John A. Tatom is an Adjunct Scholar at the Tax Foundation and Adjunct Professor in the Department of Economics atDePaul University. His past affiliations include Head of Country Research and Limit Control for the Chief CreditOfficer at UBS in Zurich, Principal Emerging Market Economist for UBS, and Research Officer at the Federal ReserveBank of St. Louis.

The Tax Foundation would like to thank the Independent Community Bankers of America for their support of this study.

Executive SummaryThis study evaluates the federal tax exemptionfor credit unions. It reviews the industry’shistory, its unique exemption, the motivationbehind this tax treatment, the eroding case forspecial treatment, the size of the tax break andits effects on credit unions, their competitors,and their members. President Bush hasrecently named a prestigious commission ontax reform to be chaired by former SenatorsConnie Mack (R-FL) and John Breaux (D-LA), so a fresh examination of the federalcredit union tax exemption is indeed timely.

Tax Loss to the TreasuryCredit unions are growing rapidly, and so

is the associated tax loss to the federal Trea-sury caused by their exemption. Indeed, thetax loss over the five-year period 2004-2008 isestimated in this study to be $12.6 billion.Extended over the typical ten-year federalbudget window, the tax loss reaches $31.3billion. The size of the tax loss is substantiallyhigher than estimates prepared by govern-ment arbiters including the Office ofManagement and Budget or the Congres-sional Budget Office.

Competitive Advantage:A Study of the FederalTax Exemption forCredit Unionsby John A. Tatom, Ph.D.

The Tax Exemption’s Original JustificationThis tax exemption has been in law for

almost 70 years because of the original con-cept of credit unions’ cooperative ownership.The original legal “field of membership” re-strictions on credit unions were designed tolimit their ability to compete by strictly defin-ing who could be a depositor and borrowerfrom a credit union, with the idea that creditunions would use their tax advantage to servelow-income borrowers and depositors. How-ever, over time credit unions have avoidedmost of the restrictions, and as a result theyhave competed directly and successfully withother financial institutions in many marketswith a major cost advantage, the tax exemp-tion. Moreover, there is no solid evidence thatcredit unions have turned the subsidy intoservice for low-income people.

Who Benefits from the Tax Exemption?Corroborated by other studies of credit

unions and banks, the direct and indirectevidence gathered for this study shows thatthe equity holders of credit unions receive thetax saving as unusual returns. These unusualreturns do not show up as relatively highdividends, however. Instead, they occur asunusually large retained earnings accumulated

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as net worth in their credit unions. The sharehold-ers’ extra income reinvested in the credit unionprovides new capital that allows the credit unionto grow faster than other institutions.

There is some evidence that certain types ofloans have lower rates at credit unions, especiallyfor loans that have become less profitable and lessavailable at banks, such as auto loans. There is alsosome evidence that part of the tax advantage isabsorbed by costs that are higher than they wouldhave been in a taxed, or more competitive, envi-ronment.

Overall, however, the dominant effect of thetax exemption is to boost the equity ratio. Overthe 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 ofbanks.

Of the 50 basis points in subsidy that the taxexemption provides, at least 33 basis points accrueto owners in the form of larger equity and largerassets. Approximately 6 basis points may accrue tocredit union borrowers through lower interestrates, and not more than 11 basis points are ab-sorbed by higher labor costs. There is little or noeffect on deposit rates or other costs.

By giving a tax exemption to credit unionswhile taxing their competitors — banks, thriftsand finance companies, financial institutions thatoffer the same consumer deposits and loans — thefederal government distorts the allocation of re-sources. It promotes the employment of depositand credit resources in the tax-free credit unionsector at the expense of all these other financialinstitutions.

Competitive Advantages Beyond the ExemptionAlong with the tax exemption, a steady ero-

sion of limits on credit union membership hasallowed credit unions to grow much more rapidlythan banks, especially over the past two decades.In 1998, the U.S. Supreme Court struck down theliberalization of membership rules, but the U.S.Congress promptly passed new legislation overrid-ing the court. As a result, credit unions haverapidly consolidated, merged and broadened theirgeographic markets, all the while maintainingtheir tax exemptions. Thus, Congress created newtensions by weakening the original case for taxexemption.

Banks currently are subject to extensive coststo insure that they are meeting the credit demandsof low-income borrowers. Credit unions wereexcluded from these provisions because of thepresumption that they must be serving such con-sumers. After all, their charters are rooted incommon bonds that seem to assume that credit

unions meet these requirements. But the evidenceshows that credit unions do not serve low- andmoderate-income people to any greater extentthan banks. For example, most credit unions havean occupational bond that requires members to beemployed, often in industries with relatively high-wage jobs.

Proposals for ReformToday credit unions continue to grow faster

than banks, have little practical limitations onmembership, and make business loans that in-creasingly have no limits on who can borrow, howmuch or for what purpose. Even the limits thatCongress has imposed, as they otherwise removedlimits on credit union markets and competition,have broad loopholes and remain under seriouschallenge by the credit union industry.

Today the principal justification for the taxexemption would seem to be that it already existsand, therefore, removing it could adversely impactthousands of institutions and their customers.Under current law, as it is being enforced, there isno good policy argument based on equity or effi-ciency for maintaining the tax exemption. Someanalysts have argued that small institutions (under$10 million in assets) should continue to be taxexempt because of their special character and,perhaps, innate inefficiencies. Notably, the corpo-rate income tax already takes size into account bytaxing low-income firms at lower tax rates (15percent, while larger firms pay rates that rangefrom 34 to 39 percent).

Removing the credit unions’ tax exemptionwould create a more equitable tax system and helplevel the playing field with other financial institu-tions. It would also raise about $2 billion in taxrevenue each year, either directly from creditunions or from more profitable and more highlytaxed banks, where some credit union depositsand 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 incredit unions, earning lower rates of return thanwould be the case at taxpaying banks.

The unusually high equity ratio of creditunions would be reduced; and management ofcapital costs would make credit unions more effi-cient, perhaps lowering operating costs andinterest rates on deposits and raising rates onloans, at least in some markets. Credit unionswould be more subject to market control andwould manage risk and return more efficiently,increasing the value of their franchises to theirowners, despite smaller relative size and slowergrowth.

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1 In March 2004, Federal Deposit Insurance Corporation Chairman Donald Powell repeated his recommendation that bank-like“credit unions ought to pay taxes,” pointing to the rapid growth of credit unions aggressively competing against banks. In thesame month, the chairman of the House Ways and Means Committee, William Thomas (R-CA), called for a greater examina-tion of tax-preferred entities, mentioning credit unions as an example.

2 For example, see New Zealand Treasury (2000) and Department of Finance, Government of Ireland (1998) for discussions ofthe identical problems in these countries and proposals to end the exemption of corporate (or company) income tax. TheIreland paper also discusses moves in the European Union to promote neutrality by eliminating tax exemptions for creditunions and their customers. The distinguished free market Finance Minister Charlie McCreevy (2000), the recently appointedEU Commissioner for Internal Markets, indicated support for the corporate tax exemption, but opposition to the broader taxexemption of interest income at Irish credit unions. However, he noted the continuing opposition of the EU Commission tostate aid to private sector activity and implies that the corporate exemption is precisely such aid. Other recent studies includeBickley (2003), Florida Tax Watch (2003) and Chmura Economics and Analytics (2004).

3 The Supreme Court case was NCUA vs. First National Bank and Trust Co. (1998).

4 The author was in the audience when this exchange occurred.

IntroductionThe competitive and legislative environment

of credit unions has changed dramatically in thepast several years and a key aspect, their exemp-tion from the federal income tax, has come underincreasing scrutiny.1 Credit unions in the U.S. andelsewhere have been free of federal income taxesfor a variety of related reasons, including theircooperative organization and ownership structure,their so-called common bond, and their missionto provide services to small or relatively low-income savers.

That status has come under increasing ques-tion both in the U.S. and abroad, largely becauseof increasing attention to the principle of neutral-ity in taxation and the equity principle that callsfor a “level playing field” or “treating equalsequally.” 2 The special tax status of credit unionshas also been increasingly challenged because ofquestions about the ability and commitment ofcredit unions to serve low-income people. Thecompetitive and tax status of credit unions weretested by a Supreme Court decision in February of1998 that insisted credit unions enforce tight“common bond” requirements in order to obtainand maintain their charters and tax exemption.3

Congress reacted swiftly. Within six months Con-gress had passed the Credit Union MembershipAccess Act (CUMAA) which authorized the verymultiple-group fields of membership that theSupreme Court had just invalidated.

While the issue of membership groups ap-pears limited, it is the key restriction that analystshad used to argue for the special regulatory andtax status of credit unions. The irony is thatCUMAA indirectly removed the special status ofcredit unions, but in their override of the SupremeCourt, Congress appeared to strongly endorse thestatus quo, which includes the special tax status ofcredit unions. Thus, there is an unresolved tensionin the regulatory and tax environment facing the

financial services industry. If nothing else, remov-ing the special status of credit unions underregulatory guidelines calls into question the re-lated federal income tax exemption.

Yet recently the Secretary of the Treasurypointedly implied that the issue will not be on thetable any time soon. In a question and answersession at the Federal Reserve Bank of Chicago’sBank Structure Conference in May 2004, Secre-tary Snow was asked if he thought the special taxstatus of credit unions was fair, if and when itwould be reviewed and whether it would be al-tered. He responded with a unqualified “No” tothe idea of reviewing the exemption.4

Whether challenges to the tax status of creditunions can be so easily dismissed is doubtful, evenif officials would like to ignore the issue. But theresponse does point to the intransigence of politi-cal forces to challenge the status quo, especiallywhen it has political appeal enjoyed by the currenttax treatment of credit unions. Whether one fa-vors or is opposed to the current tax treatment, asound understanding of its origins, history, andeffects on credit unions, their customers and theircompetitors is essential for decisions to maintainor to alter the existing preferential tax and regula-tory treatment of credit unions.

Credit unions are among the most rapidlygrowing financial firms in the country. This un-usual growth could possibly be due to special taxbreaks or other subsidies, or perhaps simply be-cause they play a unique or special role in theeconomy. But in recent years, analysts have begunto question the bases for special treatment ofcredit unions and more research has begun topoint to adverse consequences of their special taxtreatment. This study reviews the historical basisof the federal tax exemption of credit union in-come and factors eroding its support. It also looksat the consequences of the tax break and whogains and who loses from credit unions’ tax ex-empt status.

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5 See Bickley (2004).

6 See Joint Committee on Taxation (2003).

7 Credit unions originated in the Raiffeisen banks started in 1854 in rural areas of the Rhine by Friedrich Wilhelm Raiffeisen.These were cooperative banks intended to serve farmers and were the first to have a field of membership and use the sameoperating principles as today. Such banks still exist with this name, and purpose, in Austria and several other Europeancountries. Cooperative banks for artisans date back to 1850 and purchasing cooperatives date back to 1844 when the RochdalePioneers organized the first cooperative in Rochdale, England. See Credit Union League of Hong Kong,www.hkcreditunion.org. and Bickley (2003) for the historical information.

Large and Growing Tax LossThe losses from the tax exemption are quite

large, according to several alternative estimates.The U.S. Treasury estimates that taxing creditunions would raise $1.24 billion in fiscal 2005,according to Bickley (2003) who provides anexcellent overview of the issue of removing thecredit union exemption from federal income taxa-tion.5 The U.S. Congress’ Joint Committee onTaxation (JCT) estimates that the loss in federaltax revenue is about $1.2 billion in 2004 and thatthis will rise to $1.8 billion by 2008.6 A recentstudy by Chmura Economics & Analytics (May2004) indicates a much larger tax loss of $1.89billion in 2002. The most recent comparable JCTestimate for the fiscal 2002 tax loss is $0.9 billion.The most recent estimates computed for thisstudy indicate that the tax loss is even larger,about $2 billion in 2003 (calendar year), and $1.9billion in 2002. Over the ten-year revenue estima-tion period 2004 to 2013, the tax loss is expectedto be $31.3 billion.

