Drug Industry: Profits, Research and Development Spending, and Merger and Acquisition Deals
Released: 2017-12-19T00:00:00

Letter

Background

The drug industry encompasses a variety of companies involved in the research, development, distribution, and payment for chemically synthesized and biologic drugs. For the purpose of our review, the drug industry includes pharmaceutical companies that traditionally concentrate on developing or manufacturing drugs derived from chemicals and biotechnology companies that develop or manufacture biologics—more complex drugs derived from living cells.

The federal government plays a role in various aspects of the drug supply chain as well. To market drugs in the United States, drug companies must apply and receive approval from the FDA that their drugs are safe and effective. The federal government also supports R&D for new drugs, such as through grants by the National Institutes of Health (NIH), NSF, and other agencies, and through tax incentives administered by the IRS. In addition, mergers and acquisitions affecting the drug industry are subject to review by the federal government to ensure compliance with applicable antitrust laws.

Drug Research, Discovery, Development, and Approval Process

The process of bringing a new drug to the market is long and costly and involves multiple public and private entities that fund and perform R&D. (See fig. 1.) For a new drug, the entire drug discovery, development, and review process can take up to 15 years, often accompanied by high costs. The process consists of several main stages:

Basic research: This is research aimed at acquiring new knowledge or understanding without immediate commercial application or use. Basic research is often federally funded and conducted to better understand the workings of disease, which increases the potential of discovering and developing innovative drugs.

Drug discovery: This is undertaken by numerous researchers from drug companies, academia, and government searching for and identifying promising chemical entities, or chemical and biological compounds, capable of curing or treating diseases.

Preclinical testing: During preclinical testing, compounds are tested in laboratories and in animals to predict whether a drug is likely to be safe and effective in humans. If the compound is found to be promising, a drug company may decide to test it as a new drug on humans and it proceeds to the clinical trials stage. Before doing so, the company must submit to FDA and have in effect an investigational new drug application that summarizes the data that have been collected on the compound and outlines plans for the clinical trials.

Clinical trials: Clinical trials test potential drugs in human volunteers to determine if they should be approved for wider use in the general population. An investigational new drug typically goes through three phases of clinical trials before it is submitted to FDA for marketing approval. Clinical trials proceed through Phases I, II, and III, beginning with testing in a small group of healthy volunteers and then moving on to testing in larger groups of patients whom the drug is intended to treat to assess the compound’s effectiveness, rate of adverse events, and uses in combination with other drugs.

FDA Review and Approval: To market a drug in the United States, drug companies submit their research in a new drug application (NDA) or biologic license application (BLA) to FDA, which then reviews and approves the drug for marketing if it is shown to be safe and effective for its intended use. An NDA is an application to market a new chemically synthesized drug—either an innovative drug or a variation of a previously marketed drug. A BLA is an application for a license to market a new biological product (complex drugs derived from living organisms). Companies may also submit a supplement to an already approved NDA or BLA—known as an efficacy supplement—to propose changes to the way an approved drug is marketed or used, such as adding or modifying an indication or claim, revising the dose or dose regimen, providing a new route of administration, or changing the marketing status from prescription to over-the-counter use.

For the purposes of its review, FDA classifies certain NDAs as new molecular entities—products that contain active chemical substances that have not been approved by FDA previously—and certain BLAs as new therapeutic biologics. FDA generally considers drugs approved either as new molecular entities or new therapeutic biologics to be “novel” drugs—products that are often innovative and serve previously unmet medical needs or otherwise significantly help to advance patient care and public health.

Post-approval: After FDA has approved a drug for marketing, the drug company may begin marketing and large-scale manufacturing of the drug. FDA also continuously monitors the safety of the drug which includes, amongst other activities, oversight of postmarket clinical studies that it can require or request companies to complete (known as phase IV clinical trials). Drug companies may also undertake these studies independently to identify modifications to the drug such as new delivery mechanisms or additional indications for use. The company may then submit a new application or supplement application with new clinical data to FDA to market the modification as a new drug, or market it for the new use.

Patent and Market Exclusivity and Other Incentives for Drug Development

Patents and market exclusivity periods are two ways brand-name drug companies may recoup their R&D investments by limiting competition for specified periods of time. Typically, early in the R&D process, companies developing a new brand-name drug apply for a patent on the active ingredient and may additionally apply for patents on other aspects of the drug, such as the method of use, from the U.S. Patent and Trademark Office. Once a patent is granted, other drug companies are excluded from making, using, or selling the patented aspect of the drug during the term of the patent, which generally expires after 20 years from filing. In addition, federal law authorizes certain periods of exclusive marketing rights, or market exclusivity, for new FDA-approved drugs, during which time FDA generally cannot approve a similar competing version of the drug for marketing. These exclusivities are independent of the rights granted under patent and can relate to chemical entities never approved before by FDA (5 years of exclusivity); new biologics (12 years); approval of a supplement for a new condition or use or other change to a previously approved chemically synthesized drug based on new clinical studies (3 years); and orphan drugs—drugs designated to treat rare diseases or conditions (7 years); among others. Patent protection and market exclusivity are independent of one another and can run concurrently or not.

When brand-name drug products’ patents expire and exclusivity periods end, similar versions of the drug product that have been approved by FDA may enter the market. These are referred to as generics for chemically synthesized drugs and biosimilars for biologics. The Drug Price Competition and Patent Term Restoration Act of 1984—commonly known as the Hatch-Waxman Amendments—facilitated earlier, and less costly, market entry of generic drugs. A generic drug must generally be demonstrated to be equivalent to the brand-name drug product in active ingredient, dosage form, safety, strength, route of administration, quality, performance characteristics, and intended use. For biologics, the Biologics Price Competition and Innovation Act of 2009 provided an abbreviated pathway for companies to obtain approval of “biosimilar” and “interchangeable” biological products. A biosimilar must be demonstrated to be highly similar to an already approved biological product and to have no clinically meaningful differences in terms of safety and effectiveness from the reference product. See table 1 for a description of drug application types.

In addition to incentivizing drug development through patent and market exclusivity, the federal government supports new drug research both directly, through grants from—and intramural research by—agencies such as NIH and indirectly through tax incentives for companies that develop new drugs. Specifically, the Internal Revenue Code includes incentives for research-related spending in three ways: through two income tax credits—the credit for clinical testing expenses for certain drugs for rare diseases (known as the orphan drug credit) and the credit for increasing research activities (known as the research credit)—and through special methods for treatment and reporting of research and experimental expenditures, including current-year deduction to arrive at net income. In general, the credit incentives are available to companies with qualified research spending in the United States. Companies include businesses organized as corporations or non-corporate businesses such as partnerships. These provisions are described below:

Orphan drug credit: Companies may claim the orphan drug credit for half the “qualified clinical testing expenses” for drugs intended to treat rare diseases. Expenditures that give rise to the orphan drug credit may include expenses related to testing outside the United States. A company may claim foreign clinical testing expenses if there is an insufficient testing population in the United States to test the safety and efficacy of the drug. The orphan drug credit is nonrefundable; that is, while the credit can be used to reduce a company’s income tax liability generally, the credit cannot be used to generate a refund if the business has no tax liability or fully used if the credit would reduce tax liability below zero. The credit is also a component of and subject to the limitations of the general business credit.

Research credit: Companies may claim a research credit for qualified research expenditures they undertake in a given year that exceed a threshold or base amount. This incremental design of the credit is intended to create an incentive for companies to do more research than they otherwise would. Qualified research expenses are certain expenses for qualified research incurred by the taxpayer during the taxable year in carrying on a trade or business. Qualified research is research that is undertaken for the purpose of discovering information that is technological in nature and the application of which is intended to be useful in the development of a new or improved business component of the taxpayer. In general, substantially all the activities that constitute a process of experimentation relating to new or improved functions, performance, or reliability or quality are qualified research. The rate of credit can be 14 or 20 percent. Like the orphan drug credit, the research credit is nonrefundable and is a component of, and subject to, the limitations of the general business credit.

Deductions of qualified research expenses: If elected, the tax code allows businesses to currently deduct “research or experimental expenditures” from gross income in the tax year they are incurred rather than depreciate (or amortize) the assets the R&D created over time. Research and experimental expenditures include all costs incident to research, including research conducted outside the United States. Since “qualified research expenses” and “qualified clinical testing expenses” are a particular subset of research and experimental expenditures, expenditures that can give rise to either the research or orphan drug tax credits can be deducted in the year that they occur. However, these deductions must be reduced by the amount of tax credits claimed in order to prevent expenses from both generating a tax credit and being deducted from income.

