Obamacare’s Medical Devices Tax is a Heart Stopper

Almost exactly two years have gone by since I posted about the Medical Devices Tax (Obamacare, Jobs, and Global Competitiveness, November 22, 2011). In that post I worried about the negative impacts of the new tax on US employment. Two years later there is evidence that the worries were well founded even though the tax has not yet begun to bite. Since Congress may have the chance to save the day for the Medical Device Tax yet in 2013 and since there are some who would not repeal this part of Obamacare, I thought I would wade into this topic one more time.

This time I am spouting about an article written by Kent Gardner, chief economist for the Center for Governmental Research (Rochester Business Journal, November 15, 2013).  Gardner alleges that “Joint replacement earns a whopping profit for the implant manufacturers and a very good living for the surgeons and hospitals involved. And private insurers, Medicare, Medicaid and the Veterans Administration pay most of the bills.” He thinks these firms are doing just fine and uses three arguments to explain why the tax won’t have negative effects”:

1.     These firms are cartels and therefore medical device firms won’t pass the tax along to higher prices

2.     The tax will not cause US jobs to go overseas

3.     The tax will not cause any reductions in innovation and competitiveness

So let’s take a closer look at Gardner’s arguments. He says medical device firms are like cartel members. Wikipedia offers this definition of a cartel,

a formal (explicit) "agreement" among competing firms. It is a formal organization of producers and manufacturers that agree to fix prices, marketing, and production.^[1] Cartels usually occur in an oligopolistic industry, where the number of sellers is small (usually because barriers to entry, most notably start-up costs, are high) and the products being traded are usually homogeneous.

Implicit in this definition is that the cartel brings the members high or excessive profits. 

So Gardner is wrong on a lot of counts. First, there is no formal agreement among medical devices companies as there is in OPEC. Second, if there is an informal agreement to do all this bad stuff, then this is against the law – and these guys must be pretty good to have eluded the regulators for so long.

Third, these companies are not homogeneous. There is a relatively large number of medical device companies, and there is plenty of entry and exit, especially among the smaller innovative firms. . While there might be small numbers of companies in very specific segments of the industry, this is what one should expect when advanced science is behind specialization, continuous invention, and innovation. A company that leads in a particular kind of product, for example, may enjoy a monopoly position for a little while. But this is also true for cellular phones and many other electronic products – do we want to put additional taxes on Apple and Samsung because they lead their industry? Probably not. A small number of firms doing everything they can to take leadership is good for product price and quality and, of course, the consumer. Think Nokia if you want evidence that even a small number of firms can produce real competition.

Fourth, most of the data I am finding does not support the notion that these companies are making obscene or even risqué profits. I looked at rankings of profit measures by industry –published by Yahoo Finance and a consulting company, Analyxit . These rankings generally show that the Healthcare and Medical Devices sectors make very reasonable net profits as a percentage of revenue. For example Yahoo Finance found Medical Devices had a net profit ratio of about 13%, ranking it 42^nd among industries. In contrast Finance sectors had returns ranging from 36% to 81%.  The return on equity ranking showed Medical Devices at 14% with a ranking of 82^nd. Analyxit ranked Healthcare, including Medical Devices, as eighth among nine sectors based on net profits as a percentage of revenue. Again financial companies led the list with returns averaging 17%. Healthcare’s percentage was 4%. In the middle of the pack were utility companies with a ratio of 8%.

Gardner says these firms will not pass the extra cost of the tax onto consumers. He reasons… “When firms hold significant market power – as they do in this industry – the connection between cost and price has been weakened. Price is largely driven by demand factors, not cost: Monopolists already charge what the market will bear.” Gardner’s argument flies in the face of what we teach freshmen in economics every year. Market power translates into an inelastic demand curve -- which means that firms without much competition do not have to worry much about losing customers when they increase prices – and would as a matter of fact pass the extra costs caused by the tax into higher prices.

I would agree that these firms will eat the tax as a reduction in profits and not pass the cost along to medical consumers in the short-run. But this is not because these firms have market power. The main reason that profits will fall is that medical device manufacturers have long term contracts with hospitals and other health providers and cannot easily increase revenues to offset rising costs from the new tax. Won’t these firms benefit from a tidal wave of new enrollees in Obamacare? Probably not. Many of the newly insured will be younger and not require medical devices like new hips and knees.

What I showed two years ago is that while a 2.3% tax on revenue sounds trivial, the result is that the tax is a much larger percent of a company’s profits. While some people think profit is a dirty word, the fact is that profits are used to invest in research, product development, safety, and other critical outlays that invent and improve products. The more the government takes of these profits the less is available for increasing product quality and being competitive. Large for-profit firms are already seeking foreign locations and will be followed by private companies. And the negative impact on smaller entrepreneurial firms is disproportionate because in the early years a company often makes small or no profits despite having rising revenues. The upshot is that a 2.3% revenue tax will mean business losses and an end to these small businesses. Inasmuch, the bigger firms will gobble their assets and this will lead to less, not more, competition. A correlated worry is that all these firms will turn away from devices that cannot promise immediate returns or serve smaller markets. This bodes ill for future important improvements in the device industry.

But aren’t corporate taxes low? The answer is that despite some loopholes, US corporate income taxes are among the highest in the world. Domestic companies are already reducing employment and globalization means many are seeking production and market opportunities globally. The medical device news is full of stories about layoffs and new joint ventures, both domestic and foreign. Combining a high corporate tax with another 10-30% of income going to a medical device tax makes it more desirable for medical devices companies to find locations and markets where better profits can be made. China, India, Ireland, Costa Rica, Singapore and a growing list of countries are quite willing to compete on corporate profits as a way of winning production as well as R&D facilities.

The upshot is that this tax is not good for US employment nor US-based innovation and competitiveness. The US should be happy to have the world’s leading medical device companies and it should be fighting to keep it that way. Worse yet is the misleading contention that this tax increase will break up this medical devices cartel and lead to more competition. It will do just the opposite as large US companies get larger by combining with suppliers and competitors – and as they move more and more operations abroad.