and product promotion. Framing these sharply contrasting
sentiments is a long-standing policy debate over how best to improve access to expensive but
needed medicines among Americans of all ages without establishing costly new federal
entitlement programs or undermining current financial incentives for pharmaceutical innovation.
The number of new drugs entering the market year after year and their pricing have important
effects on this access.
A key issue in this debate is the forces shaping the domestic climate for the discovery and
commercial development of new medicines. One such force is federal policy. The federal
government plays a varied and far-reaching role in pharmaceutical innovation. It is a role that
encompasses a wide range of laws and programs, including direct federal funding of
pharmaceutical research and development (R&D), federal regulation of the safety and efficacy of
new medicines and the use and advertising of existing medicines, federal patent protection for
prescription drugs, federal support of biomedical research and education in universities, federal
financing of drug purchases through Medicaid and Medicare, and federal tax subsidies for R&D
and employer-provided health insurance. Indeed, the influence of federal policy on new drug
development is so profound that it is indeed difficult to imagine what the domestic climate for
pharmaceutical innovation would be like in its absence.
This report examines a small slice of the federal policies influencing pharmaceutical innovation:
the federal tax burden on the pharmaceutical industry. The federal tax code affects private
investment in new drug discovery and development in a variety of ways, and these linkages form
the core of the report. More specifically, it analyses the industry’s federal tax burden from 1995 to
2001—the most recent year for which federal corporate tax return data are available—focusing
on the provisions in the federal tax code that appear to generate significant tax benefits or
penalties for pharmaceutical firms that invest heavily in R&D. The size of the industry’s tax
burden influences its capacity to invest in innovation. The report begins with an examination of
the distinguishing traits of the pharmaceutical industry directly related to its tax treatment and
concludes with a description of legislative proposals to modify some aspect of this treatment in th
the 109 Congress.
1 In 2003, companies that were members of the Pharmaceutical Research and Manufacturers of America, the principal
U.S. trade association for the pharmaceutical industry, spent an estimated $27.4 billion on domestic pharmaceutical
research and development (R&D), up from $11.1 billion in 1994. During the same decade, the U.S. Food and Drug
Administration (FDA) approved an average of 32 new medicines per year. (See Pharmaceutical Research and
Manufacturers of America, Pharmaceutical Industry Profile 2004 (Washington: 2004), pp. 11 and 39.)
2 Between June 2000 and June 2004, the Consumer Price Index for all urban consumers (CPI-U) for prescription drugs
rose 18.6%, compared to an increase of 10.0% for the CPI-U for all items. According to the most recent data for the
Fortune 500 companies, the average ratio of after-tax income to revenues for the pharmaceutical industry in 2003 was
14.3%, compared to a median ratio for all Fortune 500 companies of 4.6%. Total promotional spending by the
pharmaceutical industry rose from over $9 billion in 1996 to over $19 billion in 2001 (see the Henry J. Kaiser Family
Foundation, Prescription Drug Trends (Washington: May 2003), available at http://www.kff.org.
Most industries have distinctive traits, essential features born of the singular technologies around
which they are built and their evolving requirements for competitive success and long-term
growth. The pharmaceutical industry is one of these industries. In the minds of many, what
distinguishes firms that develop, produce, promote, and sell patented or branded prescription
drugs is their propensity to spend heavily on R&D and advertising, concentration on certain
therapeutic categories to the exclusion of others, relatively high dependence on patents to
generate sustained growth in profits and bolster competitiveness, and vast network of foreign
operations. It turns out that most of these traits have important implications for the industry’s
federal tax burden.
The pharmaceutical industry is one of the most research-intensive of all U.S. industries. At the
same time, it receives little in the way of direct R&D funding from federal government agencies.
According to estimates made by the National Science Board, U.S. producers of drugs and
medicines spent 9.8% of net sales on domestic R&D in 2000, compared to ratios of 3.4% for all 3
industries and 3.3% for manufacturing. In the same year, U.S. producers of drugs and medicines
spent $12.8 billion of their own and other non-federal funds on domestic R&D. It is not known
how much the federal government spent on pharmaceutical R&D in 2000, but the amount
probably was tiny in comparison to industry spending; in 1997, for instance, federal spending for 4
this purpose totaled a mere $3 million. The principal trade association for the U.S.
pharmaceutical industry, the Pharmaceutical Research and Manufacturers of America (or
PhRMA), estimates that in 2003, domestic spending on pharmaceutical R&D by member firms 5
totaled $27.4 billion, up from $10.5 billion in 1993. However, the industry spent a smaller share
of domestic sales revenue on R&D in 2003 (17.7%) than in 1993 (21.6%).
Most pharmaceutical firms invest heavily in R&D because they have no other choice if they want
to survive and grow over time. Simply put, R&D is the primary engine of long-term growth in the
industry. It is said that risk and reward go hand in hand in the realm of business investment, and
this intimate connection is abundantly evident in pharmaceutical R&D. On the one hand,
discovering and developing new breakthrough drugs is a time-consuming, risky, and costly 6
process. On the other hand, firms that develop new breakthrough drugs can reap huge profits
3 National Science Foundation, Division of Science Resources Statistics, Research and Development in Industry: 2000,
NSF 03-318 (Arlington, VA: 2003), table A-20, p. 74.
4 National Science Board, Science & Engineering Indicators—2000 (Arlington, VA: National Science Foundation,
2000), appendix tables 2-54 and 2-55, pp. A-97 and A-99.
5 Pharmaceutical Industry Profile 2004, p. 39.
6 According to research findings summarized by PhRMA, the average period from synthesis of a new compound to
approval by the U.S. Food and Drug Administration (FDA) exceeded 14 years in the 1990s; only one out of every
5,000 compounds synthesized in a laboratory ends up gaining FDA approval; the cost of developing a new drug
(including the cost of failures) rose from $54 million in 1976 to $802 million in 2000; and as few as three out of 10
newly approved drugs earn enough revenues to cover their R&D cost. See Pharmaceutical Research and Manufacturers
from their sale until the firms’ patents expire or competing patented drugs enter the market.7
Advances in the technology for new drug development over the past 25 years have greatly
increased the number of drug compounds with significant therapeutic potential being discovered.
Nonetheless, there is some concern that the flow of new breakthrough drugs through the R&D
pipeline is slowing to the point where some major multinational firms might be forced to merge.
A recent study by the National Institute for Health Care Management Foundation found that only
chemical ingredients offering significant therapeutic advantages over existing drugs. In addition,
in 2002, the FDA approved 17 new drugs for sale in the United States, the lowest total since 1983 9
and far below the all-time high of 56 new drugs approved in 1996. A new wave of mergers could
affect future trends in pharmaceutical R&D investment by lessening competition in key segments 10
of the domestic market for prescription drugs.
