## Tuesday, June 01, 2021

### Incentive compatibility and state-level regulation in Indian drug quality

by Harleen Kaur, Shubho Roy, Ajay Shah and Siddhartha Srivastava.

The Indian pharmaceutical market is the third largest in the world by volume of drugs sold and is dominated by local players that produce branded generics at low prices. Existing government estimates suggest that 3.16% of drugs at retail pharmacies and 10.02% of the drugs at government pharmacies are not of standard quality. Independent surveys hint at higher estimates of inadequate quality. While India is a powerhouse of drugs export, foreign drug regulators routinely classify Indian origin drugs as not of standard quality. This problem has been around for a while. Reports of the Comptroller and Auditor General of India (CAG) and Parliamentary Committees have repeatedly highlighted the problems and poor regulatory capacity.

There is a need for better policy pathways to address these problems. In this article, we argue that an incentive problem inhibits the existing regulatory structure. The present law is set up in such a way, that it may be in the interest of the regulator to not carefully monitor the manufacture of pharmaceuticals. Unlike other areas where a statutory regulator is responsible for the safety of an industry, the legislative system of for the pharmaceutical sector does not create a body dedicated to ensuring that medicines are safe and up to standards. Alongside this, there are long-standing problems with regulators in India, where laws create arbitrary power, and the feedback loops of accountability mechanisms do not create a striving for improved state capacity. Certain solutions flow directly from this reasoning.

### The current system

Unlike the working of the market economy in most goods and services, market discipline through consumers in the field of pharmaceuticals is limited; there is market failure caused by asymmetric problem. The user (usually the patient) does not have the skills or experience to know if a pill actually contains the claimed active ingredient. When (say) a pen does not work, this is evident to a consumer. However, it is very difficult for an individual patient or even a doctor to know if a drug is substandard. When medication fails to cure the patient, this could be because of three different possibilities -- a wrong diagnosis, or the patient just did not respond to the correct drug, or a problem with drug quality. This induces an identification problem, so there is no feedback loop when a substandard drug is purchased. Similarly, when a patient does get better, a lot of the time, this would have happened through the working of the human body and is helped by a placebo effect. Here also, there are no feedback loops based on quality signals.

The consequences of inadequate quality can be grave: substandard medication can even cause the death of a patient. And even if a patient dies, it is extremely difficult to establish (after the fact) that the medication was defective.

As with most other countries, India has a law that creates a government apparatus for approval and manufacture of medicines in the country: the Drugs and Cosmetics Act, 1940 (DC Act). This divides the functions of regulation between the union government and state governments. The union government is responsible for the approval of new drugs, regulation of drug imports, and laying down standards for drugs, cosmetics, diagnostics and devices. State governments are responsible for licensing and monitoring manufacturers for drug quality and initiating legal action against offenders.

The parliamentary law does not separate the regulatory duties between the union and state governments. The primary legislation allows the union government to appoint licensing authorities (S. 33 of the Act). Under this authority, the union government has delegated licensing functions to state governments (Rule 59 under the Act).

What was the text of the law which generated this separation? Section 33 of the legislation empowers the union government to appoint the 'licensing authority' for the manufacturing and sale of drugs and the union government has used this power to anoint the state government using subordinate legislation (See rule 59 of the DC Rules). As a result of this delegation, State governments (through their State Drug Regulatory Agencies) are responsible for licensing pharmaceutical manufacturing facilities and inspecting them.

### Misplaced incentives under the law

The present arrangement of delegating inspection of manufacturing facilities to the state government, however, has problematic implications. In a unified national market, where goods flow across state borders seamlessly, pharmaceutical manufacturing factories do not limit their sales to one state. Many firms are harnessing the economies of scale that come from producing for the entire country or even the global market from a few very large manufacturing plants. Small states like Himachal Pradesh and Goa contribute disproportionately to India's total pharmaceutical production.

This unification of markets creates a problem of incentives for the state governments where these plants are located. These states benefit from the tax revenue, jobs and licensing fees that these large plants bring to the state. If the state government is vigilant and runs a tight inspection regime, it risks discouraging pharmaceutical companies from setting up plants in their state. Companies may engage in jurisdiction-shopping, taking the tax base and manufacturing jobs to states with a lax regulatory regime. On the other hand the welfare costs associated with a poor regime -- the adverse impacts on the health of users -- is not borne by the state exclusively, but by the entire country. If the state has a small population (e.g. Goa or Himachal Pradesh) and the medicine is not commonly used, the failure of the regulatory regime may be invisible to the voters of the state. Therefore, it is not in the interest of a state government to run an efficient inspection regime.

Another dimension in the incentive problems of state governments lies in the cost and complexity of regulation. State governments are being asked to spend on manpower, testing facilities and institutional capacity for regulation, while the benefits of regulation are enjoyed by customers all over India.

This incentive problem leads to a race to the bottom with states competing on laxity of regulation. As an example, while a single database for providing information about substandard drugs to the public exists, only five state regulators provide such information through this database.

Finally, even if a drug manufactured in one state is found to be substandard by a regulatory agency in another state, it is difficult to organise enforcement actions that cut across state borders.

Additionally, the separation of roles between state and union is not clear and leads to confusion about who is actually responsible for inspecting manufacturing facilities. For instance, under the DC Act, drug inspectors are responsible for inspecting manufacturing sites and detecting substandard medicines (Sections 22, 23). However drug inspectors can be appointed by both the central and state governments (Section 21), and function under the control/directions of an officer appointed by the relevant government (Rule 50).