Notably, large federal deficits in recent yearsrequire serious attention to both the spending andthe revenue sides of the budget. The sizable taxrevenue loss from the $31.3 billion tax exemptiongranted credit unions warrants more attentionthan normal in this environment, especially sincecredit unions and the tax expenditure are growingrapidly. Where does this tax loss go? Is it receivedindirectly by credit union savers in higher divi-dends or interest? Do credit union borrowersreceive the tax savings in the form of lower interestrates? Or are wages higher at credit unions? Ac-cording to the analysis in this study, the mostlikely result is that the equity holders of creditunions receive the tax saving as unusual returns.These unusual returns do not show up as relativelyhigh dividends, however. Instead, they occur asunusually large retained earnings accumulated asnet worth in their credit unions. The shareholders’extra income reinvested in the credit union pro-vides new capital that allows the credit union togrow faster than other institutions.

For many years, both in this country andabroad, industry leaders, policy analysts andpolicymakers have debated whether credit unionsplay some special role in the economy and

whether they deserve special tax treatment.Spurred by the Supreme Court challenge (1998)to the special treatment, Congress passedCUMAA. This act enhanced the availability of thetax subsidy for credit unions because it widenedthe field of membership, the group of people thatcould be customers of a credit union. The looserfield of membership requirements also allowedcredit unions, especially large ones, to expandtheir growth opportunities, reinforcing the com-petitive advantage obtained from their taxadvantages. The ability to pass on their tax savingto broader customer bases, in the form of lowerinterest rates on loans, higher rates on deposits orincreased retained earnings growth, warrants areview of the size of the tax subsidy and its inci-dence, or where the tax saving goes. The study willdetail the effects of the tax subsidy on the pricingand/or income advantages accruing to creditunions and its effects on growth, especially forrelatively large credit unions. The changing creditunion structure has allowed credit unions to ex-tend their competitive advantages to broadergroups facilitating increased competition andmarket share growth, especially for large institu-tions. Estimates of the tax loss and its effects oncredit union profitability, service prices and coststructure are most useful in assessing the benefitand cost of the federal income tax exemption.

I. The Basis of Tax Exemption—The Common Bond and HowIt Is Changing

The first U.S. credit union was chartered in1909 by the state of New Hampshire.7 The federalincome tax (and federal chartering of creditunions) came later, and credit unions were notexempt under the new tax. An administrativeruling by the Attorney General in 1917 exemptedcredit unions from federal taxation. Federal char-tering of credit unions began under the FederalCredit Union Act of 1934, but federally charteredcredit unions were not exempted from federal andstate income taxation until the act was amendedin 1937. The amendment was based on the ser-vices of credit unions to their members, accordingto Bickley (2003). Since 1937, both federal andstate-chartered credit unions have been exempt

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8 This information is drawn from a survey provided by the Office of the General Counsel, Credit Union National Association,2004.

9 See Congressional Budget Office (March 2003), p. 218.

from federal income taxation and federally char-tered institutions have been exempt from allfederal and state taxation. States have generallyfollowed the federal lead.

Only five states subject state-chartered creditunions to their state corporate income tax: Cali-fornia, Indiana, Iowa, Oklahoma and Oregon.Iowa’s 12-percent rate is the nation’s highest; theother four states have more typical rates that varyfrom 6.0 to 8.84 percent. New Hampshire im-poses two taxes, a business profits and a businessenterprise tax, that are similar to an income taxand combine for a maximum tax of 9.25 percent.Several more states impose limited tax levies suchas franchise taxes on their state-chartered creditunions. About half of all states subject state-char-tered credit unions to sales or use taxes andpersonal property taxes, and most states imposereal property taxes as well.8 These taxes are allmuch smaller than the federal income tax, buteven these small differences could affect the per-formance of federal and state-chartered creditunions.

The key factor is that credit unions are ex-empt from federal income taxation and have beenfor many years. Savings and loan associations werealso exempt from federal income taxation until1951 when their exemption, granted under thesame tax law provision as that for credit unions,was removed. Congress eliminated the exemptionsfor savings and loans and mutual savings banks onthe grounds that they were similar to profit-seek-ing corporations.9 Since then, large credit unionshave come to resemble large thrifts and banks. Itshould be noted again that while all credit unionsare exempt from federal income taxes, only feder-ally chartered credit unions are exempt from alltaxes at the state level as well. State-charteredcredit unions are not exempt from state incometaxes, franchise taxes, property or sales taxes inmany states. Thus, one way to assess the effect oftax exemption is to compare federal and state-chartered credit unions.

The rationale for tax exemption originates inthe uniqueness of the “common bond” underwhich credit unions are chartered. The commonbond determines a “field of membership” fromwhich a credit union may draw and the membersare the owners of the accumulated reserves (orretained earnings) in proportion to their shares ofdeposits. Only members may hold deposits orreceive loans from the credit union, though creditunions also make loans to other credit unions and

credit union service corporations and they canaccept deposits and make loans to non-membersunder some restricted conditions. Such loans anddeposits are quite small however. Thus, a creditunion is a nonprofit financial cooperative for taxpurposes, though they are often organized as cor-porations for legal reasons. Profit is reinvested orpaid to depositors and taxed as interest under theindividual income tax. The principal functions ofcredit unions are to accept deposits (called shares,and actually equity shares for most of the usualpurposes) from their members and to make loansto them or investments. Shares include checkableshare draft accounts, regular savings shares, moneymarket, certificates of deposit and IRA or Keoghaccounts. The principal loans to members, rankedby size, are new and used vehicle loans, first mort-gage loans, other real estate loans, and credit cardloans. The motto of credit unions summarizestheir original goals, “not for profit, not for charity,but for service.” Of course credit unions learnedlong ago that more service can come from operat-ing efficiently, earning profits and expanding theircapital base.

Regulators allow four categories of commonbonds. The earliest and most common types arethe single occupational or single associational bonds.The first limits the group to employees of thesame firm or workers in a single occupational classwho may work for many different employers. Thesecond group includes members of a social or civicgroup, which shares common loyalties, mutualinterests or mutual benefits and which providesactivities where members have contact with oneanother. Since 1982, when failing credit unionswere perceived as being unduly risky because ofthe heavy risk concentration created by the narrowcommon bond criteria, regulators have createdbroader more diverse common bonds. The thirdtype today, the multiple common bond, allowsgroups with different occupational or associationalbonds to join together. This has been the mostcontroversial because it essentially provides littleor no limit to membership; indeed this was theissue in NCUA vs. First National Bank and TrustCo. (1998). The fourth category is the communitycommon bond, which limits the field of member-ship to people who reside in or are employed in awell-defined local community. This is potentially abond with even less meaningful restriction thanthe multiple bond because it has been used toencompass such a broad geographic area and opengroup. Community charters are the fastest grow-

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ing segment of the credit union industry. One caneasily imagine a U.S. credit union restricted toresidents of the U.S., little more restricted than anationwide bank. Indeed, on July 29, 2004, theNational Credit Union Administration approved acommunity charter for the LA Financial CreditUnion, which has a field of membership of all10.1 million residents of Los Angeles County.

The common bond is unique to creditunions. It was intended to restrict who can be amember and benefit from the services of the creditunion, but it also limits the credit union fromdeveloping potentially more profitable relation-ships with depositors or borrowers. Its cooperativenature and the restrictions on its business are bothreasons given for the tax exemption. The occupa-tional and associational bonds had alwaysprovided the support for the notion that a creditunion is a cooperative effort by people of morelimited means, or perhaps low income, to makeavailable financial services to which they wouldotherwise either have no access or face prohibitivecost.

Many studies have questioned whether eventhese more traditionally chartered firms really liveup to that standard. For example, Jacob, Bush andImmergluck (2002) have shown that the incomesof credit union members are little different fromthe incomes of customers of banks and thrifts.This should not be surprising, especially in thecase of occupational credit unions, because themembers are employed, often in higher wagesectors such as teachers or trade union members.The largest credit unions are those for the airlines,aircraft production, teachers, government workersand unions. Credit unions focus on consumerbanking, while most banks depend more on busi-ness customers, but there is little reason to thinkthat credit unions are serving a social purposenot served by other readily available financialinstitutions. The basis then for special tax treat-ment could not rest on the notion that creditunions serve a disadvantaged class, though thiswas the original motivation and basis of the taxexemption.

The introduction and increasing number ofmultiple bond charters beginning in 1982 pro-vided a more important challenge to the notionthat the credit unions are damaged by their socialobjective of serving a particular field of member-ship. Until then, potential members were arguablya more limited and perhaps unprofitable group toserve than the potential depositors or borrowersfrom banks, thrifts or other financial institutions.Banking organizations and their trade groups,which have to compete with the special treatmentaccorded credit unions, campaigned to end the

competitive advantage of tax-exempt creditunions. Since the early-1980s, they havestrenuously objected to the liberalization ofthe limits imposed by the common bond, thelegal limits that had justified the credit uniontax break earlier.

Chmura (2004) suggests that the “moralhazard” of borrowers, essentially the risk thatborrowers will engage in risky activities that makeit more likely they will default on loans, wasboosted by having credit unions that serve pre-dominately people of small means. This greaterrisk might have justified tax exemption as a costoffset in the past, according to Chmura. Onecould add a greater “adverse selection” problem assuch a basis. Adverse selection means that thehighest risk borrowers are more likely to get loansthan low risk borrowers. It occurs because institu-tions that face default risk will price loans tocompensate for the risk and these higher interestrates, in turn, will discourage low risk borrowersfrom borrowing. This could be another factor thatwould worsen default rates at credit unions if theyfocus on high risk, relatively poor consumers, andare prohibited from lending to a broader class ofborrowers that might include safer borrowers, inparticular business borrowers.

The growing evidence that members of creditunions are no different from people who are bankcustomers would lead one to reject this rationale.Chmura points out that deposit insurance wouldprotect depositors from the risk of their creditunion making high risk loans to relatively poorerpeople, so that the introduction of deposit insur-ance for credit unions in 1970 eliminated unusualmoral hazard as a rationale. Actually businessloans are riskier than consumer loans (real estate,vehicle and other loans) so that the higher defaultrisk—deposit insurance relation would applymore to banks than to credit unions, if in factcredit unions were more constrained.

Another reason that is not mentioned in theliterature on the common bond is that creditunions, by having a narrow field of membership,might face greater systemic risks associated withconcentration of assets among similarly situatedborrowers. For example some of the largest creditunions serve employees of airlines, such as United,Delta, U.S. Air, and the plane manufacturing firm,the Boeing Corporation. Industry difficulties due,for example, to downturn in the economy, shifts indemand patterns or other industry specific prob-lems make credit unions likely to face greaterindustrial or geographic risk than banks in thesame areas. Because of a mandated lack of diversi-fication possibilities, credit unions might have adisadvantage compared with banks. Again, how-

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10 The personal consumption deflator (2000 = 100) is used to deflate both asset measures.

11 Chmura (2004) points out that this relatively slower growth may suggest that CUMAA did not augment the tax break forcredit union and foster their faster growth. The Chmura study suggests that the evidence on relative growth of credit unions ismixed because the average size credit union has been growing faster than that of banks since 1998. This is an overstatement,however. The faster growth of the average size simply reflects a faster pace of consolidation in the number of credit unionscompared with banks. This faster pace of consolidation more than offsets the slowdown in the relative growth rate of creditunion assets relative to those at banks. Both banks and credit unions have seen booming growth in their assets while theirnumbers are declining. Both sectors have been consolidating since the 1980s.

