Research & Commentary: Feds Reconsidering Credit Union Tax Exemption

Published June 6, 2018

The banking industry is using the tax reform law passed in December by Congress and President Donald Trump to advocate for the end of the federal income tax exemption currently provided to credit unions. Bankers claim that credit unions are similar to mutual savings banks, and thus should be regulated in a similar manner.

Credit unions have been exempt from the federal income tax since the Great Depression, to increase their ability to provide credit to lower-income families. This exemption was granted under the condition that the credit unions be “organized and operated for mutual purposes and without profit,” according to the Internal Revenue Service. However, the banking industry has argued for decades that this exemption gives credit unions an unfair advantage.

Traditionally, banks and credit unions have battled over the growth of credit unions, with banks arguing that credit unions have increasingly expanded their services into product areas banks typically provide. As nonprofit entities, credit unions are required to give surplus revenue to clients through benefits such as higher interest yields on deposits or lower rates on loans. Since they generate no profits, credit unions have nothing to tax.

How do credit unions use their tax exempt status? The Tax Foundation points to a 1979 IRS document that outlines the tax exemption’s three goals: “that credit unions would 1) help unbanked, lower-income people, 2) restrict their customer base, and 3) avoid high-risk, high-return investments.” If credit unions disregard these goals and behave more akin to banks, the exemption may no longer be appropriate.

It is important to note that removing the exemption would have an effect on tax revenue and the cost of banking. Steve Pociask, expert at The American Consumer Institute, argues ending the tax exemption and nonprofit status of credit unions would impose double taxation on members: the first tax applied to the retained earnings from better interest rates and the second applied to the income members earn.

Eliminating the tax exemption could also be counterproductive in terms of revenue. Removing the credit union tax exemption “would actually cost the federal government $38 billion in lost income tax revenue over the next 10 years. GDP would be reduced by $142 billion, and nearly 900,000 jobs would be lost over the course of next decade as well,” according to a 2017 report from the National Association of Federal Credit Unions (NAFCU). Furthermore, the NAFCU report estimates a 50 percent reduction in the credit union market share would cost bank customers “an estimated $6.9 billion to $15.7 billion per year in higher loan rates and lower deposit rates.”

In short, ending the tax exemption would force many credit unions to become full-fledged banks, also known as “demutualizing.” A likely unintended consequence of terminating the exemption could further reduce lending to those who need it most— putting a greater burden on taxpayers, who already have bailed out banks considered “too big to fail.” Although the economy has slowly improved since the 2008 recession, it would still not be shrewd to undermine a large provider of loans to small businesses and low-income families. As long as credit unions continue to provide services under the current guidelines, the exemption is appropriate. Instead of focusing on reforming credit union exemptions, policymakers ought to focus on reducing or revising unnecessary and burdensome regulations.

The following articles examine credit unions, their tax status, and their effect on the nation’s credit markets.

Reviewing the Credit Union Tax Exemption
Writing for The Tax Foundation, Erica York examines the credit union tax exemption and argues that it should only remain in place if credit unions continue to fulfill the purpose and rules outlined when the tax exemption was first put into place, which include helping unbanked, lower-income people, restricting their customer base, and avoiding high-risk, high-return investments.

Credit Unions: A Taxing Question
In this Richmond Federal Reserve Bank piece, Liz Marshall and Sabrina Pellerin examine the debate over the credit union tax exemption, how it affects the financial industry, and how ending the exemption would impact banking for those currently using credit unions.

Economic Benefits of the Credit Union Tax Exemption to Consumers, Businesses, and the U.S. Economy
This study by Robert Feinberg and Douglas Meade, prepared on behalf of the National Association of Federally-Insured Credit Unions, quantifies the benefits provided to all consumers, including bank customers, as a result of there being credit unions in U.S. financial markets.

Keep the Credit Union Tax Exemption
Writing for Real Clear Policy, Steve Pociask of the American Consumer Institute says the evidence suggests credit unions “provide substantially more benefits for consumers than costs for taxpayers, and the tax exemption should be retained.”

Don’t Tax Credit Unions … Or Community Banks, Either
R. J. Lehmann of the R Street Institute examines alternatives to ending the credit union tax exemption. “Perhaps most importantly, from a political perspective, a proposal that links community banks and credit unions arm-in-arm against the behemoth too-big-to-fail institutions that have sucked up hundreds of billions in taxpayer dollars is one that, we expect, just might be able to generate support on both sides of the aisle,” he writes.

Credit Unions: A Theoretical and Empirical Overview
Donal G. McKillop and John O.S. Wilson trace the evolution of the credit union movement. Their study examines credit unions’ objectives and considers efficiency, technology adoption, product diversification, merger, failure, and demutualization. They also explore the regulatory environment in which credit unions operate, regarding interest rate regulation, common bond requirements, taxation, deposit insurance and capital regulation. The paper also considers demutualization and the costs and benefits to credit unions of altering their organizational form.

Credit Unions Make Friends—But Not with Bankers
The St. Louis Federal Reserve examines the legislative and legal history of the battle between credit unions and the banking industry over how and when credit unions are allowed to lend to consumers.

Credit Unions vs. Banks: The Myth of the Uneven Playing Field
In this study commissioned by the Northwest Credit Union Association, Randall Pozdena and Michael Wilkerson evaluate bankers’ claims that credit unions are essentially operating as commercial banks and should be treated as such, especially as regards corporate income taxation.

Nothing in this Research & Commentary is intended to influence the passage of legislation, and it does not necessarily represent the views of The Heartland Institute. For further information on this and other topics, visit the Budget & Tax News website, The Heartland Institute’s website, and PolicyBot, Heartland’s free online research database.

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