A tax on innovation?

On 1 January 2013, the US Government introduced the much-opposed medical device tax. The legislation, which is part of the Patient Protection and Affordable Care Act (PPACA), was one of the issues at the centre of the 16-day government shutdown in October, where it was used by Congress as a bargaining tool during the negotiations.

The PPACA, also known as 'Obamacare', is key to President Obama's aim of improving the US healthcare system by increasing the affordability and quality of health insurance, lowering rates of uninsured citizens by expanding public and private insurance coverage, and reducing the costs of healthcare.

This means that US citizens who previously could not afford insurance would have plans that cover their medical needs, including access to medication and devices, thereby increasing healthcare consumption.

The new tax is a 2.3% excise on devices such as artificial joints, defibrillators, pacemakers and stents (but not devices sold over the counter, such as eyeglasses, contact lenses and hearing aids, which are exempt) to help cover the costs of the PPACA.

The government estimates that the money raised from this tax will total $30 billion over the next decade, and calls for manufacturers to pay for it themselves through the sale of their devices; the levy affects goods made and sold within the US, as well as those imported into the country.

Advocates of the tax contend that:

• the industries that would most benefit from the PPACA - the insurance, pharmaceutical and medical device sectors - should be the ones that help pay for it
• the newly insured will provide a wide customer base requiring medical devices
• the medical device industry can easily afford the tax.

Since the PPACA was introduced by the Obama administration in 2009, the medical device industry has been lobbying to repeal the tax.

Fierce opposition

Steve Ferguson is chairman of Cook Medical, one of the US's largest privately owned medical device companies, which is based in Indiana, home to the US's fifth-largest medical device industry. Ferguson has been a vocal opponent of the tax and argues against the claim that medical device firms will receive a wave of new customers from the increase in those enrolled into the PPACA.

"We've been paying the tax since 1 January and the PPACA has been a failure," he says. "Nobody has signed up, so getting new patients couldn't possibly be true. The older generation, which requires more healthcare and devices such as stents, catheters, and hip and knee replacements, are already enrolled in the system. Those people that the government is targeting are too young to need these products."

Another strong critic is the medical device industry's trade association, the Advanced Medical Technology Association (AdvaMed), which claims that the tax will result in the loss of over 40,000 jobs in the US, harm the country's global competitiveness, restrict medical innovation and be detrimental to patient care.

"We're now ten months into the tax and already we're seeing the effects - and they're not positive," says JC Scott, AdvaMed's director of government affairs. "Since it was announced, companies have been looking at how they can accommodate it and the only way to do so is through their operating budgets - by adjusting their head count via hiring freezes and job cuts, scaling back their growth plans, and reducing their R&D spend, which is the bread and butter for these companies."

Ferguson says that the tax is yet another expense that manufacturers have to take from their bottom line.

"The device tax is a gross tax, which is generally only applied to alcohol and cigarettes - things that we want to discourage the use of," he explains. "But this tax hurts the very industries that seek to help people with innovative medical devices and medicines. When you consider that the average income for a device firm is around 6-7% and you now have an additional 2.3% expense that cuts into that, the economics become extremely difficult."

Bringing a new product to market is already a huge expense that covers the cost of manufacturing, regulatory hurdles, and patent and IP protection. But, as well as the new tax, firms must invest in the systems and expertise to make sure they are compliant with paying the tax.

"While the government deems 2.3% to be a reasonable figure for the industry to pay, when combined with the 35% US corporate tax and the individual state taxes, the total tax rate for most medical devices companies will be around 50%," Ferguson explains. "You can't make cuts with paper clips, so firms are looking at R&D and employees because these are their two largest expenses."

The new tax is a levy on gross sales, whether a company makes a profit or not. This means that the 7,000 smaller start-ups that make up the bulk of the sector will be the hardest hit, as many only manufacture one product and have yet to make any profit.

Cut up rough

Before the tax came into force at the beginning of this year, firms were already bracing themselves for its effects. In November 2011, Michigan-based device manufacturer Stryker announced that it would be laying off approximately 5% of its global workforce and implementing other restructuring activities to reduce its annual pre-tax operating costs by more than $100 million before 2013, stating that this would "provide efficiencies and realign resources in advance of the new medical device excise tax".

More recently, Massachusetts' Boston Scientific announced that it would be losing 1,100 workers "because of limited prospects in certain markets and the taxes related to the healthcare overhaul".

And the job losses aren't restricted just to device manufacturers.

"In Indiana, during the last six months, Indiana University Health has announced that it is getting rid of 900 employees, the Franciscan hospitals are losing 250 and the Catholic charity system will make 600 redundancies," says Ferguson. "It's the result of a combination of factors, but mainly because the PPACA has put enormous pressure on hospitals."