Given that the pharmaceutical industry invests heavily in R&D but the prospects of delivering
highly profitable drugs to the marketplace have remained stubbornly slight, it may come as no
surprise that most pharmaceutical firms also spend large sums on promoting their branded
products directly to physicians and consumers. Firms that develop new drugs offering significant
therapeutic advantages over existing drugs seem especially inclined to spend heavily on
advertising and promotion. Early in a new drug’s life cycle, the advertising and promotion often
are aimed at capturing a major share of the market as quickly as possible; but later in the drug’s
life cycle, their main intent can shift to fending off or thwarting budding competition from
generic versions or patented substitutes known as “me-too drugs.”
Available industry data suggest that many pharmaceutical firms regard advertising and promotion
as an indispensable weapon in their quest for long-term growth. According to one reliable source,
domestic promotional spending by pharmaceutical firms totaled over $23 billion in 2003, up from
about $9 billion in 1996. More than $13 billion of the 2003 expenditures went to the distribution
of free drug samples (valued at retail cost) to physicians; another $7 billion covered the cost of
making direct sales pitches to physicians; and $3.4 billion were channeled into direct advertising 11
of America, 2002 Industry Profile (Washington: 2002), pp. 18-22.
7 For example, U.S. retail sales of Lipitor, a patented cholesterol-lowering drug sold by Pfizer, totaled $4.5 billion in
2001, up from $3.7 billion in 2000. See National Institute for Health Care Management Foundation, Prescription Drug
Expenditures in 2001: Another Year of Escalating Costs (Washington: April 2002), Table 3, p. 13.
8 National Institute for Health Care Management Foundation, Changing Patterns of Pharmaceutical Innovation
(Washington: May 2002), p. 3.
9 Iain Cockburn, “The Changing Structure of the Pharmaceutical Industry,” Health Affairs, vol. 23, no. 1 (Jan./Feb.
2004), p. 10.
10 Andrew Pollack, “Despite Billions for Discoveries, Pipeline of Drugs is Far from Full,” New York Times, April 19,
2002, pp. C1 and C7.
11 Standard & Poor’s, Industry Surveys, Healthcare: Pharmaceuticals (New York: June 24, 2004), pp. 10-11. The
estimate for spending on promotion and advertising in 2003 does not include expenditures by pharmaceutical firms for
professional meetings and events attended by physicians.
The high priority given to informing and encouraging brand loyalty among physicians reflects a
fundamental feature of the market for prescription drugs, one that is largely absent from the
markets for most goods and services: consumers rely heavily on the judgment and consent of
third parties—in this case doctors—in deciding which prescription drugs to use when stricken
with illness or injury.
Another notable distinguishing feature of the pharmaceutical industry is its fragmented
competitive structure. No single firm or small cluster of firms dominates the U.S. market for
branded prescription drugs. The U.S. Census Bureau has reported that in 1997, the four largest
producers accounted for 32% of the value of domestic shipments of medicines, the eight largest 12
for 48%, and the 20 largest for 67%. Ten years earlier, the share of the four largest was 22%,
and that of the 20 largest 65%.
Nonetheless, some firms are able to gain supremacy in certain key segments of the market. Such
dominance is most likely to arise when a firm is the first to bring a new breakthrough drug to the
marketplace. For example, in April 2004, 75% of U.S. prescriptions for anti-psychotic drugs were
filled by drugs made by three companies; three companies accounted for 60% of U.S.
prescriptions for treating migraine headaches; and 78% of U.S. prescriptions for cholesterol-13
lowering drugs were filled by drugs made by three companies. But this dominance can turn out
to be ephemeral as it rests partly on the patent protection granted to the medicines sold by these
companies and partly on the absence of competition from newer, more effective or safer
The central role played by technological innovation in the growth and transformation of the
pharmaceutical industry over time highlights another distinguishing trait of the industry: the
heavy reliance of major pharmaceutical firms on patents to generate large revenue streams and
profits and to bolster their competitiveness. Patents give their owners a temporary legal monopoly
over commercial uses of an invention. In the United States and most other advanced
industrialized nations, the life of a patent is 20 years from the date of application. A patent holder
may license other firms to exploit the invention, but it would typically do so in exchange for
royalties, which can be thought of as compensation for relinquishing exclusive control.
Pharmaceutical firms may claim patents for the design of drug compounds, their formulation as 14
drug therapies, their uses in treating illnesses, and their methods of manufacture. Industry
executives regard patents as one of the most effective means of safeguarding the competitive 15
advantages arising from investing in innovation.
12 U.S. Census Bureau, 1997 Economic Census: Concentration Ratios in Manufacturing (Washington: June 2001),
Table 2, p. 11.
13 Standard & Poor’s, Industry Surveys, Healthcare: Pharmaceuticals, pp. 12-13.
14 U.S. Congress, Office of Technology Assessment, Pharmaceutical R&D: Costs, Risks, and Rewards (Washington:
GPO, Feb. 1993), pp. 290-293.
15 F. M. Scherer, Industry Structure, Strategy, and Public Policy (New York: Harper-Collins, 1996), pp. 360-362.
The industry’s strong dependence on patents to secure the returns on R&D investment partly
explains why drug firms have long been among the most profitable of all firms. From 1960 to
1991, the reported rate of return on stockholders’ equity for the pharmaceutical firms included in
the annual ranking of the top 500 industrial corporations by Fortune magazine averaged 18.4%, 16
compared to 11.9% for all 500 firms. And as recently as 2001, pharmaceuticals ranked first in 17
return on shareholders’ equity (33.2%) among the 48 industries represented in the Fortune 500.
Perhaps the most persuasive evidence that patents are critical to the profitability of
pharmaceutical firms can be found in the differences in selling prices between branded drugs and
their generic counterparts. Medicines protected by patents typically command far higher prices 18
than the generic versions which enter the market after the patents expire.
No account of the distinctive traits of the U.S. pharmaceutical industry having a bearing on its
federal tax treatment would be complete if it were to disregard the industry’s extensive foreign
operations, including Puerto Rico. For many U.S.-based pharmaceutical firms, these operations
have a significant impact upon their financial health, competitive posture, and federal tax burden.
Most major U.S. pharmaceutical firms own foreign subsidiaries that manufacture and sell drugs
and conduct R&D; many of these subsidiaries are located in Europe and Japan, the two largest 19
regional markets (measured in U.S. dollars) for patented medicines after North America. Like
U.S. automobile producers, major pharmaceutical firms appear to have recognized three or four
decades ago that if they were to become serious long-term players in key foreign markets, they 20
needed to establish a manufacturing and research presence in each market.
The following figures illuminate the extent to which the industry has built such a presence in
important foreign markets. Perhaps the most comprehensive source of data on foreign direct
investment abroad by U.S. firms is the U.S. Department of Commerce. According to Commerce
Department data, by 2001, a total of 35 U.S.-based pharmaceutical firms with domestic assets
valued at $284.1 billion had established a total of 1,098 majority-owned foreign affiliates with 21
assets valued at $355.9 billion. Sales of the foreign affiliates in that year amounted to $77.6
billion, or 45% of total sales reported by their U.S. parent firms; and total employment by the
affiliates came to 211,600 workers, or 54% of total employment reported by their U.S. parent
firms. A second but more limited source of information on the foreign operations of U.S.
pharmaceutical firms is PhRMA. In 2003, domestic sales by PhRMA member companies
amounted to an estimated $154.6 billion, while foreign sales by U.S.-based PhRMA member
companies and the U.S. affiliates of foreign-based PhRMA member companies totaled an 22
estimated $58.1 billion, or 37% of domestic sales. In the same year, PhRMA member companies
16 Ibid., p. 342.
17 2002 Fortune 500, “Top Performing Companies and Industries,” http://www.fortune.com/fortune/fortune500, visited
April 23, 2002. In 2003, the industry’s return on shareholder equity was 22.1%, placing it fourth among the 47
industries represented in the Fortune 500.
