Tax policies distort pharmaceutical manufacturing operations

Today’s New York Times reports that pharmaceutical companies have been able to minimize US income tax payments by allocating the majority of their profits to tax havens such as Singapore, Ireland, and Puerto Rico. (Drug Makers Reap Benefits of Tax Break by Alex Berenson.) The main tactic is to claim that manufacturing activities carried out in the tax havens are adding a lot of value to the product, so that the IRS and local tax authorities will be satisfied and a disproportionate share of profits will be taxed at the tax haven’s rate. It’s worth the trouble, because rates in tax havens are typically 2-15% versus roughly 40% in the US.

The article doesn’t mention that the tremendous tax advantages gained by these tactics have caused pharmaceutical manufacturing organizations to become inefficient and isolated from market forces. Unlike other industries such as consumer electronics and apparel, where manufacturing is mainly outsourced to efficient third-parties, pharmaceutical manufacturers make minimal use of outsourcing and often run their plants at low levels of capacity utilization and with little attention to cost. In fact, plant level accounting systems are often so distorted that senior management has no idea of the real costs. The manufacturing groups get away with underperforming because when manufacturing is outsourced, tax advantages are usually lost.

However, as the industry becomes desperate for the capital and operating cost savings associated with outsourcing, a more sophisticated “tolling” model has emerged. In this scheme, the pharmaceutical company rents and nominally operates the outsourcer’s facility. This qualifies the company for most of the tax benefits of insourcing and all of the cost benefits of outsourcing. Expect to see senior management of pharmaceutical companies –who in general barely understand manufacturing operations– to increase the use of outsourcing over the next few years.

May 8, 2005

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