CRS Examines Whether Credit Unions Should Be Taxed

                       CRS REPORT FOR CONGRESS

[2] Credit unions differ in some aspects from other providers of financial services, but financial deregulation continues to lessen these differences. Deregulation has resulted from new legislation and decisions of regulatory agencies.

[3] Proponents of the taxation of credit unions argue that deregulation has led to vigorous competition between credit unions and other depository institutions. They maintain that the tax exemption gives credit unions an unfair competitive advantage over other depository institutions, and there is no market failure that justifies government intervention with a tax subsidy.

[4] Supporters of the tax exemption claim that, despite deregulation, credit unions are still unique depository institutions. They assert that the purpose of credit unions is to serve the financial needs of their members rather than to maximize profits. They argue that taxation would eliminate this service character of credit unions.

[5] In the future, technological change and deregulation will likely further increase competition between credit unions and other depository institutions. The income tax exemption for credit unions, therefore, likely will be the subject of further debate.

CONTENTS

Concept of a Credit Union

[6] Credit unions are the only depository institutions that are exempt from the federal income tax. ¹ Deregulation is reducing the unique character of credit unions. Many Members of Congress advocate a reliance on market forces rather than tax policy to allocate resources. Furthermore, some Members of Congress are interested in additional sources of revenue in order to either reduce the deficit, or offset the cost of either higher federal outlays or other tax cuts. Consequently, the exemption of credit unions from federal income taxes has been questioned. If this exemption were repealed, both federally chartered and state-chartered credit unions would probably become liable for payment of federal corporate income taxes on their retained earnings but not on earnings distributed to depositors. For fiscal year 1999 (October 1, 1998 through September 30, 1999), the Joint Committee on Taxation (JCT) estimates that federal taxation of all credit unions would raise approximately $900 million in federal income taxes. ² For fiscal year 1999, the JCT estimates that taxing only credit unions with assets above $10 million would yield approximately $800 million. ³ The issue of taxation of credit unions is examined in this report by covering the following five topics: concept of a credit union, tax status, deregulation, arguments for and against taxation, and trends.

CONCEPT OF A CREDIT UNION

[7] A credit union is a nonprofit financial cooperative organized by people with a common bond. As financial cooperatives, credit unions only accept deposits of members and make loans only to members, other credit unions, and credit union organizations. ⁴ A common bond is a unifying characteristic among members that distinguishes them from the general public. Every member of a credit union is an owner and may vote for credit union officers and policies. Credit unions do not have separate capital stock, instead their capital consists of their members' shares in accumulated reserves. ⁵ Each credit union is governed by a board of directors. The board exercises general supervision over all functional areas including membership and credit applications, interest rate policies, and records. The board elects from its membership a president, a vice-president, a secretary, and a treasurer. No elected official except the treasurer may receive any compensation. ⁶

[8] Credit unions are either federally chartered or state- chartered. As of June 30, 1996, the 11,518 federally insured credit unions had a total membership of 68.2 million and assets of $323.7 billion. ⁷ As shown in Appendix A, at the end of 1994, of total deposits of all depository institutions, credit unions held only 7.6% while banking organizations held 71.7% and thrift institutions held 20.7%. ⁸ But the share of total deposits at credit unions rose from 3.2% at the end of 1984. ⁹ Most credit unions are small. At the end of 1994, credit unions had mean deposits per firm of $20.3 million compared to mean deposits per firm of $301.7 million for banking organizations and $332.6 million for thrift institutions. ¹⁰ But some credit unions are large. As of June 30, 1996, 21 federally insured credit unions had assets of over one billion dollars; and the Navy Credit Union, the largest credit union, has assets of $8.97 billion. ¹¹ Approximately one-third of credit unions have assets of more than $10 million, and these credit unions hold about 92% of all assets in the credit union industry. ¹²

