Drug companies are warning that pricing reform spells doom. Don't fall for it

Democrats are on the verge of passing legislation that, among other things, would empower the government to directly negotiate the price Medicare pays for a handful of the costliest prescription drugs. The measure has precipitated hyperbole from industry lobbyists, who say it represents an existential threat to medical innovation. One prominent group recently claimed the bill "could propel us light years back into the dark ages of biomedical research."

The only problem? It's not true. Not all drugmaker revenues are created equal, and not all pharmaceutical research and development spending leads to equally innovative outcomes.

Forthcoming research from our think tank, the Foundation for Research on Equal Opportunity, proves what investors have long known: The R&D labs of the global pharma giants are lumbering and inefficient.

We analyzed pricing practices and R&D productivity for 17 of the world's largest pharmaceutical companies, including Pfizer, AbbVie, Novartis and Johnson & Johnson. Together, these companies represent more than 60% of global pharma revenue and 56% of industry R&D spending.

Reducing big-pharma spending likely wouldn't have a large effect on drug development. Consider this: Had the largest companies held net prices constant on a single large drug in each of their portfolios from 2012 to 2021, Americans would have spent $139 billion less on prescription drugs. Because big companies deployed about 18% of their revenue on R&D, that $139 billion in savings translates to approximately $25 billion in reduced R&D spending by the majors.

But according to our analysis, that $25 billion in R&D spending accounts for only five drugs developed in these giants' own labs. That's 1.2% of the 430 drugs approved by the Food and Drug Administration in that period.

In fact, the largest drug companies are only one-fifth as efficient as the overall industry in R&D. The big companies spend $5 billion per newly developed homegrown drug; the industry average is closer to $1 billion.

It's not surprising that big drug companies are less innovative than their smaller brethren. Because small biotechs can offer their scientists stock options, the brightest and most creative drug developers prefer to work at start-ups, where, if successful, they can retire early.

Perversely, the Medicare program handsomely rewards large, low-innovation companies to the tune of hundreds of billions of dollars. That's not how free markets are supposed to work.

In innovative industries governed by fair competition, prices go down as technology improves. But Medicare has not been such a market. Branded drugs enjoy monopoly status, on average, for the first decade after FDA approval, with some exclusivities lasting much longer. Medicare plans are forced by law to pay for many of these drugs, irrespective of their cost or benefit to patients. In Medicare Part B, doctors get a 6% commission on the price of drugs they prescribe, incentivizing them to give patients the costliest drug available and encouraging drug companies to increase their prices at every opportunity to attract more prescribers.

The Democrats' bill would help repair these distortions. It carefully targets only 20 of the 4,100 drugs covered by Medicare Parts B and D, allowing the government to negotiate prices for those that are costliest to seniors and taxpayers.

It also protects the smaller companies where most innovation actually takes place. It exempts "orphan drugs" treating rare diseases; drugs that cost the Medicare program less than $200 million per year; drugs that represent 80% or more of a company's sales to Medicare Part B or D; and drugs that represent no more than 1% of Medicare's Part B or D pharmaceutical spending. The bill requires Medicare to focus its negotiations on drugs whose monopolies have lasted 12 years or longer — more than enough time for genuinely innovative companies to generate a return on their R&D investment.

We should absolutely continue to reward truly innovative drugmakers for medicines that benefit patients. But monopolists who raise prices on decades-old drugs are not contributing to innovation. They're contributing to Medicare's insolvency.

The Congressional Budget Office recently estimated that the bill's Medicare drug reforms will reduce federal spending by nearly $200 billion from 2022 to 2031. And the CBO estimated that those savings could increase in future decades. Furthermore, when Medicare's costs decrease, seniors benefit from lower premiums and out-of-pocket costs.

Unfortunately, Democrats have loaded up their reconciliation bill with a 15% minimum corporate income tax that would force younger, innovative biotech companies to spend less on R&D. And overall, the bill's deficit reduction potential has been undermined by about $400 billion over a decade in new energy subsidies, and more than $300 billion in federal loan guarantees that may never be repaid.

Nevertheless, fiscal advocates have fought for years to improve Medicare's sustainability. Medicare drug reform — as a standalone effort — could do just that.

Avik Roy wrote this column as a special to The Washington Post.