The 2.3 percent medical device tax

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.

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update--

We recently published some thoughts on the coming medical device excise tax housed in the Patient Protection and Affordable Care Act (PPACA). The excise tax in question, a 2.3 percent levy on medical devices geared at hospitals, rehab clinics, and other medical practices, would generate $20 billion in revenue in the coming 10 years in support of a variety of efforts to deliver basic, affordable care to almost all Americans.

A pair of Senators representing the states slated to be most affected by the ill effects of the tax, Amy Klobuchar of Minnesota and North Carolina’s Kay Hagan, have asked for an outright delay in the implementation of the tax, as part of Congress’s year-end fiscal cliff deliberations with the Obama administration.  While this would provide a temporary reprieve, what are the alternatives?

We found a great piece by Robert Koshinskie, a medical device professional, where he outlines several alternatives:  outright repeal of the tax, reduction by one percent, reduction by one percent and extending the tax to retail devices, and capping the tax to certain revenue levels.  While outright repeal or singular reduction would leave a large funding gap in the PPACA (and, by Koshinskie’s own keen analysis, require some sort of rare compromise and/or political face-saving by PPACA supporters), the latter options, extending a lowered tax to retail and perhaps including a cap in revenues applied for taxation purposes, could bring in the necessary revenue for the PPACA implementation AND serve as less of a barrier to innovation.

Bringing retail into the mix of taxable devices would allow the industry to amortize the extra tax-associated costs among not only institutional players, but millions of consumers as well.  Rather than crushing companies and forcing huge drops in R+D expenditures and layoffs in our slowly-recovering economy, this would serve as another way for individuals to have skin in the game.  These factors would help to preserve a marketplace that’s more about designing and building the best products for use by healthcare professionals and the patients they serve, rather than products tailored for the tax code.

Healthcare in the United States has been a public-private partnership for many decades—let’s make sure that we keep the proper balance in this relationship, with regard to innovation.  More affordable basic healthcare, combined with a marketplace geared to continuous innovation in medical devices, will benefit individual patients and public health outcomes for years to come.