Drug Distribution, Payment, and Pricing

The distribution of, and payment for, prescription drugs involve interactions and negotiated transactions among multiple commercial entities along the supply chain from the drug manufacturer to the consumer (see fig. 2). Brand-name and generic drug manufacturers typically sell their drugs to drug wholesalers, who in turn sell the drugs to retail pharmacies or to health care providers (such as hospitals, clinics, and physicians). Pharmacies or providers dispense or administer prescription drugs to consumers. Most consumers purchasing drugs pay a portion of the drug’s price in the form of a copayment or coinsurance, with the specifics of this cost sharing dictated by the consumers’ insurance plan. Insurance plans often use pharmacy benefit managers (PBMs) to help them manage their prescription drug benefits, including negotiating prices with manufacturers, processing claims, and negotiating with retail pharmacies to assemble networks where the beneficiaries can fill prescriptions. PBMs negotiate with manufacturers for rebates on behalf of the insurance plan based on market share, volume, and formulary placement. PBMs also contract with pharmacies; contract terms and conditions may include specifics about negotiated reimbursement rates (how much the pharmacy will be paid for dispensed drugs) and payment terms. Health care providers may also negotiate with insurers for the drugs they administer. The price that payers, PBMs, and ultimately consumers pay for prescription drugs depends in part on the amount of competition and the purchasers’ negotiating power. The negotiating power is influenced by the ability to choose from competing drugs and the volume of drug purchased.

According to economic experts, the usual mechanisms that enforce market discipline may not work in the same way in the health care market as they do in other markets. In most markets—automobiles, for example—consumers are expected to be conscious of the price of goods. If a company raises the price of its goods, consumers would likely purchase fewer goods, causing the company’s revenues to decline. However, in the health care market, the purchase of goods and services is largely influenced by health care providers, who may not be well- informed about, or incentivized to consider, the prices involved. In the case of drugs, some experts argue that marketing and advertising may further distort provider decision making. In addition, if the patients’ medical bills are largely paid by insurance plans (other than copayment or coinsurance costs), then patients’ demand may not be significantly influenced by changes in price to the extent that it might be in other markets where the consumers see and pay the bill themselves.

Certain payment policies may also limit the negotiating power of insurers. For example, Medicare Part D is required to cover all drugs in six protected classes, which some experts argue reduces the negotiating power of its contractors (known as plan sponsors). In addition, some brand-name drug companies are providing coupons to consumers to mitigate patient drug costs when a company’s drugs are not covered by payer formularies or require higher patient costs than preferred drugs. Some research and experts we interviewed have noted that this practice erodes the negotiating power of insurers and the cost management utility of formularies, which may result in lower prices for the patient using the coupon but higher prices overall. In addition, patients and providers in many cases may not have clear information about the benefit relative to cost of one drug over another drug or treatment.

Consolidation and the Antitrust Review Process

Experts have said that consolidation as a result of mergers and acquisitions is one of multiple factors that could influence competition. Fewer companies producing and marketing drugs can lead to greater market dominance by certain companies and less competition.

The Federal Trade Commission (FTC) and the U.S. Department of Justice (DOJ) enforce federal antitrust laws that prohibit activities, such as price fixing and mergers and acquisitions where the effect may be substantially to lessen competition or tend to create a monopoly. Drug companies are subject to these antitrust laws. Companies are required to notify FTC and DOJ of certain pending mergers, also known as the premerger notification program. As part of its premerger review process, these agencies can approve mergers contingent on company divestiture of assets, including those related to products in development—a process known as a negotiated merger remedy. These agreements are subject to public notice and comment and result in an enforceable order. The goal of a merger remedy is to preserve or restore competition in the relevant markets. Although FTC and DOJ each have authority and responsibilities under the antitrust laws, FTC typically examines proposed drug industry mergers. In addition, FTC has authority to investigate and take action against unfair methods of competition in or affecting commerce, as well as mergers and acquisitions that may substantially lessen competition or tend to create a monopoly, including in the drug industry.

Drug Industry Profit Margins and Merger and Acquisition Deal Values Increased, and the Industry Underwent Structural Changes

Among the worldwide drug companies included in the data we reviewed, reported pharmaceutical and biotechnology revenues and profit margins for most companies grew from 2006 through 2015. The number of mergers and acquisitions among companies in the industry generally held steady from 2006 through 2015, but merger and acquisition deal values increased. Market concentration varied by the specific market level considered. Industry experts we interviewed noted that market pressures have driven structural changes in the industry.

Company-Reported Revenues and Profit Margins Grew from 2006 through 2015

According to the data we reviewed, between 2006 and 2015 estimated aggregate worldwide pharmaceutical and biotechnology sales revenue for drug companies grew from $534 billion to $775 billion in real 2015 dollars (about 45 percent), with most of the growth occurring between 2006 and 2011. The largest 25 of these companies (by 2015 pharmaceutical and biotechnology revenue) saw their aggregate sales revenue increase from $448 billion in 2006 to $569 billion in 2015, or about 27 percent. Aggregate sales revenue for all other drug companies in our data grew more sharply, from $86 billion in 2006 to $206 billion in 2015—an increase of about 140 percent (see fig. 3).

Drug companies’ average profit margins also grew from 2006 to 2015, though the trends differed for the largest 25 companies compared to the remaining companies in our data. Overall, about 67 percent of companies saw their profit margins increase between 2006 and 2015. While there was some fluctuation over time, the average profit margin was 17.1 percent in 2015 for all drug companies; profit margins were higher for the largest 25 companies (20.1 percent in 2015) than for all others (8.6 percent in 2015; see fig. 4).

To better place large drug companies’ profit margins into context, we conducted a similar examination of profit margins for large companies in other industries, specifically software companies and the largest 500 companies (by 2015 total worldwide revenue as reported in Bloomberg) representing a wide range of industries. We included the software industry separately because, like the drug industry, it has been cited as having high R&D investment and low production and distribution costs, though caution should be taken in making this comparison. Among the largest 25 software companies (by 2015 software revenue), the average profit margin began at 21.7 percent in 2006 and remained relatively stable through 2014, before decreasing to 13.4 percent in 2015 (see fig. 5). As a broader comparison, the average profit margin among the largest 500 companies was consistently lower than the average among the largest 25 drug companies and software companies. Among the largest 500 companies, the average profit margin decreased from 8.9 percent in 2006 to 6.7 percent in 2015.

The Number of Mergers and Acquisitions Generally Held Steady from 2006 through 2015, but the Values Fluctuated

The annual number of mergers and acquisitions involving drug companies generally held steady between 2006 and 2015, with some fluctuations in intervening years, based on our review of Bloomberg data. Overall, the number of transactions generally held steady, with 312 in 2006 and 302 transactions in 2015 (see fig. 6). The number of mergers and acquisitions involving one of the largest 25 companies (by 2015 pharmaceutical and biotechnology revenue) increased from 29 transactions in 2006 to 61 transactions in 2015. In contrast, the number of transactions in our data for the smaller drug companies decreased from 283 transactions in 2006 to 241 transactions in 2015. See appendix II for additional information on merger and acquisition activity of 10 large companies in the drug industry as of 2014.

While the number of transactions generally held steady between 2006 and 2015, the total value of transactions completed over this period fluctuated considerably. These fluctuations were driven by a small number of high value transactions, which tended to occur among the largest 25 companies (see fig. 7). For example, in 2009, there were three transactions each valued above $20 billion in real dollars, all of which were conducted by companies in the largest 25:

Pfizer Inc. acquired Wyeth LLC for about $71 billion,

Merck & Co Inc. acquired Schering-Plough Corp. for about $56 billion,

Roche Holding AG acquired Genentech Inc. for about $48 billion.

In 2015, about half of the total merger and acquisition transaction value came from five transactions each valued over $10 billion in real dollars, including one very large transaction by Allergan for about $72 billion. The other four transactions also involved companies among the largest 25. Much as the total value of mergers and acquisitions fluctuated considerably from year to year, median disclosed transaction values generally increased between 2006 and 2015, with considerable fluctuation among years.