18 Once a prescription drug’s patent expires, generic drugs, which are chemical equivalents of branded drugs, usually
appear immediately, and prices begin to fall. The price of a new generic drug is typically 25% to 50% lower than that
of the branded version. See Standard & Poor’s, Healthcare: Pharmaceuticals, p. 17.
19 Ibid., p. 6.
20 Scherer, Industry Structure, Strategy, and Public Policy, p. 342.
21 The data can be accessed at http://www.bea.gov/bea/di/home/directinv.htm.
22 Pharmaceutical Research and Manufacturers of America, Pharmaceutical Industry Profile 2004 (Washington:
spent an estimated $27.4 billion on R&D conducted in the United States, while foreign R&D
spending by U.S.-based PhRMA member companies and the U.S. affiliates of foreign-based 23
PhRMA member companies was an estimated $5.8 billion, or 21% of domestic R&D spending.
Although the importance of foreign markets varies from company to company, some analysts
estimate that the U.S. pharmaceutical industry derives about 40% of it revenue from foreign 24
sales. Because many countries outside the United States impose strict controls on prescription
drug prices, foreign markets tend to account for a smaller portion of overall profits than sales. But
there are notable exceptions. In 2003, for example, six of the largest U.S.-based pharmaceutical
firms received over 65% of their combined profits from foreign operations, up from about 38% in 25
Federal income taxes paid by the pharmaceutical industry from 1990 to 2001—the most recent
year for which corporate tax return data are available—are shown in Table 1. The figures on tax
liability include any alternative minimum taxes owed by drug firms.
The industry’s taxable income as shown in Table 1 represents a blend of domestic income earned
by U.S.-based corporations and U.S. affiliates of foreign-based firms and income earned abroad
by foreign branches and subsidiaries of U.S.-based corporations. Such a blend is appropriate
because the United States taxes business income on the basis of residence and not territorial
source. Consequently, corporations chartered in the United States owe taxes to the federal
government on their worldwide income, whether it is earned inside or outside the country. U.S.-
based firms also pay income taxes to foreign governments on much of the income earned by their
foreign affiliates. To avoid double taxation of this income, U.S. tax law allows U.S.-based
multinational firms to claim a credit for foreign income tax payments up to their U.S. tax liability
on the income. In addition, U.S. affiliates of corporations chartered in other countries are required
to pay federal income taxes on income they earn in the United States.
PhRMA, 2004), p. 44.
23 Ibid., p. 39.
24 Standard & Poor’s, Healthcare: Pharmaceuticals, p. 25.
25 The firms were Pfizer, Johnson & Johnson, Merck, Bristol-Myers Squibb, Abbott Laboratories, and Schering Plough.
See John A Almond and Martin A. Sullivan, “Drug Firms Park Increasing Share of Profits in Low-Tax Countries,” Tax
Notes, Sept. 20, 2004, p. 1,336.
Table 1. Federal Income Tax Liability for the Pharmaceutical Industry, 1990 to 2001
(millions of dollars)
Year Taxable Federal Income Tax Credits Income Tax After Average
Income Tax Before Claimed (Except the Credits (Except the Effective Tax
Credits Foreign Tax Credit) Foreign Tax Credit) Rate (%)a
1990 15,934 5,482 1,825 3,657 22.9
1991 17,452 6,026 2,070 3,956 22.7
1992 19,920 6,920 2,238 4,682 23.5
1993 19,997 7,092 2,441 4,651 23.2
1994 24,837 8,752 2,479 6,273 25.2
1995 23,963 8,502 1,880 6,622 27.6
1996 24,810 8,816 1,948 6,868 27.7
1997 27,627 9,729 1,983 7,746 28.0
1998 29,218 10,240 2,204 8,216 28.1
1999 30,912 10,851 1,138 9,713 31.4
2000 31,102 10,918 1,027 9,890 31.8
2001 32,958 11,435 1,060 10,375 31.5
Source: Internal Revenue Service, Statistics of Income Division, Corporation Source Book (Washington: GPO,
1990 to 2000).
a. Income tax after credits (except the foreign tax credit) divided by taxable income and multiplied by 100.
Several noteworthy trends can be discerned in the figures in the table. They make clear that the
1990s was a period of robust growth for the pharmaceutical industry: its taxable income more
than doubled between 1990 and 2001. It is also clear from the table that the industry benefitted
from available tax credits (excluding the foreign tax credit): from 1990 to 2001, its average tax
liability after credits was 79% of its average tax liability before credits. (The reason for excluding
the foreign tax credit from these calculations is explained below.) At the same time, the value of
these credits trended downward after peaking in 1994, reaching a low of $1.027 billion in 2000.
The primary force behind this decline was a phase-out of the possessions tax credit that began in
the late 1997 and is supposed to continue through 2005. As a result, the difference between tax
liability before credits and tax liability after credits narrowed considerably from 1990 to 2000,
before increasing somewhat in 2001.
The main tax credits claimed by the drug industry are shown in Table 2. Their impact on the
industry’s federal tax burden is discussed in the following sections.
Unlike the other tax credits included in the table, the foreign tax credit technically does not confer
a tax benefit on pharmaceutical firms. Section 901 of the Internal Revenue Code (IRC) holds that
a corporation chartered in the United States and paying income and related taxes to foreign
governments may claim a limited tax credit for those tax payments. This statutory provision is
intended to avoid the double taxation of income earned by foreign branches or subsidiaries of
U.S.-based corporations and repatriated to their U.S. parents. As a result, the foreign tax credit
should be added to a firm’s tax liability in measuring its tax burden. The credit is limited to the
tentative federal income tax owed on foreign-source income and may not offset any federal tax
owed on domestic-source income. In addition, the U.S. Treasury does not refund foreign income
taxes paid in excess of the tentative federal tax. Any such excess may be carried back up to two
years or carried forward up to five years, subject to the same limitations.
The pharmaceutical industry has been a major beneficiary of what was known until 1996 as the
possessions tax credit under IRC section 936 and now is called the Puerto Rican Economic
Activity Credit (PREAC) under IRC section 30A. In 2001, the industry was able to reduce its
federal income tax liability by more than 5% by claiming the credit, and it accounted for 49% of
the total value of claims for the credit by all industries. Corporations chartered in the United
States may be able to exclude from federal income tax as much as 40% of their income from
business operations they own in Puerto Rico, the U.S. Virgin Islands, and other U.S. territorial
possessions. In order to take advantage of this exclusion, a firm must derive 80% of its gross
income from business operations in one or more of these possessions and 75% of its overall gross
income from the active conduct of a business.
