The Institute of Fiscal Studies has conducted research into the Pharmaceutical Price Regulation Scheme which regulates the prices of more than £3bn worth of drugs dispensed by NHS doctors every year.

Under the PPRS, drug companies agree in secret with the Department of Health how much they can charge for their products. Prices are set to achieve an agreed level of profit.

There is great concern that the NHS drugs bill has been rising by about five per cent a year in real terms over the last decade.

Many leading commentators want harsher price controls to be introduced when the Department of Health undertakes its five year review this autumn.

But the IFS argues that the price of drugs in the UK is not excessively high by international standrds, and that the PPRS is an effective regulatory system.

Cuts could be counter productive

The pressure group argues that resisting calls for drastic reductions in drugs prices is important because substantial price cuts might damage the welfare of patients as much as the drugs firms in the long run.

The IFS warns that pharmaceutical firms will only undertake research into the next generation of drugs if they expect to earn a profitable return on their efforts.

Nick Bloom, IFS research economists, said: "If the NHS were drastically to cut the prices it pays for drugs there is little doubt that the flow of drugs would be damaged and the success of the UK's pharmaceutical industry put at risk."

However, the IFS does criticise the existing scheme for a lack of transparency, and urges that it should be opened up to greater public inspection.

Over regulation

The PPRS is also criticised for over regulating the profits drugs firms can earn. It provides insufficient rewards to successful firms and is too lenient on poor performers, the IFS argues.

An increase in the upper and lower limits of the rate of return band might increase the industry's productive efficiency and eventually lead to lower drug prices.

Mr Bloom said: "One of the major criticisms of the PPRS is that it excessively cushions firms from the rigours of market competition.