Concentration in the Drug Industry Varied by the Level of the Industry Considered

For the overall drug industry, the share of total sales accounted for by the 10 largest companies—a measure of concentration—declined between 2007 and 2014, the years for which public data were available from QuintilesIMS. The largest 10 companies (by 2014 pharmaceutical revenue) had 48.9 percent of the drug industry’s sales revenue in 2007; by 2014, their share of the industry sales revenue declined to 38.2 percent. Concentration, which can be measured by share of sales, provides a basic indication of the competitiveness of companies in an industry or specified market level within an industry. Competition in the drug industry generally is examined at the level where products are viewed as substitutes, according to FTC officials. Substitutes can be products that are the same molecular entity or, in some cases, different molecular entities that treat the same condition.

At levels narrower than the entire industry, such as drugs within the same therapeutic class or of the same molecular entity (levels that are more relevant to competition), concentration in shares of sales can be higher than in the overall industry. For example, EvaluatePharma reported that the three largest companies in the anti-diabetics market accounted for 67.5 percent of the sales in that market in 2014. Similarly, the three largest companies in the anti-rheumatics market accounted for 56.8 percent of the sales in that market in 2014, and the three largest companies in the anti-virals market accounted for 72.4 percent of the sales in that market, with the leading anti-viral manufacturer accounting for over half (52.8 percent) of worldwide anti-viral sales.

Concentration can also vary for drugs of the same molecular entity, as some generic drugs may have different numbers of manufacturers than others. For example, as of 2017, 14 companies have approved ANDAs for lisinopril, a drug for hypertension—that is, 14 companies have generic versions of the drug approved for manufacture. By comparison, only one company has an approved ANDA for efavirenz, a drug used to treat HIV infection. Greater numbers of generic manufacturers generally reduce concentration, as generic manufacturers compete with one another in addition to brand-name manufacturers. More broadly, one recent study found that of the novel drugs approved in tablet or capsule formulation since the 1984 Hatch-Waxman Act and eligible for generic competition, more than one-third had three or fewer generic approvals.

Industry Experts Noted Market Pressures Have Driven Structural Changes in the Industry, Such as in the Types of Acquisitions and Increased Specialization in Therapeutic Areas

Experts we interviewed noted that market pressures such as rising R&D costs, fewer drugs in the R&D pipeline, and the growth in sales of generic drugs have driven various structural changes in the drug industry, such as in the types of acquisitions being sought. Not all companies respond to those pressures in identical ways. For example, some experts said that some companies that traditionally manufactured brand-name drugs are expanding into the manufacturing of generic drugs. These brand-name companies may acquire a generics manufacturer to adjust the portfolio of drugs they manufacture or gain access to a generics business. Similarly, some traditionally generic manufacturers are expanding into brand-name manufacturing to acquire product lines with more generous profit margins. For both brand-name and generic manufacturers, expanding the size of their drug portfolio may improve their bargaining position with PBMs, according to two economists we interviewed. Experts also said that traditionally large companies are increasingly relying on mergers and acquisitions to obtain access to new research and are conducting less of their own research in-house. In addition, experts told us that investment in the development of traditional chemically synthesized drugs has produced increasingly lower financial returns, resulting in some traditional pharmaceutical companies turning to invest more in the development of more complicated and costly biologics. Many experts highlighted the proliferation of biotechnology companies as large pharmaceutical companies seek to acquire promising new research developments.

Many experts told us that market pressures have also driven some drug companies to move towards specialization in certain therapeutic areas, including through mergers and acquisitions. As one example, GlaxoSmithKline acquired most of Novartis’s vaccine business in 2015, bolstering its own line of vaccines and helping to raise its share of sales of the worldwide vaccine market. Simultaneously, Novartis acquired GlaxoSmithKline’s oncology business, enabling both companies to shed one line of business and focus on the newly acquired therapeutic areas.

Experts again noted that one reason companies may be specializing through mergers and acquisitions is because of the increasing cost of R&D—acquiring promising new or developed research or product lines helps companies mitigate R&D investment risk. Acquiring existing lines of business from competitors within a therapeutic area may also help a company increase its presence in a particular therapeutic area.

Another widely cited factor influencing structural changes in U.S. industries—including the drug industry—involves tax-influenced mergers, called corporate inversions. An inversion is a type of merger where a U.S. corporation merges with or acquires a company located in a foreign jurisdiction—often a lower-tax country—and reorganizes so the resulting parent corporation is located in the foreign country. This can reduce a corporation’s overall tax liability—often by reducing its U.S. tax liability. While taxes are one of many factors that may influence trends in mergers and acquisitions as discussed above, the incentive for drug companies to reduce tax burdens through inversions can be significant. In 2016, the Treasury Department issued new regulations to curb inversions.

Pharmaceutical Company-Reported Research and Development Spending Grew Slightly, while Biologics and Orphan Drugs Were a Greater Share of New Drug Approvals

Pharmaceutical company-reported R&D spending grew slightly from 2008 through 2014, while federally funded spending decreased slightly over the period. Industry spending focused on drug development rather than earlier-stage research, whereas direct federal spending, such as through NIH grants, funded a greater amount of basic research. Claims for the orphan drug credit, one of several federal tax incentives encouraging drug development, increased sharply from 2005 through 2014. Biologics and orphan drugs accounted for an increasing share of new drug approvals from 2005 through 2016. Studies we reviewed and experts we interviewed suggested that potential revenues, costs, and policy incentives influenced brand-name drug company R&D investment decisions.

Pharmaceutical Company- Reported Research and Development Spending Increased Slightly, While Federally Funded Spending Decreased Slightly, from 2008 through 2014

Our analysis of industry survey data from NSF indicate that worldwide R&D spending by U.S.-owned pharmaceutical companies and U.S.-based R&D by foreign companies increased slightly (8 percent) in real dollars from $82 billion in 2008 to $89 billion in 2014, the years for which comparable data were available (see fig. 8). According to NSF survey data, the share of this spending that pharmaceutical companies paid others to perform also increased over the period. Estimates of worldwide R&D expenditures as a percentage share of total worldwide sales averaged 13 percent and ranged from 11.5 to 14.2 percent over the period 2008 to 2014. This amount, according to estimates from QuintilesIMS, is larger than the 7.6 percent of total pharmaceutical sales revenue that the industry spent on marketing and promotion in 2014; however, due to differences in the different sources’ methodology and data, publicly reported figures are not necessarily comparable.

The NSF Business Research, Development, and Innovation Survey data indicated worldwide R&D spending for respondent biotechnology companies was $9.2 billion in 2009, dropped to $2.7 billion in 2010, rose to $6.7 billion in 2011, then decreased to $1.7 billion in 2013, the years for which worldwide data were available. The percentage of biotechnology company-reported R&D to worldwide biotechnology sales ranged widely from 43 percent in 2011 to 7 percent in 2013.

Pharmaceutical companies reported spending a greater share of sales on R&D than comparably large, R&D-intensive industries and all aggregated manufacturing and non-manufacturing industries, according to comparable Business Research, Development, and Innovation Survey data (see table 2). For example, in 2014, self-reported R&D expenditures as a percentage of total sales were higher for pharmaceutical companies than for other comparably large, R&D-intensive sectors such as semiconductor and other electronic components, software publishers, and computer system design services.

Direct federal spending for biomedical research, primarily funded through NIH, decreased 3.8 percent in real dollars from $27 billion in fiscal year 2008 to $26 billion in fiscal year 2014, after a peak of $32 billion in 2010, according to our analysis of federal survey data from NSF. NIH was the primary federal source for biomedical research and accounted for $26 billion of spending in 2008 and $25 billion in 2014. According to federal officials we interviewed, other agencies that fund biomedical research that could be relevant to drug R&D were the Department of Defense and the NSF.

In addition, state and local governments, foundations, charities, and venture capital also funded biomedical R&D, according to studies and experts we interviewed. Estimates of this spending are much smaller than those for industry and federal agencies. In 2015, National Health Expenditure estimates show that state and local governments spent $6.7 billion on research and non-industry private funders spent $5.3 billion.

Pharmaceutical Company- Reported Spending Focused on Drug Development and Federal Spending Focused on Basic Research

Pharmaceutical company spending from 2008 through 2014 focused on drug development, while federal spending focused on earlier-stage basic research. For example, in 2014 pharmaceutical companies reported allocating 13 percent of total reported domestic R&D spending on basic research, 21 percent on applied research, and 66 percent on development (see fig. 9).

