Excise Tax on Medical Devices

The Patient Protection and Affordable Care Act, more commonly referred to as Obamacare, will have far-reaching consequences in the health care industry. (See the first paragraph of this previous post for my take on how congressional bills are named.)

Without getting into the political, moral, and religious implications of the legislation, it is important to consider the economic impact.  Let’s look at one single provision of the ~400,000 word statute.  To raise tax revenue, a 2.3% excise tax on the sales of medical devices went into effect on January 1, 2013.  At first glance, this figure may not seem especially high, but this tax is on sales, not profits.

Traditional corporate taxes are paid on profits, so if a company sells $10 million of furniture, and incurs $9 million of expenses, its pre-tax profit is $1 million.  The federal corporate tax rate of 35% is applied to this figure, so $350,000 goes to the federal government and $650,000 is kept by the company.  A start-up company is likely to lose money for years, and it pays no federal tax because it is unprofitable.

The Obamacare tax on medical device companies, which manufacture a wide array of products, behaves differently.  Start-up companies now have to pay taxes despite being unprofitable, which is devastating from a cash flow perspective and could threaten their viability.  The 2.3% tax on top-line revenues has a huge effect on the profitability of mature companies as well.  These calculations below illustrate comparing 2012 vs. 2013 for three hypothetical companies with pre-tax profit margins of 20%, 5%, and -10% (start-up):

Pre-Tax Profit Margin = Pre-Tax Profit / Gross Revenue
Net Income is based on 35% corporate tax rate

20% Pre-Tax Profit Margin
	2012		2013
Gross Revenue	$1,000		$1,000
Medical Device Tax	$0		$23
Adjusted Revenue	$1,000		$977
Expenses	$800		$800
Pre-Tax Profit	$200		$177
Net Income (Profit)	$130		$115
Net Income fell by 11.5%

5% Pre-Tax Profit Margin
	2012		2013
Gross Revenue	$1,000		$1,000
Medical Device Tax	$0		$23
Adjusted Revenue	$1,000		$977
Expenses	$950		$950
Pre-Tax Profit	$50		$27
Net Income (Profit)	$33		$18
Net Income fell by 46.0%

10% Pre-Tax Loss for Start-up Company
	2012		2013
Gross Revenue	$1,000		$1,000
Medical Device Tax	$0		$23
Adjusted Revenue	$1,000		$977
Expenses	$1,100		$1,100
Pre-Tax Profit	-$100		-$123
Net Income (Profit)	-$65		-$80

Net income fell by $15, but actual cash loss was $23 because losses for a start-up can only be offset by future gains

These results are staggering, because a 2.3% tax may not register as being huge, but it is extremely problematic for the industry.  Profitability falls by 11.5% for a firm with a pre-tax profit margin of 20%, and 46.0% for a firm with a pre-tax profit margin of 5%.  Start-up companies looking to create innovative products that could help save or improve our lives now face a huge additional financial burden that could threaten their existence and cause a slowdown in entrepreneurial capital flowing into the industry.

At a time where tens of millions of baby boomers are requiring more health care services, it is instructive that many medical device manufacturers have resorted to layoffs over the past two years to cut costs in response to this excise tax.  The companies will also have no choice but to pass on costs to hospitals, physicians, and consumers, thereby increasing, rather than decreasing, the cost of health care.  This illustrates yet another example of government policy producing unintended economic consequences.

Source:  http://mblb.com/wp-content/uploads/2012/04/Medical-Symbol2.jpg