[9] The concept of a common bond is unique to credit unions. In 1970, the National Credit Union Administration (NCUA) was established by the federal government to regulate the credit union industry. The NCUA established policy guidelines for the categories of common bond: occupational, associational, and community. Credit union members in the OCCUPATIONAL category are employed by the same enterprise and may be geographically dispersed. Members of an ASSOCIATIONAL category belong to groups of individuals who participate in activities that develop common loyalties, mutual benefits, and mutual interests. An associational group must sponsor activities providing for contact among members. A federal credit union may consist of a combination of occupational and associational groups. Members in the COMMUNITY category have a common bond based on employment or residence in a geographic area with clearly defined boundaries. ¹³ Members must recognize the geographic area "as a distinct neighborhood, community, or rural district." ¹⁴

[10] In the late 1970s and early 1980s, serious economic dislocations threatened the financial stability of many federal credit unions. Hence, beginning in 1982, the National Credit Union Administration (NCUA) made a series of administrative rulings that allowed multiple-group federal credit unions, that is, combinations of existing federal credit unions that do not share a common bond. ¹⁵ At the end of 1992, only 7.4% of all credit unions had multiple common bonds, but these credit union had 43.7% of all credit union membership. ¹⁶

[11] In 1990, the American Bankers Association and several small North Carolina banks filed a lawsuit challenging the NCUA's approval of a multiple-group field of membership expansion. ¹⁷ On February 25, 1997, the United States Supreme Court, at the urging of the Clinton Administration, agreed to hear arguments in the case. ¹⁸

TAX STATUS

[12] Both state-chartered and federally chartered credit unions are exempt from the federal corporate income tax. State-chartered credit unions have always been exempt from federal income tax. In 1934, Congress passed the Federal Credit Union Act which authorized the chartering of federal credit unions. This Act contained no federal tax exemption and allowed states to tax federal credit unions in the same manner as banks. In 1937, Congress amended the Act to exempt federal credit unions from both federal and state income taxes because of their service to members. ¹⁹ Until 1951, all savings and loans (S&Ls) were exempt from federal income taxes under the same tax code provision. The Revenue Act of 1951 repealed the tax exemption for S&Ls, but the exemption for federal and state credit unions was continued under a separate tax code provision. ²⁰ But Congress provided S&Ls a de facto exemption from federal income taxes by permitting a liberal allowance for bad debt reserves. This de facto exemption continued until the Revenue Act of 1962 which reduced the liberal allowance for bad debt reserves. ²¹

[13] Again, states are legally prohibited from taxing the income of federally chartered credit unions. States vary in their tax treatment of state-chartered credit unions. A few states exempt state-chartered credit unions from their state income taxes. Many states tax state-chartered credit unions the same as state-chartered thrifts, and several states tax state-chartered credit unions the same as any other business. ²²

[14] Before the passage of the Tax Reform Act of 1986, numerous specific tax preferences were given to depository institutions (except credit unions which were and are exempt). The primary justification for these tax preferences was the extensive regulations imposed on depository institutions. These tax preferences reduced the effective tax rate on operations of depository institutions below the effective tax rate on operations of average U.S. corporate businesses.

[15] Proponents of the Tax Reform Act of 1986 contended that the tax system should be neutral concerning economic decision making. They believed that the market forces of supply and demand could more efficiently allocate resources than the tax system; consequently, tax preferences for specific industries or sectors should be eliminated or curtailed. They argued that the elimination or reduction of tax preferences would broaden the tax base and permit lower marginal tax rates; therefore, economic resources would be allocated more efficiently. Financial deregulation had been reducing both the differences among depository institutions and between depository institutions and other industries. Thus, tax preferences for depository institutions were more difficult to justify if the tax system is to be more neutral and resources are to be allocated by market forces rather than federal regulations. Consequently, the Tax Reform Act of 1986 curtailed or eliminated tax preferences of depository institutions. The three most important of these tax preferences were deductions for additions bad debt reserves, the deduction for interest to carry tax exempt obligations, and special rules for net operating losses. The more neutral federal tax system has heightened criticism of the tax exemption of credit unions.

[16] How does credit union taxation compare with that of other firms in economic terms? For a typical corporation, income taxes are paid on income from equity-financed investment whether retained or paid in dividends. Shareholders -- equity owners -- pay individual income taxes on dividends and capital gains taxes on the nominal appreciation (if any) in the value of their stock in the year that the stock is sold. Income from debt financed investment is tax exempt at the corporate level; interest paid on bonds is a deductible expense to the corporation but taxable income to bondholders. Most corporate equity investment is thus taxed twice, debt once.

