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

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.

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.