The PREAC is equal to a firm’s tax liability on possession-source income, subject to one of two
alternative caps enacted in 1993. Under one cap—known as the “economic-activity limitation”—
the credit is restricted to specified wage and depreciation costs; under the second cap—known as
the “percentage limitation”—the credit is limited to 40% of the unlimited credit a firm could
claim under rules in effect before 1993. As a result of the Small Business Job Protection Act of
repealed immediately for all other firms. In addition, the Act contains different phase-out rules
for firms subject to the percentage limitation and for those subject to the economic-activity
Table 2. Main Federal Tax Credits Claimed by the Drug Industry from 1990 to 2001
(millions of dollars, unless otherwise noted)
General Business Tax Credita Year Foreign Tax Possessions Tax
Credit Credit Orphan Drug Tax Research Tax Total
1990 1205 1666 15 NA 142
1991 1367 1883 18 235 150
1992 1613 2033 17 264 180
1993 1886 2150 19 306 208
1994 1960 2116 19 307 271
1995 2633 1611 0b 164 214
1996 2628 1651 24 252 219
1997 2204 1591 52 552 329
26 For further details on the design of the credit and congressional proposals to extend it, see CRS Report RS20695, The
Puerto Rican Economic Activity Tax Credit: Current Proposals and Scheduled Phaseout, by David L. Brumbaugh.
General Business Tax Credita Year Foreign Tax Possessions Tax
Credit Credit Orphan Drug Tax Research Tax Total
1998 2677 1459 50 630 514
1999 2938 866 66 714 222
2000 2414 689 79 802 312
2001 2280 621 70 806 416
Source: Internal Revenue Service, Statistics of Income Division (SOI), Corporation Source Book (Washington,
1990 to 2000), and unpublished data obtained via e-mail from Marty Shiley of the Corporate Returns Analysis
Section of the SOI.
a. Under IRC section 38, the general business credit is a limited, non-refundable credit against income tax that
is claimed after all other non-refundable credits, except for the credit for the alternative minimum tax. The
general business credit is the sum of the rehabilitation credit, the energy credit, the reforestation credit, the
work opportunity credit, the welfare-to-work credit, the alcohol fuels credit, the research credit, the low-
income housing credit, the enhanced oil recovery credit, the disabled access credit, the renewable
resources electricity production credit, the empowerment zone employment credit, the Indian employment
credit, the employer Social Security credit, the orphan drug credit, the new markets credit, small employer
pension plan start-up costs credit, and the employer-provided child care credit.
There is a limit on the general business credit that a corporate taxpayer may claim in a given tax year: it
may not exceed its tax liability less the greater of (a) the tentative alternative minimum tax or (b) 25% of
regular tax liability above $25,000. If the general business credit claimed in the current year exceeds this
limitation, the excess or unused credit may be carried back one year or forward 20 years. With the
exception of 1995, the combined value of the orphan drug tax credit and research tax credit claimed by the
pharmaceutical industry exceeded the total general business credit it was permitted to claim by substantial
margins. The reason lies in this limitation.
b. The orphan drug tax credit was suspended from January 1, 1995 to June 30, 1996. Under the Small Business
Job Protection Act of 1996 (P.L. 104-188), the credit was reinstated from July 1, 1996 to May 31, 1997 and
made part of the general business credit. The credit has yet to be reinstated retroactively for the period
from January 1, 1995 to June 30, 1996.
There is evidence that the pharmaceutical industry responded to the credit by establishing a
substantial manufacturing base in Puerto Rico. According to a 1992 report by the General
Accounting Office, a total of 26 pharmaceutical firms had manufacturing operations there in
produced 17 of the 21 most commonly prescribed drugs in the United States at the time.
The general business credit is composed of 18 separate and distinct tax credits. Nonetheless, the
vast share of the pharmaceutical industry’s allowable claims for the credit since 1990 appear to
center around a single credit: that for increasing research expenditures under IRC section 41. As
the data in Table 2 show, from 1991 to 2000, the amount of the research tax credit claimed by the
industry exceeded its allowable general business tax credit in every year except 1995. During the
period from 1995 to 2000, the cumulative value of claims for the research credit by the industry
exceeded the cumulative value of its allowable general business credit by $1.3 billion. Under the
rules of the general business credit, any unused credits may be carried back one year or forward
27 U.S. General Accounting Office, Pharmaceutical Industry: Tax Benefits of Operating in Puerto Rico, GAO report
GGD-92-72BR (Washington: May 1992), pp. 4-7.
for up to 20 years. So some pharmaceutical firms may have large reserves of unused research tax
credits to draw upon to reduce their regular federal tax liabilities in coming years.
The regular research tax credit is equal to 20% of a firm’s qualified spending on research 28
conducted in the United States and its territorial possessions above a base amount. It is due to
expire at the end of 2005. In order to minimize the likelihood of rewarding firms for undertaking
R&D they would have done in any event, the credit’s rate structure is incremental instead of flat.
The main direct effect of the credit is to lower the after-tax cost of qualified research. Various
rules governing the use of the credit make its marginal effective rate much lower than its statutory
rate for many firms. Firms have the option of claiming an alternative incremental research credit
with a maximum statutory rate far below the statutory rate of the regular credit. Moreover, they
may also claim a tax credit equal to 20% of payments for contract basic research to certain
organizations (mainly universities) above a base amount, in addition to either the regular or
alternative credits. The following expenses are eligible for the regular, alternative, and basic
research credits: wages and salaries of researchers, supplies and materials used in qualified
research, leased computer time for qualified research, and either 65% or 75% of payments for
The pharmaceutical industry is a leading beneficiary of the research credit among R&D-
performing industries: in 2000, drug industry claims for the credit totaled nearly $802 million, or
11% of the total value of claims for the credit. But it would be erroneous to infer from these
figures that the credit gives major pharmaceutical firms a potent incentive to raise their R&D
spending from one year to the next. The reason is that the industry seems to derive little benefit
from the credit relative to its huge outlays for R&D. There is plenty of evidence to substantiate
this notion. For example, total claims for the credit by the pharmaceutical industry were equal to
Moreover, relatively few pharmaceutical firms claim the research tax credit in a given tax year: in
1997, about one in every five federal corporate income tax returns filed by pharmaceutical firms
included a claim for the research tax credit. Additionally, even the largest U.S. pharmaceutical
firms cannot count on claiming the credit despite spending hundreds of millions of dollars or
more on R&D. In a 2001 report, CRS estimated that under current tax law, the U.S.-based
pharmaceutical company Merck was unable to claim the regular research tax credit in 1998 29
despite spending $1.8 billion on R&D, or $137 million more than in 1997. The rules governing
the use of the credit explain much of its limited usefulness to the pharmaceutical industry.