12 See, Gunther and Moore (2004a) for an example of such a cautious study.

13 CUMAA limits the size of business loans to 12.25 percent of total assets, but Small Business Administration lending andbusiness loans under $50,000 are not capped at all. According to NCUA data, in 2003 member business loans outstandingwere only $8.9 billion, or 2.4 percent of total loans and 1.5percent of total assets. Such loans are expected to become a largershare of assets, especially at large credit unions.

ever, the existence of insurance is a more effectiveremedy against such risk than is a tax exemption.Notably, the insurer and regulator, the NationalCredit Union Administration (NCUA) has anincentive to reduce these concentration risks byallowing multiple bond institutions, and this, infact, has occurred widely since the 1980s. Beforethat, such industry-specific and geographicallyconcentrated risks resulted in higher failure rates ofcredit unions. While diversification reduces risk tothe insurance fund, it weakens the justification fora tax exemption based on perceived disadvantagesof cooperative enterprise or higher risk.

Today the principal justification for the taxexemption would seem to be that it already existsand, therefore, removing it could adversely impactthousands of institutions and their customers.And these institutions and customers are per-ceived, incorrectly, to be relatively lower incomeor associated with the economic security andprogress of lower income people. This is a strongargument in terms of practical politics, but it isnot supported by fact and is an egregious violationof one of the most fundamental principles ofsound tax policy, neutrality. By having such taxdiscrimination, the exempt sector will be largerthan it would otherwise be and more inefficientthan the taxed sector, diverting scarce credit re-sources, in this case, to lower value uses.

The key issue raised by federal income taxexemption is tax neutrality, a fundamental prin-ciple of taxation. Taxing some financialinstitutions that offer the same consumer depositsand loans while not taxing others, in particularcredit unions, distorts the allocation of resources.It promotes the employment of deposit and creditresources in the tax-free credit union sector at theexpense of their competitors, banks, thrift institu-tions and finance companies.

II. The Growth of Credit UnionsCredit unions have grown much faster than

banks, a fact that often is cited as evidence of theirtax advantage. Figure 1 shows the growth rate of

credit union and bank real assets since 1973. Theexcess growth rate at credit unions was especiallynoteworthy until 1993, but not as apparent sincethen. Real assets are used because inflation influ-ences the growth rates and was much higher in the1970s and 1980s when credit union growth wasalso relatively high.10 From 1973 to 1993, realcredit union assets expanded at a 6.4 percent an-nual average rate, almost 4 percentage pointsfaster than the 2.5 percent growth rate of realbank assets. Since then, the growth rate of realcredit union assets slowed slightly to 6 percent,while real bank asset growth accelerated to 5.2percent. While credit union asset growth contin-ued to outstrip that of banks, it was only about0.8 percentage points faster.11

Comparing credit unions with banks must bedone with caution.12 Banks, especially large ones,have a more diverse base of depositors and bor-rowers than credit unions. On the asset side of thebalance sheet, banks are not so dependent onconsumers or on their depositors. Business loansare larger and more profitable (and riskier), whilebusiness loans have been nonexistent or very smallat credit unions.13 For credit unions, their mem-bers (consumers) are not only their key source ofdeposits, they are also the borrowers.

However, credit unions are pursuing greatersmall business lending. Credit unions recentlysought and won approval to do business lendingthrough Small Business Administration (SBA)guaranteed loan programs. These loans are notincluded in business loans for purposes of the legallimit on business loans. Credit unions also ad-vanced the Credit Union RegulatoryImprovement Act (H.R. 3579) in the 108th Con-gress. This act would, among other provisions,raise the limit on business lending to 20 percentfrom 12.25 percent, double the size limit on suchloans that could be excluded from the limit from$50,000 to $100,000, and exclude certain otherbusiness loans from the cap. Since 2000, businessloans outstanding at credit unions have more thandoubled, rising from $4.1 billion to $8.9 billion

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Figure 1

Real Asset Growth Has Been More Rapid at Credit Unions Until the Mid-1990s

14 Similar comparisons have been made by Schenk (2004). He and the Credit Union National Association (2004a) also arguethat credit unions consistently rate higher in consumer satisfaction than banks. This is another example of a lack of compara-bility, however, because credit unions are small and more closely tied to their consumer customer base than banks. A propercomparison would compare similar-sized institutions serving comparable customer bases. Why would one expect larger andmore business-oriented banks to earn high marks from households that are relatively unimportant as sources of a funds or asborrowers? While banks value consumer business, for many banks consumers are not the core business or the focus ofmarketing efforts.

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in 2003, a 28.8 percent annual rate of growth. Asrecently as 1997, these loans were only $2.9 bil-lion. Banks, which specialize in business loans,actually saw such loans decline from 2000 to2003. Commercial and industrial loans, farmloans and commercial real estate loans fell 3 per-cent over the period, or about $47.2 billion.

Another reason why credit unions are noteasily comparable with banks is the difference insize. At the end of 2003, total assets at insuredcommercial banks ($7.2 trillion) were 11.6 timesthe total assets of credit unions and a few banks,including Citigroup and J.P Morgan Chase, wereeach bigger than the whole credit union industry.The number of commercial banks, 7,769, was 17percent lower than the number of credit unions,but their average size was large enough to makethe average-sized bank, measured by total assets,about 14 times as large as the average sized creditunion. About half of credit unions had total assetsless than $10 million at the end of 2003, whileless than 1.5 percent of banks were this small.About half of all banks had assets in excess of$100 million at the end of 2003, while only about12 percent of credit unions were this large. Theother half of banks, those with assets less than

$100 million, are in the same size class as 88 per-cent of credit unions, but again most of those aremuch smaller than banks. Notably, the largestoverlap in terms of competition and size is in the$10 million to $100 million size class, whichincludes about half of all banks and about 30 to40 percent of all credit unions. In this class banksand credit unions primarily compete with eachother and not with the largest banks or creditunions.

A large bank, under regulatory definitions, isdefined to have assets in excess of $1 billion, butonly 82 credit unions (0.9 percent) had assets thislarge at the end of 2003. There were 424 banks,(5.4 percent of all banks) with assets this large.The average size of total bank assets ($968 mil-lion) is close to this threshold.14 The number oflarge credit unions is growing rapidly, however. Atthe end of 2000 there were a little over half asmany, only 43 credit unions (0.4 percent of creditunions), with assets over $1 billion, while thenumber of large banks was 397 (4.8 percent), notmuch different from that at the end of 2003. Thenumber of large credit unions rose 90.6 percent inonly three years while the number of large banksrose only 6.8 percent.

9

Credit unions are also changing their fields ofmembership and expanding their geographic cov-erage to become dominant financial institutions insome local markets. For example, Citizens EquityFirst in Peoria, Illinois, originally the credit unionfor Caterpillar Corporation and the largest finan-cial institution in the area, has expanded its field toinclude employees in selected employer groups andpeople in 14 neighboring counties. It is the six-teenth largest federally insured credit union with$2.6 billion in assets (at the end of 2003). AmericaFirst Credit Union, in Ogden, Utah, the twelfthlargest credit union with assets of $2.7 billion, isalso the largest institution in its area. It defines itsfield of membership to include people who live,work, worship, attend school or volunteer in anyof six counties or within a twelve-mile radius ofMesquite, Utah. The pattern of growth and changeamong the nation’s credit unions is characterizedby expanded geographic coverage, dominance insome local financial markets, and the adoption ofmore generic names with no reference to a narrowfield of operation. The top ten credit unions byasset size include credit unions based in such smalland medium-sized cities or suburbs as: Merrifield,Virginia; Raleigh, North Carolina; Alexandria,Virginia; Sacramento, California; Santa Ana, Cali-fornia; Tukwila, Washington; Tampa, Florida; TheDallas-Fort Worth Airport; San Antonio, Texas;and Manhattan Beach, California. Their assets of$2.9 to $20 billion give them a dominant share inlocal markets, though many operate state-wide ornationally.

Another feature of credit unions is that thereare very large “corporate” credit unions that pro-vide wholesale financial services to their owners,which are smaller credit unions. Credit unionscould use the correspondent banking services oflarger banks for their deposit and asset services,help with unusually large loans or more special-ized banking services, just as small banks do, butbanks are taxed and so the prices of their serviceswould include tax cost. To avoid these higher costsof wholesale financial services, corporate creditunions were set up to provide the same services ascorespondent banks. At the end of 2003 therewere 31 such institutions holding $108.8 billionin assets. The largest and oldest, U.S. CentralCredit Union in Lenexa, Kansas, holds $35 billionin assets and is owned by only 72 member creditunions. These assets are largely passed throughcredit unions, so adding them to the credit unionassets in Table 1 would be double counting. How-ever, the earnings of these credit unions are alsountaxed and no allowance has been made here orelsewhere for these untaxed assets in estimates ofthe tax loss from federal income tax exemption.

The main reason for comparing credit unionswith banks, however, is that banks are in the samecompetitive market for credit union depositorsand also, though to a lesser extent, for creditunion borrowers. In terms of a “level playingfield,” it is like-sized banks that are the most dis-advantaged by the tax exemption available forcredit unions of similar size. Banks might growmore slowly than credit unions for a variety ofreasons that do not depend on the tax advantageof credit unions. For example, since banks servebusiness borrowers and business and governmentdepositors, different growth rates in their demandsfor funds or for deposits relative to consumerdemand could result in different growth rates.This issue is not addressed here. Instead the differ-ence in growth rates is offered simply as evidenceconsistent with a cost advantage at credit unions.

While credit union assets have grown fasterthan bank assets in the past, the number of creditunions is declining, just as is the number of banks.For example, from 1999 through 2003 the num-ber of credit unions declined from 10,626 to9,369 (-11.8 percent, an annual rate of decline of3.1 percent). But this consolidation belies thevibrant growth of the sector. Besides rapid assetgrowth overall (48.3 percent), there was a largeincrease in credit union membership from 75.4million to 82.4 million (9.3 percent or 2.2 percentper year). Bank assets grew by less, a still robust 33percent, but the number of insured commercialbanks fell 6.6 percent to 7,769 at the end of 2003.The consolidation of credit unions is proceedingfaster than that of banks. The number of creditunions above $1 billion in assets more thandoubled between 2000 and 2004, from 43 to 93.

The consolidation in the number of creditunions is occurring at both federally and state-chartered institutions, with many large,aggressively growing credit unions swallowing upsmall, traditional credit unions. The decline in thenumber of federally chartered credit unions since1999 has been 12 percent, only slightly faster thanthe 11.6 percent decline in the number of state-chartered credit unions. Federally chartered creditunions are no longer growing much faster thanstate-chartered ones. At the end of 2003, 61.7percent of the 9,369 credit unions were federallychartered, still about the same percentage as at theend of 1999, despite their slightly faster pace ofdecline. However, asset growth at federally char-tered credit unions has slowed relative to others,just as overall growth of credit union assets hasslowed relative to bank assets. Figure 2 shows therelative size of federal credit union assets com-pared with assets of banks and state-charteredcredit unions.

