The healthcare reform bill heading to the floor of the Senate includes new drug company “fees” and increased Medicaid drug rebates that together total more than $40 billion over the next decade, part of the $80-billion “shared responsibility” deal agreed to by the pharmaceutical industry, the White House, and Senator Max Baucus (D-Montana). In reality, however, these taxes and rebates will inflict higher prices on the sick and the elderly, and hardly dent pharmaceutical profits.

According to the White House, the proposed $2.3 billion per year “fee” on brand name pharmaceutical companies is “intended to recapture part of the benefits these businesses will get from reform.” But the political objectives behind a measure don’t determine who ultimately bears its true cost. In economic terms, this “fee” is nothing more or less than an excise tax on brand name drugs, similar to the excise taxes now imposed on such products as alcohol and tobacco.

One thing economists agree on about excise taxes is that they mostly show up as higher prices for consumers, unless consumers have the flexibility to significantly shift or cut back their purchases as prices rise. Due to patents and other protections, brand name pharmaceutical companies are essentially granted a monopoly until generic competition is permitted. Because consumers generally have limited flexibility, the fee will result in higher drug prices. In fact, a study by the Rand Corporation found that a 1-percent increase in the price of brand name drugs generates only a .05 to .08 percent decrease in demand. So drug companies will be able to increase prices on consumers by close to the full amount of the tax and realize just a small decline in sales.

The proposed $2.3 billion per year ‘fee’ on brand name pharmaceutical companies is nothing more or less than an excise tax on brand name drugs.

The drug fee isn’t the only policy in the Senate bill that will hit the sick in the wallet. The bill also increases the rebates that drug manufacturers are required to pay the government when Medicaid covers purchases of their products from retail pharmacies. The Senate Finance Committee bill raises the rebate for brand name drugs from 15.1 percent to 23.1 percent of the average wholesale price, and to 11 percent to 13 percent for generic drugs. A similar proposal from the House Energy and Commerce Committee would increase the rebate to 22.1 percent for brand name drugs and expands the rebates for drugs provided to 7 million "dual-eligibles" (those beneficiaries eligible for both Medicare and Medicaid) who receive coverage through Medicare.

The rebate policy is similar to the drug fee, except that the rebate is imposed only on the drugs paid for by Medicaid rather than all drug sales. For the branded drugs, limited consumer flexibility to cut back on purchases allows the manufacturers to raise prices and offset the additional cost. For generic drugs, where near-perfect competition generally drives profits down to a bare minimum and price to marginal cost, the prices paid by consumers have nowhere to go but up.

Limited consumer flexibility to cut back on purchases allows the manufacturers to raise prices to offset the additional cost.

These are not unproven theories. In a study of the original Medicaid drug rebate program, the Congressional Budget Office concluded that drug companies responded by launching their products at higher prices and giving smaller rebates to private consumers. Similarly, economist Fiona Scott Morton concluded, “Drugstore prices rose … for drugs where Medicaid was a large purchaser, and in markets with many generic competitors.” Boosting the rebates will just amplify the price increases caused by the original rebates.

And while the economics of these fees and rebates can be simply understood to filter through the pharmaceutical companies and result in the sick paying more for healthcare to subsidize the care of other sick, the politics is more nuanced. There has hardly been a single complaint by the drug industry against these policies, given that it is part of a negotiated deal they have decided to support. The industry's silence may also reflect a realization that it is their customers, not their stockholders, who will end up bearing the brunt of the pain. If so, it’s time for patients to speak up against what the Senate is poised to do to them.

Alex Brill is a research fellow at the American Enterprise Institute.

FURTHER READING: This article has been adapted from a recent AEI Tax Policy Outlook. Among Brill’s many articles for The American, “A Fat Tax That’s Hard to Swallow,” co-authored by Aparna Mathur, criticizes a congressional proposal to tax sugary drinks. Brill most recently wrote “About That Stimulus: The Shovel Wasn’t Ready” with Rachel Forward, outlining the administrative red tape choking stimulus spending.

Image by Dianna Ingram/Bergman Group.