Only one of the credits shown in Table 2 can be rightly said to be targeted at the main products of
the pharmaceutical industry, and that credit is the orphan drug tax credit. Not surprisingly, the 30
industry is its main beneficiary. Under IRC section 45C, a firm may claim a tax credit equal to
28 For more details on the design of the credit and initiatives in the 108th Congress to modify it, see CRS Report
RL31181, Research and Experimentation Tax Credit: Current Status and Selected Issues for Congress, by Gary
29 CRS Report RL30479, The Research and Experimentation Tax Credit: Current Law and Selected Policy Issues for
the 106th Congress, by Gary Guenther, pp. 38-39.
30 In 2000, firms classified in the drug industry accounted for 70% of the total value of claims for the credit.
half the cost of human clinical trials for drugs intended to treat rare diseases. Such a credit has the
potential to stimulate significant increases in investment in the development of drugs to treat such
diseases because human clinical trials, which are conducted in three phases, are the most time-31
consuming and costly step in the new drug development process. A rare disease or condition is
defined as one likely to affect fewer than 200,000 individuals residing in the United States, or one
likely to affect more than 200,000 such individuals but for which there is no realistic prospect of
recovering R&D costs from U.S. sales alone. The credit applies to the cost of supplies and the
wages and salaries of researchers used in clinical trials for orphan drugs only; the cost of any
structures and equipment used in the trials cannot be added to the base for the credit. It is
permanent and a component of the general business credit and thus subject to its limitations.
Since the orphan drug credit was enacted in 1983 as part of a package of measures aimed at
stimulating increased investment in the development of new drugs to treat rare diseases and
conditions, over 225 such drugs have gained regulatory approval in the United States. Ironically,
some of them went on to become major sources of revenue for their producers, including Glaxo
Wellcome’s anti-AIDS drug Retrovir AZT, Amgen’s anti-anemia drug Epogen, and Genentech’s 32
human growth hormone Protropin.
Generally, the federal tax burden on an industry refers to how the tax code affects an industry’s
return on investment through the definition of taxable income, adjustments to taxable income
(e.g., deductions and exemptions), tax rates, and adjustments to tax liability (e.g., tax credits and
minimum tax payments). In essence, these provisions serve two purposes: (1) raising revenue to
fund government operations and programs and (2) giving firms incentives to engage in activities
favored by policymakers. The tax credit for increasing research expenditures exemplifies the
second purpose. Reduced to its simplest terms, an industry’s federal tax burden denotes how
much of its profits are sacrificed in order to comply with current tax law. As this burden rises,
firms have fewer funds to invest as they please.
Economists define a firm’s tax burden as its share of real pre-tax economic income paid in taxes.
But it is difficult to determine a firm’s economic income from business tax return data because of
provisions in the tax code that drive a wedge between economic income and taxable income. So
alternative approaches must be used to measure business tax burdens, such as substituting taxable
income as determined under current federal tax law for pre-tax economic income. Such an
approach is taken here.
A common 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 income subject to tax, expressed as a
percentage. As such, the ratio expresses the net effect of the federal tax code on the industry’s pre-
tax returns on past investments. This effect summarizes the ways in which the tax code both
penalizes and rewards the economic activities of the firms making up the industry.
31 Pharmaceutical Research and Manufacturers of America, 2002 Industry Profile, pp. 19-22.
32 Standard & Poor’s, Healthcare: Pharmaceuticals, p. 21.
There are some drawbacks to using average effective tax rates to measure an industry’s federal
tax burden. One problem is that the rates reflect the impact of the tax code on the returns to an
industry’s previous investments and thus may overstate or understate the federal tax burden on
current or possible future investments. Furthermore, average effective tax rates cannot accurately
measure the federal tax burden for an industry because they fail to 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. A better measure might be the marginal effective tax rate for an industry,
which would capture the net effect of such provisions on the pre-tax returns on new investment 33
by an industry. Unfortunately, it is impossible to compute such a rate for most industries
because the value of some important tax benefits (e.g., expensing of R&D costs) cannot be
calculated using available corporate financial or tax return data, and not all firms in an industry
invest in the same mix of assets to the same extent. Nonetheless, if average effective tax rates are
applied consistently across industries and time, they can indicate whether or not their federal tax
burdens differ and to what extent.
Table 3 shows the average effective federal tax rates for the drug industry and major U.S.
industries from 1995 to 2001. 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). As such, they address neither the domestic tax burden on
domestic income nor the worldwide tax burden on worldwide income for the industries. Instead,
the rates represent something of a hybrid of the two measures, showing the federal tax burden on
domestic income plus foreign income that has been recognized for federal tax purposes. As noted
earlier, the foreign tax credit should be excluded from an industry’s net tax liability because its
purpose is to avoid the double taxation of foreign-source income. Including it would understate
the federal tax burden on the industries.
It is clear from the table that the federal tax burden of the pharmaceutical industry gradually
increased from 1996 to 2001, bringing it into line with the average tax burden for all industries.
This trend may come as a surprise to those who believe that the industry has long been taxed
relatively lightly. The principal force behind the industry’s rising tax burden was the phase-out of
the possessions tax credit that commenced in 1997. As was noted earlier, pharmaceutical firms
have been among the largest beneficiaries of the credit. One way to illustrate this point is to
compute the industry’s tax burden in the absence of the credit. If the credit had been unavailable
in 1998 and 1999, the pharmaceutical industry’s average effective tax rate would have been
almost identical to that of all industries: 33.6% compared to 33.5%.
33 The marginal effective tax rate on business income is the expected pre-tax rate of return minus the expected after-tax
rate of return on a new investment, divided by the pre-tax rate of return. It typically accounts for the statutory tax rate,
accelerated depreciation allowances, and economic rates of depreciation adjusted for inflation. Nonetheless, the rate
can be adjusted to reflect the influence of other detailed provisions of the tax code. In essence, the rate summarizes the
tax incentives to invest in a particular asset or set of assets. As such, it may bear little relation to an industry’s average
effective tax rate, which measures the actual tax paid in a given year as a share of actual capital income in that year
earned from all past investment. For more information on the computation and uses of the marginal effective tax rate,
see Don Fullerton, “Marginal Effective Tax Rate,” in The Encyclopedia of Taxation and Tax Policy, Joseph J. Cordes,
Robert D. Ebel, and Jane G. Gravelle, eds. (Washington: Urban Institute Press, 1999), pp. 231-233.
Table 3. Average Effective Tax Rates for the Drug Industry and Major U.S. Industries
from 1996 to 2001 (%)
Industry 1996 1997 1998 1999 2000 2001 Average Rates
1996 to 2001
All Industries 33 33 33 33 33 33 33
Agriculture, Forestry & Fishing 28 26 28 28 28 28 28
Mining 33 34 33 35 31 33 33
Construction 30 30 30 30 31 31 30
Manufacturing 33 33 33 33 33 32 33
Drugs 28 28 28 31 32 32 30
Transportation, Warehousing & Public 33 32 32 33 32 32 32
Wholesale & Retail Trade 33 33 33 33 33 33 33
Finance, Insurance & Real Estate 34 34 34 34 34 34 34
Information and Services 32 28 33 33 34 32 32
Source: Calculated by CRS from figures taken from Internal Revenue Service, Statistics of Income Division,
Corporation Source Book (Washington: GPO, 1996 to 2001).
