Too Many Windows: The Medical Device Tax

Industry Insights from Ty Hagler

In historic downtown Beaufort, South Carolina, the colonial-era homes exhibit, what can only be construed in-context, an architectural oddity. 

Each of the windows of these beautiful homes extends all the way down to the floor.  The architects found ways to make this oddity attractive, but one would question this puzzling choice, unless you had knowledge and understanding of the local property codes and tax laws of colonial-era South Carolina.  

Economics teaches us that people are rational actors and will respond to incentives in unexpected and creative ways. Apparently, local officials had written the code to include taxation levels of residential homes, based on their number of windows.  With the help of their architects, the equally-creative homeowners would simply change out all of the windows for doors once a year when the tax assessor visited.

This brings us to the coming 2.3 percent medical device tax is going into effect on January 1, 2013, as part of the Patient Protection and Affordable Care Act (PPACA).  There has been a lot of very real upheaval, and not just rhetoric, in the device industry over the excise tax, as it is 2.3% of gross sales, as opposed to net sales.  The effect of taxing the gross, according to industry forecasts, can effectively mean a 50 percent reduction in profitability for device firms, in light of the fact that many of them find their prices locked in three-year contracts with their customers. Over the short term, the tax will force many companies to slash R&D budgets and lay off workers

The PPACA does provide an exemption for devices sold at retail.  Initially, this means that eyeglasses, contact lenses, and hearing aids would escape this taxation, but the cost of being designated as a ‘taxable medical device’ is so severe, that product designers have a strong incentive to develop new medical devices that would be available to the public at retail for individual use, where they might otherwise have had the incentive to develop the same device to be optimized for Medicare reimbursement. And Medicare is a key component of the PPACA’s effort to cover almost all Americans with basic, affordable healthcare.

The IRS is scrambling to contain this hole by applying a new set of rules to determine whether a device is available for retail.  This creates a rather interesting arms race scenario, pitting product designers familiar with the consumer goods/retail industry and the tax regulators who are struggling to define the boundary of this exception.

Thus, without immediate reform, the brave new world beyond the Affordable Care Act will find a lot of medical devices that look like those beautiful homes in Beaufort. We’d rather see a bigger box for facilitating innovation performance, with greater attention to actual needs of customers—hospitals and other care organizations—and their ultimate end users, patients, the people actually named in the healthcare reform legislation itself.