10

Figure 2

Taxed Banks and CUs Grew More Slowly Than Federally-Chartered CUs Until the 1990s

Table 1

Selected Differences in the Performance of Federal- and State-Chartered Credit Unions (2003)

All insured CU Federal CU State CUMean Total Mean Total Mean Total

________________ _________________ _________________Total assets ($ millions) $65.1 $610,156 $58.3 $336,585 $76.1 $273,572Net worth (percent of assets) 10.72% 10.80% 10.62%Delinquent loans (percent of loans) 0.77% 0.76% 0.78%Total loans (percent of assets) 61.64% 60.27% 63.33%Net income (percent of assets) 0.95% 0.97% 0.92%Gross income ($ millions) $3.86 $36,147 $3.42 $19,765 $4.56 $16,382Interest margin (percent of assets) 3.27% 3.25% 3.30%Operating expenses (percent of assets) 3.09% 3.03% 3.16%

0

10

20

30

40

50

60

70

80

90

100

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

1974

1973

State-Chartered Credit Union Assets as a Percentage of Federally-Chartered Credit Union Assets

Bank Assets as a Multiple of Federally-Chartered Credit Union Assets

Federally chartered credit unions are morenumerous, and they are slightly more profitablethan state-chartered institutions, but in terms ofassets, they are smaller, on average. Table 1 showsthat federal credit unions, which again account forabout 61.6 percent of the total number in 2003,account for 55.2 percent of total credit unionassets, though the mean asset size of $76.1 millionis 23 percent smaller than that for state-charteredcredit unions. Federally chartered credit unionshave a larger total gross and net income, about54.7 percent and 56.4 percent of the respectivetotals, but these shares are smaller than the relativenumbers, so that the average income measure forfederal credit unions is smaller reflecting theirlower average asset size. As a return on total assets,the net income of federal credit unions is slightly

larger (0.97 percent) than that for state-charteredcredit unions (0.92 percent), though both areclose to the one-percent rule of thumb for banks.The interest margin for federal credit unions isslightly smaller, but their operating expenses arealso smaller than those of state-chartered institu-tions. The smaller federal credit unions have, onaverage, a higher equity ratio (net worth to assets),but the implied rate of return on equity at federalcredit unions (8.98 percent) exceeds that of theaverage state credit union (8.66 percent).

III. The Sources of CompetitiveAdvantage: Sponsorship and TaxExemption

The academic literature on credit unions haspaid little attention to the federal income tax

11

15 The estimate is based on a conservative assumption that real credit union assets grow at the 6 percent pace they registered from1993-2003 and that prices rise at a 2 percent rate, the same as over the ten-year period 1993-2004. Interest rates are assumedto average levels of the same earlier ten-year period.

16 Florida Tax Watch (2003) estimates the tax loss in Florida alone is $102 million. In Florida, as in several other states, all creditunions are exempt from state and local taxes, except for state-chartered credit unions that face real and tangible property taxes.The estimate includes all tax savings that arise from special exemptions from taxes for credit unions.

exemption of credit unions. Instead, the emphasison credit union competitive advantage has focusedon sponsorship (see the review of the literature inEmmons and Schmid (2001), for example). Thetypical or traditional common bond of creditunions has been either a single occupational bondor an associational bond. In both cases, the com-pany, union or workers sponsor the credit unionand provide valuable resources. In a fair tax sys-tem, sponsors would account for such subsidies asgrants and not as tax-deductible expenses andcredit unions would show these subsidies as in-come. But sponsors are likely accounting for thesesubsidies as tax-deductible expenses, reducingtheir own taxes, and compounding the inequitiesin the tax system. Again in an equitable system,these benefits from sponsors would be taxableincome that is not currently measured in creditunion net income.

Occupational credit unions are the most nu-merous. For example, Emmons and Schmid(2001) point out that in 1996 about 75 percent ofcredit unions had an occupational common bond.One example of the benefit of sponsorship is freeor subsidized services. In 2003, there were 2,003credit unions (21.4 percent) that had an annualoccupancy expense of zero or less. Another one-third (34.1 percent) had occupancy expenses ofless than $2,000 per month, so that more thanhalf of all credit unions (55.5 percent) had averagemonthly occupancy costs below that level. An-other 11 percent had occupancy expenses rangingfrom $2,000 to $4,000 per month and 11 percenthad rents from $4,000 to $8,000 per month.Thus, 77.5 percent of all credit unions had occu-pancy costs less than $8,000 per month. Theimportance of tax exemption in holding downcost has not been the focus, despite the fact that itwould swamp the value of all other subsidies ofcredit unions.

Because of the focus on sponsorship, a keyissue in credit union research has been why firmssponsor them and who benefits, with the latterquestion focusing on whether borrowers benefitthrough lower loan rates or depositors gainthrough higher deposit rates or some combinationof the two. A related issue is who controls a creditunion: the sponsor, members (either as depositorsor borrowers), or the market. Another importanttax policy issue is the incidence of the cost advan-

tage that credit unions have whether arising fromsponsorship, free services from members or taxexemption. In addition, a cost advantage couldaffect the market for competing providers, espe-cially banks and thrifts. Before taking up thequestion of incidence however, it is important toassess the value of the tax exemption.

IV. How Large Is the Tax Loss and HowBig is its Implied Advantage forCredit Unions?

The easiest way to estimate the tax loss is toestimate the tax that would have been paid if netincome were subject to federal corporate incometaxes. Based on data for all insured credit unions,net income in 2003 was $5.8 billion and thecomputed taxes would have been $2 billion. Theeffective tax rate would have been 33.97 percent.Government budget estimates often include afive-year revenue loss estimate and a ten-yearrevenue loss estimate. For the period 2004 to2008, the five-year revenue loss estimate is $12.6billion and the ten-year estimate is $31.3 billion.These losses indicate a much more substantialsubsidy and tax revenue loss than existing govern-ment estimates.15

Chmura (2004) estimates a tax loss of $1.9billion for 2002, based on a tax rate of about 33.3percent, and net income was $5.7 billion in 2002.Applying the tax rate to the slightly higher netincome in 2003 would result in an estimated taxloss of the same $1.9 billion in 2003.16 Thesmaller estimates by Chmura Economics andAnalytics and by government sources cited belowprobably arise because they do not take into ac-count firms that have no earnings or negative netincome and therefore would pay no federal in-come tax. However, this source of differencecannot explain much of the difference with gov-ernment estimates because the losses are small. In2003, 12 percent of all credit unions fell in thiscategory and reduced the total net income ofinsured credit unions by $117 million. Nettingtheir losses against all income would understatethe potentially taxable net income of credit unionsand understate the total tax liability.

The Joint Committee on Taxation (JCT)regularly estimates the “tax expenditure”associated with the federal income tax exemption.A tax expenditure is the revenue lost because of a

12

Table 2

Federal Tax Expenditures for theCredit Union Exemption(Joint Committee on Taxation Estimates)

Fiscal Tax ExpenditureYear ($billions)

2004 $1.22003 0.92002 0.92001 0.72000 0.81999 0.91998 0.81997 0.91996 0.81995 0.71994 0.41993 0.4

tax break, computed assuming that the beneficia-ries of the tax break would not alter their behaviorin its absence. It is comparable to the estimatehere or in Chmura. The JCT’s latest estimate forfiscal year 2004 is $1.2 billion, according toBickley (2003). Table 2 shows recent historicaldata for the tax loss from JCT publications.

Although JCT estimates are lower than thosecompiled for this study, they show the amount oftax revenue lost because of this exemption hastripled in only 11 years.

The Office of Management and Budget(OMB) in the Office of the President also esti-mates the tax loss due to the federal tax exemptionof credit unions. Their estimates are similar andfollow a similar methodology as the JCT. Forexample, in the Federal budget, OMB estimatesthat the tax loss was $1.3 billion in both 2003 and2004.17 The OMB five-year tax loss estimate for2005-2009 is $7.88 billion, which is far smallerthan our estimate of $13.66 billion for the sameperiod.

Based on an assessment of all credit unions,however, the tax loss is substantially larger, about$2 billion. This is over one-third of net income ofcredit unions, so the repeal of the tax exemptionwould add about 50 percent to the costs of creditunions, especially larger ones (credit unions withover $75 million of current net income, in thiscase, because they face marginal tax rates of 34 to39 percent).

Chmura (2004) also suggests that their esti-mate is likely to be too high, largely because credit

unions would manage themselves to reduce tax-able income, if, in fact, they were subject tofederal income taxation. For example, banks tendto use provisions against bad debt to reduce in-come and boost capital reserves in order to cuttaxable income. If credit unions were taxed, theywould likely boost their debt provisions to lowertaxable income as well.

However, depending on the incidence of thetax, explained in Section V below, credit uniontaxes might be even higher than the estimateshere. For example, credit unions, faced with ahigher cost of capital, might be able to raise theirinterest rates or lower deposit rates to cover thehigher cost. To the extent that credit unions wereable to keep deposits and loans while passingalong their higher taxes, gross and taxable incomewould be larger than currently projected andtherefore their tax payments would be as well.

If credit unions did not have the ability topass on the higher taxes, credit unions would tendto be smaller and some could be forced to close.In this case, the taxable income of credit unionswould be lower than current net income and theestimated tax gain from credit unions reportedhere would be too large. However, in this case,financial services business would switch fromcredit unions to banks, thrifts and finance compa-nies, raising taxable income and tax liabilitiesthere. In fact the tax receipts from those largerinstitutions would be higher on the same incometransferred from credit unions because they aregenerally in higher tax brackets. Thus, removingthe federal income tax exemption for creditunions could raise more tax receipts than the esti-mates here because their behavioral changes wouldincrease the tax base at credit unions or at theircompetitors, whether the credit union sectorshrinks or remains as large as it is today.

V. The Incidence of the Tax Loss –Who Gets the Tax Subsidy?

Who gets the $2 billion of annual tax sub-sidy? The answer to this question is importantbecause it reveals who benefits from the tax ex-emption and who is the key constituency formaintaining it. It also reveals who does not gainfrom the subsidy, though they may be the in-tended beneficiaries. And are there effects of thetax exemption on credit union competitors? Thepossible beneficiaries are:

• credit union depositors (higher rates paid ondeposits),

• credit union borrowers (lower interest rates

17 See Office of Management and Budget (2004), Table 18-1, p. 287.

13

18 Emmons and Schmid (2003) provide a nice review of the tension between banks and credit unions and explain that the taxexemption could either cause credit unions to be inefficient or it could give them a competitive advantage. They view theseeffects as mutually exclusive, but tax-exempt status could lead to both results. It is also possible that tax exemption could bethe result of greater inefficiency that occurs because of restrictions on credit unions, as well as the cause of greater inefficiency.

on loans),• credit unions managers and/or workers

(higher wages or other payments to manag-ers, workers or the suppliers of services tocredit unions),18 or

• credit union owners could benefit fromlarger retained earnings and capital of creditunions providing support for faster growthas well as a larger cushion against risk ormismanagement.

A related argument is that credit union spon-sors, at least for occupational credit unions,benefit because they value the benefits of creditunion services to their members as part of thehuman resources benefits they provide their em-ployees. Any subsidy reduces the cost of thesebenefits and contributes to employee compensa-tion, even if there is no direct effect on the netbenefits of credit union customers other than theconvenience of employer provided financial ser-vices. Hansman (1996) argues that these benefitsfor sponsor firms explain the popularity andgrowth of occupational credit unions. If thesecredit unions were taxed, it would raise their costsand reduce the sponsors’ incentive to sponsor orsubsidize a credit union.

If market prices for deposits, loans or re-sources used in credit unions are affected, then itis also possible that the effects of tax exemption oncredit unions also affect their competitors. Ameland Hannan (1998) argue that non-local banksand non-bank firms, such as thrifts and creditunions, have no effect on bank deposit rates.Moreover, in regulatory analyses of banking com-petition for merger or other antitrust issues, creditunions are routinely ignored, implicitly assumingthat credit unions do not affect pricing of bankingservices. Yet, as Emmons and Schmid (2000)emphasize, banks continue to oppose the legis-lated advantages of credit union charters.

