Reviewing the Credit Union Tax Exemption

January 30, 2018

The federal tax code exempts several businesses and industries from taxation for various reasons. One example of this is the exemption for state and federal credit unions. As lawmakers continue to evaluate the structure of the tax code, reviewing the justification for this expenditure would be worthwhile.

In 1934, Congress passed the Federal Credit Union Act and made a variety of financial institutions exempt from paying corporate income taxes. Then, in 1951, Congress removed the exemption for some financial institutions while specifically granting the exemption for credit unions to remain in the IRS Code.

An Internal Revenue Service (IRS) document from 1979 provides some explanation for why lawmakers decided credit unions should be tax-exempt. It can be summed by these three reasons: that credit unions would 1) help unbanked, lower-income people, 2) restrict their customer base, and 3) avoid high-risk, high-return investments.

The document explains that customers of tax-exempt institutions are “wage earners of moderate means” with no other place to deposit their savings. And to join credit unions, customers were required to have a common bond; for example, they must be employees of a particular business or residents of a well-defined neighborhood. A final distinction was favoring safe, low-interest investments such as small personal loans. Thus, the function of credit unions, Congress argued, was ostensibly unlike that of other financial institutions.

It is these ideas that justified the tax expenditure of exempting credit unions from paying corporate income taxes. The Joint Committee on Taxation estimates that in 2018, the tax expenditure for credit unions will cost $2.9 billion in terms of lost income tax revenue. The Committee projects the annual cost will rise to $3.2 billion by 2020, making the five-year cost from 2016 to 2020 total $14.4 billion.

Given the change in the financial sector over the last several decades, it would be useful for lawmakers to reexamine the extent to which credit unions currently fulfill their original purpose. If they have strayed from their intended function and now resemble other taxed financial institutions, their exemption would represent a disparity across similar economic activities. The aforementioned IRS report even stated that if Congress felt in 1951 that credit unions had “resembled taxable financial institutions,” it “seems probable” that Congress would have removed their tax-exempt status.

Regular congressional review of all tax expenditures, like the exemption for credit unions, could help unveil areas of the tax code with potential for reform.

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