The trick America's biggest drug companies are using to screw over taxpayers

There's a mystery lurking in America's national medicine cabinet.

Americans pay the highest prices in the world for lifesaving medicines — roughly triple what people in the world's other big economies pay for the same name-brand, on-patent drugs. The cost of producing a medicine generally doesn't vary much — so it stands to reason that the US's big pharmaceutical companies should therefore earn far more in the US than they earn elsewhere. Simple math.

But take a look at the corporate disclosures of America's largest pharmaceutical companies, and a puzzling hole opens. The six major US pharmaceutical firms that provide fairly detailed data reported making $215 billion worth of sales in the US for 2022. Given America's systematically higher prices, their sales abroad were logically more modest — totaling $170 billion. Despite this discrepancy, the companies reported earning very, very little in profits — in some cases, absolutely nothing — in the US. Of their $100 billion combined profit, the companies said $90 billion was made abroad, while a paltry $10 billion came from their US operations. That comes out to a profit margin of 5% in the US and a margin of over 50% abroad. What's going on?

Tax avoidance, of course. When questioned, pharmaceutical companies inevitably respond that they pay all the tax that they legally owe. A Merck representative, for example, said that Merck "complies with all tax rules on a worldwide basis." But these explanations are a smoke screen. Most of America's major pharmaceutical companies have simply perfected the art of legally shifting the profit on their US sales out of the country to low-tax jurisdictions.

It is undeniably allowed by the tax law, but it is still an outrage. Americans are not only paying through the nose for their prescriptions but also receiving none of the benefits from having a robust "American" pharmaceutical industry. The tax revenues from US sales are being paid abroad, rather than being reinvested in new research at the National Institutes of Health. Pharmaceutical-manufacturing jobs are being created abroad, rather than at home.

While the battle to lower drug prices is likely to drag on for years, there are clear ways for the US to prevent this sort of profit shifting that will not only make the tax system fairer but also allow Americans to recapture some of the value they're creating for these giant companies.

Pay no attention to the profits behind the curtain

To get a sense of just how much money these pharmaceutical companies are moving around, it's useful to look at a case study. Take AbbVie, the producer of the blockbuster immunosuppressive drug Humira, which is used to treat a variety of conditions, including arthritis and Crohn's disease. An investigation by Democratic Sen. Ron Wyden of Oregon found the company booked 99% of its profit abroad in 2020, despite generating only three-quarters of its sales overseas. More recently, AbbVie claimed it's actually losing money in America: The company reported a $5 billion loss on its US operations in 2022, while generating a $18 billion profit outside the US. Rather remarkably, AbbVie reported only $12 billion in non-US sales, meaning its reported profit outside the US exceeded its revenue.

AbbVie is an especially poignant example, but it's hardly alone. Merck, the maker of the blockbuster (and expensive) drug Keytruda, reported earning only $1 billion in profit on its $27 billion in US sales in 2022, while reporting that it earned $15 billion abroad on its $32 billion in sales overseas.

Pfizer, which famously produced the first mRNA coronavirus vaccine, now reports — unlike in the past — making a bit of money in the US. Even then, the discrepancy is quite large: $5 billion in the US in 2022 and $30 billion abroad. Before the surge in revenues and profits associated with its successful vaccine, Pfizer somehow always seemed to lose money in the US.

At this point, profit shifting is the industry norm: Of the eight biggest US pharmaceutical companies, only Gilead reports earning the majority of its income in the US. The other seven companies appear to have paid the US government just over $2 billion on their $108 billion global profit in 2022 (this sum includes Eli Lilly, which reports the distribution of its tax payments but not the distribution of its earnings). Governments outside the US actually collected more tax revenue from these seven "American" pharmaceutical companies than the US government: $11.5 billion.

Large legal loopholes

The offshore migration of these pharmaceutical companies' profits may seem egregious, but the tax gymnastics are generally legal. In fact, the US corporate-tax code effectively incentivizes American pharmaceutical companies to play this game.

On paper, America's corporate-tax rate is 21%, but the country's largest and most profitable pharmaceutical companies don't pay anything close to that. The effective tax rate for most of the big pharmaceutical companies on the profits they keep in the US is much closer to 10%. But since most of their profits are shifted overseas, the eight largest US pharma companies end up paying only about 3% of their global profit to the US Treasury. Most average American households have a far-higher tax burden.

