At times, it appears that a major segment of the drug industry cannot avoid being the center of controversy. Firms that develop, produce, and sell brand-name or patented drugs have been praised for their successes in developing safer or more effective versions of existing medicines and new medicines that advance the treatment of a variety of diseases. Yet these same firms have been rebuked for selling the same drugs at higher prices in the United States than in many other developed countries; their attempts to minimize competition from cheaper generic drugs; their relatively high profitability; and spending as much or more on advertising and product promotion than research and development (R&D). Framing these contrasting sentiments is a continuing debate among lawmakers over the best way to improve access to medicines for Americans of all ages and income levels, without establishing costly new federal entitlement programs or undermining key incentives for new drug development. An important issue in this debate is the likely impact of initiatives of this sort on the commercial development of new medicines. Some initiatives would entail significant changes in one or more of the federal policies affecting new drug development. The federal government plays a varied and far-reaching role in that process. This role encompasses a variety of laws and programs, including direct federal funding of drug-related research and development (R&D), federal regulation of the safety and efficacy of new medicines and the use and promotion of approved medicines, federal patent protection for prescription drugs, federal support of biomedical research and education in universities, federal financing of drug purchases through Medicaid and Medicare, and federal tax subsidies for research and the purchase of health insurance and medicines. This report examines one of the federal policies influencing the domestic climate for new drug development: federal taxation of firms that develop, produce, and sell drugs as a main line of business. As will be seen, the federal tax code affects the incentive to invest in new drug development in several ways. The net result of these interactions forms the core of the report. More specifically, the report analyses the drug industry's federal tax burden from 1995 to 2006, the most recent year for which federal corporate tax return data are available. This burden refers to the federal income taxes paid by drugmakers as a percentage of their taxable income; tax returns with and without net income are used to compute the industry's federal tax burden. Depending on its size, this burden has the potential to constrain the incentives for business investment in new drug development. The report begins with an examination of the distinguishing traits of the drug industry, then identifies the tax provisions that have the biggest impact on the industry's return on investment, and concludes with an assessment of the effects of federal taxation of the industry on the incentives to invest in new drug development. As discussed in this report, the drug industry encompasses a varied collection of corporations, all of whom derive the largest share of their income from one or more of the following commercial activities: (1) manufacturing biological and medicinal products; (2) processing botanical drugs and herbs; (3) isolating active medicinal ingredients from botanical drugs and herbs; and (4) producing pharmaceutical products intended for internal and external use in such forms as tablets, capsules, powders, ointments, and solutions. This group of firms includes both large, traditional pharmaceutical firms that tend to concentrate on developing small-molecule drugs from chemicals, makers of generic versions of such drugs, and small, fledgling biotechnology firms that focus on developing biologics, which are large-molecule drugs derived from living cells. In the period examined here, the vast majority of drug firms had no net income, and thus no tax liability. But drug firms with net income accounted for most of the industry's assets and gross income. It is unclear from available business tax data if the drug firms with losses were primarily producers of pharmaceuticals or biologics. Excluded from the group of drug firms discussed here are firms organized as non-corporate entities, such as partnerships and limited liability companies. It is not known how much these firms contribute to total income, assets, employment, or tax liability for the drug industry. But their shares are unlikely to be substantial, since the drug firms (e.g., GlaxoSmithKline, Merck, Pfizer, Lilly, Amgen) that account for most industry profits and taxes are all organized as corporations. The information presented here may be of use to the 111 th Congress as it weighs the advantages and disadvantages of proposals to modify how health care is financed and delivered in the United States. Many industries have distinctive traits, which can be thought of as defining features tied to the goods and services they sell, the technologies used to produce them, and the main forces driving competitive success and long-term growth in employment and output. The drug industry is one of these industries. What arguably distinguishes firms that develop, produce, promote, and sell patented or branded drugs is their propensity to invest heavily