Should we tax medical devices?

Like most aging runners, my wife’s knees aren’t what they used to be. Fortunately, there is a solution to this problem—knee replacement has become nearly routine surgery.  The Agency for Healthcare Research and Quality reports 718,000 hospital stays in 2011 were due to “knee arthroplasty” or total knee replacement. The rate per 10,000 population nearly doubled from 1997. Yes, the aging of the population has something to do with the increase—yet even among 65-84 year olds the rate increased by 59% (http://www.hcup-us.ahrq.gov/reports/statbriefs/sb165.jsp). And yes, the rising rate of obesity explains part, but not all, of the trend.

We needn’t look to sophisticated studies for the reason as joint replacement surgery can significantly improve quality of life. A 2011 “meta analysis” of over 100 studies concluded that nearly 90% of artificial knees were still doing the job 10 years after surgery. As these studies necessarily involved surgeries that took place before 2000, results have almost surely improved. For most patients, an artificial knee (or hip) can be expected to last 15-20 years. Recovery time is getting shorter, too. Many patients are back to driving in a month. If you can’t walk without pain, an implant would seem to be an easy choice.  Provided you can convince your insurer to foot the bill.

Which brings us to the cost of artificial joints. Did you wonder why the medical device industry gets its very own tax under the Affordable Care Act? American health care’s dysfunction has enabled the medical device industry to earn very robust profits, thus making it a target for special treatment. Does this tax make sense?

Hospitalization for osteoarthritis was the second most expensive condition treated in U.S. hospitals in 2011: Osteoarthritis hospitalizations cost nearly $15 billion, about 4% of the cost of all hospitalizations (http://www.hcup-us.ahrq.gov/reports/statbriefs/sb160.jsp). And 90% of these hospitalizations were for joint replacement.

Joint replacement earns a whopping profit for the implant manufacturers and a very good living for the surgeons and hospitals involved. And private insurers, Medicare, Medicaid, and the Veterans Administration pay most of the bills. In an August 3 article, The New York Times told the story of Michael Shopenn, a 67-year old who, like my wife, had to quit a sport he loved because of joint pain. In his case, the problem was deemed a “pre-existing condition” by his insurer and wasn’t covered. Between the cost of the device and the cost of the surgeon and the hospitalization, the bill would have been about $78,000 in 2007 at his local medical center. Instead, he chose to have the procedure performed in Brussels for a total cost of $14,000, including airfare and lodging for two.

The article notes that there are only five major firms in this business. Economists suggest that they function as a cartel—a kind of multi-firm monopoly. In a truly competitive market, firms only cover their costs and consumers get the best price possible. By contrast, a cartel keeps prices and profits high by charging more than cost.

This is not a simple morality tale with an obvious conclusion i.e. “Let’s just tax the evil monopolists!” After all, the cost differential highlighted in the Times story is only partly about the implant. It has as much, perhaps more, to do with how physicians and hospitals get paid in the U.S. versus most of Europe. That’s a much larger debate we’ll not address here.

The industry argues that the tax will shift jobs overseas. Some suggest that the tax will just get passed onto consumers. And others predict a reduction in innovation if their profits are curtailed by taxation.

The tax is unlikely to shift jobs overseas, as the tax applies to all medical devices, regardless of place of origin. Companies will make the manufacturing decision based on the same criteria as before—cost and quality of labor and the local business climate.

Nor do I think that the tax will be simply shifted onto consumers. That would be true if competition ruled and consumers were paying a price that was close to cost. When firms hold significant market power—as they do in this industry–the connection between cost and price has been weakened. Price is largely driven by demand factors, not cost: Monopolists already charge what the market will bear. Yes, some consumers will pay more. But in much of health care, the monopoly providers often confront powerful payers and pricing depends on that balance of power. Who will actually bear the burden of the tax is unclear.

Will the industry invest less in innovation if they are less profitable? Economists generally believe that a firm’s competitive instincts are dulled when the firm is highly profitable. Innovation is risky. If a firm is generously rewarded already, why take on risk? There are countless examples in the history of business. A case can be made that Kodak’s competitive drive was dulled by its remarkable profitability. IBM lost its edge when it became the dominant computer manufacturer. Microsoft’s innovations slowed when its market share was at its peak. So I’d bet that the medical device tax won’t make much of a difference to their level of innovation. The tax won’t bite hard enough to make these firms hungry.

What we need is a more competitive medical device industry. This would reduce the cost of joint replacement, make the procedure more readily available to those of us who walk with pain, and slow health care inflation. And it could spur innovation in newly vibrant market.

But unless these firms are caught fixing prices, there are no legal options to force them to be competitive. We do know that the Affordable Care Act, title notwithstanding, is going to significantly increase public spending on health care. A tax on medical devices may be a more acceptable way to pay the bill than many of the obvious alternatives.