Companies' ability to keep their US tax bill low is made possible by the US's treatment of money made overseas. Through 2017, US companies were allowed to indefinitely defer US tax payments of profits earned offshore. Many companies, unsurprisingly, found ways to move profits to no-tax jurisdictions in the Caribbean and Europe. The most common way to do this was by parking their intellectual property — such as the patents that give them a legal monopoly to sell a drug they've developed — in no- or low-tax jurisdictions. Add in overseas manufacturing, and almost all profits earned on US sales were shifted to the low-tax jurisdictions. AbbVie, for example, located the right to profit from Humira in its Bermuda subsidiary and manufactured the drug in Puerto Rico, which is considered outside the US for tax purposes since the island is a territory rather than a state. So all the profit for the drug was technically attributed to the division in no-tax Bermuda. Even though the profits were being legally booked as profits in the Caribbean or Irish subsidiary of a US firm, in many cases, these companies kept the funds in a US bank account or invested in US bonds. The firms could even take out a loan in the US using the overseas cash as collateral, so clearly the money wasn't "trapped" offshore. The overall result was a mess, and there was no doubt that the corporate-tax code needed to be reformed.

But instead of solving the problem, the 2017 Trump corporate-tax reform made it worse. The law imposed a special 10.5% tax rate on profits made outside the US. This would seem to solve the issue — money parked in other countries was still subject to collection from the Treasury. But the new rules allowed companies to blend all of their foreign profits together in one big pot: A company with some profits in a high-tax country such as Germany could use its mandatory payments there to offset some of the earnings attributable to no-tax jurisdictions such as Bermuda. It couldn't do the same with its US profit. So with a bit of accounting, companies could avoid paying the minimum tax on their offshore income. The overall result was an "America last" tax code: US pharmaceutical firms got a big tax cut, while the incentive to move production of new drugs to low-tax jurisdictions such as Ireland remained.

US trade data corroborates this story. The US has a large trade deficit in pharmaceutical products with other countries — a bulk of the imports are coming from low-tax jurisdictions such as Ireland, Singapore, Switzerland, and Belgium. Even the companies themselves report to their shareholders that they pay low effective rates because of tax-haven countries. Merck's latest annual 10-K report explained that the differentials in tax rates were due to "operations in jurisdictions with different tax rates than the US, particularly Ireland and Switzerland, as well as Singapore and Puerto Rico." None of this is particularly hidden.

What's more, the superlow rate enjoyed by American pharmaceutical companies isn't necessary for these firms to be internationally competitive. Denmark's Novo Nordisk reports paying tax at about the Danish corporate rate (22%), and it pays that tax mostly in Denmark, even though its biggest market is the US. Even Switzerland's Novartis pays the majority of its tax in Switzerland.

To add insult to injury, in many cases, these profits come from drugs developed through research made possible by National Institutes of Health funding and US tax credits for research and development. Despite this support, the US gets neither the biopharmaceutical-manufacturing jobs nor the tax revenues from medicines brought to market by US companies — it gets stuck with only the tab. If that sounds like a raw deal, that's because it is.

A spoonful of medicine to make the taxes go down

America's pharmaceutical companies have made great contributions to medicine. But there's no reason to think that they wouldn't make the same contribution to human health if they actually paid US taxes on the profits from their US sales. Economic theory and global practice show that any increase in their income taxes would be absorbed by the shareholders of the big pharmaceutical companies, not those buying their drugs — the pharmaceutical companies already charge the absolute maximum possible on their patent-protected medicines, and they certainly aren't doing so to cover the cost of their nonexistent US tax bill.

Common-sense reforms can help end this practice. One idea is to subject all overseas profits to a 15% minimum tax, assessed on a country-by-country basis to avoid accounting tricks. Another is to place limits on pharmaceutical firms' ability to claim tax credits for research on the development of drugs when the intellectual property is then shifted outside the US — this would also eliminate the incentive to offshore pharmaceutical production and US jobs. The net result would be more biopharmaceutical investment in the US, more tax revenues for the US Treasury, and, ultimately, a more resilient and more innovative US economy.

Brad W. Setser is the Whitney Shepardson senior fellow at the Council on Foreign Relations (CFR).

Tess Turner is a research associate at the Council on Foreign Relations (CFR).