The impact of indirect government controls on U.S. drug prices and R&D.

• Author: Santerre, Rexford E.

In this article, we hypothesize that the growth of real drug prices in the United States may have been slowed over time because of indirect government controls taking the form of moral suasion, political threats, and crowding-out. We argue that these indirect control mechanisms are accentuated when government controls a greater share of drug spending. Using national data for the United States, we test this hypothesis and show empirically that an increasing share of government spending on pharmaceuticals was associated with a slowing of the growth of real drug prices during the period from 1962 to 2001. We also show that this reduction in the growth of real drug prices had a meaningful impact on pharmaceutical R&D and number of life years lost. More specifically, we determine that the resulting government-induced loss of capitalized pharmaceutical R&D expenditures was between $251 and 256 billion (in 2000 dollars) from 1962 to 2001 and conclude that the federal government's influence on real drug prices may have cost the U.S. economy between 187 and 191 million life years between 1962 and 2001.

The Legal Setting

Beginning in 2006, the Medicare Prescription Drug, Improvement, and Modernization Act (MMA) of 2003 will provide about 40 million Medicare recipients with the eligibility to receive prescription drug insurance coverage in the United States. (1) Under the MMA, various private health insurance plans are expected to compete among themselves to provide drug coverage to Medicare beneficiaries. Up until now, many of the nation's most elderly and frail Medicare recipients were without prescription drug coverage. Thus, not surprisingly, many look upon the MMA as representing the first major expansion of the Medicare program since 1965 and a milestone in U.S. healthcare policy (Oberlander 2003).

While many Medicare recipients will pay a lower out-of-pocket price for drugs under the act, the MMA is not without its critics. One contentious issue pertains to the manner in which drug prices are determined under the act. Specifically, the MMA, as enacted, contains a noninterference clause: "The Secretary of Health and Human Services (HHS) may not interfere with the price negotiations between drug manufacturers and pharmacies and prescription drug plan (PDP) sponsors. In addition, the Secretary may not require a particular formulary or institute a price structure for the reimbursement of covered Part D drugs" (S1860D-1 as cited in the Republican Policy Committee 2004).

Recently, however, legislation has been introduced to modify various aspects of the MMA, including its noninterference clause (e.g., S. 1992, S. 1950, and S. 2053). (2) The idea behind the removal of the noninterference clause is that the federal government will be able to use its considerable size and buyer clout to "'negotiate" even more favorable prices from drug manufacturers and thus save large sums of money for both the elderly and society--money that can be used for other necessities of life such as food, clothing, and shelter.

However, the noninterference clause contained in the original Medicare law lasted less than 20 years. In 1983, the federal government introduced the Diagnosis Related Groups (DRG) system, which established prospectively regulated rates to pay for hospital services provided under part A of the Medicare Act. Furthermore, less than 10 years later, the federal government created the Resource Based Relative Value Scale (RBBVS) system. The RBRVS pays physicians under part B of the Medicare Act based on their time and effort in providing services. Both of these payment systems are essentially price controls and conflict with the language in the original Medicare Act. However, the concern is that the government might simply use its buying clout to "administer" or "control" prices rather than negotiate them. Economic theory suggests that price controls will have a negative impact on drug development for two reasons. First, regulations that suppress drug prices reduce expected revenues relative to costs and thereby make R&D investment less attractive from the firm's (and investors') perspective. This is especially the case with biotechnology firms that are "burning cash" provided by equity investors and that have no current profits or sales to fired R&D spending. Second, suppression of drug prices will also reduce the firm's cash flows, which have been shown to be a particularly important source of financing for pharmaceutical R&D (Grabowski and Vernon 2000; Vernon 2004, 2005). Again, with biotech firms, the expectation that drug prices will be driven down or held flat means that future revenues will be held down as well: the return on investment of existing drugs may fall below the opportunity cost of capital. The capital markets (both debt and equity) will not provide the funds necessary to support future R&D if the government forces rates of return below the opportunity cost of capital. Indeed, we have shown empirically that more than one-third of all new drug launches would have been lost from 1980 to 2001 if the U.S. government had limited pharmaceutical price increases to the same rate of increase as the general consumer price index, thereby reducing pharmaceutical cash flows (Giaccotto, Santerre, and Vernon 2005).

Given the social significance of new drug discovery and development and the anticipated negative impact of pharmaceutical price controls, challenges to the noninterference clause contained in the MMA should be taken seriously. This study empirically investigates how government influence in the past has affected real drug prices in the United States. Evidence on the effect of governmental influence on real drug prices is then used to predict the amount of B&D spending, lives lost, and the corresponding economic costs that may be attributed to this government influence. The empirical findings will serve as a conservative indication of what we might expect with the removal of the noninterference clause from the MMA.

Government's Indirect Influence on Pharmaceutical Pricing

Unlike the governments of many countries in Europe and Canada, the U.S. government has in the past not directly controlled the drug prices paid by private consumers and insurance companies. However, in the absence of direct private price controls, the different levels of government (e.g., federal and state) in the United States possess various ways to indirectly control private drug prices. Some of these methods of government influence may not be mutually exclusive, and some may be more invasive than others. For discussion purposes, the three mechanisms of government influence are classified as moral suasion, threat, and crowding-out.

Governments, especially the federal government, can sometimes use moral suasion, or jawboning, to persuade companies like drug manufacturers to moderate price increases. Moral suasion is particularly effective when company goals otherwise clash with national objectives. The steel industry in the early 1960s provides a prime example of government's use of moral suasion (Scherer and Ross 1990). In 1962, U.S. Steel announced a steel price increase averaging $6 per ton. The price increase drew sharp criticism from President Kennedy, who pointed out that the national economy was experiencing a recession. In response to Kennedy, U.S. Steel eventually rescinded the price increase.

A similar example relating to the drug industry occurred during the 1990s (Pear 1993). In response to the perception of high and rising drug prices, President Clinton's health policy advisers suggested several initiatives, including direct price controls and the reprimanding of companies whose prices were judged to be "excessive." Under heavy lobbying from the drug industry, the government backed away from more direct price controls and leaned toward using "government exhortation" rather than "compulsion" as a means to influence drug prices (Pear 1993). By potentially reducing a company's franchise value through a tarnished national image, the general idea was that adverse...