Lawmakers’ Tax Rate to Help Pay for Reconciliation is 1,900 Percent

August 31, 2021

As lawmakers look for ways to pay for trillions in new spending, they are considering changes to prescription drug pricing under Medicare Part D. As explained here, H.R. 3, the Elijah Cummings Lower Drug Costs Now Act, would use the leverage of steep excise tax penalties to make drug manufacturers lower their prices, generating about $581 billion in cost savings (not new tax revenue) for the federal government.

While the excise tax penalty is referred to as a 95 percent tax rate, it actually amounts to a 1,900 percent tax rate because of how the proposal defines the tax base. In other words, under the H.R. 3 tax penalty, a drug that sells for $100 would incur a $1,900 tax.

One way to understand how that happens is with a sales tax example. When you purchase a $1.00 soda and it faces a 6 percent sales tax, the total you pay for the soda is $1.06. The 6 percent tax rate is a “tax-exclusive” rate, meaning that the 6 cents is paid in addition to the underlying price of the soda. But there is another way to state tax rates, and that is the “tax-inclusive” rate. If we wanted to see the “tax-inclusive” rate for the soda, we would compare the tax paid to the total paid for the soda including the tax. That would look like 6 cents of tax compared to the total of $1.06, for a “tax-inclusive” rate of 5.7 percent (.06/1.06).

The “tax-inclusive” rate will always be lower than the “tax-exclusive” rate. At low tax rates, the two are fairly close. However, at higher tax rates, the two diverge.

The distinction is important because H.R. 3 outlines the “tax-inclusive” rates—always the lower way to state the tax rate—that would be applied to drug sales if manufacturers do not agree with the price negotiations. The tax-inclusive rates would start at 65 percent, rising by 10 points for each period of noncompliance, and would top out at 95 percent.

The Joint Committee on Taxation (JCT) describes the tax liability that would be incurred under H.R. 3 with this example:

Assume that, prior to imposition of the excise tax, Manufacturer A charged $100 for drug A. If, after imposition of the excise tax, Manufacturer A charges [the same] $100 and does not separately state a tax, the price is deemed to be $35, and Manufacturer A owes $65 in tax. In other words, $65/($65+$35) equals 65 percent. Because Manufacturer A did not state a separate charge as tax, it is presumed that the price charged includes the excise tax.

Alternatively, Manufacturer A could separately state a price of $100 and a tax of $186, in which case it would owe $186 in tax. In other words, $186/($186+$100) equals 65 percent.

As the JCT example illustrates, the 65 percent tax-inclusive rate is equivalent to a 186 percent tax-exclusive rate. The table below shows the tax-inclusive and tax-exclusive rates for the entire H.R. 3 tax rate schedule.

Tax Rates Could Reach 1,900 Percent Under H.R. 3
Tax-Inclusive Rate Tax-Exclusive Rate Tax and Underlying Price for a $100 Drug without separately stated tax Tax and Underlying Price for a $100 Drug with separately stated tax
65% 186% $35 deemed price
+ $65 deemed tax
= $100 total
$100 stated price
+$186 stated tax
=$286 total
75% 300% $25 deemed price
+$75 deemed tax
=$100 total
$100 stated price
+ $300 stated tax
=$400 total
85% 567% $15 deemed price
+$85 deemed tax
=$100 total
$100 stated price
+ $567 stated tax
=$667 total
95% 1,900% $5 deemed price
+$95 deemed tax
=$100 total
$100 stated price
+ $1,900 stated tax
=$2,000 total

Source: Author calculations based on H.R. 3.

The JCT expects that all manufacturers would either participate in the price negotiation process (or pull a particular drug out of the U.S. market entirely) rather than pay the excise tax on drug sales—so the excise tax itself does not raise revenue.

It is the threat of 1,900 percent excise taxes on sales that provides enough leverage to force companies to lower their prices, thus H.R. 3 would generate cost savings, not new tax revenue, for the federal government. That, of course, would come at the cost of decreased research & development spending and a reduction in innovation that would reduce the number of new drugs available. Paying for the reconciliation bill by forcing companies to lower drug prices under the threat of a 1,900 percent tax is not a productive path for lawmakers to pursue.

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The tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates.

A sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding.

An excise tax is a tax imposed on a specific good or activity. Excise taxes are commonly levied on cigarettes, alcoholic beverages, soda, gasoline, insurance premiums, amusement activities, and betting, and make up a relatively small and volatile portion of state and local tax collections.