Magazine Article | May 30, 2014

Dysfunctional Tax Policy Harming Life Science Innovation And Jobs

Source: Life Science Leader

By John McManus, president and founder, The McManus Group

It is now undeniable that federal tax policy has as big an impact on innovation in healthcare as any other healthcare policy that impacts Medicare, Medicaid, or commercial insurance coverage and reimbursement. Two examples now gaining increasing attention in Washington make that abundantly clear:

  1. the excise tax on medical devices
  2. the corporate tax law known as “inversion,” which enables an American company to reincorporate into a lower-taxed foreign country.

Medical Device Tax Costing Jobs and Research
Congress enacted a 2.3 percent excise tax on medical devices as a $28 billion scheme to extract revenue out of that industry in order to help fund Obamacare. The argument at the time was that the medical device industry would benefit from all the new covered lives that Obamacare would produce, so it should do its part by helping to finance the program.

That logic was flawed because most of the device business is for seniors, which Medicare already covered. Moreover, after the Supreme Court made the Medicaid expansion optional, nearly half of the states refused to cover those low-income, uninsured adults. And a recent McKinsey study found that about three-fourths of the people enrolled in the new health exchange previously had coverage.

Because the device tax is an excise tax on gross revenue, it is far more pernicious than an income tax and grows more expensive over time. Imagine a small device company – which dominate the industry – with $20 million in revenue and a 5 percent profit of $1 million. Assuming it had a 25 percent corporate tax rate, it would pay $250,000 in income tax. The 2.3 percent excise tax on revenue requires it to pay an additional $460,000 tax, which balloons its federal tax by 184 percent!

The results are even more dire for companies that are not yet making a profit. A recent survey by the Medical Device Manufacturers Association of its members found that 64 percent work at companies that are not yet profitable, but are generating revenue and, therefore, subject to the tax. One CEO complained, “The device tax takes our profit to a loss.”

How are device companies responding to this new burden? Job layoffs and reduced research and development:

  • That same survey found that two-thirds of companies were reducing or halting job creation or relocating outside of the U.S. as a direct result of the device tax. More troubling, nearly half of the companies reported reducing R&D to pay for the tax, 18 percent, on average.
  • A more comprehensive survey undertaken by Advamed found that in the first year of the tax’s implementation (2013), 14,000 workers in the device industry were laid off, and 30 percent of companies had decreased R&D.

The Republican-controlled House has voted numerous times to repeal the medical device tax, but the Democratic-controlled Senate has not permitted a vote on the bill. Majority Leader Reid (D-NV) has employed a parliamentary tactic known as “filling the amendment tree,” which denies the Senate from voting on the device tax repeal or any other issue that is not already incorporated in the underlying bill.

It is now undeniable that federal tax policy has as big an impact on innovation in healthcare as any other healthcare policy that impacts Medicare, Medicaid, or commercial insurance coverage and reimbursement.

However, pressure is building by Senate Republicans to permit a vote on a two-year suspension of the tax as part of the must-pass tax extender package. If the Democratic leadership allows the Senate to work its will, it could be a baby step to earning back its reputation as the most deliberative body in the world, and this job and R&D killer could be terminated on the installment plan.

Antiquated Tax Code Incents Foreign Ownership of U.S. Companies
Meanwhile, Congressional paralysis on comprehensive tax reform has left U.S. corporate tax rates among the highest in the world and continues to distort decision-making of many American pharmaceutical executives by making it irrational to maintain their primary base of operation in the U.S. The latest example is New York-based Pfizer’s proposed merger with the smaller U.K.- based Astra Zeneca, in part, to benefit from Britain’s lower tax rate.

The deal is known as an “inversion,” whereby the multinational U.S.-based company becomes an expatriate by acquiring the smaller foreign company. The U.S. tax code encourages this behavior because U.S.-based companies are taxed at the 35 percent rate for worldwide income, but they can defer U.S. tax on income earned abroad until it is repatriated. Most other countries have a territorial system, which only taxes income where it is earned.

An inversion enables the company to pay only U.S. taxes on its U.S. income, and not its worldwide income. In Pfizer’s case, it had $69 billion in foreign profits indefinitely invested abroad because it did not want to subject those earnings to the high U.S. tax rate. Pfizer CEO Ian Read proudly stated that the deal would “liberate the balance sheet and tax of the combined companies.”

Valeant’s acquisition of Biovail, a Canadian company, enabled it to achieve a low single-digit tax rate. It is now attempting a hostile takeover of California-based Allergan and touting the tax savings that can be achieved to maximize shareholder value and slash Allergan’s current 25 percent rate. Allergan is a profitable company that has been growing by double digits for years and devotes about 15 percent of revenue to R&D. Valeant lost money on $500 million less revenue than Allergan last year and devotes only about 3 percent to R&D, preferring to acquire alreadysuccessful products. Yet the distorted tax code makes the acquisition of Allergan a distinct possibility.

Of course these mergers do much more than erode the U.S. tax base. They often result in substantial job loss, particularly in the U.S., and reduced R&D for the cures of tomorrow. These “efficiencies” have been publicly discussed as a benefit to shareholder value, even though there may be less value to the society at large over the long run. What happens to these high-wage, high-skilled jobs that beget other good jobs? Who is going to support the economy and provide the tax base for investments in our future? Is America going to cede these jobs to Europe, Latin America, and East Asia?

What is Congress doing about inversions?
Ways and Means Chairman Camp (R-MI) introduced comprehensive tax reform legislation that would lower the U.S. corporate tax rate to 25 percent and move to a territorial system that eliminates incentives for inversions.

On May 8, 2014, Finance Chairman Senator Ron Wyden (D-OR) issued a public statement saying that he and Senator Carl Levin (D-MI) intend to introduce legislation to stymie the growing trend of U.S. companies inverting and moving their tax domiciles outside of the U.S. His bill would have a retroactive effective date of May 8, 2014. In addition, the bill increases the current 20 percent threshold of foreign company ownership to invert to 50 percent. While that bill is more punitive than the Camp approach, it does not address the underlying international inequities that are distorting company decision-making.

Unfortunately, with comprehensive tax reform stalled, the prospect of any action in this area looks remote.

Current U.S. tax policy, including the medical device excise tax and the dysfunctional corporate tax, has harmed U.S. innovation and U.S. job creation in the life sciences industry. It is high time that Congress begins solving these problems, even if it’s through a piecemeal approach like a temporary suspension of the device tax.