Wonking Out: Attack of the pharma phantoms

Last Thursday, Brad Setser of the Council of Foreign Relations — esteemed by cognoscenti for his forensic analyses of balance of payments data — testified to a Senate committee about global tax avoidance by pharmaceutical companies. This issue may not have loomed large on many people’s radar screens, and with everything else going on, you may wonder why you should care. But there are at least two reasons you should.

First, at a time when people are once again angsting about budget deficits — much of the angst is insincere, but still — it’s surely relevant that the U.S. government is losing a lot of revenue because multinational corporations are using accounting tricks to avoid paying taxes on profits earned here.

Second, now that it’s looking increasingly likely that Donald Trump will be the Republican presidential nominee, it seems relevant to note that his one major legislative success — the 2017 tax cut, which was supposed to bring corporate investment back to America — was, in practice, an “America last” bill that encouraged corporations to move even more of their reported profits, and to some extent their actual production, overseas.

About pharma: The U.S. health care system, unlike health systems in other countries, isn’t set up to bargain with drug companies for lower prices. In fact, until the Biden administration passed the Inflation Reduction Act, even Medicare was specifically prohibited from negotiating over drug prices. As a result, the U.S. market has long been pharma’s cash cow: On average, prescription drugs cost 2.56 times — 2.56 times — as much here as they do in other countries.

Strange to say, however, pharmaceutical companies report earning hardly any profits on their U.S. sales.

Setser notes that 2022 was an exceptionally profitable year for six major pharma companies, but the pattern — large revenue in the U.S. market, with very low reported profits — has been consistent over time.

How do the pharma giants do that? Mainly by assigning patents and other forms of intellectual property to overseas subsidiaries located in low-tax jurisdictions. Their U.S. operations then pay large fees to these overseas subsidiaries for the use of this intellectual property, magically causing profits to disappear here and reappear someplace else, where they go largely untaxed.

The pharmaceutical industry, where patents rather than manufacturing facilities are companies’ principal assets, is exceptionally well suited to this kind of tax gaming. But it’s not unique. Over time, we have increasingly become a knowledge economy, in which a large share of business investment involves spending on intellectual property rather than on plant and equipment.

And whereas factories and office buildings have specific locations, intellectual property pretty much resides wherever a corporation says it resides. If Apple decides to assign a lot of its intellectual property to its Irish subsidiary, causing a huge surge in Ireland’s reported gross domestic product, nobody is currently in a position to say it can’t.

How do we know that big overseas profits mainly reflect tax avoidance rather than economic reality? That’s easy: Look at where the profits are being reported. As Setser also pointed out, following up on the work of Gabriel Zucman (who just won the American Economic Association’s prestigious John Bates Clark medal; congratulations, Gabriel!), the great bulk of U.S. corporations’ reported overseas profits are in tiny economies that can’t possibly be major profit centers but do offer low taxes on reported earnings.

Which brings us to the Trump tax cut. The core of that tax cut was a reduction in profit taxes, based on the premise that America’s relatively high official corporate tax rate was causing large-scale movement of capital overseas. But that corporate capital flight, it turns out, wasn’t real; it was a statistical illusion created by tax avoidance.

By the way, this isn’t just a U.S. problem. The International Monetary Fund estimates that about 40% of global foreign direct investment — investment that involves control of foreign subsidiaries, as opposed to portfolio investment, such as purchases of stocks and bonds — is actually “phantom” investment driven by tax avoidance that doesn’t correspond to anything real.

It’s not surprising, then, that the Trump tax cut never delivered the promised investment boom. As it happens, right now we actually are seeing a boom in manufacturing investment — but that’s being driven by the Biden administration’s green industrial policy rather than across-the-board tax cuts.

But wait, it gets worse. One particularly ill-drafted feature of the 2017 tax law, with the acronym GILTI (I am not making this up), ended up giving corporations an incentive to shift actual production as well as reported profits overseas. As Setser points out, GILTI is probably a major factor in a recent surge in U.S. imports of pharmaceuticals.

Now, there are some very well thought-out proposals to address corporate tax avoidance. Unfortunately, they’re almost surely moot as long as the House is controlled by a party that wants to deny the IRS the resources that it needs to go after tax evasion.

But you should still bear in mind that cracking down on tax avoidance could significantly reduce budget deficits. And you should also bear in mind that the Trump administration’s only major domestic policy initiative was a flop.

This article originally appeared in The New York Times.