By comparison, federal spending consistently funded a greater amount of basic research, according to our analysis of data from NSF’s Survey of Federal Funds for Research and Development. Studies show that basic research often supplies the innovation upon which the industry develops drugs. For example, as shown in figure 10 below, NIH obligated 54 percent, or $13.6 billion of its total $25 billion of drug related spending, for basic research in fiscal year 2014. This is more than twice as much as the $6.3 billion that NSF data show pharmaceutical companies reported spending domestically for basic research that year. NIH also funded applied research that includes more targeted research and activities aimed at translating basic research into new treatments for patients. For example, NIH supports clinical research through the National Center for Advancing Translational Sciences and several other NIH Institutes and Centers. This includes supporting pre-clinical and early-stage clinical trials; promoting and initiating collaborations and partnerships among industry, academia, and other stakeholder communities, such as patient advocacy groups, to address research barriers; and facilitating data sharing, according to agency officials. In accordance with the definition of “development” provided by NSF for the Survey of Federal Funds for Research and Development, NIH classifies R&D activities as “research.” Therefore, NIH does not report any of its activities as strictly drug development, according to agency officials.

Studies and experts we interviewed suggested that the relative roles of R&D funders and performers are evolving. For example, some experts noted that there is less distinction between public and private investment in R&D than in the past because publicly funded research institutions, such as universities, are frequently involved in financial relationships with industry for commercial development. Some industry experts also noted NIH’s role in fostering these collaborations. As previously noted, there has been a proliferation of smaller, biotechnology-focused companies and greater use of acquisition and licensing agreements by larger, traditional pharmaceutical and biotechnology companies to build their earlier-stage product pipelines rather than conducting early research in-house. Experts suggested that this trend is a response to the increasing complexity and cost of R&D concurrent with the advent of biotechnology and waves of patent and exclusivity expirations for large companies.

In addition, traditional pharmaceutical companies also performed less R&D internally than in the past, according to NSF data. Worldwide R&D spending paid for and performed by pharmaceutical companies decreased in real dollars from $61.7 billion in 2008 to $58.2 billion in 2014 and as a share of total worldwide R&D spending. Conversely, the share of the worldwide pharmaceutical R&D spending that was paid for by the company and performed by others, such as through purchased R&D services, increased from 25 percent in 2008 to 35 percent in 2014.

Federal Tax Provisions Encourage Drug R&D, with Claims for the Orphan Drug Credit Increasing Sharply

Similar to the R&D spending trend identified above from the NSF data, various IRS tax data consistently indicate that drug R&D activities did not change significantly—with the exception of the orphan drug credit, which over time increased sharply. Inflation-adjusted claims by all industries for the orphan drug credit increased five-fold between 2005 and 2014, from about $280 million to about $1.5 billion (see fig 11).

Claims for the other tax credit that incentivizes drug development—the research credit—were more stable than the orphan drug credit between 2005 and 2014. As shown below in figure 12, IRS estimates of research credit claims for pharmaceutical-related corporations reached a high of $1.5 billion in 2007, but then fell to about $1.2 billion in 2014, a level close to the beginning of the period. This may be due in part to the fact that we were not able to obtain a specific estimate for the research credits claimed by biotechnology companies. By comparison, research credit claims grew for all industries over the period, particularly from 2012 to 2014.

According to IRS data, between 2005 and 2014 the pharmaceutical manufacturing industry spent, on average, about $22.5 billion per year (in real dollars) in qualified research spending that factored into the calculation of the research credit (see fig. 13). Spending peaked in 2007 at $25.5 billion and then generally declined from 2007 to 2014. This amount of spending—reported on tax returns as meeting the requirements of qualified research spending as noted above—is less than half of the research spending reported by NSF’s Business Research, Development, and Innovation Survey data. These research spending differences can reflect both differences in the definitions of research spending in each data source and in the specific industry definitions used in the different data sources.

The ability of companies to deduct research expenditures in the year they are incurred simplifies tax accounting for research spending and reduces the after-tax cost of research investments. The amount of research spending deducted by large pharmaceutical corporations that submitted an IRS form M-3 has been largely consistent between 2010 and 2013, the years for which data were available (see table 3). Specifically, research expenditure deductions in real dollars increased to $30.7 billion in 2013 after a low over the period of $24.9 billion in 2012. The table also shows that the amounts shown as research expense on the financial statements of the same corporations were slightly higher than the amount deducted on tax returns in each year.

Novel Drugs Consistently Accounted for About Thirteen Percent of New Drugs Approved in the United States from 2005 through 2016, and Biologics and Orphan Drugs Each Grew as a Share of Approvals

The number of approvals for drugs FDA considered novel drugs increased from 20 in 2005 to 45 in 2015 but declined to 22 approvals in 2016, according to FDA data and reports (see fig. 14). Novel drugs accounted for between 8 and 18 percent of all drug approvals each year and averaged 13 percent over the period. The remaining majority of drug approvals each year included those not considered novel because they had chemical substances that were previously approved by FDA or were modifications to existing drugs.

Biologics and orphan drugs each represented an increasing share of all drug approvals from 2005 through 2016. As shown in figure 15, biologics grew from 8 percent of all drug approvals in 2005 to 17 percent in 2016.

Biologics also represented an increasing share of the subset of all approvals that were considered novel drugs—from 10 percent of novel drugs approved in 2005 to 32 percent in 2016.

Orphan-designated drugs as a share of all drug approvals grew even more dramatically from 5 percent of all drug approvals in 2005 to 21 percent in 2016 (see fig.15). Orphan drugs as a share of novel drug approvals ranged from 22 percent in 2007 to 42 percent in 2015.

We also examined drug approval trends by product category. The product categories that led the largest number of drug approvals fluctuated over time, but oncology drugs were among the most frequently approved in all but 2 years from 2005 through 2016. Of the 263 drugs approved by FDA in 2016, the most common product categories were oncology (55 approvals) and metabolism and endocrinology (38 approvals). For the 22 novel drug approvals in 2016, the most common product categories were oncology (5 approvals) and neurology (4 approvals).

Studies and Experts Suggest Potential Revenues, Costs, and Policy Incentives Influenced Drug Industry Research and Development Investment Decisions

Studies and industry experts we interviewed, including economists and industry association officials, suggested several drivers for drug company R&D investment decisions. These investment choices were influenced by revenue, cost, and regulatory and other policy incentives:

Potential revenues: High revenue potential, typically associated with a large potential number of patients or the potential for high drug prices, is an important incentive for R&D investment, according to experts and some research. Studies show that potential market size, measured by revenue, is a determinant of R&D investment and market entry for both brand-name and generic drug companies. Companies also seek to maximize potential revenues by investing in the development of drugs that can command high prices, and drugs that address unmet medical needs or differentiate them from competitors. This includes investment in drugs for niche markets that may have limited competition, such as orphan drugs. Experts also noted that some companies invest to extend patent protection or exclusivity periods for existing drugs as a means to extend revenue generation by delaying or limiting the effect of generic competition— sometimes referred to as “evergreening” or “patent hopping.”

Cost reduction: Drug development costs, particularly for novel drugs, are increasing and companies have sought various ways to reduce their costs or limit risk. Experts we interviewed suggested that drug companies have attempted to reduce costs by focusing on drugs for which clinical trials are perceived to be less costly, drugs perceived as more likely to receive FDA approval, modifications to existing drugs rather than the development of novel drugs, outsourcing of clinical trials, and acquisition of R&D projects already underway.

Policy incentives: Often regulatory and other policy incentives influence potential revenues and risks and, in turn, R&D investment, according to experts. For example, exclusivity periods and patent protection, expedited review programs, and tax incentives were cited as influencing R&D investment. The supply of new science from federally funded research may also influence company investment decisions. Expectations about payer reimbursement could also influence potential pricing and investment decisions, according to some experts. For example, one expert noted that payers typically do not resist high prices for oncology drugs.

These drivers may also explain the observed brand-name drug approval trends for biologics, orphan drugs, and drugs for certain disease areas. For example:

Biologics: Some experts noted that recent technological advances have spurred opportunity and investment in new biologics. The longer period of FDA market exclusivity for biologics relative to traditional chemically synthesized drugs may also be attractive to drug developers. In addition, there are currently few biosimilar drugs available to compete for market share once BLA exclusivity expires. Though FDA had approved seven biosimilars for marketing between 2010—the year the approval pathway for biosimilar biological products was established—and September 2017, and was reviewing additional applications, some experts suggest that the added cost and difficulty in developing biosimilars may hinder entry of biologics’ competitors relative to the entry seen for traditional generics.

