Brad Setser has more to say about how the lack of enforcement with respect to transfer pricing in the Big Pharma sector has not only cost us Federal tax revenues but perhaps in American jobs in his “The Irish Shock to U.S. Manufacturing?” (May 25, 2020):
America’s production of pharmaceuticals and medicines peaked in 2006, back before the global financial crisis. Output now is about 20 percent below its 2006 level. Pharmaceuticals tend to be capital not labor intensive. High quality pharmaceuticals aren’t made in sweat shops. Pharmaceuticals certainly weren’t the kind of industry that most economists expected to be on the losing end of trade liberalization twenty years ago. Yet America’s consumption of pharmaceuticals didn’t peak in 2006. Only U.S. output. Imports have increased substantially since 2006. Imports of pharmaceuticals have increased from $65 billion in 2006 to $151 billion in 2019. As a result, the trade deficit in pharmaceuticals has increased from $32 billion at the end of 2006 to $93 billion in March of this year. That is about 0.4 percent of US GDP, or just under 10 percent of the total trade deficit in manufactures. The bulk of these imports are from countries that pay high wages. The two biggest sources of imports are Ireland and Switzerland. Many of the usual arguments around the gains to consumers from trade don’t really apply here. The imports are of patent protected goods, so they don’t expand consumer choice. And U.S. pharmaceutical prices are notoriously high—imports from Ireland and Switzerland haven’t brought U.S. pharmaceutical prices down to European levels. The bulk of the gains from trade here almost certainly go to the owners of the pharmaceutical companies who benefit from lower taxes. And the main loser is the U.S. Treasury. Right now, the United States pays the highest prices in the world for its medicines (many of which derive from NIH research) while U.S. pharmaceutical companies are often taxed at quite low effective rates.
I want to do two things here starting with an explanation of the Irish transfer pricing game and later a small complaint about his Swiss tale. He cites a story about an Irish affiliate of Pfizer by Tom Bergin and Kevin Drawbaugh:
Pfizer has used transactions between companies within its group to allow an Irish subsidiary based in Ringaskiddy – Pfizer Ireland Pharmaceuticals – to buy the rights to patents developed in the United States and then use them to make drugs which are sold back to U.S. affiliates. Even though the Irish and other overseas units pay $3.2 billion a year in royalties to use such patent rights, the higher prices at which Pfizer in the United States imports manufactured drugs from affiliates means almost all the profits from these drugs are reported overseas. Drugs which were discovered in the United States, manufactured in Ringaskiddy and sold back to the United States include anti-cholesterol treatment Lipitor – the best-selling prescription drug of all time – and epilepsy drug Lyrica, which generated revenue of over $5 billion last year for Pfizer … Pfizer does have manufacturing plants in the United States but filings for its overseas units show non-U.S. companies supply over 80 percent of U.S. sales. Those sales generate margins of around 40 percent for Pfizer’s overseas arm – earning it over $17 billion in 2013. However, Pfizer has reported losses on its U.S. business in each of the past five years.
Pfizer is not alone with very aggressive transfer pricing, which we will outline in an example based on its 10-K filing below. But let’s consider Switzerland in light of an interesting comment over at Angrybear which included this:
do we not want importation of cheaper pharmaceuticals as long as the US can adequately tax gains? Cheaper medicine is a necessary part of alleviating health care costs.
Brad notes Irish and Swiss wages are not exactly low but are those drugs we import from low taxed Swiss affiliates really produced in Switzerland? One of Pfizer’s competitors is a U.S. based multinational that has declared that its intangible assets are owned in Switzerland while production is actually performed in the Visigrad economies:
On the face of it, the Visegrad countries – the Czech Republic, Hungary, Poland and Slovakia – are doing well economically. The data for GDP per head suggest a gradual convergence in living standards with Western Europe. They continue to attract a disproportionate share of inward investment in EU manufacturing, and their integration into EU-wide supply chains helps to explain why they are now collectively Germany’s most important trade partner, ahead of China and the US.
This other multinational relies on contract manufacturers in the Visegrad nations in order to take advantage of both low wages but also modest corporate tax rates. But most of the profits end up in Switzerland as the contract manufacturers and distribution affiliates receive only modest operating margins. The Swiss principle then pays the U.S. affiliate only a modest royalty rate for the use of U.S. developed intangible assets reaping the lion’s share of profits even though this Swiss entity employs very few people. Now to our illustration of how abusive the transfer pricing for Big Pharma gets based on Pfizer’s 2013 financials, which showed $50 billion in worldwide sales with 60 percent of those sales made by foreign distribution affiliates. Distribution costs represent 30 percent of sales and the typical transfer pricing policy leaves it with a gross margin = 35 percent so operating profits are only 5 percent of sales. Of that, $1 billion is captured by the U.S. distribution division with foreign distribution affiliates receiving $1.5 million. Production costs are only 20 percent of sales so consolidated profits represent 50 percent of sales or $25 billion. The contract manufacturers receive profits = $2.5 billion leaving “residual” profits equal to 40 percent of sales or $20 billion. One might think the appropriate royalty rate would be 40 percent of sales, which would mean the U.S. parent would receive $20 billion but in a lot of cases the royalty rate is only 10 percent so the U.S. captures only $5 billion in royalties with the remaining $15 billion left in the Swiss tax haven. In other words, this multinational enjoys both low production costs and an incredibly low effective tax rate. Now one might wonder how this transfer pricing abuse can be considered arm’s length. Well, there will be some law firm or accounting firm that will write some fanciful defense if the multinational pays them a lot to be their advocate.
