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To have their products covered by the Medicaid program—which provides prescription drugs to most of the roughly 60 million lower-income people enrolled in the program—drug manufacturers must enter into a rebate agreement with the Centers for Medicare & Medicaid Services. For a brand-name drug purchased in the fee-for-service sector on behalf of a Medicaid beneficiary, the manufacturer agrees to rebate to Medicaid a percentage of the price it receives on certain private-sector sales of that drug. Like the changes in the Hatch-Waxman Act, that rebate affects firms’ incentives to incrementally modify certain drugs. If a company raises the price of a brand-name drug faster than the rate of inflation, it must pay a larger rebate. However, that provision does not apply to the way a modified version of an existing drug is priced in relation to the original drug. Thus, if a manufacturer wants to raise the price of a drug more quickly while avoiding the additional rebate, it can develop a new version of the drug—for example, with a different dosage or form of delivery—and introduce it at a higher price. For firms, that option is more valuable when Medicaid is a drug’s primary source of revenue. Indeed, a recent study finds that newer drugs with high Medicaid sales and no generic competitors “are significantly more likely to [be introduced in] new versions” than other drugs are. Modified products command significantly higher prices for the same dosage—in the range of 7 percent to 20 per-cent higher—than earlier versions of the drugs do. (In general, generic competition makes it more difficult to charge higher prices for brand-name drugs because such competition increases the likelihood that a drug will lose sales to generic versions if its price is set too high.) Medicaid’s pricing rules have affected some drug companies’ decisions about R&D by encouraging the development of incrementally modified versions of drugs with high Medicaid sales. Those rules avoid other difficulties and R&D distortions that the government could create if it tried to set drug prices itself. But studies of the impact of the Medicaid rebate program, along with studies of the effects of the Hatch-Waxman Act, illustrate that firms’ R&D investments are responsive not only to market forces but also to public policy—sometimes in unanticipated ways.
Federally funded research plays a major role in the discovery of new pharmaceuticals. Most of the important new drugs introduced by the pharmaceutical industry over the past 40 years were developed with some contribution from public-sector research.1 In the past decade, federal outlays on health-related research and development have totaled hundreds of billions of dollars at the National Institutes of Health (NIH) alone. Although only some of that spending was explicitly related to pharmaceuticals, much of it was for the basic research on dis-ease mechanisms that underlies the search for new drugs. Federally supported basic research in genomics, molecular biology, and other life sciences has greatly expanded the drug industry’s technological opportunities, stimulating private investment in pharmaceutical R&D. Given the extent of public R&D spending in the life sciences, however, there is a risk that such spending could “crowd out” (or discourage) private investment in some cases by substituting for it rather than complementing or stimulating it. The government’s focus on basic research, while the drug industry concentrates on applied research and development, tends to minimize that risk. But the distinction between basic and applied research is not always clear—and it has blurred to some degree as drug development has become more dependent on scientific knowledge. Aggregate statistical data suggest that, overall, private R&D spending responds positively to federal R&D. In specific cases, however, the government may have funded some research that the private sector otherwise would have paid for. Identifying where such direct crowding out has occurred is difficult, but it is probably more likely to happen in areas where potentially valuable commercial applications of government-funded research are more apparent. In addition, an indirect form of crowding out may occur if increases in federal R&D spending cause total employment in the research field to rise. Higher demand for researchers could cause research salaries—and thus firms’ labor costs—to increase. Salaries are more likely to be affected in that way when federal funding is growing rap-idly. In general, however, federal funding trains many graduate students for research careers in the drug industry, contributing indirectly to the productivity and profit-ability of pharmaceutical R&D.