Incidence of the Tax ExemptionFigure 3 can be used to summarize the inci-

dence effects of tax exemption. A basic model ofthe loan market is shown there. The analysis fo-cuses on loans, but it applies more generally tototal assets and these terms are used interchange-ably in applications of this analysis below. Thedemand for credit union loans shown implies thatcredit unions can make more loans if the interestrate on loans is lower. If the loan rate were set in abroader market (including banks, thrifts, loan

brokers and finance companies, say) then thedemand for loans would be horizontal at a mar-ket-determined interest rate and the position ofthe supply curve for loans would determine thequantity of credit union loans. Two supply curvesare drawn that differ according to whether creditunion income is taxed. The higher supply pricecorresponds to the supply price of loans if creditunions are subject to federal income tax.

The supply curve in each case is upward slop-ing and includes the cost of producing anadditional dollar of loans. It includes the addi-tional operating expenses and the additional costof deposit funds and net worth in order to fundthe dollar of loans. If any of these costs rise asloans expand, then the curve is upward sloping.The interest cost of deposits could rise as loansrise because a higher deposit volume could requirethat credit unions offer higher deposit rates. Thelatter component of cost could be unaffected bythe size of credit union assets if credit unions are arelatively small part of the deposit market andessentially take the deposit rate determined bybanks and thrifts as given. This is likely and sup-ported by the data here since credit union assetsare little more than one-tenth the size of bankassets. There is some evidence, noted below, thatcredit unions may pay higher rates to fund largerloan volume and if that is the case the slope of thecredit union loan supply curve is steeper than itwould otherwise be.

Note that the supply curves in Figure 3 arebased on long-run supply price. The distinctionhere, as opposed to short-run supply, is that itincludes the cost of capital since capital is variablein the long run and has to be compensated at themarket price of capital in order to remain in thissector instead of moving to other business. More-over, the supply of loans or assets in credit unionsrequires that firms hold more equity as a bufferagainst expected and unexpected losses as theirassets increase. Economic analyses often focus onthe short run, where capital or equity may betreated as fixed, and conclude that an income taxcannot affect output or price. For financialinstitutions, capital is not fixed even in the shortrun. Since income, in the long run, includes acompetitive return to owners this element of costmust also be included in the supply price andchanges in tax rates affect the cost of equity capitaland therefore the supply price.

Higher taxes raise the cost of equity capital or

14

19 The after tax-rate of return on equity is (1-t) times the before-tax rate of return, where t is the tax rate. Thus the supply priceof equity capital measured vertically in Figure 3 would rise by 1/(1-t) times the cost of equity capital as t rises from zero to one-third. When the tax rate is one-third the cost of equity capital and the new supply price will rise by an amount that is 50%percent larger than the cost of equity in the absence of the federal tax.

Figure 3

The Effect of a Tax on Credit Union Income

L 0 L 1

i 1

i 0

Interest Rate

Supply(with tax)

Supply(no tax)

Loans

Demand

the amount that has to be earned to compensatethe owners. More loans require that credit unionshold larger capital and capital has a required rateof return, so that the supply price of loans includethis cost of equity capital. Taxation of the returnto equity would raise this cost, shifting the supplycurve upward and to the left as shown in thechart. If the tax rate is about one-third, then thiscomponent of the supply price would rise about50 percent.19 In recent years the rate of return onassets, which equals the weighted cost of equity,has been about one percent (see Table 1), so thattaxing credit unions would raise this cost by 50basis points. This is the extent of the tax subsidyper dollar of assets.

According to Figure 3, removing the tax ex-emption would raise the rates charged by creditunions for loans (from i0 to i1) and borrowerswould reduce the amount borrowed from creditunions. Since total assets of credit unions wouldfall (L0 to L1), the amount of capital required by

credit unions would also fall. Note that the inter-est rate on loans would not rise as much as theupward shift in the supply curve because loandemand would fall for such a large increase, ac-cording to Figure 3. If the supply curves are flat,indicating that cost, especially credit union de-posit rates, do not depend on loan volume, thenthe tax would be fully reflected in higher loanrates.

On the other hand, if the demand curve forloans were flat, the tax increase would not affectloan rates. In this case, loan value and desiredretained earnings and capital would fall more, andloan rates would not rise. So long as loan volumefalls, deposit rates could decline if their volumeaffects credit union deposit rates. In this case, therise in supply price could be partially offset by ashift down in the cost of deposits. This wouldlessen the effect of the removal of the tax exemp-tion on loan rates and on the volume of loans.The extent to which the removal of tax exemption

15

would raise loan rates, reduce deposit rates, oraffect loans or desired capital depends on how flatthe demand or supply curves are.

Another way that loan interest rates would beunaffected by tax exemption is if competitionforces the subsidy to be passed on to depositors orto managers or other suppliers of credit unionresources. Such a rise in cost would offset the taxsubsidy, shifting the “no tax” supply curve in Fig-ure 3 back up toward its “with tax” position. Inthis case the tax exemption would be absorbed byother resource costs, and if it is completely passedon in this way there would be no net effect onloan volume or the size of the credit union sectordue to the tax exemption. There is evidence onthese issues that can inform an answer to the ques-tion of who gets the $2 billion and how it ispassed to them.

Evidence on the Incidence of the Tax ExemptionEarly studies of credit unions explored

whether credit unions paid higher deposit rates orcharged lower loan rates. Other potential inci-dence effects, such as higher compensation orother costs, lower sponsor outlays or larger networth, were ignored. The results of these studiesare mixed. Flannery (1974) argued that the evi-dence supported lower loan rates. Emmons andSchmid (2000) point out that a later study foundthat deposit rates were higher, but a 1986 studyfound that both borrowing and lending rates werenot different than at other institutions. Manystudies over the years, including several cited byEmmons and Schmid (2000), support the hy-pothesis that the more diffuse ownership of creditunions has led to higher expenses at credit unions,an indication of what is called “expense–prefer-ence theory.” This is the notion that managers atinstitutions without strong discipline from stock-holders and the capital markets will maximizetheir own well being instead of profits by payingthemselves high wages or other less obvious perks.Such an agency problem is especially acute at non-profit institutions or cooperatives, where equitydoes not trade and managers may be able to re-place the owners as the residual claimant of profit.

Some analysts have found some effects ofcredit unions on local pricing of bank services,however. Tokle and Tokle (2000) find that localcredit union market share of deposits has a signifi-cant positive effect on deposit rates (significant forone- and two-year certificate of deposit (CD)rates, but not regular saving deposits, which arecalled shares at credit unions). This study is basedon a small sample in rural Nevada and Montanain 1998, however. More recently, Hannan (2002)found that the credit union deposit-market share

has a significant positive effect on deposit rates atbanks for the three rates he studied: checkingdeposits, money market deposit accounts andthree-month CDs, respectively. His study focuseson banks in 100 metropolitan areas in 1998, usingdata from Bank Rate Monitor. Emmons andSchmid (2001) also provide evidence that higherloan demand at credit unions raises deposit ratesat credit unions. They take this as evidence of a“sponsor control” hypothesis, however, as opposedto member control, either by dominant creditunion borrowers or dominant credit union de-positors. The more important point is that it alsosuggests that deposit rates at credit unions are notdetermined in competitive deposit markets withbanks. Some evidence below questions that im-plicit result, however.

Few studies have looked at loan rates at creditunions and whether they affect comparable rates atbanks. However, Feinberg (2001 and 2002) findsthat the credit union market share of deposits has asignificant negative effect on new car loans in astudy of six years of data (1992-97) for a panel ofbanks. That is, the larger is the share of creditunions in the deposit market, the lower are newcar loan rates at banks. This suggests that the tax-exempt credit union market share depresses newcar loan rates at all financial service institutions.

Higher Loan Rate or Lower Deposit Rates?If the incidence of the tax exemption fell on

depositors or shareholders, who in this case are thesame people, credit unions could be expected topay higher rates on deposits than non-exemptinstitutions (banks and thrifts).

Table 3 shows selected rates from a survey byBank Rate Monitor at the end of 2003. The evi-dence is mixed for loan rates, but the only depositrate sampled, that on one-year CDs, is sharplyhigher at credit unions than at non-exempt insti-tutions. For loan rates, credit unions werecharging a slightly higher rate on 30-year mort-gage loans, but less on one-year adjustable ratemortgages and much less on home equity loans.The largest difference was for new car loans wherecredit unions charged much lower rates. Thissurvey suggests that the incidence of tax exemp-tion falls on both borrowers and depositors atcredit unions, but relatively more heavily on loanrates, especially car loan and credit card rates, thanthe more competitive rates on real estate loans,especially first mortgages, or deposits.

If the tax treatment of income affects thepricing of loans at credit unions, it should beapparent in the pricing of loans and deposits atfederal and state-chartered institutions. State-chartered credit unions are not exempt from state

16

Table 3

Do Credit Unions Charge Less and Pay More Interest?

Loan Credit Unions Banks Thrifts30-year fixed mortgage 5.88% 5.83% 5.80%1-year adjustable mortgage 3.64 3.80 4.11$10,000 home equity loan 4.54 5.03 4.5248-month new-car loan 5.84 7.14 7.33Variable credit card 10.20 13.13 14.591-year CD 1.71 0.98 1.34

Based on data compiled on Dec. 18, 2003Source: Bankrate.com

Table 4

Federal Credit Unions Do Not Charge Lower Interest Rates or Pay HigherDeposit Rates Than State-Chartered Credit Unions

December 31, 2003

Federal StateCredit Unions Credit Unions

First mortgage loan 6.3% 6.2%Other real estate 6.3 6.1New vehicle loan 5.9 5.7Used vehicle loan 7.0 6.6Credit card 11.5 11.7Regular shares 1.1 1.1Share drafts 0.5 0.5CD (1 year) 1.7 1.7Money market shares 1.1 1.1

Source: National Credit Union Administration

taxes, while federally chartered institutions are. Ifthere is some incidence of taxes on loan interestrates or on rates paid on deposits at credit unions,the differences should show up in differences inthe average interest rates on different types ofloans or deposits for these two groups of creditunions. Federal credit unions would be expectedto charge lower interest rates as competition in-duces them to pass along some of their tax savingto borrowers. Federal credit unions could alsocompete by offering higher rates on deposits thanstate-chartered ones. The NCUA reports interestrates paid and charged at each type of institutionsince 1992 in their on-line statistics (2003) forvarious periods (see Table 4).

At the end of 2003 there were noticeabledifferences in the rates on the key types of loansoffered, but the rates at federal institutions were

actually somewhat higher for mortgage loans,other real estate loans, and for new and used carloans. Only credit card interest rates were slightlylower at federal credit unions than at state-char-tered ones. Thus, it does not appear that theincidence of the tax exemption falls on lower loanrates which may be highly impacted by marketforces. Similar comparisons of earlier end-of-yeardata from 1992 to the present show the sameresult.

The bottom entries in the table show ratespaid by the two groups of four types of deposits.They are identical, so the incidence of tax exemp-tion does not appear to fall on deposit rates either.Again, the same pattern of equal rates shows up inearlier data. The incidence of the tax exemptiondoes not show up in higher deposit rates at federalcredit unions.

The pattern shown in Table 4 holds over timeas well. In the Appendix, the raw data for theseinterest rates from 1992 to 2003 are shown in alonger table. The differences between the interestrates at federal and state-chartered institutions areshow in Table 5. Where the rates differ, they areshown in bold when they conform to the tax inci-dence hypothesis, that is, the rates on loans arelower and rates on deposits are higher at federallychartered institutions. Note that most of the en-tries show no difference. For deposit rates, onlytwo entries are consistent with the incidence hy-pothesis and nine other non-zero entries are of thewrong sign. The mean difference for the depositrates is zero, which is consistent with the argu-ment that credit union deposit rates are set in abroader deposit market in which credit unionsmake up a small market share.