[17] Commercial banks and thrift institutions are taxed as other corporations except for the tax treatment of depositors. In compensation for their deposits, depositors receive a mix of interest payments and free or below cost services. Interest payments received by depositors are subject to the individual income tax. Free or below cost services are not subject to the individual income tax, but the cost of providing these services are expenses to the commercial bank or thrift. Since it is not administratively feasible to allocate the reduced cost of financial services among depositors, it is not possible to levy income taxes on these services. ²³ Thus, at least part of banks' income from debt is exempt from both corporate and individual tax. Bank equity income is taxed twice; debt once -- at the most.

[18] Income of credit unions is exempt at the corporate level, whether retained or distributed. And as with banks, a portion of the income distributed to members in compensation for their deposits -- member "dividends" -- is subject to individual income tax, while the portion distributed as enhanced member services is not taxed. Thus, in contrast to corporations -- including corporate banks -- no credit union income is taxed twice; credit union income is taxed once -- at the most -- under the individual income tax. Taxing credit unions in a manner similar to corporate banks would require, at least, applying corporate tax to retained credit union earnings. ²⁴

[19] Finally, this discussion of financial institutions has thus far omitted the tax treatment of another type of financial intermediary: life insurance companies. Life insurance companies receive special treatment under the corporate income tax; they are subject to a low level of tax compared to other financial intermediaries (excepting, of course, credit unions). Further, the earnings of depositors (i.e., policyholders) are lightly taxed under the individual income tax because the inside buildup on insurance policies is not subject to tax.

DEREGULATION

[20] Over the past 25 years, most of the distinctions between credit unions and other depository institutions have been eliminated or reduced because of deregulation; consequently, the justification for the tax exemption for credit unions has been increasingly questioned. ²⁵

[21] Proponents of deregulation argue that resources can usually be more efficiently allocated by market forces than government regulations. They do not advocate the elimination of all regulations but rather a greater reliance on market forces. Proponents maintain that deregulation increases competition which benefits customers through better access to services at lower prices. Furthermore, deregulation leads to more integrated financial markets which improves national economic efficiency. Both federally chartered and state-chartered credit unions have been deregulated as discussed in the following section. The discretionary powers of state-chartered credit unions compared with federally chartered credit unions vary among states.

[22] Deregulation can be divided into price, geographic, and product deregulation. ²⁶ Price deregulation concerns the loosening or elimination of restrictions on interest rates that depository institutions may pay on supplies of funds and charge on loans. Price deregulation has caused credit to be rationed more by price than by availability. Many individual savers have benefitted from price deregulation because they have earned higher interest rates on their deposits. ²⁷

[23] Geographic deregulation has been particularly important to commercial banks and bank holding companies which were prevented by federal and state banking laws from offering full service interstate banking. The Office of the Comptroller of the Currency has made rules that have expanded intrastate bank branching. ²⁸ The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (P.L. 103- 328) authorized nationwide interstate banking through the holding company format effective September 29, 1995. Effective June 1, 1997, under this law, the federal bank regulatory agencies may approve mergers between banks in different states unless the home state of one of the banking institutions has opted out by enacting a law explicitly prohibiting merger transactions involving out-of-state banks that applies equally to all out-of-state banks. ²⁹

[24] In 1991, the National Credit Union Administration permitted credit union to share branches, thus giving them an inexpensive way of expanding their geographic coverage. ³⁰ In May 1992, the Office of Thrift Supervision permitted nationwide branching by all thrift institutions. ³¹

[25] But credit unions still have some restrictions on branching. For example, a federal credit union may not establish a new branch office for the purpose of adding a group [combining with another credit union through a multiple-group charter]. ³²

[26] PRODUCT DEREGULATION is blurring the distinctions among products offered by different types of depository institutions (e.g., checking accounts, credit cards, mortgages, etc.). Product deregulation has been accelerated by the mergers of some large financial and nonfinancial firms. Also, many firms have found methods of circumventing existing laws in order to offer additional financial products. Even the distinction between the banking industry and the securities industries appears to be crumbling as bankers create new financial products resembling securities, and security firms innovate new financial products resembling loans and deposits. ³³

[27] Deregulation has resulted in the rapid expansion of most services offered by credit unions. Larger credit unions tend to offer a wider range of services than smaller credit unions. Deregulation has been implemented by legislation and rulings by the National Credit Union Administration. But credit unions, compared to other depository institutions, still have restrictions on their powers to lend and invest funds. ³⁴ For example, credit unions may only "extend lines of credit to their members, to other credit unions, and to credit union organizations." ³⁵ Also, credit unions are prohibited from making commercial loans.