in R&D and advertising, a focus on certain therapeutic categories to the exclusion of others, a strong reliance on patents to generate profits and bolster competitiveness, and an extensive network of foreign subsidiaries. As this report shows, several of these traits have important implications for the industry's federal tax burden. The drug industry is one of the most research-intensive of all U.S. industries. This means that it spends a large amount on R&D relative to its receipts. At the same time, drug firms receive little direct R&D funding from federal government agencies. According to estimates by the National Science Foundation, U.S. producers of drugs and medicines spent the equivalent of 12.7% of domestic net sales on domestic R&D in 2005; by contrast, the same ratio that year was 3.3% for all industries and 3.6% for manufacturing. U.S. producers of drugs and medicines spent $34.8 billion of their own and other non-federal funds on domestic R&D in 2005, while federal spending on domestic drug R&D totaled only $41 million. Many drug firms invest heavily in R&D simply because it has long served as the industry's primary engine for growth in sales and profits. Those that become industry leaders achieve and sustain their stature by developing a steady stream of products that gain wide acceptance among doctors and their patients. Though discovering and developing new drugs often is a time-consuming, risky, and costly process, firms that succeed can earn sizable profits, at least until generic versions of the drugs or so-called me-too patented drugs enter the market. Because drug patents have a finite life, leading drug firms face continuing pressure to develop new and innovative drugs to lay a solid foundation for future growth. Those firms whose development efforts falter often end up struggling to survive in the face of stiff generic competition for their key drugs whose patent protection has expired. In recent years, some firms in this position have merged with larger, more successful firms in order to remain in business, while those that develop so-called blockbuster drugs prosper. Advances in the technology for finding promising new drug candidates over the past quarter century have greatly increased the number of drug compounds with significant therapeutic potential being discovered. Yet the entry of new breakthrough drugs into the market appears to have slowed considerably in the past 10 to 20 years. A 2002 study by the National Institute for Health Care Management Foundation found that 35% of the 1,035 new drug applications approved by the FDA from 1989 to 2000 were new molecular entities (NMEs), which the FDA defines as drugs containing novel active ingredients, and that about one-third of those NMEs (or 15% of new drug approvals) were deemed to offer significant therapeutic advantages over existing drugs. In addition, the number of NMEs approved by the FDA has decreased steadily since reaching a peak of 56 in 1996: a total of 17 NMEs were approved in 2007. Most major drug firms also spend large sums on promoting the use of their branded products directly to physicians and consumers. Firms that develop new innovative medicines seem especially inclined to invest heavily in advertising. Early in a new drug's commercial life cycle, advertising and promotion typically are aimed at capturing a major share of the market as quickly as possible. But later in the cycle, the main thrust of these efforts often shifts to fending off or thwarting competition from generic drugs or me-too drugs. According to one source, promotional spending by drug firms totaled $10.4 billion in 2007, down from $12.0 billion in 2006, but up from $4.3 billion in 1996. Of the amount spent in 2007, $3.7 billion went into direct advertising to consumers, and $6.7 billion was directed at physicians and other health care providers. The high priority given to informing doctors and encouraging what seems to be a form of brand loyalty among them reflects a fundamental feature of the market for prescription drugs that is absent from the markets for many other consumer goods and services. In deciding which drugs to use in treating an illness, consumers defer to the judgment and consent of third parties—namely, doctors and insurance companies. Another distinguishing trait of the drug industry is its fragmented competitive structure. This fragmentation has two critical aspects. One concerns the markets for brand-name drugs themselves; the other is related to what might be described as the technological focus or orientation of drug firms. No single firm or small cluster of firms dominates the domestic market for branded drugs. According to U.S. Census Bureau, in 2002, the most recent year for which figures are available, the four largest producers contributed 34% of the value of domestic shipments of medicines; the eight largest, 49%; and the 20 largest, 70%. The absence of a dominant seller is partly due to the multitude of therapeutic categories and the high cost of carving out a position of dominance in any particular category. Some drug formularies, which are lists of approved drugs that are covered under specific insurance plans, encompass as many as 16 therapeutic categories and over 100 sub-categories. Drugs classified in one sub-category generally cannot be substituted for drugs in another sub-category.