Orphan drugs: In addition to the exclusivity and orphan drug credit incentives to develop orphan drugs, an industry expert we interviewed also suggested that it is easier to get FDA approval for orphan drugs, and another suggested that it is less costly to develop them. In addition, orphan drugs can often garner high prices compared to non- orphan drugs, according to an industry report.

Disease areas: Certain drug classes or disease areas, such as drugs for oncology or multiple sclerosis drugs, can garner higher prices and, in turn, more R&D investment because they often have fewer competitors, are often administered by providers who are insensitive to price, or are perceived as particularly life-saving, according to some experts we interviewed. In addition, some experts suggested that NIH investment in oncology research and gains in personalized medicine have resulted in many more research opportunities in which companies can invest. For example, many new oncology drugs are approved for treatment of tumors with specific genetic markers, and research suggests these drugs are more likely to succeed in clinical trials and face a less-elastic demand curve that, in turn, can facilitate higher pricing.

According to several experts we interviewed, a company’s R&D focus on fewer therapeutic areas of more profitable drugs or niche markets may come at the expense of drug development in less lucrative disease areas—those that affect many patients but in which drugs are more costly to bring to market or have existing generic competition—for example, cardiovascular disease. According to a study of drug development pipeline data, the number of new drugs in all phases of clinical development to treat cardiovascular disease, a leading cause of death in the United States, declined from 1990 to 2012, whereas the number of new cancer drugs increased over the period.

Research Suggests Market Concentration Affects Drug Prices, and Mergers May Affect Drug Company Innovation

Research we examined in our literature review suggests that the level of competition in a relevant market influences drug prices. Competition also matters for innovation. Certain empirical economic studies suggest that mergers among brand-name drug companies can negatively impact companies’ innovation post-merger.

Research Finds High Market Concentration Is Associated with Higher Drug Prices

The relationship between competition and drug price is well documented in the drug industry, and industry experts and available research point out that competition dynamics differ for brand-name and generic drugs. Brand name companies producing drugs under patent or exclusivity protection have monopoly pricing power unless alternative drugs that treat the same condition are available. For brand-name products that face competition from such therapeutic alternatives, companies compete on price, differentiation from competitors, or both. We and others have reported that brand-name drug companies consider the availability and price of therapeutic alternatives along with potential market size, the perceived value of the drug relative to competitors, and other factors when determining the price for a new drug. Conversely, generic drugs compete on price with the brand-name or other generic manufacturers of the same drug. As we have reported, and as experts we have interviewed agreed, generic drug companies compete primarily on price.

Based on our literature review, we did not identify any empirical studies that examined the impact of drug industry concentration changes from mergers and acquisitions on drug prices post-merger. However, empirical studies we reviewed suggest that less competition—that is, a more highly concentrated market—is associated with higher drug prices, particularly for generic drugs. The following summarizes studies we reviewed on the effect of generic and brand-name competition:

Generic competition: Most notably, once brand-name drugs lose patent and marketing exclusivity and generic versions of drugs enter the market, drug prices fall and continue to decline as additional generic manufacturers enter. The price moderating effect of generic competition is well documented by FDA, FTC, the IMS Institute for Healthcare Information, and other research. FDA found that for drugs sold from 1999 through 2004, the first generic competitor reduced the drug price only slightly lower than the brand-name on average, but the second generic competitor reduced the drug price by nearly half. For drugs that attracted nine or more generic manufacturers, the average generic price fell 80 percent or more. The IMS Institute for Healthcare Information reported similar findings in 2016 based on its review of generics that entered the market between 2002 and 2014. The introduction of generics reduced the price of those drugs by 51 percent in the first year and 57 percent in the second year with price reductions driven, in part, by the increasing number of competitors. In addition, a 2017 study of 1,120 drugs available as generics between 2008 and 2013 determined that drugs with less market competition, measured by higher concentration, had higher price increases over the period compared to drugs in the cohort with the lowest concentration.

Brand-name competition: For brand-name drugs, studies show that the presence of therapeutic alternatives in the market reduces the launch price—the price the company sets for a new drug. For example, an often-cited 1998 study of launch prices for 130 new molecular entities showed that a greater number of brand-name therapeutic alternatives was associated with substantially lower launch prices for new brand-name drugs compared to their predecessors. More recently, there are examples of therapeutic alternatives creating market pressure on, and thus reducing prices of, brand-name drugs, such as multiple brand-name hepatitis C therapies that became available between 2013 and 2014.

Research has also found that some brand-name drug companies are able to maintain or even raise prices for their drugs—despite competition from therapeutic or generic alternatives—for various reasons, such as product differentiation or brand loyalty stemming from marketing or prescribing patterns. For example, brand-name companies may actually increase prices for some of their drugs to capture the price-insensitive segment of the market. Research also suggests that the extent of price reductions resulting from the entry of generic drugs into a market can differ by the characteristics of the drug and may be less dramatic for biosimilar drugs than traditional generic drugs. For example, the 2016 IMS report noted that price reductions under these circumstances occurred faster for oral drugs than for injectable drugs, which often attract fewer generic competitors. Another 2017 study examining the state of generic competition found that injectables and drugs with other formulations, such as topical or inhaled drugs, were more likely than oral drugs to have only one or two manufacturers. Certain literature we reviewed and experts we interviewed suggested that biosimilars will moderate prices for biologic drugs, but not to the same extent as traditional generics do because they are more costly to manufacture and may be less consistently substituted for the brand-name drug; however, more time and research will be needed to understand the effects given the small number of biosimilars on the market.

Studies Find Competition Matters for Innovation, and Some Suggest a Negative Impact of Mergers on Drug Company Innovation

Competition is also relevant to innovation, according to economic studies we examined. As noted, brand-name drug companies compete to develop new products and differentiate their products from therapeutic alternatives. The analysis of how competition affects innovation is a fact- specific process. There is empirical evidence suggesting that, in certain circumstances the incentive to invest in R&D could be enhanced with more competitors. For example, a 2014 study examining multiple manufacturing and non-manufacturing industries demonstrated a positive relationship between competition and innovation (measured by patents), productivity, and R&D expenditures. While drug innovation comes from multiple sources and increasingly from smaller innovative biotechnology companies, the industry relies on large drug companies to invest in the expensive clinical trials needed to develop and bring new innovations to market.

We also identified several merger retrospective studies. These studies suggest that there are varied impacts of drug company merger and acquisition on innovation, including both inputs (e.g., R&D spending) and outputs (e.g., patents and new drug approvals).

A 2009 study of 27 large, brand-name drug company mergers found that the mergers had a statistically significant negative impact on company R&D spending and patent issuance in the third year post- merger compared to non-merging companies. The authors concluded that the findings contradict the idea that mergers deliver advances in innovation that could outweigh possible anticompetitive risks.

A 2007 study of 165 large mergers between 1988 and 2000 suggested that large companies sought to merge in response to patent expiration or product pipeline gaps, and small companies sought to merge as a response to financial trouble. When controlling for companies’ propensity to merge, small merging companies— defined as companies valued less than $1 billion—grew more slowly in R&D spending, sales, and R&D employees post-merger compared to similar non-merging companies. However, the study did not find these effects to last beyond one year and did not find differences in these growth rates between large merging companies and non- merging companies. Overall, the authors concluded that while merger in the drug industry is a response to being in trouble for both large and small companies, there is no evidence that it is a solution.

Another 2009 study examined the number of approvals for new molecular entities—innovative drugs—as a means to examine outputs rather than only R&D spending. The study suggests that while mergers and acquisitions may help small companies, they are not an effective way for larger companies to increase output of new molecular entities. For example, for a sample of 30 mergers and acquisitions with 10 years of data before and after the merger, the study found that for large companies the number of new molecular entities did not increase and may actually have declined slightly following merger or acquisition. Smaller companies, however, experienced an increase in new molecular entities after merger or acquisition.

Other studies suggest mergers and acquisitions may have a positive impact on innovation using certain measures. For example, a 2006 study of 160 acquisitions involving drug companies between 1994 and 2001 estimated that companies with declining R&D pipeline and sales were more likely to engage in acquisition and that outsourcing R&D through acquisitions was a successful strategy to stabilize declines in drug R&D pipelines. This study estimated that 71 percent of acquiring companies either maintained or improved the health of their research pipelines after merger.

