What is the effect on supply when there is improvement in technology and increase in excise tax?

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Volume 47, Issue 5, June 2018, Pages 854-871

https://doi.org/10.1016/j.respol.2018.02.010Get rights and content

When the Affordable Care Act (ACA) was enacted on March 23, 2010, the federal government included a 2.3% excise tax on medical devices to help cover the costs of the expanded health insurance coverage. Medical device manufacturers criticized this excise tax, insisting that the tax would harm their research and development (R&D) investment and performance and thus should be abolished (Gravelle and Lowry, 2014). According to a Research America (2016) report, total R&D spending in medical and health care industries was $158.7 billion in 2015, with the medical device industry as one of the top five R&D-intensive industries. One of the largest medical device manufacturers, Stryker Corporation, estimated that this new excise tax would cost it approximately $100 million in 2013. Yet no prior study has examined whether the medical device excise tax affects firms’ R&D investment and performance in a negative way. In this article, I thus investigate how the excise tax affects R&D investment and various performance metrics (i.e. sales revenue, gross margins, and earnings) for medical device firms.

The excise tax could affect the medical device industry in different ways. On the one hand, the statutory incidence of the medical device tax on firms could increase the cost of production and shift the market supply curve upward. Then, the tax incidence would reduce firm sales, profits, and R&D investment if the price elasticity of market supply was relatively lower than market demand. On the other hand, if medical device manufacturers have high price elasticity with respect to the tax, they could pass the excise tax to consumers through prices (i.e. the tax is “passed forward”) and keep their original profits and margins. Therefore, the effects of the medical device tax on firm R&D and performance could differ depending on the elasticity of supply and demand for medical devices (Harberger, 1962), which is worthwhile to investigate empirically.

To identify the effects of the medical device tax on firm R&D investment and performance, I use the difference-in-differences (DD) framework. Specifically, I compare a treatment group of firms producing medical devices with a control group of high-tech firms producing non-medical devices, such as pharmaceutical products (Barry, 2005; Wolf and Terrell, 2016), before and after the excise tax incidence. For the empirical analysis, this article focuses on four different types of firm-level variables: (1) R&D expenditures, (2) sales revenue, (3) gross margins, and (4) earnings (profits). Analyzing the COMPUSTAT data from 2006 to 2015, I find that the medical device tax significantly reduced R&D expenditures, sales revenue, gross margins, and earnings by approximately $34 million, $188 million, $375 million, and $68 million, respectively, for firms in the treatment group.

In addition, the empirical findings suggest that the excise tax affected operating costs and market strategies for medical device manufacturers. These firms reduced their operating costs to alleviate the excise tax burden. They also significantly increased the global market sales intensity (i.e. the degree to which their sales revenue comes from operations in foreign countries) and global market diversification (i.e. the degree to which they diversified their businesses across different foreign markets) after the tax incidence because medical device sales outside the United States are tax-exempt. Furthermore, these firms increased customer market diversification (i.e. the degree to which they diversified their major customers in the United States) in an effort to reduce market power of major customers, to facilitate the passing of the excise tax to consumers through price.

This article contributes to the literature in two major ways. First, to the best of my knowledge, this article is the first to assess the effects of the medical device tax on firm performance and R&D investment. One recent study (Schmutz and Santerre, 2013) forecasted how much the excise tax would reduce R&D spending in the medical device industry. This article differs in the way it estimates the ex-post causal effects of the excise tax on firm performance in addition to R&D investment. As the medical device industry is highly R&D intensive and R&D is a primary driver of firm productivity and economic growth (Minniti and Venturini, 2017; Siliverstovs, 2016), it is critical to understand how the government tax policy affects firm performance in the R&D-intensive industry. Yet previous research has mostly focused on investigating the impact of R&D subsidies or tax credits on R&D investment in non-medical device manufacturing industries (Bloom et al., 2002; Bronzini and Iachini, 2014; Czarnitzki et al., 2011) or the pharmaceutical industry (Grabowski and Vernon, 2000; Scherer, 2001; Vernon, 2005).

Second, as the medical device market has not previously been subject to an excise tax, the estimation results in this article help clarify how medical device firms respond to the ad valorem excise tax and pass their tax burdens to customers. In particular, the empirical findings for the reduction in firm gross margins due to the excise tax suggest that firms in the medical device industry cannot fully pass the tax to consumers through prices, and therefore they reduce their operating costs to alleviate the excise tax burden. In addition, in contrast with other government policies, such as R&D subsidy or tax credit programs, the sample firms in this study do not suffer from a self-selection bias from participating in government programs, because the ACA excise tax is applied to all manufacturers, producers, and importers in the US medical device industry.

The rest of this article proceeds as follows: Section 2 explains the introduction of the medical device tax by the ACA, reviews previous literature on the effects of government tax policy on firm R&D, and demonstrates how the medical device tax affects firm R&D investment and performance. Section 3 describes the COMPUSTAT data and presents the descriptive statistics of the sample. Section 4 establishes the empirical strategy for identifying the effects of the medical device tax on firm R&D investment and performance and presents the empirical results. Section 5 provides concluding remarks.

The ACA, also known as “Obamacare,” was signed into law by the former US president Barack Obama on March 23, 2010. It included three key mandate provisions (i.e. employer, individual, and dependent coverage) to expand health insurance coverage to universal levels. To help cover the costs of the expanded health insurance coverage, the ACA also included several new taxes and fees imposed on several sectors.1

To examine how the medical device tax affected firm R&D investment and performance, I use the COMPUSTAT data from 2006 to 2015, which covers the periods before and after the tax incidence by the ACA.9

To analyze the effects of the medical device tax on firm R&D and performance, I use a standard DD framework. For the identification strategy, I compare the medical device manufacturers with firms producing pharmaceutical products, ophthalmic goods, and hearing aids before and after the tax incidence in 2013. Under this DD framework, I estimate the following model:yi,j,t=α1I(Med.Device)·I(Post2013)+α2I(Med.Device)+α3I(Post2013)+Xi,j,t'α4+Tt'α5+ϑj'α6+εi,j,t,where yi,j,t is the R&D expenditure

This study examines how the medical device excise tax affects firm R&D investment and performance. Using the DD framework as the identification strategy, I compared R&D investment and performance (i.e. sales revenue, gross margins, earnings, ROE, ROA, and Tobin’s q) for firms in the medical device and other high-tech industries before and after the tax incidence in 2013. The empirical results suggest that the ACA medical device tax significantly reduced R&D investment, sales revenue, gross

The author thanks Neil Bruce, Terry Shevlin, Stephen Turnovsky, Jun-Koo Kang, Eric Zivot, Seik Kim, Ju-Yeon Lee, Laura Jolly, David Spalding, Carl Weems, Jonathan Fox, Jennifer Margrett, Carla Peterson, and attendees of the public finance and corporate finance seminars at the University of Washington, Iowa State University, KAIST, and Peking University for their valuable comments. The author also thanks the editor and the anonymous reviewers for their constructive feedback.

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