CRS Report: Medical Device Tax Burden Falls On Consumers

March 6, 2015

The Congressional Research Service recently released a report on the Medical Device Tax in the Affordable Care Act. It fairly enumerated most of the critiques of the tax, which are wide-ranging and substantial. (Here was ours.) It also stated the principal argument for the tax – essentially, that it’s a source of revenue for the government.

The most important economic analysis in the report was the argument that the tax would not be a substantial drag on the medical device industry, because demand for medical devices is relatively inelastic and the cost of the tax could be passed on to consumers. In simpler terms, the CRS argument is that the medical device companies will simply add the tax in to the prices of the goods that they sell, and people will just have to accept the higher prices:

The analysis suggests that most of the tax will fall on consumer prices, and not on profits of medical device companies. The effect on the price of health care, however, will most likely be negligible because of the small size of the tax and small share of health care spending attributable to medical devices.

I have a couple of things to say about this argument. On its face, it sounds kind of reasonable – and I actually don’t dispute the economics at all. I do agree that most – but not all – of the tax will fall on consumers, because consumers have no choice but to buy their medical devices.

But that’s not really a very nice-sounding story, is it? Don’t worry, the consumers will ultimately be hit with the tax, and they’ll just have to deal with it because they need their pacemakers! I don’t think there’s anything wrong with that argument as economics, per se, but it’s a little bit ugly in moral terms.

Furthermore, I take umbrage at the idea that the tax is simultaneously (1) an important source of revenue, (2) passed on to consumers of health care, and (3) “negligible” to health consumers. What the CRS has done, here, essentially, is use language that implies the revenue is an important number when it’s given to the government, but a small number when it’s taken from consumers.

This is, of course, silly. A number is the same size no matter whose balance sheet it appears on – and if anything, American consumers probably feel like $38 billion is a much larger number than the federal government does.

But it’s especially silly in light of what the Affordable Care Act actually does with the money. It taxes medical devices companies, who pass the extra cost onto consumers, raising health care costs. Then it applies the revenue it has earned to subsidies for consumers, to help them with their rising health care costs.

This diagram is by no means complete. There are many taxes other than the Medical Device Tax. And many of the consumers who will ultimately take on the burden of the device tax won’t receive subsidies. But the flowchart above does show the extent to which the law as a whole shifts costs around in a circle. It is a little bit like the public policy equivalent of a perpetual motion machine.

Perpetual motion machines are a long-discredited idea in physics, where people try to construct a free source of energy in the form of a machine powered solely by the energy it creates on its own. This is impossible; it violates the laws of thermodynamics.

In a certain sense, fiscal policy has its own laws of thermodynamics. Passing costs along from businesses to individuals to government back to businesses ultimately doesn’t create money, but it could very well lose it through the same kind of inefficiency or entropy that stops perpetual motion machines from working. Taxes and spending programs have administrative and compliance costs. Some revenue gets lost in the shuffle.

Here’s an example of that entropy in practice: the CRS report addressed the lower-than-expected collections we covered last year. The main CRS explanation for the revenue shortfall was a lack of taxpayer compliance, which often happens on complex taxes. Particularly, the theory was that general manufacturers who weren’t specifically in the medical device industry (but manufactured some medical devices) were failing to file:

A July 2014 report issued by the Treasury Inspector General for Tax Administration (TIGTA) found that the number of medical device excise tax filings and the amount of associated revenue reported are lower than estimated. According to the TIGTA report, the IRS processed 5,107 tax returns with reported medical device excise taxes of $913.4 million for the quarters ending March 31 and June 30, 2013. The IRS estimated between 9,000 and 15,600 quarterly Form 720 tax returns with excise tax revenue of $1.2 billion for this same, two-quarter period. In other words, actual medical device tax collections were 76.1% of projected collections during this period.

Some firms might not have known that they were subject to the tax. For example, TIGTA noted that the North American Industry Classification System (NAICS) code is unreliable for identifying businesses that may be subject to medical excise tax reporting. While most of the businesses that filed tax payments during TIGTA’s observation period in 2013 were classified as being in the “medical equipment and supplies manufacturing” industry, some manufacturers were in other, nonmedical specific manufacturing categories. TIGTA recommended that the IRS take further actions to reduce noncompliance with the tax, such as issuing notices to potential nonfilers.

There is a certain intellectual bankruptcy in defining an arbitrary category – “medical devices” – and then levying a special tax on that category alone. It leads to definitional games about what goods fall into the arbitrary category and what goods don’t.

The answer is not – as the Treasury Inspector General recommends – to crack down on noncompliance. That’s a second-best solution. The best solution is to repeal the tax.

This blog post also appears on our Forbes contributor page.

Related Articles