Agency Comments

We provided a draft of this report to the Department of Health and Human Services, FTC, IRS, and NSF for review. These agencies provided technical comments, which we incorporated as appropriate.

As agreed with your office, unless you publicly announce the contents of this report earlier, we plan no further distribution until 30 days from the report date. At that time, we will send copies to the appropriate congressional committees, relevant agencies, and other interested parties.

In addition, the report will be available at no charge on the GAO website at http://www.gao.gov.

If you or your staff have any questions about this report, please contact John E. Dicken at (202) 512-7114 or DickenJ@gao.gov or Oliver Richard at (202) 512-8424 or RichardO@gao.gov. Contact points for our Office of Congressional Relations and Office of Public Affairs can be found on the last page of this report. Other major contributors to this report are listed in appendix III.

Appendix I: Scope and Methodology

This appendix provides further details on our scope and methodology in addressing each of our three reporting objectives, which are to describe: (1) how the financial performance and structure of the drug industry have changed over time; and (2) how reported research and development spending and new drug approvals have changed; and (3) what is known about the potential effects of consolidation on drug prices and new drug development. In addition, the appendix describes how we selected officials to interview and the steps we took to assure the reliability of the data we analyzed.

How the Financial Performance and Structure of the Drug Industry Have Changed Over Time

Analysis of Sales Revenue and Profit Margins

To describe reported pharmaceutical and biotechnology sales revenue and profit margins, we used the Bloomberg Terminal to identify pharmaceutical and biotechnology companies that were still active as of the time of our review. Bloomberg uses a proprietary hierarchical classification system (the Bloomberg Industry Classification System) to categorize companies into different primary industries. We used the Bloomberg Terminal’s company classification browser to obtain an initial set of companies that currently have reported pharmaceutical or biotechnology revenue. We restricted the drug companies in our review to those that were categorized under the “Pharmaceutical & Biotechnology” Bloomberg Industry Classification System (BICS) level 2 category, which indicated that Bloomberg characterizes the company as being primarily a pharmaceutical or biotechnology company. Using this list, we downloaded each company’s reported pharmaceutical and biotechnology sales revenue, total sales revenue, profit margin, return on assets, and return on equity for each company’s fiscal years 2006 through 2015, which were the most current data available. To provide a comparison, we followed the same procedure to obtain data for software companies over the same period. We selected software companies as a comparison because they have high research and development (R&D) and low manufacturing costs similar to drug companies. Sales revenues were adjusted to reflect real 2015 U.S. dollars using the gross domestic product price index.

When examining sales revenues, profit margins, return on assets, and return on equity, analyses were limited to the subset of companies with complete data over the 10-year period for the variables included in the analysis. We did not have a count of how many companies might have existed throughout the review period, but which had no data available on any of the variables we examined. Profit margin, return on assets, and return on equity were each weighted by the company’s industry-specific sales revenue (pharmaceutical and biotechnology or software) prior to averages being computed. To identify the “largest 25” companies for analyses, we first restricted data to companies that had data for the variables being examined for 2006 through 2015, then identified the 25 drug companies with the largest pharmaceutical and biotechnology revenue in 2015. This provided a consistent cohort of large companies to examine longitudinally for each analysis.

We also examined profit margins for the largest 500 companies by total worldwide 2015 sales revenue. We obtained a list of the largest 500 companies in 2015 from the Bloomberg Terminal that were still active during our review. Using this list, we downloaded each company’s BICS level 2 category; total sales revenue; pharmaceutical, biotechnology, and software revenues; and profit margins for each company for fiscal years 2006 through 2015. We removed any companies primarily classified by Bloomberg under one of those industries since we had analyzed these separately. For the remaining companies in our largest 500, we subtracted any reported pharmaceutical, biotechnology, and software revenues from their total sales revenues since some companies may have reported such revenues despite not being classified primarily as one of these types of companies. We then weighted each of the remaining companies’ profit margins by their remaining total sales revenue prior to calculating an average. This weighting differed slightly from the industry- specific sales weighting used in the earlier analyses of drug and software companies’ profit margins. For the software industry, the Congressional Budget Office only indicated that it had high R&D and low manufacturing costs similar to drug industry; it did not suggest the same for other lines of business that software companies might additionally be involved in. Because we had no reason to isolate industry-specific revenues for our remaining largest 500 companies, we weighted their profit margins by their total sales revenues. As with the prior profit margin analyses, analysis of the largest 500 sales weighted profit margins were limited to companies with data available for each of company fiscal years 2006 through 2015.

Analysis of Mergers and Acquisitions

For analyses of mergers and acquisitions, we again relied on data from the Bloomberg Terminal. We restricted our search to mergers and acquisitions that were completed from January 1, 2006, to December 31, 2015, and which featured a drug company on both sides of the transaction (e.g., as the acquirer and as the acquired company in the case of acquisition of a full company). The “largest 25” companies were determined by their 2015 pharmaceutical and biotechnology sales revenue only—because not every company could be expected to have a merger or acquisition transaction in every year, we did not make this a requirement to be included in the merger and acquisition analyses. We used what Bloomberg reported to be the completed transaction values in our analyses, and we adjusted the values to consistently reflect real 2015 dollars.

Many companies were not included in analyses due to incomplete data, therefore the results of our analyses of these data do not reflect the entire industry. Bloomberg obtains much of its information from public filings, which provide companies considerable leeway in deciding what to report and how. For mergers and acquisitions, approximately 40 to 50 percent of the completed transactions in Bloomberg’s data between 2006 and 2015 did not have disclosed transaction values. Bloomberg officials told us that transaction values are often missing for private companies.

Analysis of Concentration

To examine overall industry concentration we used pharmaceutical industry and company-specific sales data from QuintilesIMS from 2007 through 2014, the years for which data were publicly available. We also examined publicly available industry reports and generic drug approvals data for discussion of concentration across different therapeutic areas. Our findings on industry concentration and the variation of concentration across therapeutic classes is limited to these examples.

How Reported Research and Development Spending and New Drug Approvals Have Changed

Analysis of Research and Development Spending

To examine how reported R&D spending changed over time, we analyzed data from the Business Research, Development and Innovation Survey maintained by the National Science Foundation’s (NSF) National Center for Science and Engineering Statistics for years 2008 through 2014, the most recent years for which data were consistently available. The Business Research, Development and Innovation Survey data are collected annually from a probability sample of for-profit companies with a U.S. presence, which are classified in select manufacturing and nonmanufacturing industries based on their North American Industry Classification System (NAICS) code. We analyzed aggregate company- reported worldwide R&D expenditures and worldwide sales for respondent companies designated with NAICS code 3254 for pharmaceuticals and medicines. We also examined pharmaceutical company-reported domestic R&D expenditures by character of work— basic research, applied research, or development—as defined by NSF as well worldwide and domestic R&D expenditure by performer (whether R&D was paid for and performed by the company, or paid for by the company to be performed by others). We also examined worldwide expenditures and sales for companies designated as biotechnology research and development companies (NAICS 541711); however estimates were not available for 2008 or 2014 and were less reliable in the years between. We therefore reported biotechnology expenditures and sales separately from pharmaceutical companies and limited the majority of our analysis to pharmaceutical companies. For comparison, we also examined worldwide R&D expenditure and sales for comparably large industries with high R&D intensity as well as all manufacturing and all non-manufacturing industries. All spending and sales data were adjusted to real 2015 U.S. dollars using the gross domestic product price index. We also examined the Business Research, Development and Innovation Survey sample selection and sampling error information for each year of the survey. Finally, we compared worldwide and domestic R&D expenditure and sales trends to spending and sales reported by Pharmaceutical Research and Manufacturers of America (PhRMA)—a national trade association.

To examine federal spending trends, we analyzed publicly available data from NSF’s National Center for Science and Engineering Statistics’ Survey of Federal Funds for Research and Development on obligations for research in biomedical related fields made by federal agencies identified as funding drug-related research between fiscal years 2008 and 2014, years consistent with available industry data from NSF’s Business Research, Development, and Innovation Survey. Data represent federal agency obligations for basic and applied research in the fields of biological sciences, medical sciences, and other life sciences as reported by federal agencies. Obligations were adjusted to real fiscal year 2015 U.S. dollars using the gross domestic product price index. We identified agencies that fund drug-related research based on interviews with officials from the National Institutes of Health (NIH), NSF, and other industry experts. The Survey of Federal Funds for Research and Development is a census of federal agencies that conduct R&D, and provides data on obligations by agency and field of science rather than by specific industry or use. Our estimates of federal spending may be imprecise because the data preclude us from pinpointing spending specific to drug R&D projects, and because the type of research that federal agencies typically fund often has an impact on many different research areas that may not be specific to drugs. We also reviewed budget documents from NIH and reviewed select studies for spending estimates by non-federal or industry sources.

