Markets

Continued Government Failures on Drug Pricing

(Bryan Sikora/Dreamstime)
An executive order adds to problems stemming from existing policies, instead of freeing up competition by deregulating the U.S. market.

In an effort to lower U.S. drug prices, President Trump has signed an executive order tying Medicare’s payments for drugs to the prices paid in other nations. Under this “most favored nation” rule, Medicare’s payments under Part B, which covers medicines typically administered in doctors’ offices, along with Part D, which covers self-administered medicines mostly obtained from pharmacies, could not exceed the lowest price paid in any developed country.

Trump’s gut instinct on drug prices is right: They are too high in the United States and too low abroad, but his advisers led him down the wrong path in addressing this disparity. The pricing disparity stems from government failures preventing price competition, among sellers here and buyers abroad. And the proposed “solution” adds additional layers of government controls that would do little to lower U.S. prices and could actually increase the foreign freeriding that understandably riles the president.

The international pricing disparity that led to the signing of the most-favored-nation rule is profound. A 2020 report by the White House Council of Economic Advisers (CEA), which I chaired until recently, found large and increasing differences in drug prices here and abroad. For example, after adjusting for per capita GDP, Canada paid a mere 35 percent of the price in the United States for the 200 top-selling drugs. Switzerland’s per capita GDP in 2017 was actually 11 percent higher than that of the United States, yet the Swiss paid 39 percent of U.S. prices. Fifteen years ago, other developed countries were paying about half what Americans paid. Now it’s down to less than a third.

The fundamental source of the pricing disparity is very simple but poorly understood. Economic evidence abounds that reduced competition among sellers raises prices while reduced competition among buyers lowers them.

In the United States, there are, owing to government policies, adverse incentives for price competition among drug sellers, raising prices here. Overseas, there’s virtually zero competition among drug buyers — in most nations, a single-payer health-care system buys all drugs. This lower prices abroad.

Instead of adding government mandates to a problem caused by existing government policies both here and abroad, freeing up competition by deregulating the U.S. market and fighting for stronger trade enforcement would address the disparity more smartly — and more squarely sync with the president’s overall economic agenda.

Drug development is tremendously expensive. But by the time a drug gets to a foreign market, early costs are sunk. So, when a foreign government uses its clout to push the price of a drug down, it’s generally better for a drug company to accept that price than to walk away. It is better to make something than nothing. Moreover, small countries have no incentive to contribute to innovation by accepting higher prices, as their sales have a negligible impact on the worldwide revenues that drive innovation — and therefore have virtually no impact on the supply of new drugs coming into their counties.

This is, however, larceny on a global scale. If China steals the intellectual property of American drug companies, as was alleged for COVID vaccines, there is bipartisan outrage. The failure to pay an appropriate price for new medicines is essentially the same thing, as the impact on innovation and investment is similar.

The same can be said about the forced technology transfers and mandated equity stakes as a condition for selling in a country, a practice also associated mainly with China. Trade negotiators should not allow other nations to make such demands. Giving up equity or IP for free should not be an entrance charge for doing business in a country, but neither should giving up products for free. These are simply different forms of price controls.

The president’s order attempts to address the price disparity by importing these price controls, having Medicare pay the same, artificially low prices paid by governments abroad. But this would have little effect on prices here at home and would likely increase freeriding by foreign countries.

Here’s why. A CEA report in 2018 found that 70 percent of profits on patented medicines come from U.S. sales. Drug manufacturers wouldn’t be willing to lose all their U.S. profits by lowering their prices to, say, the level demanded by Switzerland. Rather, they would walk away from the Swiss market altogether if, as would appear likely, the Swiss would be unwilling to pay anything close to American prices.

Economists would generally expect that if large and small markets were forced to have the same price, the shared price would be close to that of the larger market. However, European countries would never pay close to U.S. prices. They are more likely to wait for patent terms to expire. A single payer does not have to compete by offering its “clients,” whose premiums are mandated by taxes, the latest drugs.

So U.S. prices would likely not budge — and freeriding might actually increase, as other countries waited for medicines to come off patent. They would thereby contribute even less to fund the research and development that is paid for by patented sales.

The executive order also does little to address the main reason why U.S. drug prices are so high: government disincentivizes price competition among sellers. The 2018 CEA report found that the vast majority of the 50 most expensive U.S. drugs lack serious price competition.

A commonsense deregulatory solution would remove these barriers. To take one example, physicians should not be, as they are today, financially incentivized by Medicare to administer more-expensive drugs. This is important because doctors prescribe seniors many biologics, which is half of U.S. drug spending today

To the extent possible, drugs currently administered in physicians’ offices and covered under Medicare Part B should be administered at the pharmacy under Part D, where price competition works better. Further, the “Medicaid model” — where value and prices are established in a private market and then discounted for the government — could be applied to Medicare, but in a less draconian way.

Finally, and perhaps most important, policymakers should reduce the FDA’s excessive barriers to market entry. Just imagine what the tech industry would look like if it took a decade — and more than $2 billion — to bring a new product to market.

The FDA should create an office of deputy commissioner for competition — and task him or her with identifying ways to get medicines to market more quickly and cheaply without sacrificing safety. COVID has made many more people aware of the value of the FDA being more responsive to innovation, something that has been appreciated by non-COVID patients for a long time.

Contrast these reforms with another executive order signed in July, the “rebate rule.” It ensures that large middlemen who negotiate lower prices for health plans earn less. The private sector routinely limits or cuts out middlemen and does not need government intervention to achieve this. These middlemen are large, a market response to counter patent monopolies, which enable them to have earnings that ultimately come out of savings they achieved for their clients — in this case health plans. Government restrictions on them may therefore raise and not lower prices, which explains why the drug industry lobbied for this rule, something that it would not have been expected to do for a rule sold as a way to lower prices. Economists are almost universally skeptical of the regulation of sophisticated business-to-business transactions, such as vertical price control of this type, and it adds yet another layer of government mandates.

White House economists are supposed to serve as a firewall against bad economic policies such as the most-favored-nation order — and were central to blocking them in the past. This time, though, they were unable to talk the president out of the bad advice from the doctors and lawyers at the Department of Health and Human Services. Non-economists mandating pricing for health care, a sector that accounts for not too far from a fifth of the U.S. economy, may be as damaging as economists running operating rooms.

Tomas J. Philipson is a professor at the University of Chicago. He served as a member and acting chairman of President Trump’s Council of Economic Advisers from 2017 to 2020.

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