Crucially, the DC Act and Rules do not clarify the instances in which the drug inspectors are to be appointed by the central government and when they are to be appointed by the state government. Neither do they outline a scheme of accountability wherein the quality enforcement actions of the drug inspectors can be scrutinised or audited by either a state or central body.

This results in a quality enforcement framework where there is no clear statutory body responsible for the failure in drug quality at the central or state level and therefore no incentive for individual drug inspectors to investigate and prosecute quality violations adequately. Both levels of the governments may consider the other responsible for the failure to inspect a facility.

### Solutions proposed in the prevailing literature

There are broadly two schools of thought on how to reform the problem of drug quality in India. The first set of arguments favour the creation of a new central regulatory authority (Pharmaceutical Enquiry Committee (1954), Drug Policy (1994), Mashelkar Committee Report (2003)). The second set of arguments suggest that the existing State Drug Regulatory Authorities (SDRAs) be strengthened for better implementation of drug quality regulation (Hathi Committee Report (1975), Department-related Parliamentary Standing Committee on Health and Family Welfare 59th Report on the Functioning of CDSCO (2012)).

Does the solution to the problems of drug quality in India lie in building a single agency at the union government and giving it high powers to investigate and punish? In thinking about the federal architecture of the Republic, there is merit in the separation envisaged in the 1940 Act. It is difficult for the union government to build an operational capability in any field, which is effective all across the country. The Constitution of India is imbued with federalism: India is not a unitary country ruled from New Delhi, but a union of states. The Constitution envisages a limited role for the union government: the establishment of standards for quality of goods to be transported from one State to another (See Entry 51 of List I of Schedule 7 of the Constitution).

Multiple legislative attempts have been made so far to create a centralised drug authority along the lines of these recommendations but without much success. In all these instances, the bills have been opposed by state manufacturers associations and state drug regulators. But going beyond these political economy constraints, there are concerns about this pathway to policy design. Simplistic centralisation, drawing on the existing text of the DC Act, will be problematic both on the grounds that decentralisation is a valuable approach and on the grounds that the present Act has flaws on incentive compatibility. The proposals for reform have not analyzed the incentive problems and ambiguity created by the 1940 legislation. The regulatory framework for pharmaceuticals in India suffers from multiple failures which need to be addressed, over and beyond the question of decentralisation. For example, you can check the inspection dates and reports of all drug manufacturing plants in the U.S (here), but we do not know when Indian manufacturing plants are inspected. There is no obligation on either the state or union governments to regularly inspect manufacturing plants, and the DC Act is the site where such obligations need to be imposed upon state agencies.

One possibility lies in reversing the focus of state-level agencies from factories to consumers of their state. E.g. if a factory makes drugs in Goa which are sold in Maharashtra, their quality characteristics would be the responsibility of the Maharashtra drugs regulator. Such a drugs regulator would achieve greater alignment with the interests of consumers in Maharashtra, and have a reduced conflict of interest with jobs and prosperity. However, there are difficulties in establishing the powers of the Maharashtra drugs regulator over a factory in Goa. There are also dangers of creating barriers to inter-state commerce.

### How to reshape incentives

Better working of regulators. An extensive body of knowledge has developed in India, in the last decade, on the working of regulators and regulation. This literature has argued that the path to high state capacity in regulation lies in: Clarity of purpose, the role/composition/working of the board, formal processes for legislative/executive/judicial functions which are written into the law, reporting and accountability mechanisms, the budget process, and low powers of investigation and punishment (FSLRC 2015, Roy et. al. 2019, Kelkar and Shah 2019). This knowledge needs to be brought into a deeper transformation of the DC Act.

Transparency reforms that reshape incentives. A low cost intervention could be based on reputation costs and can usefully be placed at the level of the union government. There are multiple channels through which drug testing is taking place in India today. Whenever a drug is found to be substandard, the union government should obtain this information and upload that information to a publicly available repository along with the name of the manufacturer and the state in which it was manufactured. This will impose a cost on states which are lax on inspecting manufacturing facilities. The public will come to associate drugs from that state to be of poor quality and avoid them. Pharmaceutical firms will then face a market based penalty if they locate manufacturing facilities in states with lax regulatory regimes. On the other hand, states which set up good regulatory regimes will benefit from the positive publicity. Pharmaceutical manufacturers would gain respectability and may even command a price premium by locating their manufacturing facilities in states with a reputation for high inspection standards. Consequently, such states would gain from licensing fees, revenue, and jobs by establishing a good regulatory regime. Therefore, with a modest work program at the union government, naming and shaming bad actors and their state level regulators, we can reverse the incentive problem and create a virtuous cycle instead of the present race to the bottom.

Greater transparency would also kick off market discipline. Households would become more aware of quality characteristics associated with the brand names of various drugs and that would kick off greater pricing power in the hands of higher quality drugs. This process would, however, be curtailed by the extant system of price controls for drugs.

### Conclusion

The current regulatory framework does not adequately define the objective, functions or powers of the de-facto regulators, the CDSCO and the SDRAs in the primary law or rules thereunder. This leads to creation of unaccountable regulators that have misaligned incentives. In this article, we have shown elements of a drug regulatory regime that are consistent with the federal vision of the Republic, and can effectively reshape the incentives of state level regulators. The union should be responsible for national public goods : drug quality standards, cGMP standards, randomised testing on a national scale, and release of this testing data. The laws that create state level regulators need to draw on modern Indian thinking about how regulators should be constructed. Put together, these reforms will modify the incentives of state level regulators.

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The authors acknowledge the support of Thakur Foundation in this work, and valuable conversations with Dinesh Thakur and Prashant Reddy. All errors are ours.

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