The Medical Device Excise Tax: Another Barrier to Innovation
The Affordable Care Act (ACA) passed in 2010, generally known as “Obamacare”, imposes a new 2.3 percent federal excise tax on medical device manufacturers set for implementation in January 2013. The Congressional Budget Office (CBO) anticipates that this medical device excise tax will generate $20 billion dollars. According to the CBO, this is but one of Obamacare’s 18 separate tax increases totaling approximately $800 billion over 10 years. This excise tax, applied to annual revenue rather than to net profits, will be assessed on all medical devices sold in the U.S. – including those that are imported – but does not apply to those medical devices manufactured and sold overseas by U.S. companies.
What is the potential financial impact of this excise tax on U.S. medical device manufacturers? In a September 2011 study (Employment Effects of the New Excise Tax on the Medical Device Industry) commissioned by the Advanced Medical Technology Association (AdvaMed) and conducted by Furchtgott-Roth Economic Enterprises, economists Diana Furchtgott-Roth and Harold Furchtgott-Roth found that, based on a sample of seven medical device manufacturers, the effect of the 2.3 percent excise tax would have reduced their net profits from a low of 6.8 to a high of 40 percent. The study’s authors offered this onerous conclusion:
The effect of the tax on earnings of U.S. companies is likely to be significant. In 2006, medical device manufacturers reported taxable income of $13.7 billion and paid $3.1 billion in corporate taxes. The United States already has one of the highest corporate income taxes in the world. The new 2.3 percent excise tax will roughly double their total tax bill and raise the average effective corporate tax rate to one of the highest effective tax rates faced by any industry in the world.
According to medical device industry analyst Jeff Jonas, of Gabelli & Co. of Rye, NY, the actual impact of the excise tax on a medical device company can be mitigated in a variety of ways, including: the excise tax being deductible from a company’s income tax (making its true impact closer to 1.4 percent); a research and development (R&D) tax credit of nearly 2 percent which can also be deducted from corporate income taxes; larger medical device manufacturers raising prices while reducing costs and discretionary spending; and lower corporate tax rates on foreign operations which will also allow larger medical device manufacturers to offset the effects of the excise tax. Jonas’ analysis sheds light on how this 2.3 percent excise tax can have its effective impact reduced on larger, financially successful medical device manufacturing firms. But, as noted in the Furchtgott-Roth Economic Enterprises study, Jonas’ analysis does not adequately address a critical segment of the manufacturing device industry:
… the new tax will be paid both by firms that have the net income and those that do not. The tax will be especially harmful to companies that innovate and tend to suffer losses in the first years or when investing in research and development for a new product but would still be required to pay the tax.
The U.S. medical device industry is considered highly competitive and fragmented, with hundreds of active firms in the market and 95 percent of them reporting annual sales revenue less than $100 million. A June 2009 joint study (Medical Technology and Venture Capital: A Fruitful Yet Fragile Ecosystem) undertaken by the Medical Device Manufacturers Association (MDMA) and the National Venture Capital Association (NVCA), found that 80 percent of companies employ fewer than 50 employees, while 98 percent employ less than 500 workers. Given the intensity of competition in this R&D focused industry, it should not be surprising that the industry generates constant innovations. A March 2012 study, The Economic Impact of the U.S. Advanced Medical Technology Industry, prepared by Battelle Technology Partnership Practice for AdvaMed, found that between 2004 and 2009, there were 19,267 U.S. patents identified for “surgical and medical instruments” and 7,884 patents for “other medical equipment” (for a combined total of 27,151 patents).
In a January 2011 PriceWaterhouseCoopers report, Medical Technology Innovation Scorecard: The Race for Global Leadership, 32 of the 46 medical device companies worldwide with $1 billion or more in annual sales are identified as U.S companies. While the U.S. remains the leader in medical device innovation, there are early indications that this primacy is slipping. According to the PriceWaterhouseCooper report, medical device entrepreneurs express frustration with the vicissitudes of the FDA medical device regulatory approval process; health insurance companies negotiating narrower profit margins on devices; and the impending 2.3 percent excise tax on their products. These frustrations among industry executives are translating into real concerns among venture capitalists.
In an October 2011 study (Vital Signs: The Crisis in Investment in U.S. Medical Innovation and the Imperative of FDA Reform) co-sponsored NVCA and the Medical Innovation & Competitiveness Coalition, 156 NVCA members (representing approximately $10 billion of NVCA invested capital during the 2008-2010 period) responded to a survey on their life science sector investment strategies. According to the survey results, 42 percent of venture capital firms planned to make fewer medical device investments over the next three years, while only 22 percent planned to increase medical device investments over this period. Furthermore, 61 percent of venture capitalist survey respondents identified FDA regulatory concerns as the most significant factor affecting their investment decisions, and 38 percent cited it as the leading reason for shifting operations outside the U.S. Not surprisingly the medical device industry is gradually moving offshore to seek clinical data from trials, new product registration, and initial revenue resulting from an accelerated regulatory approval process, with developing nations emerging as the leading markets for smaller, faster, more affordable medical devices.
In the August 15, 2012 edition of the PriceWaterhouseCoopers LLP/National Venture Capital Association Money Tree Report, venture capital funding for the medical devices industry dropped to 10 percent of total funding dollars in the second quarter of 2012, compared to 12 percent in the first quarter of 2012. With the January 2013 implementation date looming, venture capitalists are looking at prospects for their return-on-investment and now actively factoring in the economic effects of the excise tax on their prospective clients. The result is that this excise tax is making it difficult for smaller, innovative medical device firms to acquire venture capital necessary to survive and prosper.
The implications of the impending excise tax are significant for medical device companies, American patients, and the U.S. economy. It is quite likely that many small, innovative medical device companies will not receive the venture capital funding necessary to fund their devices, and thus they will not provide their life sustaining technologies to patients. Furthermore, those companies receiving venture capital funding may not bring their medical devices to the U.S. initially, or at all. Based on a November 2010 study (FDA Impact on U.S. Medical Technology Innovation) surveying over 200 small and medium-sized medical device companies that was undertaken by Josh Makower of Stanford University (and actively supported by both the MDMA and the NVCA), Dr. Makower found that on average, innovative new medical devices are available to U.S. citizens two full years later than patients in other countries, and in certain cases, Americans have had to wait up to six years longer than patients in other countries. These survey results did not factor in the full effects of the medical device excise tax, which may lengthen wait times.
Finally, the excise tax, which disproportionately harms small and medium-sized medical device manufacturers, along with FDA regulatory approval process concerns, will further threaten U.S. leadership in generating medical technology innovation. To encourage a globally competitive, innovative U.S. medical device industry and arrest global industry leadership decline, a change in public policy is warranted: repeal the medical device excise tax before its full effect is felt.