For loan rates there are also more differencesthat are non-zero and consistent with the tax-incidence hypothesis, about 30 percent of theobservations, but there are slightly more pairs ofobservations that have the wrong sign. Only creditcard rates are lower at federal credit unions inmore than two years and have a mean that is nega-tive for the whole period. This pattern isconsistent with the argument above that loan ratesat credit unions are not different than in the taxedsector of the financial industry because creditunions are a small part of a very competitive mar-ket. For car loans and credit cards, there is morediversity and indeed, the credit card rates appearto be systematically lower at federal as comparedwith state-chartered institutions. Subjecting allcredit unions to the federal income tax is notlikely to affect market rates on credit cards outsideof credit unions and will have little effect on over-all loan rates at credit unions. Credit card loansaccount for only 5.8 percent of credit union loans

17

Table 5

Difference in Interest Rates at Federal and State-Chartered Credit Unions: 1996-2003

Excess of Rate at Federal over State-Chartered Credit Unions1996 1997 1998 1999 2000 2001 2002 2003 Mean

First mortgage loan 0 0 0 0.1 0 0.1 0.1 0.1 0.0Other real estate – 0.1 0 0 0 – 0.1 0.1 0.1 0.2 0.0New vehicle loan 0 – 0.1 0 0 0 0.0 0.1 0.2 0.0Used vehicle loan 0.2 0 0 0 – 0.1 0.1 – 0.1 0.4 0.1Credit card – 0.2 – 0.2 0 – 0.1 – 0.2 0.1 – 0.2 – 0.2 – 0.1

Regular shares – 0.1 – 0.1 0 – 0.1 0 – 0.1 0.1 0 0.0Share drafts 0 – 0.1 0 0 0 0.0 0 0 0.0CD (1 year) 0 – 0.1 0 – 0.1 – 0.1 0.0 0 0 0.0Money market shares – 0.1 0 0 0 – 0.1 0.1 0 0 0.0

bold = consistent with incidence expectations

and even adding in all other unsecured creditunion loans raises the share to 10.4 percent ofloans and 6.6 percent of total assets. Thus even ifall of the incidence of the $2 billion tax break forcredit unions (50 basis points as a percent of as-sets) fell only on these loans, removing the taxbreak would have little effect. The supply price ofassets would rise about 5 basis points (6.6 percentof 50 basis points).

Emmons and Schmid (1999, 2001, and2004) have produced several studies that point tostrong competition between banks and creditunions. They find that an increase in credit unionparticipation leads to an increase in bank marketconcentration a year later. Moreover, increasedbank market concentration leads to increasedmembership in credit unions. This is an exampleof what is sometimes called “bi-directional causal-ity.” It results, they suggest, from increased bankconcentration resulting in higher prices for bank-ing services and/or lower deposit rates. Thus, bankconcentration leads bank customers to switch tocredit unions. However, increased credit unionmembership presumably boosts competition infinancial markets so that banks are forced to con-solidate, continuing a cycle of increasing growthof credit unions and increased concentration inbanking. Recall, however, that the trend of con-solidation that raises concentration is alsooccurring at credit unions, which are declining innumber as well.

Are Employment Costs Higher at Credit Unions?Emmons and Schmid (2000) also provide a

useful review of the literature on credit unionsefficiency, noting in particular, that Fried, Lovelland Vanden Eeckaut (1993) find that credit

unions exhibit the same degree of widespreadoperating inefficiency as found at other depositoryinstitutions. Employment costs make up abouthalf the operating costs of credit unions and aboutone-fourth (25.9 percent) of total credit uniongross income or cost. Relative to total assets in2003, this is about 1.54 percent.

Chmura (2004, p. 33) compares the em-ployee compensation costs of credit unions andbanks. For six asset classes, ranging from under $2million to over $500 million of assets, Chmurafinds that credit unions’ employee compensationcost per dollar of assets is about 11 basis pointshigher, on average, and higher in all but two assetclasses of credit unions. The two exceptions areinstitutions with assets from $10 to $50 million,where the share is smaller at credit unions by onebasis point, and over $500 million, where theshare of credit unions is smaller by eight basispoints. The highest levels of excessive employeecompensation cost occur for credit unions in the$2 to $10 million class where compensation is 26basis points higher than at comparably sized banks(1.86 percent vs. 1.60 percent). The other is agroup of large credit unions those with assets of$100 to $500 million, where credit unions havecompensation that is larger by 30 basis points ofassets (1.69 percent vs. 1.39 percent). Generallythen, it appears that credit unions may haveslightly higher employee compensation costs, butthere are exceptions and they are not clearly linkedto asset size. For the next to smallest and the nextto largest asset size classes, credit unions appear tohave smaller employee compensation costs. Whilecredit unions appear to have higher employercosts, perhaps reflecting that the tax exemptionbenefit is partially being captured by the managers

18

and workers in credit unions through higherwages or lower productivity, the difference is notlarge nor does it vary systematically by size ofcredit union. While the lower employee cost at thelargest credit unions suggests that bank competi-tion may constrain employee costs moreeffectively, the effect does not continuously dimin-ish with the size of credit unions, casting doubt onthis channel of incidence.

Emmons and Schmid (2000) find that thereis a positive relation between relative wage levels atcredit unions (compared with average local wages)and asset size for occupational credit unions spon-sored by employers, at least for credit unions withassets up to about $65 million. This was the aver-age size credit union in 2003. They interpret thisto mean that the cost of financial distress riseswith asset size and so the sponsor of the creditunion pays higher wages to induce managers ofthe credit union to shirk less. One alternative thatthey do not rule out, however, is that credit unionsize, per se, raises the cost of a sponsor monitoringthe management, or what is called “agency cost,”so that the agents (management) can get awaywith higher wage premiums. More important, anywage premium declines with asset size for largerinstitutions, according to their evidence, and thissupports the notion that competitive pressures andsuperior management at large credit unions con-trols shirking without bribes or premiums fromsponsors. It is not likely then that the tax subsidyfor credit unions has been absorbed by signifi-cantly higher employee and management costs.

Does the Tax Break Accrue to Owners ThroughRetained Earnings, Larger Assets and Net Worth?

A final possibility is that the tax break is ab-sorbed by the expansion of credit union assets to asize that can be supported by the enhanced excessearnings of the credit unions. A tax break initiallyraises the rate of return on assets and equity, giventhe volume of loans, assets and equity. More im-portantly, it shifts the supply price of loans downor to the right because the cost of equity capitalfalls.

When the loan demand is flat at an interestrate determined in broader loan markets (includ-ing banks and other financial institutions), theincidence of the tax break shows up in the size ofcredit union loans (assets). In the absence of adecline in loan rates, an increase in deposit rates,or a change in the other costs of new loans, thesupply of loans would tend to expand, so that thenew supply of loans would equal i0 in Figure 3 at alarger quantity of loans and equity. Equity will risedue to the increased loan (asset) supply and be-cause the equity ratio will rise in response to the

higher rate of return on equity.Given the required rate of return on equity,

the cost of equity and of assets (loans) will rise asthe equity ratio, the ratio of net worth to assetsincreases. This brings the supply price of loansback to its initial level at i0 in Figure 3, but at alarger supply of credit union assets. In this case,the incidence of the tax break is confined to thelargest possible increase in the size of credit unionassets and equity.

Again, in this case, removing the tax breakwould shift the supply curve up and lower the sizeof credit union assets and loans. At the initialsupply of loans, L0, the supply price rises 50 basispoints if the initial rate of return on assets is onepercent. Loan interest rates would not be affected,however, nor would the interest rate on deposits(if it is also determined in a competitive depositmarket with banks and thrifts and where creditunions are a relatively small share of the market),nor would the other costs of credit unions. Themaximum size effect of the removal of the taxexemption is to lower assets and to lower the net-worth-asset ratio by one-third. The ROA wouldinitially be lowered by the tax increase and thedecline in the net worth-asset ratio would furtherdepress the ROA of taxed credit unions. Ulti-mately the ROA would decline to the same extentas the equity ratio, one-third under the assump-tions here, but regulatory constraints could keepthe equity ratio from declining this much.

Under these assumptions the incidence of thetax exemption is to raise credit union assets. Therate of return on assets would rise due to the taxexemption as well, because of the rise in the equityratio and its effect boosting the cost of capital.Reversing this process indicates the effects of re-moving the tax exemption. To the extent that thedemand for loans is not horizontal or that othercosts are not raised by the tax exemption, theremoval of the tax exemption would not reduceassets as much.

To examine whether the incidence of the taxexemption falls on the size of the tax-exempt insti-tution, a comparison of rates of return and equityratios at federal and state-chartered credit unionscould be helpful. If a tax break is made availableto federal credit unions only, then it would bereflected in an initial rise in their rate of return onassets and assets. Competition would lead thesecredit unions to expand assets and the equity ratiowith the equity generated by higher earnings. Inthe end, the tax-favored credit unions would ex-pand relative to the less favored credit unions, therate of return on equity would be unchanged, butthe rate of return on assets and the equity ratiowould be higher at federal credit unions than at

19

Figure 4

The Rate of Return on Assets at More Heavily Taxed State Credit Unions Is Not Lower

0

2

4

6

8

10

12

14

16

18

20

200320022001200019991998199719961995199419931992

Perc

ent

Rates of Return at Federal and State Chartered Credit Unions

State ROA

State ROE

Federal ROA

Federal ROE

state-chartered credit unions.Figure 4 suggests that the competitive as-

sumption, that the ROE at federal credit unionswould return to its initial value (the ROE at state-chartered credit unions) holds fairly well. In factthe rate of return on equity is slightly smaller forthe lower-taxed federal credit unions than for thestate-chartered ones. In 2003 the federal ROE was9.54 percent, somewhat above the 8.95 percentrate at state-chartered institutions. But for the fullperiod and over the past six years the rate of returnis actually smaller, on average, at federal creditunions. From 1998 through 2003, the averageswere 8.96 percent at federal credit unions and9.10 percent at state-chartered institutions, forexample. Thus the basic long-run assumption doesnot hold for the period and the relative size ofrates of return does not even fit the initial effect oftax exemption, which should make the rate ofreturn on equity initially higher at federal creditunions.

The absence of equality of long-run ROEsmeans that it is not so likely that the two keyincidence conclusions will hold either. First, thefederal ROA is higher, but not by enough to sug-gest that the incidence of the tax-exempt statusfalls on size alone. In 2003, the Federal creditunions had an ROA of 1.03 percent, 8 basispoints above that of state-chartered institutions.However, from 1998 to 2003, the average ROAwas 0.99 percent at both sets of institutions. Thus

the ROA evidence does not support the notionthat the incidence of tax exemption falls on therelative size of the institutions.

