Competitive Advantage: A Study of the Federal Tax Exemption for Credit Unions
Special Academic Paper
Executive Summary This study evaluates the federal tax exemption for credit unions. It reviews the industry’s history, its unique exemption, the motivation behind this tax treatment, the eroding case for special treatment, the size of the tax break and its effects on credit unions, their competitors, and their members. President Bush has recently named a prestigious commission on tax reform to be chaired by former Senators Connie Mack (R-FL) and John Breaux (D-LA), so a fresh examination of the federal credit union tax exemption is indeed timely.
Credit unions are growing rapidly, and so is the associated tax loss to the federal Treasury caused by their exemption. Indeed, the tax loss over the five-year period 2004-2008 is estimated in this study to be $12.6 billion. Extended over the typical ten-year federal budget window, the tax loss reaches $31.3 billion. The size of the tax loss is substantially igher than estimates prepared by govern-ment arbiters including the Office of Management and Budget or the Congres-sional Budget Office.
This tax exemption has been in law for almost 70 years because of the original concept of credit unions’ cooperative ownership. The original legal “field of membership” restrictions on credit unions were designed to limit their ability to compete by strictly defin-ing who could be a depositor and borrower from a credit union, with the idea that credit nions would use their tax advantage to serve low-income borrowers and depositors. However, over time credit unions have avoided most of the restrictions, and as a result they have competed directly and successfully with other financial institutions in many markets with a major cost advantage, the tax exemption. Moreover, there is no solid evidence that credit unions have turned the subsidy into service for low-income people.
Corroborated by other studies of credit unions and banks, the direct and indirect evidence gathered for this study shows that the equity holders of credit unions receive the tax saving as unusual returns. These unusual returns do not show up as relatively high dividends, however. Instead, they occur as unusually large retained earningsaccumulated as net worth in their credit unions. The shareholders’ extra income reinvested in the credit union provides new capital that allows the credit union to grow faster than other institutions.
There is some evidence that certain types of loans have lower rates at credit unions, especially for loans that have become less profitable and less available at banks, such as auto loans. There is also some evidence that part of the tax advantage is absorbed by costs that are higher than they would have been in a taxed, or more competitive, envi-ronment. Overall, however, the dominant effect of the tax exemption is to boost the equity ratio. Over the past ten years, credit unions have had an eq-uity ratio — the ratio of equity to total assets — that is more than 25 percent larger than that of banks.
Of the 50 basis points in subsidy that the tax exemption provides, at least 33 basis points accrue to owners in the form of larger equity and larger assets. Approximately 6 basis points may accrue to credit union borrowers through lower interest rates, and not more than 11 basis points are ab-sorbed by higher labor costs. There is little or no effect on deposit rates or other costs.
By giving a tax exemption to credit unions while taxing their competitors — banks, thrifts and finance companies, financial institutions that offer the same consumer deposits and loans — the federal government distorts the allocation of re-sources. It promotes the employment of deposit and credit resources in the tax-free credit union sector at the expense of all these other financial institutions.
Along with the tax exemption, a steady ero-sion of limits on credit union membership has allowed credit unions to grow much more rapidly than banks, especially over the past two decades. In 1998, the U.S. Supreme Court struck down the liberalization of membership rules, but the U.S. Congress promptly passed new legislation overriding the court. As a result, credit unions have rapidly consolidated, merged and broadened their geographic markets, all the while maintaining their tax exemptions. Thus, Congress created new tensions by weakening the original case for tax exemption.
Banks currently are subject to extensive costs to insure that they are meeting the credit demands of low-income borrowers. Credit unions were excluded from these provisions because of the presumption that they must be serving such con-sumers. After all, their charters are rooted in common bonds that seem to assume that credit unions meet these requirements. But the evidence shows that credit unions do not serve low- and moderate-income people to any greater extent than banks. For example, most credit unions have an occupational bond that requires members to be employed, often in industries with relatively high-wage jobs.
Today credit unions continue to grow faster than banks, have little practical limitations on membership, and make business loans that increasingly have no limits on who can borrow, how much or for what purpose. Even the limits that Congress has imposed, as they otherwise removed limits on credit union markets and competition, have broad loopholes and remain under serious challenge by the credit union industry. Today the principal justification for the tax exemption would seem to be that it already exists and, therefore, removing it could adversely impact thousands of institutions and their customers.
Under current law, as it is being enforced, there is no good policy argument based on equity or efficiency for maintaining the tax exemption. Some analysts have argued that small institutions (under $10 million in assets) should continue to be tax exempt because of their special character and, perhaps, innate inefficiencies. Notably, the corpo-rate income tax already takes size into account by taxing low-income firms at lower tax rates (15 percent, while larger firms pay rates that range from 34 to 39 percent).
Removing the credit unions’ tax exemption would create a more equitable tax system and help level the playing field with other financial institutions. It would also raise about $2 billion in tax revenue each year, either directly from credit unions or from more profitable and more highly taxed banks, where some credit union deposits and assets would migrate in a competitive market. Finally, it would raise the rate of return on some $65 billion of capital that is squirreled away in credit unions, earning lower rates of return than would be the case at taxpaying banks.
The unusually high equity ratio of credit unions would be reduced; and management of capital costs would make credit unions more efficient, perhaps lowering operating costs and interest rates on deposits and raising rates on loans, at least in some markets. Credit unions would be more subject to market control and would manage risk and return more efficiently, increasing the value of their franchises to their owners, despite smaller relative size and slower growth.