Note: As calculated here, the average effective tax rate for an industry is the ratio of its federal income tax
liability after all credits except the foreign tax credit to its worldwide taxable income, expressed as a
If marginal effective federal tax rates could be computed for typical investments by the industries
shown in Table 3, it is likely that the drug industry would still have the lowest rate. The reason
lies in certain tax preferences that tend to benefit pharmaceutical firms disproportionately but are
not fully reflected in average effective tax rates. These preferences involve both deferral of
federal income taxes and accelerated depreciation. Three tax preferences in particular may yield
significant tax savings for U.S.-based pharmaceutical firms and thus deserve further exploration:
(1) the deferral of federal income taxes on net income retained by foreign subsidiaries of U.S.-
based corporations; (2) the expensing (or immediate deduction) of most R&D costs; and (3) the
expensing of advertising and promotional costs.
As was noted earlier, the federal government taxes corporations based or chartered in the United
States on their worldwide income and grants them tax credits for any foreign income tax
payments they make on foreign-source income up to their federal tax liability on that income. But
not all foreign income is treated equally for U.S. tax purposes. Profits earned by foreign branches
of U.S.-based corporations are taxed at the appropriate federal rates in the year when it is earned,
regardless of whether the profits are repatriated. In contrast, profits earned by foreign corporate
subsidiaries of these corporations is subject to U.S. taxation only when they are repatriated to the
parent firms as dividends, royalty payments, or other income. The subsidiaries’ profits may be
taxed by the host countries, but any profits they retain are exempt from federal income taxation
until the profits are repatriated. Such an exemption represents a deferral of U.S. income tax
Deferral of this sort can generate significant tax benefits, particularly in cases where firms locate
subsidiaries in countries with lower tax rates than the United States. The reason lies in the time
value of money: a dollar received today is worth more than the same dollar received in the future. 34
Therefore, the longer a taxpayer can defer a tax payment, the less it is worth in current dollars.
As a result, U.S.-based firms owning subsidiaries in countries with lower tax rates than the United
States can reduce their real tax burden by having the subsidiaries retain their earnings indefinitely.
The tax benefits arising from the opportunity to defer federal taxes on foreign-source income give
U.S.-based firms a robust incentive to invest in countries with lower income tax rates than the 35
There is reason to believe that U.S.-based pharmaceutical firms reap significant tax benefits from
this opportunity. According to a recent report in Tax Notes, the effective foreign income tax rate
on the foreign profits of six major U.S. pharmaceutical firms was 17.6% in 2003; the maximum 36
U.S. corporate tax rate in the same year was 35%. The same report found that at the end of
unrepatriated foreign profits. Another report in Tax Notes pointed out that six pharmaceutical
firms were among the top 20 U.S.-based multinational firms out of a total of 67 ranked according
to accumulated undistributed or unrepatriated foreign earnings included in their 2003 10-K 38
reports filed with the Securities and Exchange Commission. What is more, the controlled
foreign corporate subsidiaries (CFCs) of U.S.-based pharmaceutical firms appear to exhibit a 39
relatively strong propensity to retain earnings. At the end of 1996, for instance, these
subsidiaries reported having retained earnings equal in value to 40.3% of their assets; by contrast, 40
the same ratio for controlled foreign subsidiaries in all industries was 11.4%.
34 To some analysts, the deferral of tax payments is analogous to receiving an interest-free loan from the federal
government. For more details on the benefits of tax deferral, see Emil M. Sunley, “Deferral of Tax,”in The
Encyclopedia of Taxation and Tax Policy, Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle, eds. (Washington:
Urban Institute Press, 1999), pp. 70-73.
35 U.S. Congress, Senate Committee on the Budget, Tax Expenditures: A Compendium of Background Material on
Individual Provisions, committee print, 106th Cong., 2d sess. (Washington: GPO, Dec. 2000), p. 32.
36 The six firms are Pfizer, Johnson & Johnson, Merck, Bristol-Myers Squibb, Abbott Laboratories, and Schering
Plough. See John A. Almond and Martin A. Sullivan, “Drug Firms Park Increasing Share of Profits in Low-Tax
Countries,” Tax Notes, Sept. 20, 2004, p. 1,337.
37 Ibid., p. 1,338.
38 The analysis focused on the top 100 of the Fortune 500 in 2003. Of these companies, 67 reported unrepatriated
foreign profits of $352.5 billion in 2003. Six of the top 20 companies were pharmaceutical firms: Pfizer, Merck,
Bristol-Myers Squibb, Schering-Plough, Eli Lilly, and Wyeth. They reported a total of $95.6 billion in accumulated
unrepatriated foreign profits in 2003, or 27% of the total for the entire sample of 67 companies. See John A. Almond
and Martin A. Sullivan, “While Congress Dawdles, Trapped Foreign Profits Surge,” Tax Notes, June 28, 2004, pp.
39 Direct foreign investment by U.S. corporations may take different forms, including establishing foreign branches,
partnerships with foreign-based firms, and separate corporations. For U.S. tax purposes, a foreign corporation is
considered a controlled foreign corporation (or CFC) when U.S. shareholders own more than 50% of its outstanding
voting stock or more than 50% of the value of all its outstanding stock on any day during the foreign corporation’s tax
40 The calculations are based on data received via e-mail from John Miller of the Statistics of Income Division of IRS
on May 15, 2002.
Given that the pharmaceutical industry is a major beneficiary of the ability of U.S.-based
multinational firms to defer federal taxes on the profits earned by their foreign corporate
subsidiaries, it should come as no surprise that the industry might also benefit more than many
other industries from a provision in the American Jobs Creation Act of 2004 (AJCA, P.L. 108-
Under IRC section 965, which was added by AJCA, U.S. corporations may claim a deduction
equal to 85% of cash dividends in excess of a base-period-amount they receive from their CFCs
and invest in the United States under an eligible plan approved by a top corporate officer and the
board of directors. For corporations subject to a marginal tax rate of 35%, the deduction lowers
the rate on any dividends received to 5.25%: 0.35 x 0.15. Corporations may claim the deduction
once, and they may do so either in their last tax year before October 22, 2004 (the date of
enactment for the AJCA) or their first tax year during the 12 months starting on October 22, 2004.
The base-period amount for a corporation is the average amount of cash dividends it received
from CFCs in three of the five most recent tax years ending on or before June 30, 2003; the years
with the lowest and highest repatriation amounts are disregarded. There is a limitation on the
amount of cash dividends that may be deducted: it is the greater of $500 million; or the amount
shown on a firm’s financial statements as earnings permanently reinvested outside the United
States; or in the case of firms whose financial statements do not specify an amount of earnings
permanently reinvested outside the United States but do report a tax liability for those earnings,
the amount of that liability divided by the maximum corporate tax rate of 35%.