In addition, we obtained estimates of R&D spending by state and local governments and non-industry private funders for 2015 from National Health Expenditure account estimates. These estimates include spending for all biomedical research by these categories and thus also likely overestimate spending specific to drug development.

Analysis of Tax Incentives

To identify tax provisions that provide incentives for drug research and development, we reviewed reports by the Joint Committee on Taxation and the Congressional Research Service. We obtained and analyzed aggregate tax return data from the Internal Revenue Service (IRS) Statistics of Income division for the orphan drug credit and research credit claimed by relevant industries and all returns (all industries) for years 2005 to 2014, the latest ten years for which data were available. Specifically, we analyzed claims from companies with IRS Principle Business Activity codes for pharmaceutical manufacturing, drug wholesalers, and scientific research. IRS’s industry codes are based on NAICS definitions, and corporations are instructed to report the industry code for which it derives the highest percentage of its total receipts. These data are reviewed by Statistics of Income division staff for accuracy. The scientific research industry category includes corporations conducting biotechnology research and development, but also includes firms conducting research in nanotechnology and physical, engineering, and life sciences. As a result, we chose not to report research credits claimed by corporations in the broader scientific research industry category as being related to drug development, but we do report orphan drug credits claimed by corporations in this industry category. We also obtained and examined reported qualified research expenses for pharmaceutical manufacturing companies for years 2005 to 2014. IRS’ Statistics of Income division produces estimates based on a representative stratified sample of corporate returns. IRS provided additional information on the corporations that reported claiming the orphan drug and research credits; in both cases a high percentage of the claims came from large corporations that are included in the stratified sample with certainty. As a result, we concluded that the estimated credit totals are reliable given that the estimates are largely based on returns that were certain to be included in the sample. The amount of research and orphan drug credits claimed represents claims rather than amounts utilized due to limitations of the general business credit. Reported estimates therefore may reflect the upper bounds of what was utilized from claimed amounts. IRS also provided additional data on total deductions claimed for qualified research expenditures and amounts reported on financial statements from Form M-3, for 2010 to 2013. These data were limited to large corporations that filed form M-3, which is required for corporations with $10 million or more of assets. All claims were adjusted to 2015 U.S. dollars using the gross domestic product price index.

Analysis of Drug Approvals

To examine trends in new drug approvals, we obtained and analyzed data from the Food and Drug Administration (FDA) for new drug applications (NDA) and biologic license applications (BLA) and NDA- and BLA-efficacy supplements approved by the FDA’s Center for Drug Evaluation and Research between 2005 and 2016, the most recent ten years of available data at the time of our review. We determined which drugs FDA considered novel drugs by reviewing publicly available reports and resolving any discrepancies with agency officials. We analyzed these data to determine the type of drugs FDA approved, such as the product category and whether the drug was designated an orphan drug.

Finally, we interviewed agency and industry experts and reviewed relevant academic, government, and industry literature on R&D investment trends and reasons for such trends.

What Is Known about the Potential Effects of Consolidation on Drug Prices and New Drug Development

Literature Search on Consolidation Impacts

To determine what is known about the impact of drug industry consolidation on drug price and drug development, we reviewed studies obtained from a literature search. To identify relevant publications, we used a number of bibliographic databases, including ProQuest, Scopus, PubMed, National Technical Information Service, Lexis, Social Science Research Network, and the National Bureau of Economic Research. We reviewed the following document types: scholarly peer reviewed material, government reports, working papers, and policy research organization publications published by a U.S. publication from 2005 forward. We concluded our searches in August 2017. To the resulting list of publications, we added articles identified in our own background research and articles suggested by industry experts, including certain heavily cited papers published prior to 2005. From the revised list, we selected publications that empirically evaluated the effect of drug industry consolidation (mergers and acquisitions) on drug price or innovation (new drug development or R&D spending). We also selected publications that included empirical analyses of drug industry or subindustry concentration or competition and drug price or drug development. Finally, we reviewed the data sources and methodology used to support the assertions of each publication and included those that met our methodological criteria. See the bibliography at the end of this report for the 22 publications included in our review.

Interviews

To inform our understanding of the drug industry for all three objectives including structural changes that have taken place, reasons for consolidation trends, drivers of drug company R&D investment trends, and any impacts of consolidation on drug price or innovation, we interviewed drug industry experts including three drug trade associations, four advocacy organizations, two financial ratings agencies, and officials from the FDA, IRS, NSF, Federal Trade Commission (FTC), and NIH. We selected these experts to obtain a variety of industry perspectives. We also interviewed seven academic economic experts about economic factors influencing consolidation and other structural changes, R&D investments, and potential consolidation impacts. We selected these economic experts based on citations in our literature review and suggestions from FDA and FTC officials.

Data Reliability

To ensure that the data used to produce this report were sufficiently reliable, we took several steps. We performed data reliability checks on the data we obtained from the Bloomberg Terminal, such as comparing select companies’ financial data to company annual reports, checking for outliers, and discussing reliability issues with Bloomberg representatives. We did not independently verify the accuracy or completeness of the information reported by the companies. We verified the reliability of NSF’s Business Research, Development and Innovation Survey data used in this report by reviewing relevant documentation, including relative standard errors for specific measures, and by interviewing agency officials who were knowledgeable with the data. We also interviewed knowledgeable NSF officials regarding the reliability of reported Federal Funds for Research and Development survey data and compared reported obligations to NIH budget documents. To verify the reliability of aggregate tax return information, we reviewed relative standard errors for reported measures and interviewed knowledgeable agency officials. We verified the reliability of FDA-provided information by cross-referencing it against other published FDA sources and by interviewing knowledgeable agency officials. After taking these steps, we determined the data were sufficiently reliable for the purposes of our reporting objectives.

We conducted this performance audit from April 2016 to November 2017 in accordance with generally accepted government auditing standards. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objectives. We believe that the evidence obtained provides a reasonable basis for our findings based on our audit objectives.

Appendix II: Mergers and Acquisitions of Ten Large Drug Companies from 2006 through 2015

The following table reflects mergers and acquisition transactions from 2006 through 2015 for 10 large drug companies, as measured by their 2014 pharmaceutical and biotechnology revenue. Transactions reflect those reported in Bloomberg that were completed from January 1, 2006, through December 31, 2015, and had values of at least $500 million in real 2015 dollars.

Appendix III: GAO Contact and Staff Acknowledgments

GAO Contacts

Staff Acknowledgments

In addition to the contact named above, Robert Copeland, Assistant Director; Yesook Merrill, Assistant Director; Rebecca Abela, Analyst-in- Charge; Reed Meyer; Brandon Nakawaki; Edward Nannenhorn; Laurie Pachter; and Matthew Rabe made key contributions to this report. Also contributing were George Bogart, Muriel Brown, Sandra George, Sarah Gilliland, and Giselle Hicks.

Bibliography of Research Articles Used in GAO Literature Review

We reviewed literature to identify what is known about the impact of drug industry consolidation on drug price and drug development. We included publications that empirically evaluated the effect of drug industry consolidation (mergers and acquisitions) on drug price, of which we did not identify any publications. We also reviewed publications that included empirical analyses of the impact of concentration or competition on drug price.

Berndt, Ernst R., and Murray L. Aitken, Brand Loyalty, Generic Entry and Price Competition in Pharmaceuticals in the Quarter Century after the 1984 Waxman-Hatch Legislation, National Bureau of Economic Research Working Paper 16431 (October 2010).

Berndt, Ernst R., and Rena M. Conti, Specialty Drug Prices and Utilization After Loss of U.S. Patent Exclusivity, 2001-2007, National Bureau of Economic Research Working Paper 20016 (March 2014).

Berndt, Ernst R., Rena M. Conti, and Stephen J. Murphy, The Landscape of US Generic Prescription Drug Markets, 2004-2016, National Bureau of Economic Research Working Paper 23640 (July 2017).

