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. 

ObamaCare, Jobs, and Global Competitiveness

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.