In recent months, four of the six largest U.S. pharmaceutical firms have announced plans to
repatriate $56 billion in foreign profits to take advantage of the temporary deduction on dividends
received. One analyst expects that pharmaceutical firms will account for about half of all the 41
profits repatriated by publicly held companies.
Pharmaceutical firms also appear to derive significant benefits from the tax treatment of research
expenditures under IRC section 174. The provision permits business taxpayers to deduct qualified
R&D expenses in the year when they are incurred. Such treatment is known as expensing. To be
eligible for expensing, R&D expenditures must meet the following criteria: they must relate to a
firm’s trade or business; they cannot be considered capital costs; and they must be directed at
“activities intended to discover information that would eliminate uncertainty concerning the 42
development or improvement of a product.” In practice, only the wages and salaries of research
personnel and cost of supplies and materials used in qualified research and related overhead costs
may be expensed. By contrast, the cost of structures and equipment used in this research must be
recovered over 15 years and three years, respectively, using allowable depreciation methods.
For most firms, spending on R&D creates intangible assets (such as patents) that can generate a
substantial flow of revenues over a number of years. More often than not, the economic life of
these assets exceeds one year. In theory, a firm’s spending on R&D represents a cost that should
41 Alex Berenson, “Drug Makers Reap Benefits of Tax Break,” New York Times, May 8, 2005, p. 20.
42 See Internal Revenue Service Final Regulation §1.174-2(a)(1).
be recovered against taxable income over its expected economic life using an appropriate 43
depreciation method rather than fully recovered in the year when the expenses are incurred. But
when the tax code treats R&D costs as a current expense rather than a capital expense, a subsidy
arises in the form of a lower marginal effective tax rate on the returns to R&D investment. In fact,
expensing reduces the marginal effective tax rate on the returns to investment in affected assets to 44
zero. This means that the user cost of capital for R&D investment is typically lower than for
many alternative investments a firm might make, including purchases of new plant and
Pharmaceutical firms are likely to benefit more from this tax subsidy for R&D investment than
most other firms because of their relatively strong propensity to invest in R&D. In 2000,
according to estimates by the National Science Foundation (NSF), pharmaceutical firms plowed
an estimated 9.8% of their domestic sales revenue into domestic R&D, compared to domestic
R&D-to-domestic sales ratios of 3.4% for all firms, 3.3% for manufacturing firms, and 3.8% for 45
non-manufacturing firms. In the same year, pharmaceutical firms spent $12.2 billion on R&D,
according to the NSF. Given that the average effective federal tax rate for the pharmaceutical
industry was 32% in 2000, and assuming that the entire $12.2 billion in R&D expenses was
eligible for expensing, the tax savings that year for the industry as a whole attributable to IRC 46
section 174 may have totaled $3.9 billion.
Pharmaceutical firms also benefit from the tax treatment of outlays for business advertising.
Under current law, advertising expenses are deductible in the year when they are incurred if they
pass two tests: (1) they are reasonable in amount; and (2) they relate to a firm’s lines of business.
These expenses can serve the purposes of developing goodwill among customers or soliciting
There is a clear parallel between the tax treatment of outlays for advertising and outlays for R&D:
both are expensed. It will be recalled that expensing leads to the taxing of any income generated
by affected assets at a marginal effective rate of zero.
In the case of advertising, such tax treatment would be justified on economic grounds if
advertising yielded no benefits for a firm lasting beyond the same year when it is done. Yet there
is reason to think that some spending on advertising is equivalent to acquiring an intangible asset
with an economic life greater than one year. In certain markets (including prescription drugs),
43 Estimates of the rate of depreciation for R&D capital range from 15% to 30% per year. See James R. Hines, Jr., “No
Place Like Home: Tax Incentives and the Location of R&D by American Multinationals,” NBER Working Paper 4574
(Cambridge, MA: National Bureau of Economic Research, Dec. 1993), p. 7; and Bronwyn H. Hall and John van
Reenen, “How Effective Are Fiscal Incentives for R&D? A Review of the Evidence,” NBER Working Paper 7098
(Cambridge, MA: National Bureau of Economic Research, April 1999), p. 6.
44 Because of the availability of a research tax credit, the marginal effective rate on a portion of business R&D
investment is actually negative.
45 National Science Foundation, Division of Science Resources Statistics, Research and Development in Industry:
2000, NSF 02-312 (Arlington, VA: May 2003), table A-20. The NSF definition of R&D covers compensation for
researchers and the cost of materials, supplies, and overhead.
46 It should be noted that this tax savings would not necessarily change if the R&D expenses had been depreciated
according to a formula reflecting the economic lives of the intangible assets they created. But the savings would be
spread out over a longer period, possibly a number of years, reducing its present value in current dollars.
advertising appears to generate intangible assets such as brand recognition and consumer loyalty,
and these assets have the potential to boost a firm’s sales and sustain them at levels they might not
otherwise attain. For instance, Ernst R. Berndt and three colleagues found in a 1994 study of the
U.S. market for anti-ulcer drugs that efforts by leading manufacturers to promote H2-antagonists
prescription drugs to physicians through detailing and medical journal advertising had
“substantial effects” on the growth of domestic demand for the drugs and the sellers’ market 47
shares from 1977 to 1993. In reaching this conclusion, they divided these marketing efforts into
those aimed at expanding overall demand for H2 antagonist drugs and those aimed at expanding
the market shares of the leading sellers. They then estimated that the cumulative value of the
marketing intended to expand overall demand depreciated at a rate of zero, but that the
cumulative value of the marketing intended to expand market shares depreciated at an annual rate 48
of close to 40%. Other analysts have estimated that the depreciation rate for the intangible assets 49
created by commercial advertising in general falls in the range of 20% to 30%.
To the extent that advertising creates intangible assets with economic lives extending beyond one
year, the immediate deduction permitted by current tax law favors investment in advertising over
investment in assets with longer tax lives. What is uncertain, however, is the actual rate at which
advertising loses economic value. There is conflicting evidence about the economic life of
advertising in general, and the same evidence indicates that the depreciation rate may differ
considerably by type of advertising (e.g., television advertising, magazine advertising, radio 50
advertising). As a result, it seems reasonable to conclude that it is uncertain to what extent the
tax code subsidies investment in advertising.
Pharmaceutical firms are likely to benefit more from the expensing of advertising expenditures
because of their relatively strong propensity to invest in advertising. In 2001, the pharmaceutical
industry claimed deductions for advertising equaling 4.8% of business receipts; for all industries, 51
the comparable ratio was 1.2%. The industry claimed a total deduction of $10.5 billion for
advertising in 2001, yielding a tax savings of $3.3 billion at the industry’s average effective
federal tax rate of 31.5% that year.
Tax policy is one of many channels through which the federal government influences the
domestic climate for pharmaceutical innovation. In theory, tax law could bolster this climate by
lowering a firm’s user cost of capital and increasing its internal funds (or retained earnings) for
such investment relative to other kinds of business investment.
