Device Tax Repeal Stayin’ Alive

The U.S. House of Representatives voted 270-146 on June 7, 2012, to repeal the scheduled 2.3% medical device excise tax that is to take effect in 2013.

The vote was bipartisan with 37 Democrats joining Republicans to repeal. There are now nervous Democrats in the U.S. Senate from medical device manufacturing states up for reelection in November who want to show voters they’re looking out for jobs back home.

Bipartisanship, jobs and an American industry that is still leading the world would seem like a good recipe for a compromise to get the bill heard and passed in the Senate.

DOA in Senate?

However, the Democratic-controlled Senate, immediately after the House vote, said through a spokesperson that there would be no hearings scheduled. The White House then jumped in to say the veto pen was waiting for the bill if it reached the President’s desk.

It would seem the repeal of the device tax has no chance, but some of those nervous Democratic senators want to revisit the issue before having to explain themselves to voters in the fall.

When the health care reform law, referred to as “Obamacare, ” was being negotiated a couple of summers ago, the medical device industry, led by AdvaMed, successfully negotiated a proposed $40 billion device tax down to $20 billion over ten years. When the midterm elections in 2010 gave Republicans control of the House, device manufacturers redoubled efforts to repeal the tax.

Does repeal have a chance?

Nervous Senate Democrats

Tim PennyFormer Democratic Congressman and deficit-hawk Tim Penny from Minnesota told OTW that it seemed unlikely that the Senate would act on this before the presidential election. But given the noise influential Democratic Senators like Amy Klobuchar of Minnesota and John Casey of Pennsylvania are making, Senate leadership might have to give the bill some acknowledgment to protect those members. Even Massachusetts’ Republican Senator Scott Brown’s high profile Democratic challenger, Elizabeth Warren, is calling for repeal of the tax.

As a percentage of total employment, Minnesota, Utah, Delaware and Massachusetts have the largest concentrations of medical technology jobs, according to AdvaMed. The top 10 states, including New Jersey and California, have 12 Democratic senators.

Because Republicans have made repealing “Obamacare” a top legislative priority, many Democrats are afraid to vote to dismantle any part of the Affordable Care Act (ACA) and having to admit the law isn’t perfect.

Democrats: Offset Must Be Sound

But, says Penny, this is not a vote against “Obamacare, ” and strengthens the ACA by giving it the right revenue stream. Penny said the repeal bill is good public policy because it recovers overpayments from people who received too much in subsidies to buy health insurance.

Senator Al FrankenWhen the bill to repeal was proposed, the main argument made by Democrats was that loss of the tax revenue would add to the national debt. “I still think we need to eliminate the tax, ” said Minnesota Democratic Senator Al Franken, “But any plan to do so must be offset in a responsible and fiscally sound way.” Republicans found the money to cover the estimated $29 billion, ten-year cost of repealing by changing rules governing what happens when taxpayers qualify for insurance subsidies under a prior year’s lower income and then make more money than expected.

The law limits what those people would have to repay. The House bill would make them return all overpayments. The White House called this a tax increase.

Killing the Goose

Whether or not this issue becomes electorally relevant in November, the narrative of killing the goose that continues to lay golden eggs of profits and jobs in places like, Indiana, Massachusetts, Minnesota and California, is a powerful economic story in an election about the economy. Mitt Romney went out to NuVasive, Inc. in San Diego this spring and praised the work of device companies while criticizing the heavy regulatory burden and taxes on companies in the U.S., citing how Europeans seem to do it better.

Tax Impact Debated

The potential impact of the device tax has been hotly disputed. The device industry already announced layoffs, citing the anticipated tax, as a reason.

Opponents of repeal say the device industry is trying to renege on a deal they agreed to when the ACA was passed. They also point out that device makers will benefit because tens of millions of currently uninsured potential customers will now have the resources to pay for new hips and knees. When the law passed, Bill Frist, M.D., the Senate’s former Republican Majority Leader proclaimed that the new law was good for everyone involved in health care. Steve Ubl, head of AdvaMed to told investors that the added tax combined with additional patients is probably a wash for device makers.