Dave, Chintan V., Aaron S. Kesselheim, Erin R. Fox, Peihua Qiu, and Abraham Hartzema. “High Generic Drug Prices and Market Competition: A Retrospective Cohort Study.” Annals of Internal Medicine, vol. 167, no. 3 (2017): 145-151.

Department of Health and Human Services. U.S. Food and Drug Administration. “Generic Competition and Drug Prices.” 2015. Accessed July 31, 2017. https://www.fda.gov/AboutFDA/CentersOffices/OfficeofMedicalProductsa ndTobacco/CDER/ucm129385.htm Grabowski, Henry G., David B. Ridley, and Kevin A. Schulman. “Entry and Competition in Generic Biologics.” Managerial and Decision Economics, vol. 28, no. 4/5 (2007): 439-451.

Iacocca, Kathleen, James Sawhill, and Yao Zhao. “Why Brand Drugs Priced Higher Than Generic Equivalents.” International Journal of Pharmaceutical and Healthcare Marketing, vol. 9, no. 1 (2015): 3-19.

IMS Institute for Healthcare Informatics. Price Declines After Branded Medicines Lose Exclusivity in the U.S. (Parsippany, N.J.: IMS Institute for Healthcare Informatics, 2016).

Lu, Z. John, and William S. Comanor. “Strategic Pricing of New Pharmaceuticals.” The Review of Economics and Statistics, vol. 80, no. 1 (1998): 108-118.

Olson, Luke M., and Brett W. Wendling, Working Paper No. 317: The Effect of Generic Drug Competition on Generic Drug Prices During the Hatch-Waxman 180-Day Exclusivity Period, Bureau of Economics, Federal Trade Commission (Washington, D.C.: April 2013).

Regan, Tracy L. “Generic Entry, Price Competition, and Market Segmentation in the Prescription Drug Market.” International Journal of Industrial Organization, vol. 26, no. 4 (2008): 930-948.

Richard, Oliver, and Larry Van Horn. “Persistence in Prescriptions of Branded Drugs.” International Journal of Industrial Organization, vol. 22, no. 4 (2004): 523-540.

Tenn, Steven, and Brett W. Wendling. “Entry Threats and Pricing in the Generic Drug Industry.” The Review of Economics and Statistics, vol. 96, no. 2 (2014): 214-228.

We also reviewed publications that empirically evaluated the effect of drug industry consolidation on innovation—including new drug development or R&D spending—as well as publications on the impact of concentration or competition on innovation.

Banerjee, Tannista, and Arnab Nayak. “Comparing Domestic and Cross- Border Mergers and Acquisitions in the Pharmaceutical Industry.” Atlantic Economic Journal, vol. 43, no. 4 (2015): 489-499.

Comanor, William S., and F.M. Scherer. “Mergers and Innovation in the Pharmaceutical Industry.” Journal of Health Economics, vol. 32 (2013): 106– 113.

Danzon, Patricia M., Andrew Epstein, and Sean Nicholson. “Mergers and Acquisitions in the Pharmaceutical and Biotech Industries.” Managerial and Decision Economics, vol. 28, no. 4/5 (2007): 307-328.

Higgins, Matthew J., and Daniel Rodriguez. “The Outsourcing of R&D Through Acquisitions in the Pharmaceutical Industry.” Journal of Financial Economics, vol. 80 (2006): 351-383.

Getz, Kenneth A., Rachael Zuckerman, Joseph A. DiMasi, and Kenneth I. Kaitin. “Drug Development Portfolio and Spending Practices After Mergers and Acquisitions.” Drug Information Journal, vol. 43, no. 4 (2009): 493-500.

Grabowski, Henry, and Margaret Kyle. “Mergers and Alliances in Pharmaceuticals: Effects on Innovation and R&D Productivity,” in The Economics of Corporate Governance and Mergers. Northampton, M.A.: Edward Elgar Publishing, Inc., 2008.

Munos, Bernard. “Lessons from 60 Years of Pharmaceutical Innovation.” Nature Reviews Drug Discovery, vol. 8 (2009): 959-968.

Ornaghi, Carmine. “Mergers and Innovation in Big Pharma.” International Journal of Industrial Organization, vol. 27, no. 1 (2009): 70-79.

Thakor, Richard T., and Andrew W. Lo. Competition and R&D Financing Decisions: Theory and Evidence from the Biopharmaceutical Industry, National Bureau of Economic Research Working Paper 20903 (September 2015).

Related GAO Products

Investigational New Drugs: FDA Has Taken Steps to Improve the Expanded Access Program but Should Further Clarify How Adverse Events Data Are Used. GAO-17-564. Washington, D.C.: July 11, 2017.

Generic Drug User Fees: Application Review Times Declined, but FDA Should Develop a Plan for Administering Its Unobligated User Fees. GAO-17-452. Washington, D.C.: May 25, 2017.

Physician-Administered Drugs: Comparison of Payer Payment Methodologies. GAO-16-780R. Washington, D.C.: August 1, 2016.

Generic Drugs Under Medicare: Part D Generic Drug Prices Declined Overall, but Some Had Extraordinary Price Increases. GAO-16-706. Washington, D.C.: August 12, 2016.

Medicare Part B: Data on Coupon Discounts Needed to Evaluate Methodology for Setting Drug Payment Rates. GAO-16-643. Washington, D.C.: July 27, 2016.

Drug Shortages: Certain Factors Are Strongly Associated with This Persistent Public Health Challenge. GAO-16-595. Washington, D.C.: July 7, 2016.

Medicare Part B: CMS Should Take Additional Steps to Verify Accuracy of Data Used to Set Payment Rates for Drugs. GAO-16-594. Washington, D.C.: July 1, 2016.

Corporate Income Tax: Most Large Profitable U.S. Corporations Paid Tax but Effective Tax Rates Differed Significantly from the Statutory Rate. GAO-16-363. Washington, D.C.: March 17, 2016.

Drug Safety: FDA Expedites Many Applications, But Data for Postapproval Oversight Need Improvement. GAO-16-192. Washington, D.C.: December 15, 2015.

Medicare Part B: Expenditures for New Drugs Concentrated among a Few Drugs, and Most Were Costly for Beneficiaries. GAO-16-12. Washington, D.C.: October 23, 2015.

Prescription Drugs: Comparison of DOD, Medicaid, and Medicare Part D Retail Reimbursement Prices. GAO-14-578. Washington, D.C.: June 30, 2014.

Drug Shortages: Public Health Threat Continues, Despite Efforts to Help Ensure Product Availability. GAO-14-194. Washington, D.C.: February 10, 2014.

Corporate Tax Expenditures: Evaluations of Tax Deferrals and Graduated Tax Rates. GAO-13-789. Washington, D.C.: September 16, 2013.

Prescription Drugs: Comparison of DOD and VA Direct Purchase Prices. GAO-13-358. Washington, D.C.: April 19, 2013.

Medicare Part D Coverage Gap: Discount Program Effects and Brand- Name Drug Price Trends. GAO-12-914. Washington, D.C.: September 28, 2012.

International Taxation: Information on Foreign-Owned but Essentially U.S.-Based Corporate Groups Is Limited. GAO-12-794. Washington, D.C.: July 16, 2012.

Prescription Drugs: FDA Has Met Performance Goals for Reviewing Applications. GAO-12-500. Washington, D.C.: March 30, 2012.

Drug Pricing: Research on Savings from Generic Drug Use. GAO-12-371R. Washington, D.C.: January 31, 2012.

Prescription Drugs: Trends in Usual and Customary Prices for Commonly Used Drugs. GAO-11-306R. Washington, D.C.: February 10, 2011.

Brand-Name Prescription Drug Pricing: Lack of Therapeutically Equivalent Drugs and Limited Competition May Contribute to Extraordinary Price Increases. GAO-10-201. Washington, D.C.: December 22, 2009.

Tax Policy: The Research Tax Credit’s Design and Administration Can Be Improved. GAO-10-136. Washington, D.C.: November 6, 2009.

Prescription Drugs: Improvements Needed in FDA’s Oversight of Direct- to-Consumer Advertising. GAO-07-54. Washington, D.C.: November 16, 2006.

New Drug Development: Science, Business, Regulatory, and Intellectual Property Issues Cited as Hampering Drug Development Efforts. GAO-07-49. Washington, D.C.: November 17, 2006.