The equity ratio implication fares somewhatbetter, but not by enough to support the idea thatincidence only affects asset and equity size. Theequity ratio (not shown) of the federal creditunions is not much larger. Since 1997, the meanequity ratio was larger, but not by much. For thepast six years, the average federal equity ratio was11.06 percent, about 23 basis points higher thanat state-chartered credit unions. In 2003, the fed-eral equity ratio was 10.80 percent, only 28 basispoints higher than the 10.52 ratio for state-char-tered credit unions. One possible reason is thatthe tax burden at state-chartered credit unionsmay not be large enough to make a differencebetween the two types of institutions.20

Another consideration is that equity ratios aredetermined not only by the economics of theinstitution, especially its tax status, but also byregulatory constraint. Regulators evaluate theequity ratio as a positive factor in determining theperformance of credit unions. Thus equity ratiosdo not simply reflect the influence of economicfactors such as the exemption from state taxes.The equity ratio at state-chartered institutionscould be higher than expected because of regula-tory pressures to hold it up relative to where itwould be if tax considerations alone were takeninto account. That would, in turn, require the

20

20 The NCUA, the federal credit union regulator, and CUNA, the national trade association for credit unions, do not publicizedata on taxes paid by state-chartered credit unions, so it is difficult to evaluate the significance of these taxes directly. Mostinstitutions use the NCUA’s call report template to report their costs so that taxes are included in “miscellaneous operatingexpenses” on in the case of sales taxes sometimes in “operating fees.”

21 See CBO (2004), for example.

22 In 2003, commercial and industrial loans and commercial real estate accounted for 11.5 percent and 7.9 percent of bankassets, respectively. While credit unions are expanding their business lending, which could be more safely and profitablysupported by their relatively high equity ratio, it remains minuscule in comparison.

23 The average ROA for the ten years 1994-2003 was 1.01 percent, below the average for banks, 1.21 percent. Gunther andMoore (2004b) argue that using summary measures for each firm’s performance ratio is superior to ratios computed for thegroup. Using data for individual credit unions and summary measures for banks prepared by the FDIC does not alter theconclusions here, however.

ROA for state-chartered institutions to be higheras well to hold up the ROE.

If the tax break did not fully affect the size ofthe tax-free sector, then the loan rate would belower and/or operating costs or deposit rateswould be higher to offset the tax break at an un-changed asset size. In all three cases, assets, or thesize of the tax-free sector, would be less affected bythe tax break. When the rate of interest on loans isdepressed or the non-interest operating cost israised, assets are not as affected, but the equityratio still rises because the cost of equity capital isreduced relative to the cost of deposits. When thetax break is passed on in the form of higher de-posit rates only, there is little or no effect on theequity ratio or asset size. In this case the cost ofboth deposits and of equity capital rise, providinglittle or no incentive to boost the equity ratio orassets.

The evidence above for loan rates, especiallyfor credit card and auto loans, suggests that inci-dence could fall somewhat more heavily on loanrates (about 6 out of 50 basis points according tothe analysis there). To the extent that tax inci-dence falls on deposit rates or other costs [nomore than 11 basis points according to theChmura (2004) evidence above] the supply pricerises to offset its reduction due to the tax break.The supply curve in Figure 3 does not shift downas much and credit union assets and equity are notboosted as much by the tax break. Similarly inthese cases the removal of the tax break would notreduce the size of the untaxed credit union sectoras much.

This evidence indicates that the effect of thesubsidy does not fall on the equity ratio or size,which is surprising in light of other evidence. Forexample, research on government sponsored enter-prises (GSEs) shows that the effect of the publicperception that debt of these institutions is backedby the full faith and credit of the U.S. governmentfalls largely on the companies (assets or equityratio) and not on their interest rates or overalloperating costs.21

There is also some evidence that the effect onthe asset structure of credit unions is the domi-nant one. A comparison of credit unions withbanks shows that the incidence of credit union taxexemption falls largely on the equity ratio of thecredit union sector. In 2003, the equity ratio of allcommercial banks, at 9.10 percent, was well belowthe 10.7 percent rate for credit unions (see Table6). This 17.8 percent larger equity ratio is consis-tent with the tax incidence analysis which suggeststhat credit unions should have a much largerequity ratio than banks if their tax exemptionmainly affects their equity size. While the equityratio at credit unions is not large enough to justifya conclusion that incidence falls completely on thesize of the equity ratio, it does suggest that this isthe major effect.

However, banks are riskier than credit unionsbecause they are much more dependent on loansto the more cyclical and secularly risky businesssector.22 Thus even on a long-run basis, one mightexpect banks to have a higher ROE than creditunions. Equality of ROEs applies to equally riskyfirms; riskier firms should have a higher ROE tocompensate for greater risk, so that only the risk-adjusted ROEs are equal. On a risk-adjusted basis,the equity ratio at credit unions would be evenlarger than the actual difference. The smaller eq-uity ratio at banks may also reflect size differences.Larger financial intermediaries are more diversi-fied and hold smaller equity ratios. For example,banks with assets below $100 million held equityequal to 11.27 percent, less than the 11.87 per-cent held by credit unions in the same size class.

The latest year’s data underestimate the usualdifference in these ratios. In 2003 the averagecredit union equity ratio was only 10.72 percent.As Figure 5 shows, however, the equity ratio for allcredit unions was unusually low and that of banksrelatively high in 2003, 17.8 percent larger thanthat of the average bank ratio. For the past tenyears shown in Figure 5, the credit union equityratio was 26.6 percent larger than at banks. Creditunions consistently have higher ratios and usually

21

Table 6

Credit Unions Hold Larger Equity Ratios and Earn Lower Rates of Return onAssets (2003)

CUCredit Unions Banks Equity____________ ______________ ______

Equity Equity ExcessSize Class ROA Ratio ROA Ratio (%)

All 0.95 10.72 1.4 9.1 17.8< $100 million 0.66 11.87 0.94 11.27 5.4

$100 million to $1 billion 0.96 10.68 1.26 9.9 7.9> $1 billion 1.15 9.89 1.43 8.92 10.8

Figure 5

Credit Unions Have a Higher Equity Ratio Than Banks

0

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16

Banks

Credit Unions

2003200220012000199919981997199619951994

Credit Unions Hold Higher Ratios of Net Worth to Total Assets

Perc

ent

ratios that are much higher than in 2003. In fact,the average excess for the past ten years accordsvery well with the maximum incidence of taxexemption on the equity ratio, especially whenone considers that riskier banks would choose tohold higher ratios even if the tax treatment werethe same.

Banks have a higher rate of return on assetsthan credit unions despite their higher tax rate. In2003 the ROA at commercial banks based on netincome and end-of-year assets equaled 1.4 per-cent.23 This reflects the shift in larger banks todiversify their income generating products. Thehigher ROA for banks and lower equity ratiocombine to produce a higher ROE at banks. In2003, banks earned a 15.4 percent ROE, wellabove that of credit unions (10.2 percent). Thismeans that the actual equity ratio difference un-derstates the tax incidence effect on the size ofcredit unions. Thus comparing banks and creditunions is fraught with difficulties because of manyfundamental differences in the businesses besidestheir tax treatment.

Another strong indication of the effect of thecredit union tax subsidy is the chartering patternof credit union and banks. There are many factorsthat influence whether a bank or credit unionobtains its charter from the state or from the fed-eral government chartering institution (the Officeof the Comptroller of the Currency or the NCUA,

respectively). There is no difference in the taxtreatment of state-chartered and federally char-tered banks, but there is a difference for creditunions. Since federally chartered credit unionshave more tax advantages than state-charteredcredit unions, there should be relatively more ofthem, given other factors that influence this deci-sion. And there are relatively more of them. Forbanks at the end of 2003, 30.6 percent (2,814 outof 9,181 banks) were federally chartered, while61.6 percent of credit unions were federally char-tered at the same time, about twice the share offederal bank charters.

A key difference between banks and creditunions is that bank shareholders can make asset

22

decisions that are almost completely separate fromtheir demand for banking services. People whobank at one institution can be stockholders inanother, and shareholders in a bank do not haveto be depositors or borrowers. Credit union share-holders cannot sell their ownership claims. Thisputs their equity claims under the full control ofmanagement, and this can lead to capital marketinefficiency. Active capital market evaluation con-tributes to enhanced efficiency at banks, holdingdown the equity ratio and boosting ROA in orderto raise the ROE. It also provides strong incentivesagainst sponsor abuse or managerial abuse ofowner interests.

While the evidence on the incidence of thetax break is mixed, this largely reflects the equalityof data on credit union costs and loan rates. Mostof the analysis and inferential conclusions heresupport the view that the principal benefit of thetax incidence is to boost the size of the creditunion sector and not to lower loan rates or boostdeposit rates for credit union customers.

SummaryWhile the tax expenditure arising from credit

union tax exemption is large and growing, datalimitations, especially on comparable interest ratesand cost, preclude a definitive estimate of theincidence of the tax. The overall effect of the taxexemption can be measured as the rise in the rateof return on assets, before taxes, that would berequired to keep the rate of return on assets, aftertax, unchanged. With a tax rate of one-third andaverage rate of return on assets of one percent, theROA before taxes in the absence of the exemptionwould have to be 1.50 percentage points, or 50basis points higher. This is the size of the subsidy(per dollar of assets) that accrues to the beneficia-ries of the current tax exemption.

Research on GSEs and credit union researchsupport the view that the principal incidence oftax exemption is an increase in the total assets andequity ratio of the credit union sector. However,direct evidence comparing more or less highlytaxed credit unions that are all exempt from fed-eral income taxation is not very supportive of thisconclusion. Evidence on other incidence effects isalso not strong except for some evidence thatcredit unions charge lower interest rates on loans,especially on those loans where efficient nationalmarkets do not constrain credit union pricing,

most notably credit card loans and to a lesserextent car loans.

Based on the evidence analyzed here, theconclusions are that some 6 basis points of the 50basis point subsidy accrues to credit union bor-rowers through lower interest rates, while no morethan 11 basis points are absorbed by higher laborcosts. There is little or no effect on deposit rates orother costs. Thus, 33 to 44 basis points of thesubsidy accrue to owners in the form of largerequity and larger assets. No allowance has beenmade for the reduced credit union costs of spon-sors, but to the extent that these are large it is atransfer within the firm and has little or no effecton the size of credit unions or tax receipts. Endingtax exemption could be expected to reduce therelative size of credit unions and to reduce theirgrowth rate. Existing taxpaying financial servicefirms would gain market share, absorbing the lostmarket share of credit unions and boosting taxrevenues even more. The equity ratio of creditunions would be reduced; management of capitalcosts would make credit unions more efficient,perhaps lowering operating costs and interest rateson deposits and raising rates on loans, at least insome markets. Credit unions would be more sub-ject to market control and would manage risk andreturn more efficiently, increasing the value oftheir franchises to their owners, despite smallerrelative size and slower growth.

VI. Proposals for Change

Abolish the Exemption or Leave it Only for SmallCredit Unions?

One proposal for tax reform that often arisesis to leave the tax exemption for small creditunions and abolish it for large, complex creditunions. One specific proposal is to restrict thefederal income tax exemption to institutions withtotal assets of less than $10 million.24 The ratio-nale for this proposal is that only the larger creditunions are similar and competitive with banks andother financial intermediaries, at least from ahousehold or consumer standpoint. In addition,smaller credit unions generally have traditional ornarrow common bonds and are more likely toserve the purpose of the cooperative credit unionmovement. Bickley (2003) and the Joint Commit-tee on Taxation estimate that the $1.2 billion taxexpenditure or subsidy to credit unions in 2004

24 Chmura Economics and Analytics (2004) notes that the Reagan administration proposed that credit unions with assets inexcess of $5 million lose their federal income tax exemption as part of their broad tax reform that occurred in 1986. Thisrecommendation was apparently rejected in congressional debate over the otherwise sweeping reforms. Indexed for inflation,the Reagan-era exemption would be about $8 million today. The Carter administration also had proposed removing the taxexemption for all credit unions, according to Chmura.

23

would have been cut to $1.0 billion if only thosewith assets greater than $10 million are included.This suggests that about $200 million in lost taxrevenue is due to the tax exemption of small creditunions. As noted above, however, the tax loss forall credit unions is closer to $2 billion and remov-ing the exemption for credit unions with assetsbigger than $10 million would represent the bulkof any tax gain, according to this study’s estimates.