Such redundancies will also have a detrimental impact on the economies of the surrounding areas, according to Scott.

"Local communities benefit from the demand for other goods and services that these positions directly create, as well as indirect services such as housing and shops," he says. "Workers in the medical device industry earn more than the average US worker. Their average salary is significantly - at least 40% - higher than other manufacturing industries; it's the crown jewels of manufacturing."

Ferguson looks at the bigger picture: "The president says he wants jobs in manufacturing, but with this tax, he's driving manufacturing out of the US and, because firms are having to lay off staff and reduce their investments in R&D, he's compromising the country's position as the world leader in medical device innovation."

Moving on and out

Cook Medical produces around 16,000 medical devices a year. While the company says it will not be making any staff cuts, according to Ferguson, the tax has had a compounding effect on business, particularly considering pressures such as the country's complicated regulatory system and tax codes.

"The slowness of the approval process through the FDA is a real problem," he explains. "We used to introduce 100% of our products in the US; now they are all launched elsewhere."

As well as faster regulatory systems, the tax rates of other countries are more attractive when compared with the cost of manufacturing in the US.

"Canada has a 15% tax rate and Ireland has 12.5% so, compared with the US rate of 35% as well as additional state taxes, those types of differentials become very important, especially when you're choosing where to do your value-added manufacturing," he says. "Looking at the economics, you're going to produce in the location where you have the lowest tax rates. In our case, we've discontinued our plans
for local expansions to try and adjust for this increase in our expenses."

But Cook Medical has not closed the doors on its growth strategy. The firm previously had plans to build five new plants in the mid-west, which would have created approximately 1,500 jobs, but "as our tax burden increases and the challenges of expanding our facilities in the US grow, we are now looking to produce new devices in countries where we have existing facilities, such as Ireland, Denmark and Australia," Ferguson explains.

Paying the price

One of the arguments of device tax advocates is that the medical device industry should just get on with it; similar levies have been placed on other industries - alcohol, cigarettes, fuel and air travel - for years and they have built the tax into their prices.

For medical device firms, however, this is not an option, at least in the short term. Their customers are hospitals, physicians and other healthcare providers that buy devices through multiyear contracts, so the prices are already fixed.

"Because of the industry's highly competitive nature and the purchasing agreements with hospitals, it is difficult for companies to incorporate the tax into their prices," says Scott. "The medical imaging sector, in particular, has a complicated business model; it does not buy imaging machines every year, so there will be a delayed effect, and many machines are leased."

But anti-tax campaigners contend that, ultimately, the tax will hit those who matter the most: the patients.

"The most significant factor is the reduction in R&D and investments," says Scott. "Slowing down the rate of innovation means that providers and patients will have less access to technology. Innovation counts for approximately 29% of total R&D spend for medical device companies - not an insignificant amount. And if they have to make cuts in this area, the result is that there will be fewer innovative products available to patients."

Ferguson agrees: "Innovation relies on people looking to solve medical problems," he says. "Some companies can relocate manufacturing and do things to soften the blow of the new tax, while others will have to look at jobs and R&D. Employees are crucial to R&D and making redundancies will affect it. If you don't have the money to reinvest in products then you lose the resultant innovation - and the quality of patient care is lost."

The battle continues

Even though the legislation is in place, the fight against the tax is no lost cause. While the industry missed out on abolishing the tax in October, the government shutdown made the general public more aware of its effects and what it could mean for the future of medical care.

"The fight goes on," says Scott. "AdvaMed is in the process of evaluating where the government will go next and how it will fund the PPACA. Once the government clarifies this issue, then we'll be able to take a stance. Not only will we continue to talk to policymakers, but the general public is also now familiar with the new tax and its impact on the industry, which is a positive."

Ferguson likewise will continue his mission to enlighten the US Government. "One thing we've done as an industry is educate members of Congress about the impact of the tax," he says. "As they have begun to realise the industry's nature and the impact of the tax, we have picked up some bipartisan support. So, when they tour their districts to talk to firms and employees, they'll understand the impact."

AdvaMed has also carried out its own tours of manufacturers.

"One of the most heartening things to come from all this is that employees are now expressing their concerns about the new tax - how it has hit sales and, in turn, their jobs and their own healthcare - and showing that they understand why it should be repealed," says Scott. "In particular, from a medical imaging perspective, the US environment has been very challenging with reimbursement issues, the economic slowdown and now the medical device tax. It all affects the value of medical imaging and is damaging to what is a promising industry."