But the Medical Device Manufacturers Association (MDMA) and AdvaMed issued statements and published research that claims to show that the tax hurts the industry and disputes that there will be new, if any, business from the additionally insured. They say the newly insured aren’t the demographic age and health group for which devices are developed.

Companies also object to paying 2.3% of total revenue, regardless of whether or not the business made money. This will hurt innovation, they say, as companies with small margins or trying to get profitable, will be hurt most.

Industry Corporate Tax Rate

The device industry reported taxable income of $13.7 billion in 2006 and paid $3.1 billion in corporate taxes. That’s a roughly 23% effective tax rate—right around the 25% average for all industries, said a study by the Tax Foundation. Add a $3 billion annual new tax on top of that, and the industry would pay more like $6 billion in taxes or a roughly 45%—well over the industry-wide average.

The report said industry will likely be able to pass along the cost of the tax increase to consumers because it is unlikely patient demand for devices, particularly life-saving, devices will decline dramatically.

Matson: Impact on Earnings and Volumes

So who’s right? What is the most probable impact of the tax on industry and procedure volumes?

We turn to Mike Matson of Mizuho Securities, one of orthopedics’ most senior Wall Street analysts.

Mike MatsonIn a March 21, 2012 analyst note, Matson stated, “Assuming reform remains unchanged, the medical device excise tax…will only be partially offset by an increase in procedures as the uninsured gain coverage”.

Matson expects 2013 earnings by device companies he covers, to be reduced by 5%. However, he says Stryker Corporation and Zimmer Holdings, Inc. have indicated they fully expect to offset the tax, while NuVasive and Orthofix International, NV expect to partially offset the tax.

In general, Matson says larger-cap companies more likely to offset the tax than smaller-cap companies given a smaller impact and greater P&L flexibility.

However, Matson anticipates the tax to be somewhat offset by increased procedure volume as the uninsured start to gain coverage in 2014. “In the longer run, health reform should decrease the uninsured population by around 30 million people in 2016. While the uninsured group tends to skew younger, middle-aged individuals (45-64 years old) make up 27% of the uninsured population.”

He therefore expects the number of insured middle-aged people to increase by 7.5 million or 9%. “Since we estimate that middle-aged people account for 36% of med tech procedures, we expect this to result in a 3% increase in med tech procedures between 2014 and 2016.”

Exhibit 1:  Potential Impact of Medical Device Excise Fee and Management Plans

Source: Company reports and Mizuho Securities USA estimates

While Matson says it’s straightforward to calculate the impact of the tax (see Table), what’s less clear is the companies’ ability to offset it.

One way to pass it on is through a price increase. “But given a lack of pricing power, we think that this is highly unlikely. So we think the companies must either offset the tax with cost reductions or see their earnings reduced. We expect most companies to attempt to do the former but not all will be successful.”

Here is how some companies have said they intend to deal with the tax during quarterly conference calls with analysts:

NuVasive: “We will figure out what we can with regard to offsets. But we don’t expect to be able to dramatically offset the tax…There are just not enough levers for us to pull.”

Orthofix: “One of the major initiatives and goals of improving our operating margins was to absorb [the tax]…It is certainly harder for a company that is smaller than a company that is bigger, but we have been planning on it for quite a bit of time and continue to look for efficiencies to cover it.”

Stryker: “We expect to be able to deliver greater than double-digit or greater growth in 2013, inclusive of absorbing the med device tax.”

Zimmer: “We do expect to be able to fully offset the medical device tax in 2013 through the savings that we’ll be achieving both in cost of goods and SG&A.”

More Procedures Not Enough

While expecting a 3% increase in procedures, Matson estimates there would have to be an average 8% increase in procedures to fully offset the impact of the tax. He also notes the volume benefits will come several years after the companies begin paying the tax.

The repeal effort could become moot depending on the outcome of the Supreme Court ruling expected in late June on the law’s constitutionality. The court could overturn the entire reform package or eliminate selected provisions, including a mandate that requires individuals to have health insurance.

That would be the worst outcome for companies, says Matson—the tax without the extra business.