Competitive Advantage: A Study of the Federal Tax Exemption for Credit Unions

Abstract

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.

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 higher than official estimates.

Equity holders of credit unions receive the tax saving as unusual returns, which show up as unusually large retained earnings. The shareholders' extra income reinvested in the credit union provides new capital that allows the credit union to grow faster than other institutions.

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 absorbed by higher labor costs. There is little or no effect on deposit rates or other costs.

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. Also, credit unions would manage risk and return more efficiently, increasing the value of their franchises to their owners, despite smaller relative size and slower growth.

Keywords: credit unions, tax incidence, tax policy, baking