ARGUMENTS FOR AND AGAINST TAXATION

[28] Proponents of taxation of credit unions argue that deregulation has caused extensive competition among depository institutions. These institutions actively compete for deposits by offering the best terms, including the highest rate of return to depositors. Depository institutions also compete for borrowers by offering the best loan terms including the lowest interest rates. Proponents of taxation argue that the concept of the common bond has continued to weaken. For example, the OmniAmerican Federal Credit Union

     . . . counts 137,000 members employed at 1,300 businesses and

[30] Supporters of the credit union tax exemption emphasize the uniqueness of credit unions compared to other depository institutions. Credit unions are nonprofit financial cooperatives directed by volunteers for the purpose of serving their members. Credit unions provide many services free or below cost in order to assist members. These services include small loans, financial counseling, and low balance share drafts. The NCUA argues that the taxation of credit unions would create pressure to eliminate these subsidized services. Furthermore, taxing credit unions would raise the cost of credit to many people without an alternative source of credit. Concern has been expressed in Congress about the access of lower income families to basic depository services.

[31] The American Bankers Association (ABA) cites surveys that concluded that members of credit unions had higher average incomes, higher average educational levels, and a higher rate of home ownership than non-members. ³⁷ Hence, the ABA argues that the credit union industry is giving a faulty image of their membership. ³⁸ Yet an official of the Credit Union National Association cites a recent survey conducted by Gallup for the ABA that found that the average household income of bank customers was $51,000 per year compared to $46,000 per year for credit union members. ³⁹

[32] Finally, supporters of the tax exemption argue that credit unions are subject to certain regulatory constraints not required of other depository institutions and that these constraints reduce the competitiveness of credit unions. For example, credit unions may lend only to members. These restrictions arguably impose an implicit tax on credit unions.

TRENDS

[33] In the future, technological change and deregulation will likely further increase competition between credit unions and other depository institutions. It should be noted that thrift institutions were exempt from the federal income tax until 1951. The tax exemption for thrift institutions was eliminated because Congress felt that the relationship between thrifts and their members had substantially changed. In the 1980s and early 1990s, the credit union industry grew more rapidly than other depository industries, and this more rapid growth may continue. Since many believe that an economically neutral tax system requires that financial institutions engaged in similar activities should have the same tax treatment, the income tax exemption for credit unions likely will occasion continuing debate.

          APPENDIX A: DISTRIBUTION OF DEPOSITORY INSTITUTIONS

² U.S. Congressional Budget Office. Reducing the Deficit: Spending and Revenue Options. Washington, U.S. Govt. Print. Off., March 1997. p. 384.

³ Ibid. The Congressional Budget Office states that approximately two-thirds of credit unions have assets of $10 million or less, but these credit unions hold only about eight percent of all assets in the credit union industry.

⁴ Kessler, Richard P., Jr. Credit Unions in the 1990s. Consumer Finance Law, vol. 47, no. 1, winter 1993. p. 4.

⁵ Ibid.

⁶ Pugh, Olin S. and F. Jerry Ingram. Credit Unions: A Movement Become an Industry. Reston, virginia, Reston Publishing Company, Inc., 1984. p. 7.

⁷ National Credit Union Administration. 1996 Midyear Statistics for Federally Insured Credit Unions. Alexandria, Virginia, 1997. p. 7.

⁸ Amel, Deal F. Trends in the Structure of Federally-Insured Depository Institutions, 1984-94. Federal Reserve Bulletin, vol. 82, no. 1, January 1996. p. 5.

⁹ Ibid.

