Is Our Credit Card System Broken?

Peter Van Doren

A recent New York Times op‐​ed by Obama administration deputy assistant treasury secretary Aaron Klein declares that the market for credit cards is “broken and predatory.” The problem is that many credit cards offer cash or other rewards for use, and those rewards are financed by a portion of the interchange fees that merchants must pay to process the cards. The merchants, in turn, pass this expense onto their customers in the form of higher prices. Klein argues this places a hidden tax on customers who pay cash or use non‐​reward cards. He assumes these customers are lower income than reward card users.

I have reviewed the evidence about the distributive effects of reward card use, and it is not very supportive of this view.

Klein’s argument assumes that consumers with different incomes buy the same goods at the same stores at the same prices, and higher income consumers pay with reward cards while lower income consumers pay with cash or non‐​reward cards. But if consumers with different incomes shop at different stores or buy different goods, merchants cannot pass on rich card users’ rewards costs to poor customers. For example, if cardholders buy premium products, and cash holders buy generic, and merchants charge higher margins for premium products, the cardholders pay for their own rewards.

But what about those products bought by both cash and reward card customers within the same store? Why don’t merchants offer cash discounts? Federal law guarantees merchants the right to offer cash discounts. Most merchants do not do so because the costs of handling cash are real and substantial.

A final requirement for Klein’s redistribution hypothesis to be true is that, for items within a store that both cash and card customers purchase, the interchange fees charged to merchants for card use are passed through to all consumers through price increases. How much of the interchange fee is passed onto consumers through price increases?

Evidence from taxes on producers or changes in foreign exchange rates suggests that the pass‐​through rate is about 50 percent in the long run. More directly analogous evidence comes from the cap on debit card interchange fees mandated by the Durbin Amendment to the 2010 Dodd–Frank financial reform legislation.

Did consumers benefit from the interchange fee reduction? The large banks affected by the debit‐​fee rule totally offset their $6.5 billion loss in debit card interchange fees by charging higher checking account fees. Monthly maintenance fees on checking accounts doubled, decreasing the share of consumers with free checking accounts from 60 percent to 20 percent. And an intensive study of gasoline stations found no reduction in prices for consumers.

So, reductions in debit‐​interchange fees did not benefit consumers. Thus, the original incidence of such fees when they were first imposed may well have been largely on merchants.

But let’s assume the best case for the redistribution hypothesis: Cash and card consumers buy the same products in the same store, and prices increase to reflect all card interchange fees; thus cash customers pay a “tax.” Are card customers higher income and cash customers lower income? Two‐​thirds of adults earning less than $40,000 per year have credit cards. Some 98 percent of credit cardholders own a rewards card, including 82 percent of cardholders earning less than $20,000 per year.

So even if cash customers pay a “tax,” the relationship between rewards card ownership and income is very weak. The distributional consequences are not obviously regressive.

What if we compare reward and non‐​reward credit cards? High‐​FICO (that is, credit‐​score) cardholders earn money from rewards cards while low‐​FICO cardholders lose money. But again, the relationship between winners and losers and income is low. High‐​income consumers with high FICO scores benefit from rewards credit cards largely at the expense of high‐​income consumers with low FICO scores.

So, a more neutral summary of the evidence regarding the effects of rewards cards is as follows:

Those with better credit scores, regardless of income, benefit from rewards programs, which are partially “paid for” by interchange fees charged to merchants. Those interchange fees, in turn, may or may not be passed on to consumers who use cash, depending on whether those consumers buy the same goods and services from the same merchants as those using credit cards. But even then, the pass‐​through is a proximate result of decisions by merchants not to offer cash discounts, often because the administrative cost of doing so is greater than any benefit they would reap through larger margins on cash transactions.