Medical Device Tax Is Recouping Some of the Excess Profits from the ACA

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Thursday, 17 October 2013 04:48

The NYT ran a column by Topher Spiro which defended the medical device tax. The column neglected to give the main rationale for the tax, it will recoup some of the excess profits that the industry will accrue as a result of the Affordable Care Act (ACA).

The logic here is fairly straightforward, medical devices are like prescription drugs, they can cost a lot to develop, but are cheap to produce. Companies get back their research costs by charging prices that are far above their production costs, which they are able to do as a result of patent monopolies.

To take a simple example, suppose a medical device company has a new screening device that it sells for $1 million. It cost $100,000 to manufacture, so it will make $900,000 from each device it sells. Before the ACA it had expected to sell 1000 copies of this screening device. That would gross it $1 billion, or $900 million in excess of its production costs.

As a result of the ACA more people will have access to health care and therefore demand for the screening device will increase. Suppose it were to rise by 10 percent. In this case the industry's revenue would rise to $1.1 billion and the profit over production costs will increase to $990 million.

Since the industry had not anticipated the ACA when it developed the screener, and had not expected these extra sales, this additional $90 million is pure gravy in the form of unanticipated profits. The logic of the tax is to take away this gravy to limit the windfall that device manufacturers enjoy as a result of the ACA.

It is also worth noting that the corruption cited in Spiro's column is the predictable result of a situation in which a product sells at price far above its marginal cost as a result of government protection. This is the same problem that we see in the prescription drug industry.

The economist's solution would be to devise a mechanism for funding research that would allow drugs and medical equipment to be sold in a free market. However because of the power of the affected industries and the dominance of protectionists in national politics, the efficiency of patent protection in these sectors is rarely discussed.