Credit Unions: Congress should rescind tax exemption

Northwestern Financial Review, May 1-May 14, 2005 by Tatom, John A

President Bush recently named a prestigious commission on tax reform, so a fresh examination of the federal credit union tax exemption is 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 to be $12.6 billion. Extended over the typical 10year federal budget window, the tax loss reaches $31.3 billion. The size of the tax loss is substantially higher than estimates prepared by government arbiters including the Office of Management and Budget, and the Congressional 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 defining who could be a depositor and borrower from a credit union, with the idea that credit unions would use their tax advantage to serve low-income borrowers and depositors. Over time, however, credit unions have avoided most of the restrictions, and as a result have competed successfully with other financial institutions 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.

Evidence 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 earnings accumulated 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, environment.

Overall, however, the dominant effect of the tax exemption is to boost the equity ratio. Over the past 10 years, credit unions have had an equity 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 six basis points may accrue to credit union borrowers through lower interest rates, and not more than 11 basis points are absorbed 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 - the federal government distorts the allocation of resources. 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.

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, there is no good policy argument based on equity or efficiency for maintaining the tax exemption. Some analysts have argued that small institutions should continue to be tax exempt because of their special character and, perhaps, innate inefficiencies. Notably, the corporate income tax already takes size into account by taxing low-income firms at lower tax rates (15 percent, while larger firms pay rates from 34 percent 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.

John A. Tatom is an adjunct scholar at the Tax Foundation and adjunct professor in the Department of Economics at DePaul University, Chicago. The Tax Foundation would like to thank the Independent Community Bankers of America for their support of this study. Reprinted with permission.