The OMB estimates that the ten-year revenuegain for 2004 to 2013 from taxing the creditunions with assets in excess of $10 million is $12billion. The five-year estimate (2004–2008) is $5billion, including $0.6 billion in 2004 and $1billion in 2005. The 2004 estimate is smallerbecause it is assumed that the proposal is imple-mented for only half of 2004.25 Our estimate is$12.5 billion for the 5-year period and $31 billionfor the ten-year period. The estimates are notmuch different than the tax revenue gain fromtaxing all credit unions.

This proposal would leave the exemption forvery small credit unions, but it would restoreneutrality for larger credit unions. This is called apractical solution because only about half of creditunions (51.1 percent) had total assets in excess of$10 million in 2003. So only 4,792 would be-come taxable and of these, nearly 6 percent hadno income in 2003, so only about 4,512 wouldhave had a tax bill, based on reported net income.However, taxing these credit unions, 48.1 percentof all the credit unions in the country, would tax98.1 percent of the net income of all credit unionsand collect 98.9 percent of the revenue from tax-ing all of them. Thus, it appears that such aproposal would yield $2 billion as well, subject torounding error, but would impact fewer than halfof all credit unions.

Only $22 million in additional revenuewould be raised by applying the corporate tax rateto the net income of credit unions with assetsunder $10 million. And only $120 million moreof net income would be taxed if all credit unionnet income were taxed instead of the income ofthe larger institutions. This is much lower thanthe $200 million gain indicated by the JCT —about one tenth as much, but the reasons for thedifference are not clear. While the estimate heremakes the “practical solution” more appealingbecause of its negligible revenue loss, it still resultsin a failure of neutrality for small credit unionsand other firms. Genuine tax neutrality wouldrequire taxing all net income of all credit unions,

without regard to size.Therefore, excluding taxation of small credit

unions simply because they are small is largely apolicy choice and would doubly compensate themfor being small. The income tax system alreadyaccounts for size, taxing firms with lower incomeat lower marginal tax rates. For example, firmswith taxable income less than $50 million pay a15 percent rate. Over 35 percent of credit unionswould have faced this rate in 2003. For firms withincomes from $50 million to $75 million, themarginal tax rate is 25 percent, applied to incomeover $50 million. Some 6.5 percent of all creditunions would have faced this marginal tax rate in2003. Adding in the 12.8 percent of credit unionsthat had no net income in 2003, brings the totalto over half of all credit unions with a net incomeof $75 million or less. Larger credit unions, atleast with incomes over $75 million, face marginaltax rates from 34 percent to 39 percent. So mostcredit unions would face lower tax rates than thelarger ones, even if all credit unions were subjectto the federal income tax, just as firms in otherindustries are. Is there any reason why generallysmall, low-income credit unions should pay nofederal income tax when small firms in other in-dustries do?26

Neutrality would require that the tax rates ofall small firms, not just small credit unions, wouldhave to be lower. This could be accomplished bycreating a tax threshold for net income above zero.Then all small firms could face a more favorabletax rate, not just credit unions. For example a zerotax bracket up to $50 million would exempt al-most half of all credit unions and similarlysituated firms in the rest of the financial sectorand other industries as well. But of course thisscheme conflicts with the notion that all firmswith net income should pay taxes, even if theyface a different marginal tax rate because of size.

Another proposal that has arisen to correctthe unequal treatment of credit unions is to ex-tend the Community Reinvestment Act (CRA) tocredit unions. This would clearly provide moreaccountability for credit unions to ensure thatthey serve their communities, especially their low-income individuals, in a manner proportionate totheir tax-exempt status. Banks currently are sub-ject to extensive costs to insure that they aremeeting the credit demands of low-income bor-rowers. Credit unions were excluded from theseprovisions because of the presumption that theymust be serving such consumers. After all, their

25 See CBO (2003), proposal 21.

26 The effective or average tax rate of credit unions for all institutions would have been 33.7% of income if all were taxed and thiswould rise to 33.97% if only larger institutions were taxed.

24

charters are rooted in common bonds that seem toassume that credit unions meet these require-ments. But the evidence shows that credit unionsdo not serve the poor to any greater extent thanbanks. For example, most credit unions have anoccupational bond that requires members to beemployed, often in industries with relatively highwage jobs.

Subjecting credit unions to CRA require-ments would compound problematic and costlyregulations. Some bank regulators recently rede-fined large banks to be those with assets largerthan $1 billion instead of $250 million. The rea-son for this change in classification was simply toreduce the set of large banks that are subject torelatively higher regulatory costs related to CRA.Small banks face a lower CRA regulatory burdenbecause they are deemed to be more community-oriented in their competition for earning assetsand deposits and there is a regulatory interest inholding down the regulatory burden on smallbanks. While extending the more burdensomeCRA regulatory requirements to credit unionswould help level the playing field, it would be amove away from regulatory efficiency. Creditunion officials have argued that the NCUA al-ready examines credit unions on CRA-typecriteria even though credit unions are not explic-itly covered by the act. Certainly extension ofCRA requirements to credit unions could awaitreform of existing CRA requirements, which hasbeen on the regulatory agenda for several years.

VII. ConclusionsBickley (2003) has emphasized that until

1951, savings and loan associations were not sub-ject to the federal income tax. He suggests that itwas the changing financial environment that al-tered the relationship of thrifts to their membersand caused the loss of their special tax treatment.The implication is that the changing relationshipof credit unions to their members (changes in thecommon bond and field of membership) willultimately lead to the end of the federal incometax exemption of credit unions. Whether thatparallel is correct and predictive for credit uniontaxation remains to be seen. Certainly renewedcalls for a new round of fundamental tax reformare indicators that tax system fairness will be ad-dressed. However, entrenched political support forprotecting the status quo for credit unions doesnot bode well for quick tax equity reforms. Neu-trality requires that similar firms be taxed equally.But are credit unions the equal of banks or thrifts?Many voters view their credit union as an exten-sion of the employee benefits granted by theiremployer or employee association, a service of a

social organization to which they belong, or per-haps a community service related to a communitythey live in. But when the bond that defines thecustomer base extends to a community, like therecent decision upholding the charter for the LosAngeles County Credit Union, it is difficult to seethat the bond is more than any other corporatebusiness model defining a customer base.

Fiscal neutrality would require removing thespecial tax treatment of credit unions. One sugges-tion is that the special tax status for smallinstitutions be maintained while eliminating it forlarger credit unions that have equally broad poten-tial customer bases, and that have commercialoperations, expenses and income comparable tolarge banks and thrifts. This would seem to be acompromise policy path. Large financial firmswould be subject to the same tax treatment, butthe proposal would protect the tax exemption ofsmall credit unions that adhere to their statutorymission to provide services and benefits to peopleof low economic status that may not be availableotherwise.

However, small credit unions are as likely tobe service facilities that are part of an employeebenefits package, and like other benefits areefficiently produced. Tax reform has long recog-nized that untaxed employee benefits result in aninequity for the nation’s taxpayers and the direc-tion of change is certain, if slow and halting.Studies show that credit unions have not beenparticularly effective in reaching audiences thattruly have limited access to loans, saving facilitiesor other financial services offered by credit unions.One of the greatest impediments to access is thelack of a job or occupational connection, andoccupational credit unions do not overcome theseobstacles. Even associative or community-basedcredit unions do not serve the jobless with loansor other financial assistance. Few workers wouldfind their ability to obtain car or mortgage loansor to find attractive saving options to be elimi-nated by the absence of their credit union.

There are broad constituencies that wouldresist tax reform, some of whom have considerableweight politically. First are the leaders and em-ployees of credit unions that would see the creditunion movement, purportedly and perhaps once,as a social movement under threat. Second, manypopulist groups would see imposing a higher coston credit unions as an attack on the poor or low-income voters. Many credit unions are tied totrade unions, and while trade unions are decliningand of relatively small numerical importance, theyoften loom large as potent political forces whenacting as a voting block. Thus Treasury SecretarySnow’s reluctance to see any issue in the reform of

25

taxation of credit unions, noted at the beginningof this paper, and the Congress’ haste to protectthe breakdown of limits on the membership ofcredit unions are understandable from a politicalperspective. They are not understandable from theperspective of sound tax policy, however.

Tax reform of credit union income taxation isa “no-brainer” when viewed in a broad tax neu-trality context. It is also compelling when theeither the size of the revenue loss or the ineffec-tiveness of the tax break for achieving any socialgoal is considered. Reform would likely have to bepart of a more compelling tax reform package if itis to ever be adopted. This is ironic because the taxloss from credit unions is very large, about $2billion per year currently and over $30 billion overthe next ten years. This study could not find anynet benefit to members that could not or wouldnot be available in the absence of tax-subsidizedcredit unions. Most notably, the credit unionsubsidy, by its very nature, has largely failed todeliver financial services to low-income people.The origins of the credit union tax exemption

reach back to the Great Depression, a time whenbasic financial services were limited. Today, how-ever, the financial services industry is highlycompetitive, and its products and services areaccessible to all consumers. Credit union membersare just like other consumers who use banks in-stead of credit unions. Credit unions are notcompelled by regulators to meet a higher standardin the service of low- and moderate-income cus-tomers, and there is no evidence that they do sovoluntarily. The $650 billion credit union indus-try may have outgrown in size and scope itsoriginal, tax-exempt mission.

From the perspectives of tax fairness andsound tax policy, where the least economic distor-tion and inefficiency is desired, taxation of creditunions warrants prompt and genuine consider-ation in any tax reform debate.

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Appendix: Interest and Dividend Rates at Federal andState-Chartered Credit Unions

1996 1997 1998 1999 2000 2001 2002 2003

Fed. State Fed. State Fed. State Fed. State Fed. State Fed. State Fed. State Fed. State

First mortgage loan 8.6% 8.6% 8.4% 8.4% 8.4% 8.4% 8.2% 8.1% 8.2% 8.2% 7.6% 7.4% 6.9% 6.8% 6.3% 6.2%

Other real estate 9.2 9.3 9.2 9.2 9.2 9.2 8.7 8.7 9.1 9.2 7.7 7.6 6.9 6.8 6.3 6.1

New vehicle loan 8.2 8.2 8.1 8.2 8.1 8.1 7.7 7.7 8.1 8.1 7.3 7.2 6.7 6.6 5.9 5.7

Used vehicle loan 8.3 8.1 9.4 9.4 9.4 9.4 8.9 8.9 9.2 9.3 8.5 8.4 7.6 7.7 7.0 6.6

Credit card 13.0 13.2 13.0 13.2 13.0 13.0 12.7 12.8 12.7 12.9 12.2 12.5 11.9 12.1 11.5 11.7Regular shares 3.4 3.5 3.4 3.5 3.3 3.3 3.1 3.2 3.2 3.2 2.4 2.3 1.7 1.6 1.1 1.1

Share drafts 2.1 2.1 2.0 2.1 2.1 2.1 1.8 1.8 1.8 1.8 1.2 1.2 0.8 0.8 0.5 0.5

CD (1 year) 5.3 5.3 5.4 5.5 5.4 5.4 5.1 5.2 5.9 6.0 3.0 3.0 2.3 2.3 1.7 1.7

Money market shares 3.7 3.8 3.9 3.9 3.8 3.8 3.7 3.7 4.0 4.1 2.4 2.4 1.7 1.7 1.1 1.1

* Bold figures indicate that the sign of the difference in rates is consistent with a tax incidence effect: higher deposit rates and lower loan rates at federally chartered credit unions.