Saturday, August 12, 2006


There's a good post on the Tax Analysts site, Economic Analysis: Drug Firms Move Profits to Save Billions, by Martin A. Sullivan.
Moving profits from the United States to low-tax jurisdictions is the way prosperous U.S. pharmaceutical companies keep their taxes low. And that domestic-to-foreign shift has clearly accelerated in recent years. By Tax Analysts' calculations, in 1999 foreign profits accounted for 39.2 percent of worldwide profits of large U.S. drug companies. By 2005 that percentage had jumped to 69.9 percent.
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When one affiliate of a multinational corporation makes a sale or loan to another affiliate, profits are shifted. When the terms of the transactions are set so that affiliates in low-tax countries get the better deals, the low-tax affiliates get larger shares of the profits and the multinational group reduces its overall income tax burden.

Pharmaceutical companies own a lot of marketing intangibles and patents that are developed in one or just a few locations and then used worldwide. Determining fair terms for interaffiliate transactions involving intangible assets involves a great deal of subjective judgment, so those determinations are a constant source of conflict between drug companies and the IRS.

The data strongly suggest the IRS is losing the battle.

How much is the IRS losing? Determining where profits belong is never a clear-cut call, but profits generally track the location of value-creating economic activity. Sales and long-term assets, segmented by geographic location, are two measures of economic activity that are available from company annual reports. As shown in Figure 3 (on page 474), foreign assets on average accounted for 41 percent of worldwide assets and foreign sales accounted for 44 percent of worldwide assets from 2003 to 2005. If we use those measures as profit indicators, foreign profits should be roughly 43 percent of the worldwide total instead of the actual figure of 66 percent. The difference — 23 percent — is the amount of worldwide profit that arguably should be reassigned to the United States.

The nine largest drug companies had total pretax profits of $42.6 billion in 2005. If 23 percent of that number, or $9.8 billion, were shifted back to the United States and taxed at an average rate of 30 percent, the treasury would take in an additional $2.9 billion — in just one year, from just nine companies.
One of the principal drivers behind escalating health care costs is the rapidly rising cost of prescription drugs that are protected by patents. I happen to believe that patent protection is necessary to encourage investment in new drugs. According to this report in, "The pharmaceutical industry is a far riskier investment than the broad market as a whole, as defined by its distribution of returns since the Dec. 29, 2000, inception of the current S&P Pharmaceutical index." Taking away patent protection would throttle the industry, meaning that the development of new medicines would be dramatically slowed.

Presumably, the use of the tax dodges described by Sullivan have resulted in an increase in the stock price of pharmaceuticals. The economic question, that I cannot answer, is whether this has resulted in greater investment in new drug development.

In a sense, the question raised by Sullivan's report is a specialized version of a question posed in another Tax Analyst report by Joseph J. Thorndike, What's a New Democrat to Do?:
[T]he fundamental issue of tax policy in a global economy [is] the future of progressive taxation in a world of mobile capital. Taxes on capital income have long been regarded as a vital component of tax fairness. But in recent decades, experts have begun to question whether capital income should be taxed at all. Even more striking, some economists have suggested that taxes on capital income can't be made to work, at least not over the long term.

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