The Medical Device Tax and the Theory of the Firm

Sometimes when a party gets really good and the guests have had one too many schnapps I am confronted by an eager inquiring mind with the highly perceptive question – What is the theory of the firm and how does it relate to medical device companies? With so many eyes and ears eagerly waiting for an answer I am more than willing to clear my throat and pontificate until the last ounce of Jack has been poured over the last extra-large ice cube.

The main idea of my answer is that the theory of the firm is the economist’s way of explaining many behaviors of firms. And it turns out that the Medical Device Tax issue is a perfect application of how public policy affects US firms. Professors are always looking for examples to help amplify what they teach. The Medical Devices Tax is a great way to teach economics!

A part of the Obamacare Legislation, the Medical Devices Tax levied a new tax of 2.3% on the value of medical devices sold in the USA (devices exported to other countries are exempted). So if a medical device manufacturer sells a $1000 ultra-hip Elvis-shaped hip to a hospital in Florida, they will net $977 instead of the full $1000. That does not sound like a major deal. But it is estimated that this tax will bring in about $30 billion in revenue to the government to help pay for Obamacare. This $30 billion will be taken from the revenues of medical device firms who received it from consumers or insurance companies. 

Ever since its passage, there has been a push to eliminate the tax and to find other ways for Obamacare to raise that $30 billion. The push goes on today. I stole much of what I am writing today from an excellent report written by Senator Dan Coats of the Joint Economic Committee, dated July 7, 2015 and cleverly entitled “An Economic Analysis of the Medical Devices Tax.” http://www.jec.senate.gov/public/_cache/files/b1537d7e-df45-450f-a32f-512a865119dd/an-economic-analysis-of-the-medical-device-tax-final.pdf

The government’s case is as follows. Because more people are being covered under Obamacare – more people will get hip replacements and buy more medical devices in general. That means the demand for medical devices will increase. The Theory of the Firm says that firms will respond to that increase in demand in one or more ways:

·        Increase the price of medical devices

·        Increase the amount of medical devices produced.

·        Increase hiring of workers and other inputs to produce the extra devices

Despite the extra costs associated with raising output, the theory would generally conclude that the increased revenues generated by higher output and/or prices would increase revenues more than the costs – and thus profits would rise. This leads to the conclusion that Obamacare raises profits for medical device makers and thus these companies can afford to pay some of that back to the government. And of course – Old Uncle Sam needs the money to pay for Obamacare because so many people cannot afford to pay for medical services.

Notice that these firms already pay taxes on profits and lots of other things but the belief is that they can afford another $30 billion that would go to the government from the newly imposed sales tax.

To complete the analysis, therefore, we have to calculate the impact of the extra $30 billion tax on these companies that make hips and knees and so many other medical devices. If we find that the tax is too much – that is, the tax raises company costs more than Obamacare raises their revenues, then the firms (and their many customers) may have been harmed by this tax. Since I am running out of Jack and since this thing is getting too long, let me be brief here. Take a look at Coat’s report for more details about the below points.

First, the revenue effects may be smaller than expected since those folks newly covered by Obamacare probably will not be intensive users of medical devices as opposed to general health care and drugs. Us older folks who love to shop for the coolest hips and knees are already covered by Medicare. So we don't count.

Second, the freedom of firms to raise prices according to the increase in demand is much constrained by regulation in the Obamacare. Those prices have already been pretty much influenced by Medicare – this is not like a market for Midwestern corn.

Third, taking the first and second points together means not much improvement to profits of medical devices makers. If neither output nor prices are improved by Obamacare, then there is little to cover the extra costs imposed by the tax.

Fourth, while a 2.3% tax on revenues seems small – the impact of that tax on profits could be a much bigger hit. A company with a million dollars of sales might only have after tax profits of $23,000. Notice that in that case 2.3% of $1 million of sales is exactly the amount of profits. So while the hit on net sales is small, the impact on profits could be very large. In this example it would wipe them out. Of course, the impact on profits depends on the actual firm, whether it is small or large, diversified or not, etc. But clearly, for firms that need a lot of sales to generate a dollar of profits – this kind of tax is a killer.

Fifth, if profits are dinged then companies have to adjust. Postponing research and development is one possibility. Replacing labor with robots might save a buck or two. Reducing pension benefits is possible. Perhaps finding a production location with lower income taxes is yet another. Ireland has both lower profits taxes and wonderful Irish Whisky.

Sixth, none of this bodes well for the rest of the economy. As we are taxed more and pay more for fewer medical devices, that leaves less money in our collective pockets to stimulate the private economy. We struggle to improve employment opportunities in the USA and this tax does nothing but impede that process.

On that note let me end. There are other ways to raise $30 billion to support Obamacare. I am in favor of a tax on Donald Trump’s hair. But that’s just me. Read Coat’s fine report because it lists a number of good ideas for how to fund Obamacare without inflicting harm on an industry, its workers, and on the US economy in general.