¹⁰ Ibid.

¹¹ National Credit Union Administration. 1996 Midyear Statistics for Federally Insured Credit Unions. p. 30.

¹² U.S. Congressional Budget Office. Reducing the Deficit: Spending and Revenue Options. p. 384.

¹³ National Credit Union Administration. Chartering and Field of Membership Manual. Washington, December 1989. p. 1-4.

¹⁴ Ibid., p. 3.

¹⁵ For a comprehensive examination of multiple-group credit unions, see: U.S. Library of Congress. Congressional Research Service. CRS Report 97-267 E. Multiple-Group Federal Credit Unions, by Pauline Smale. 5 p. and U.S. Library of Congress. Congressional Research Service. CRS Report 96-997 A. Multiple-Group Credit Unions: Litigation and Potential Legislative Responses, by M. Maureen Murphy. 15 p.

¹⁶ Kaushik, Surendra, and Raymond Lopez. The Structure and Growth of the Credit Union Industry in the United States: Meeting Challenges of the Market. American Journal of Economics and Sociology, vol. 53, no. 2, April 1994. p. 238-239.

¹⁷ U.S. Library of Congress. Congressional Research Service. Multi-Group Federal Credit Unions, Smale, p. 1.

¹⁸ Marriott, Anne. Credit Unions Get Day in High Court. The Washington Times, vol. 16, no. 56, February 25, 1997. p. B7.

¹⁹ The Tax Exemption Through the Ages. Credit Union. January 1986. p. 9.

/20/U.S. Congress. Joint Committee on Taxation, (Prepared for use of the Committee on Ways and Means and the Committee on Finance). Tax Reform Proposals: Taxation of Financial Institutions. Washington, U.S. Govt. Print. Off., September 12, 1985. p. 43.

²¹ Biederman, Kenneth R. and John A. Tuccillo. Taxation and Regulation of the Savings and Loan Industry. Lexington, Mass., Lexington Books, 1976. p. 5.

²² Pugh, p. 51-52.

²³ Most developed nations with value-added taxes exclude financial services from taxation because it is not administratively practicable to measure value-added received by customers.

²⁴ In theory, it might be argued that since members are also equity owners of credit unions, a portion of income and benefits accruing to stockholders is actually distributed credit union equity- like earnings, and simply taxing retained earnings would apply tax to only a part of income from equity-like investment. However, it is not administratively feasible to assess the value of these distributed equity-like benefits, and proposals to tax credit unions have been limited to applying the corporate income tax to retained earnings.

²⁵ For an overview of the federal regulatory structure, see: U.S. Library of Congress. Congressional Research Service. CRS Report 93-841 E. Commercial Banks, Thrifts, and Credit Unions: the Federal Regulatory Structure, by F. Jean Wells and Pauline H. Smale. 6 p.

²⁶ The structure and some of the content of this examination of deregulation is based on the following source: U.S. Library of Congress. Congressional Research Service. CRS Report 87-800 E. Financial Deregulation: A Status Report, by F. Jean Wells. 7 p.

²⁷ Ibid., p. 3.

²⁸ Amel, p. 3-4.

²⁹ U.S. Library of Congress. Congressional Research Service. CRS Report 94-744 A. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, by M. Maureen Murphy. p. 1-2.

³⁰ Amel, p. 4.

³¹ Ibid.

³² Kessler, p. 10.

³³ For an analysis of this issue, see: U.S. Library of Congress. Congressional Research Service. CRS Report 97-235 E. Glass- Steagall Act/Financial Modernization Issues in the 105th Congress, by William Jackson. 25 p.

³⁴ For a summary of these restrictions, see: Kessler, p. 8-9.

³⁵ Kessler, p. 5.

³⁶ Gilpin, Kenneth N. Piggy Banks with Muscles. The New York Times, vol. 146, no. 50,715; February 26, 1997. p. B1.

³⁷ American Bankers Association. Credit Union Reality Check, 1996. p. 2.

³⁸ Ibid.

³⁹ Stokeld, Fred. Banks Getting Testy Over Competition from Credit Unions. Tax Notes, vol. 75, no. 1, April 7, 1997. p. 46.