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Structural and economic reasons the credit union exemption is a good idea.
The debate about the credit union tax exemption periodically flares up, the most recent episode prompted by remarks by Senator Orrin Hatch (R-UT). (Read NCUA Board Chair Mark McWatters letter in response.) The complaint is that credit unions have evolved into nearly identical financial institutions as banks and, therefore, have an unfair advantage when competing with banks.
The emotion regarding the credit union tax exemption is noteworthy given that other industries have tax exempt not-for-profit participants as well as for profit taxed entities. For example, we have both for-profit and tax-exempt, not-for-profit universities. Another example is hospitals, where for-profit institutions and tax-exempt, not-for-profit organizations also compete in the marketplace. However, like credit unions, non-profit universities and hospitals have their own tax policy challenges: Recent tax reform added a tax on very large university endowments, and many states have tried to revoke the state property tax exemption on hospitals that aren’t providing enough charity care.
The key difference in tax policy between the institutions in these other industries is not that the tax-exempt offer a different array of services compared to their taxable peers. Rather, they have a different ownership structure—a for-profit has owners who receive any profits generated by the organization’s activities, whereas a not-for-profit does not. Credit unions do not have stockholders; they are member-owned. Any and all financial benefits of the credit union belong to its member-owners.
As such, it seems confusing to rationalize revoking the credit union tax exemption because they offer the same services as banks, just as it would be poor logic to revoke the tax exemption of universities because they offer the same services as for-profit schools. Some comment that, perhaps, the tax exemption should only be revoked for very large credit unions. Again, would they suggest that large non-profit hospitals lose their tax exemption, but small ones retain it? This stance is especially surprising given that the largest credit unions serve military personnel and retirees.
Shifting from tax policy to simple economics, taxing credit unions would reduce the supply of financial services, especially to families and working-class individuals, the primary customer segments for the credit union industry. Credit unions can only grow when their equity capital grows. Because credit unions do not have stockholders, they cannot raise external capital; they can only make more loans if they grow capital, and the only way to grow capital is through retaining earnings.
Consequently, the simple math is that a tax of 21 percent on credit unions’ annual surplus will reduce lending growth by 21 percent. They could compensate for the tax by lowering rates paid to members on deposits or raising rates charged for loans. Competitors of credit unions would welcome this reduction in competition due to the lower supply of loans and/or higher interest rates on loans.
Industry observers have also wondered if losing the tax exemption would put certain credit unions under financial stress and cause institutions to merge. As described above, taxation would reduce a credit union’s ability to lend money but not, by itself, cause financial distress. Because taxes are assessed on profits, marginally profitable credit unions will pay little in the way of taxes.
If a healthy credit union hits a rough patch (such as due to loan or fraud losses) that produces an immediate reduction of capital, it could take the credit union longer to replenish capital (this may be impacted by tax savings depending on the specific circumstances). Such a credit union might be driven to merge to more quickly solve this temporary capital impairment.
A more likely merger path would be that credit unions would seek to merge with a bank or convert to a bank charter. A major disadvantage of the credit union charter is that credit unions cannot raise capital to grow and cannot use equity incentives to attract and motivate executives. A credit union board could easily determine that its fiduciary duty compels converting to a bank charter given that the credit union charter no longer offers any advantages and a long list of disadvantages (membership restrictions, restrictions on the types of loans offered and ability to raise capital). It is hard to see a value in the credit union charter without tax exemption.
Overall, the recurring distraction of re-examining the credit union tax exemption is noteworthy compared to other industries with taxable and tax-exempt competitors, such as universities and hospitals. It seems a tax would decrease the supply of loans and/or increase the costs of loans to families and individuals. And, indeed, it could significantly increase the number of credit unions merging with banks or converting to banks. Like other institutions that exist to provide a needed service and are not-for-profit, credit unions should be tax exempt.
Stephen Morrissette is adjunct associate professor of strategic management at the University of Chicago Booth School of Business and lead faculty at CUES’ Strategic Growth Institute™, slated for July 23-26 at the University of Chicago.
Also read “New ‘Merger’ Option” about the credit union holding company structure, also by Morrissette.
A credit union’s strategic plan must be built on its unique market and membership situation, including taxation. Read more in “The Launch Pad for Strategy.”
