The Impact of Indirect Government Controls on U.S. Drug Prices and R&D

By Santerre, Rexford E.; Vernon, John A. et al. | The Cato Journal, Winter 2006 | Go to article overview
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The Impact of Indirect Government Controls on U.S. Drug Prices and R&D


Santerre, Rexford E., Vernon, John A., Giaccotto, Carmelo, The Cato Journal


In this article, we hypothesize that the growth of real drug prices in the United States may have been slowed over time because of indirect government controls taking the form of moral suasion, political threats, and crowding-out. We argue that these indirect control mechanisms are accentuated when government controls a greater share of drug spending. Using national data for the United States, we test this hypothesis and show empirically that an increasing share of government spending on pharmaceuticals was associated with a slowing of the growth of real drug prices during the period from 1962 to 2001. We also show that this reduction in the growth of real drug prices had a meaningful impact on pharmaceutical R&D and number of life years lost. More specifically, we determine that the resulting government-induced loss of capitalized pharmaceutical R&D expenditures was between $251 and 256 billion (in 2000 dollars) from 1962 to 2001 and conclude that the federal government's influence on real drug prices may have cost the U.S. economy between 187 and 191 million life years between 1962 and 2001.

The Legal Setting

Beginning in 2006, the Medicare Prescription Drug, Improvement, and Modernization Act (MMA) of 2003 will provide about 40 million Medicare recipients with the eligibility to receive prescription drug insurance coverage in the United States. (1) Under the MMA, various private health insurance plans are expected to compete among themselves to provide drug coverage to Medicare beneficiaries. Up until now, many of the nation's most elderly and frail Medicare recipients were without prescription drug coverage. Thus, not surprisingly, many look upon the MMA as representing the first major expansion of the Medicare program since 1965 and a milestone in U.S. healthcare policy (Oberlander 2003).

While many Medicare recipients will pay a lower out-of-pocket price for drugs under the act, the MMA is not without its critics. One contentious issue pertains to the manner in which drug prices are determined under the act. Specifically, the MMA, as enacted, contains a noninterference clause: "The Secretary of Health and Human Services (HHS) may not interfere with the price negotiations between drug manufacturers and pharmacies and prescription drug plan (PDP) sponsors. In addition, the Secretary may not require a particular formulary or institute a price structure for the reimbursement of covered Part D drugs" (S1860D-1 as cited in the Republican Policy Committee 2004).

Recently, however, legislation has been introduced to modify various aspects of the MMA, including its noninterference clause (e.g., S. 1992, S. 1950, and S. 2053). (2) The idea behind the removal of the noninterference clause is that the federal government will be able to use its considerable size and buyer clout to "'negotiate" even more favorable prices from drug manufacturers and thus save large sums of money for both the elderly and society--money that can be used for other necessities of life such as food, clothing, and shelter.

However, the noninterference clause contained in the original Medicare law lasted less than 20 years. In 1983, the federal government introduced the Diagnosis Related Groups (DRG) system, which established prospectively regulated rates to pay for hospital services provided under part A of the Medicare Act. Furthermore, less than 10 years later, the federal government created the Resource Based Relative Value Scale (RBBVS) system. The RBRVS pays physicians under part B of the Medicare Act based on their time and effort in providing services. Both of these payment systems are essentially price controls and conflict with the language in the original Medicare Act. However, the concern is that the government might simply use its buying clout to "administer" or "control" prices rather than negotiate them. Economic theory suggests that price controls will have a negative impact on drug development for two reasons.

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