The Medical Device Tax Hurts Weak, Strong, Sick and Healthy

Americans were reminded on April 15 about the painful financial burden that our government places on its citizens. Other taxes, while less visible, are also painful.

Take the 2.3 percent medical device excise tax, for example, in effect since January 1 as part of the Affordable Care Act, The rationale behind the passage of the tax was that sales of medical devices will expand because of additional numbers of newly-insured Americans who will be able to have access to these devices. Therefore, according to legislators, the industry should pay back some of its gains.

The Joint Tax Committee estimates that the tax will raise $29 billion over the next decade. But the nation's economy may see an even higher amount in lost labor and capital cost as a result of the tax.

Although the tax may have been passed with the best of intentions-or it may have been payback to the industry for not supporting the Affordable Care Act-it has had the effect of discouraging production of medical devices in the United States and lowering employment in the industry. The medical device industry is shrinking as a proportion of the American manufacturing sector.

That's why a majority of senators and representatives have now voted for repeal. Last month the Senate joined the House of Representatives and voted 79 to 20 to repeal it as an amendment to the 2014 budget resolution.

Although the Senate's repeal is symbolic, the number of Democrat votes suggests that a stand-alone bill to get rid of the tax might have some chance of success.

Democrats such as New York's Chuck Schumer and Minnesota's Al Franken, both stalwart supporters of the Affordable Care Act, joined Republicans in passing the repeal.

Members of Congress are rethinking the tax because the industry is already starting to shed jobs. Employment in the medical device industry has declined over the past two years, even as the manufacturing sector has grown.

In 2009, the year before the passage of the Affordable Care Act, the medical device industry employed 409,000 workers. In 2011, the latest year available, the industry employed 387,000 workers.

Members of Congress are concerned about shrinking employment. California, with almost 70,000 industry employees (down from 76,000 in 2009), has the largest share of the medical device manufacturing industry. Minnesota and Indiana follow with 22,000 and 21,000 employees each, respectively. Other states with more than 10,000 employees include Florida, Illinois, Massachusetts, New Jersey, New York, Ohio, Pennsylvania, Texas, and Wisconsin. Total labor compensation per employee in the industry is more than $86,000 annually. These jobs form a segment of the growing advanced manufacturing sector.

The tax applies to manufactured medical devices, but excludes those for direct sale to consumers, eyeglasses, and other products. As with all excise taxes, it raises the price of goods to the American consumer.

The federal government has applied excise taxes to some goods, such as gasoline, to support a trust fund for the payment of infrastructure, such as roads. The federal government also applies excise taxes to "sin" goods such as alcohol and tobacco whose consumption the government may reasonably seek to discourage.

The Affordable Care Act provides no economic justification for the new excise tax other than as a means of raising revenues to cover the costs of the new healthcare program. Excise taxes are often inefficient means of raising federal revenues.

Using Census Bureau data, I calculate that medical devices were an increasing share of U.S. manufacturing during the recession years of 2007-2009, growing from 3.2 percent to 3.7 percent of national manufacturing employment and from 2.3 percent to 2.8 percent of national value of manufactured shipments. Value added grew from 3.7 percent to 4.4 percent of national value added, and capital expenditures grew from 2.6 percent to 2.9 percent of national manufacturing capital expenditures.

The positive trends of medical devices within the broader U.S. manufacturing sector from 2007 to 2009 were reversed between 2009 and 2011. During the latter period, the medical device manufacturers declined in importance as a share of every economic indicator. This decline in the relative importance of medical devices in U.S. manufacturing coincides exactly with the passage of the new tax on medical devices.

Excise taxes affect all firms, whether they are profitable or not. Loss-making firms will still owe the excise tax, so they could be in the peculiar position of paying taxes to the federal government while not making any profits themselves. The tax is especially harmful to companies that innovate, and so can suffer losses in the first years or whenever they invest in research and development for a new product.

Such a company might have large market share, but no profits, in the initial years after research takes place. Companies that innovate frequently have losses, but they would have to pay the tax anyway. Thus, the market share tax could be an unintentional tax on innovation, and innovation would move offshore.

American-domiciled firms are at a significant disadvantage compared to foreign competitors. Both small and large international firms are placed at a disadvantage relative to their foreign competitors.

Large companies will move jobs abroad or place a higher share of their new employment abroad as the relative profitability of sales in foreign markets increases. Start-up companies will increasingly locate abroad rather than in the United States.

It's no surprise that Congress is changing its mind about the medical device tax, just as it changed its mind in 1993 about the 10 percent luxury tax on yachts, passed in 1990, which hurt the boat-building industry in New England.

With employment shrinking in the medical device industry, and a majority of members of Congress voting against the tax, the big question is not if the medical device tax will be repealed, but when.