https://www.imf.org/external/pubs/ft/weo/2019/02/weodata/weorept.aspx?pr.x=41&pr.y=13&sy=2018&ey=2018&scsm=1&ssd=1&sort=country&ds=.&br=1&c=193%2C122%2C137%2C124%2C546%2C156%2C423%2C138%2C935%2C196%2C128%2C142%2C182%2C172%2C359%2C132%2C134%2C576%2C174%2C936%2C532%2C176%2C184%2C178%2C144%2C436%2C146%2C136%2C528%2C158%2C112%2C542%2C111&s=PPPPC&grp=0&a=
October 15, 2019
Per capita Gross Domestic Product, 2018
United States ( 62,869)
Australia ( 52,379)
Austria ( 52,172)
Belgium ( 48,327)
Canada ( 49,690)
Denmark ( 52,279)
Finland ( 46,596)
France ( 45,893)
Germany ( 52,386)
Greece ( 29,072)
Hong Kong ( 64,199)
Iceland ( 55,941)
Ireland ( 79,617)
Israel ( 37,994)
Italy ( 39,676)
Japan ( 44,246)
Korea ( 43,290)
Luxembourg ( 106,372)
Macao ( 115,913)
Netherlands ( 56,489)
New Zealand ( 40,096)
Norway ( 74,357)
Portugal ( 32,412)
Puerto Rico ( 39,424)
Singapore ( 101,387)
Spain ( 40,172)
Sweden ( 53,652)
Switzerland ( 65,010)
Taiwan ( 53,074)
United Kingdom ( 45,741)
* Data are expressed in US dollars adjusted for purchasing power parities (PPPs), which provide a means of comparing spending between countries on a common base. PPPs are the rates of currency conversion that equalise the cost of a given “basket” of goods and services in different countries.
Notice the remarkable per capita GDP for Ireland, significantly higher than that of the United States. Irish corporate tax policy has had much to do with this.
Per capita Gross Domestic Product, 2018
United States ( 62,869)
Ireland ( 79,617)
https://fred.stlouisfed.org/graph/?g=tphd
August 4, 2014
Real per capita Gross Domestic Product for Switzerland and Ireland, 2007-2019
(Percent change)
https://fred.stlouisfed.org/graph/?g=tphk
August 4, 2014
Real per capita Gross Domestic Product for Switzerland and Ireland, 2007-2019
(Indexed to 2007)
Thanks for the breakdown PGL, super helpful and informative.
I recall the pharmaceutical lobbying for protectionism ensure only drugs developed here can be sold here and thus they can continue to keep the prices inflated. This comes despite legislation being proposed to allow for importation of drugs from Canada at Canada price, regardless of the origin of development:
https://www.cipa.com/cipa-survey-of-americans-finds-64-purchase-medications-from-canada-due-to-affordability/
“Customers reported spending $250 per month per prescription on average to order a 90-day supply of prescription medications for personal use, and saving approximately $246 (or 50 percent) per month by importing their medications from Canadian pharmacies.
Not only do Americans save money from purchasing prescriptions from Canada, they predict serious health consequences without this option. Approximately 32% say they would only be able to fill some medications. Another 11% would not be able to purchase any of their medications. Previous reports have highlighted the issue of patients going off medications or rationing and the resulting harm to health along with the costs to the health care system. Further, since many who import their medications from Canada are seniors on Medicare, non-adherence and the resulting health implications and costs are a burden to the American taxpayer.”
The common defense of lobbyists is always to project decreased spending in R&D and innovation. Is there anyway to convince the industry/ governments that all this innovation does not matter if it means a choice between the medicine or not being bankrupt.,Even now pharma libertarians are pushing the idea that UK has been the most successful country w/r/t corona because they seem to be closest to a vaccine, and considering a New Zealand a failure because they do not have one. https://www.bloomberg.com/opinion/articles/2020-07-22/british-response-to-covid-19-has-been-world-class?sref=htOHjx5Y
“Now to our illustration of how abusive the transfer pricing for Big Pharma gets based on Pfizer’s 2013 financials, which showed $50 billion in worldwide sales with 60 percent of those sales made by foreign distribution affiliates… One might think the appropriate royalty rate would be 40 percent of sales, which would mean the U.S. parent would receive $20 billion but in a lot of cases the royalty rate is only 10 percent so the U.S. captures only $5 billion in royalties with the remaining $15 billion left in the Swiss tax haven. In other words, this multinational enjoys both low production costs and an incredibly low effective tax rate. Now one might wonder how this transfer pricing abuse can be considered arm’s length. Well, there will be some law firm or accounting firm that will write some fanciful defense if the multinational pays them a lot to be their advocate.”
This is so incredibly disappointing, especially it seems even more unlikely given the venue issues. Nor is the EU likely to be of much assistance/cooperation seeing as they do not have the same issues. Additionally, Switzerland’s banks were recently audited by Transparency International and they’ve reformed them, everything your describing sounds arguably legal.
The point I was trying to dig at was, as pointed out before, we cannot force companies to manufacture the drugs here. So what steps in their process is ripe for (efficient) enforcement or legislation. I think we could get even more specific than Setser’s idea of having. A different rate for each country, but rather do it per industry. If the patent/discovery exists in the US, and the sales are made in the US, is there a way to directly tax the sales based on ownership of the patent, in the same way the Obama era proposals on tax inversion were based on the time elapsed? (Apologies if this question is confusing).