The importance of research and development (R&D) spending by the pharmaceutical industry and its resulting innovations is clearer than ever as millions of people are getting vaccinated against COVID-19. In a new report, the Congressional Budget Office (CBO) analyzes federal policies that influence R&D spending in the pharmaceutical industry. The report highlights how taxes affect R&D investment incentives, underscoring the importance of structuring the tax code so that it is not biased against investment.

Before diving into tax policies that affect pharmaceutical R&D expenditures, it’s helpful to review some background first. Developing new drugs is costly and risky; on average, it takes 10 years to develop a new drug and average costs per drug range from under $1 billion to more than $2 billion. Ultimately, only about 12 percent of drugs that enter the clinical trial phase are approved for introduction by the FDA.

On average, pharmaceutical companies spend about one-quarter of revenues on R&D, a larger share than other knowledge-based industries like semiconductor manufacturing and software developers, according to the CBO. In 2019, the industry spent $83 billion on R&D.

Determinants of R&D spending by the pharmaceutical industry include the expected cost of drug development, the expected revenue earned from a new drug, and the policies that influence the supply of and demand for drugs, including regulations, health-care programs, direct purchases or subsidies—and taxes.

Taxes can affect both the demand for prescription drugs and the supply of prescription drugs.

Tax policy affects demand for prescription drugs primarily through an income tax exclusion for employer-sponsored health insurance, a tax benefit that costs about $170 billion per year, the largest permanent individual income tax expenditure in the tax code.

Employer contributions for employee health coverage are not counted as taxable income for employees, which reduces the cost of providing health coverage. In turn, that leads to more generous health insurance coverage, which indirectly stimulates pharmaceutical R&D spending. But the exclusion has other effects too, like distorting employer decisions on pay and likely contributing to widening disparities in wage compensation.

Tax policy affects the supply of drugs by altering the expected after-tax return to a new drug through expensing deductions, credits, and the tax rate.

The tax code currently allows businesses to fully and immediately deduct the costs of their R&D investments instead of taking depreciation deductions over time. Full expensing ensures the tax base is not biased against investments in the first place—firms pay the proper amount of tax on their net income, compared to taking delayed deductions for R&D costs that would overstate profits due to inflation and the time value of money.

Additionally, the tax code offers credits that reduce the amount of taxes companies owe to incentivize R&D spending. The R&D tax credit is based on a company’s incremental R&D spending and the Orphan Drug Credit is based on clinical trial costs for drugs related to uncommon diseases.

Many companies use a mix of the various credits and full expensing deductions, but they cannot claim multiple tax preferences for the same expense. Ultimately, the effect of each policy is to increase the expected after-tax return to a new drug (said another way, to reduce the after-tax cost of R&D spending), thus incentivizing greater levels of spending and a larger supply of new drugs.

Changes to credits, exemptions, deductions, and tax rates can change the incentives to invest in R&D. For instance, the 2017 tax reform law included changes that both increased and decreased R&D incentives.

The CBO report found the net effect of the 2017 tax law on R&D investment is unclear. The lower corporate tax rate, from 35 percent to 21 percent, increased the incentive to invest in R&D by increasing the expected after-tax return. But the 2017 law reduced the Orphan Drug Credit by half, and beginning in 2022 will require companies to deduct R&D expenses over five years instead of immediately—both changes that reduce R&D incentives.

Investment in R&D is central for driving long-term technological change and innovation. As the pandemic comes to an end and the economy begins to recover, the tax code should not become a headwind to R&D activity, either through a higher corporate tax rate as proposed by the Biden administration or by allowing R&D amortization to take place as scheduled. Instead, lawmakers should examine ways to make the tax code more conducive to innovation in general, i.e., across industries and activities.