47 Ernst R. Berndt, Linda Bui, David Reiley, and Glen Urban, “The Roles of Marketing, Product Quality and Price
Competition in the Growth and Composition of the U.S. Anti-Ulcer Drug Industry,” Working Paper 4904 (Cambridge,
MA: National Bureau of Economic Research, Oct. 1994), pp. 35. Detailing is the widespread industry practice of
promoting drugs directly to physicians by sending marketing representatives to doctor offices and hospitals.
48 Ibid., p. 36.
49 See Mark Hirschey, “Intangible Capital Aspects of Advertising and R&D Expenditures,” Journal of Industrial
Economics, vol. 30, no. 4, June 1982, pp. 375-389.
50 U.S. Congressional Budget Office, Reducing the Deficit: Spending and Revenue Options (Washington: GPO, 1997),
51 Internal Revenue Service, Statistics of Income Division, 2001 Corporation Source Book, Publication 1053
The user cost of capital is the cost a firm incurs as a result of owning a tangible or intangible
asset. It embraces both the opportunity cost of passing up other investments and the direct costs
of ownership, such as depreciation, the acquisition cost of the asset, and taxes. In general, the user
cost of capital indicates the rate of return an investment project must earn in order to be
profitable. As a firm’s user cost of capital declines, the number of investment projects it can
profitably undertake increases, all other things being equal. Empirical research indicates that
business investment responds to changes in the user cost of capital, although the magnitude and
stability of the response over the course of the business cycle are subjects of ongoing debate and 52
research among economists.
One factor affecting the user cost of capital is the tax burden on the return to an investment a firm
makes. Generally, the lower this burden, the lower the cost of capital, all other things being 53
equal. A measure of this burden widely used by economists is the marginal effective tax rate.
This rate, which is calculated by subtracting the after-tax rate of return on a new investment from
the pre-tax rate of return and dividing by the pretax rate of return, reflects the statutory income
tax rate faced by a firm, modified by any tax provisions that effectively reward and penalize the
firm for making a particular investment.
Under current law, the federal tax burden on the returns to R&D investment could be relatively
low because of two tax subsidies for such investment discussed earlier: (1) the tax credit for
increases in research spending above a base amount under IRC section 41, and (2) the option to
expense qualified research outlays under IRC section 174. In combination, they raise the after-tax
rate of return on R&D investment relative to other investments a firm could make, such as
purchases of plant or equipment or instituting a new training program for employees. In fact, the
combined effect of the credit and the expensing allowance is to subject the returns to R&D
investment to a negative rate of taxation, which is to say that after-tax rates of return exceed pre-54
tax rates of return.
The same two tax subsidies can also boost R&D investment by increasing a firm’s cash flow or
supply of internal funds. Some firms base their annual R&D budgets on the amount of money
they expect to have on hand after paying all expenses in a given year. For them, the cost of
internal funds may be significantly lower than the cost of external funds, such as money raised
through borrowing or issuing new stock. Small start-up firms are particularly likely to find
themselves in this position because potential investors or lenders may lack the information
needed to evaluate carefully their prospects for commercial success. A firm’s supply of internal
funds depends on how much it earns in profits and how much of those profits it must set aside to
pay its income tax liability. Firms that rely heavily on retained earnings to finance new R&D
investments should be able to invest more as their tax liabilities fall, all other things being equal.
Of course, the increased cash flow could be used for many other purposes, including hiring new
employees, training current employees, or paying higher dividends to shareholders.
52 Harvey S. Rosen, Public Finance, 6th edition (New York: McGraw-Hill/Irwin, 2002), p. 409.
53 For a discussion of the impact of taxes on the user cost of capital, see Jane G. Gravelle, “Cost of Capital,” in The
Encyclopedia of Taxation and Tax Policy, Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle, eds. (Washington:
Urban Institute Press, 1999), pp. 68-70.
54 See CRS Report 95-871 S, Tax Preferences for Research and Experimentation: Are Changes Needed?, by William
There are no studies assessing the impact of current federal tax law on the incentive to invest in
pharmaceutical R&D. But the seemingly weak effect of the research tax credit on domestic
spending on this R&D noted earlier (see “Research Tax Credit”) does suggest that federal tax
policy has little influence on this incentive.
A better indicator of the link between tax policy and pharmaceutical innovation might be the
pharmaceutical industry federal tax burden as measured by average effective tax rates. In 2001,
the industry’s rate was nearly the same as the average rate for all industries. Nonetheless, the
average pharmaceutical firm spends a much higher percentage of its revenue on R&D than the
average firm. This contrast underscores the central role played by innovation in the growth and
competitive dynamics of the pharmaceutical industry. Current tax law may have little impact on
the incentive to invest in pharmaceutical R&D, but substantial increases in the industry’s federal
tax burden could affect its ability to invest in new drug development.
A number of bills were introduced in the 108th Congress aimed in whole or in part at influencing 55
certain aspects of industry behavior by changing its tax treatment. It is conceivable that some of
their sponsors were responding to the widespread disaffection among Americans with the pricing
policies, profitability, and advertising strategies of the pharmaceutical industry. Many of these
initiatives would have imposed tax penalties on pharmaceutical firms that failed to curb or
jettison certain practices, or that engaged in certain activities (e.g., spending on direct-to-
consumer advertising). A few would have given these firms robust tax incentives to achieve
certain desired objectives, such as investing in domestic vaccine production.
Only one of these measures, H.R. 4520, became the focus of significant legislative action. The
House passed the bill by a vote of 251 to 178 on June 17, 2004, and the Senate followed suit by
approving an amended version (by substituting the revenue language from S. 1637) on July 15,
2004. An agreement between the conferees from the House and Senate was reached in early
October, and the House approved the agreement on October 7, followed by the Senate on October
11. The version of H.R. 4520 signed into law by President Bush does not include a provision in
the House-passed version modifying the orphan drug credit. But it does contain a number of
provisions that have important implications for the future federal tax burden of the
pharmaceutical industry, such as a phase out and repeal of the extraterritorial income exclusion
for exports, a phased-in deduction for income arising from domestic production, and a temporary
sizable cut in the U.S. tax rate on certain income earned abroad by subsidiaries of U.S.-based 56
55 See H.R. 149, H.R. 354, H.R. 1733, H.R. 2038, H.R. 2640, H.R. 3155, H.R. 3758, H.R. 3865, H.R. 4520, H.R. 4899,
S. 477, S. 2053, and S. 2307.
56 For an overview of the American Jobs Creation Act of 2004, see CRS Report RL32652, The 2004 Corporate Tax
and FSC/ETI Bill: The American Jobs Creation Act of 2004, by David L. Brumbaugh.
The pricing of drugs and the profits and advertising strategies of major pharmaceutical firms th
remain key concerns in the 109 Congress. One bill related to this concern that would alter the th
tax treatment of many pharmaceutical firms has been introduced in the 109 Congress. H.R. 575
would deny a tax deduction for any amount spent by a business taxpayer on “direct-to-consumer”
advertising of prescription drugs as of January 1, 2005.
Analyst in Public Finance