President Obama has recently underlined two related themes -- improved opportunities for workers and opening up trade opportunities abroad for US firms. Breaking down trade barriers, it is explained, would increase opportunities for exports and that too would lead to more jobs. I will write another blog post about the recent attempts toward a free-trade agreement with Pacific countries. This posting will instead focus on ObamaCare and jobs.
I had a few minutes between Fox News and Glee so I decided to read “The Patient Protection and Affordable Care Act.” That is I weighed into the 2074 page tome sometimes referred to as ObamaCare. It doesn’t exactly read like Dr. Seuss so I focused on the part of the bill that explains a new $20 billion tax on the revenues of medical device companies. A medical device company, as we all know, makes pumps for old men like me who need a little extra help in the bedroom. They also make parts for hips, knees, and shoulders as well as devices like catheters, stents, scalpels, and pacemakers. As you can imagine, this kind of production takes a lot of capital and skilled workers. Wages are good. These are good jobs. One would hope that in this century our national policy would be aimed at allowing these companies to be as competitive as possible. It would be great to see these companies expanding employment in places like Indiana, Massachusetts, and Minnesota.
But the truth is that policy seems to be doing just the opposite. ObamaCare was passed in 2010 and we know that this Medical Devices Tax will go into effect in 2013. There are some in Congress who are trying to repeal this part of the bill but so far they have been unsuccessful. The House has the votes to repeal but the Senate does not.
The tax will be levied on a company’s revenues and amounts to 2.3%. My first response to 2.3% was to say that 2.3 is a really teeny number. If I lost 2.3 pounds I would still look like an elephant. Big deal – slap those rich medical device makers with 2.3%! They can surely afford it. Right? WRONG! There are estimates this 2.3% tax increase could lead to a reduction of 10-30% of the medical device workers in the USA. My first reaction was No Way Jose. To understand where this comes from we have to open up our General Accounting Textbook. Really? Yes really!
Let’s make this easy. Let’s suppose Davidson Peepee Pumps (DPP) sells 10,000 pumps each year and earns revenue of $40 million per year. Let’s now suppose that DPP Inc has labor costs of about $10 million per year and another $27 million in material, capital, energy, and other costs. That leaves them profits before taxes of $3 million. Since it is a privately held company – DPP nets $3 million. No, not quite. DPP has to pay corporate income taxes. Let’s suppose it pays 25% of the profits to the government – that means old Lar has about $2.25 million to give to his mean kids or to go on Mediterranean cruises. Of course, he may want to use a good bit of that to buy some new machines or otherwise invest in the enhanced competiveness of the company.
Now let’s bring in the sales tax of 2.3%. In 2013 DPP has to pay 2.3% of $40 million. That means old Lar has to pay another approximately $920 thousand to the Federal government. His $2.25 million after income tax profit is now a $1.3 million after income and after revenue tax profit. Notice that while the tax is 2.3% of sales it has reduced after tax profits from $2.25 million to $1.33 million. That is a 41% reduction in after-tax profits. In summary a 2.3% sales tax reduces profits by 41%.
You sharp cookies will notice immediately that DPP is not a real company and Old Lar is really a worn out economics professor. You will claim that I have rigged the numbers to exaggerate the claim. But go ahead and do your research and talk to any profitable medical device company and ask them for some real numbers. I am betting that you will not get a reduction in after tax profits of less than 25% caused by this single feature of ObamaCare. Worse yet, my example assumes a fairly profitable company and a low tax rate (a medical device company could be paying as high as 50% on income to federal, state, and local jurisdictions). What about young entrepreneurial ventures with sales larger than $5 million (since the act exempts those with less than $5 million) that might take 5-10 years to generate good profits? During those 5-10 years they would be even further in the red because of this sales tax approach. Note that any medical device company that does not generate a decent profit in any given year will have losses in those years because of this onerous sales tax approach.
So much for you sharp cookies. Let’s move on to you other cookies. You might say – who cares if we take another $920,000 from DPP? Medical device companies don’t need such high profits anyway. But let’s be serious. In today’s slow growth economy there are not many companies confident about the economy. Most companies are in the hunker-down mode trying to reduce their costs as much as possible. They do not know how long this slow growth period will last and they obviously are not giggling as they go to their favorite credit unions.
So even if you don’t like profits of these companies, the more probable truth is that the 41% decrease in DPP profits is going to spur the company to reduce costs even more. In this case, let’s look at what happens if DPP protects its profits by reducing labor costs by $920,000. Labor costs drop from $10 million to about $9 million, a decrease of about 10%. The 2.3% sales tax now becomes a reduction in labor expenditure of about 10%. If US medical device companies employ approximately 400,000 workers, then we are looking at a possible reduction in labor force of approximately 40,000 US workers.
High tech companies that have already survived the recession by replacing labor with capital will continue to do so in the face of a new tax increase. Of course there is no real reason for these companies to wait until 2013 since it may take a little time to get ready for the year when the new tax is introduced. These high tech companies are not apt to reduce their non-labor costs since labor is uniquely saddled with higher healthcare, pension, and other employment handicaps.
Sadly, the above analysis is the more optimistic of two scenarios. In the above example we only lose 10% of the current workers. Another likely aspect of the revenue tax coupled with other aspects of ObamaCare is for these companies to close their operations in the USA .This means that all or most of these jobs are in jeopardy. A 40% reduction in after-tax profits is another way of saying that the US is not the best location to remain competitive. US medical device makers have to compete against companies located on foreign soil.
Not only is labor often cheaper in these others countries but these countries may also have lower profit taxes and regulatory bodies more conducive to quicker product approvals. Boston Scientific, an important US medical device company, recently announced a decision to invest $150 million in a Chinese factory. Boston Scientific is not the only one weighing its options for overseas locations. Higher taxes, tougher price controls, and slower regulatory approvals from the FDA are not exactly the ways to improve US national competitiveness.
The upshot is that no matter how you look at this new revenue tax on medical device companies, it is a job killer. Companies that face large reductions in their profits will not stand still. Capital intensive high tech companies are going to make most of their adjustments with labor. This means they will fight for survival by either reducing their US labor forces or by doing more of their work overseas.
It was thought that since ObamaCare brought more people into the health system with means to pay, healthcare companies should pay for this increase in taxes with higher revenues. But given what we already know about the pricing pressures and expected reductions in payouts from insurers, it is not clear that medical device companies are going to benefit much from a larger number of people covered. 2011 is not too soon to revisit parts of ObamaCare if we REALLY CARE about employment.