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ASSESSING THE COSTS & BENEFITS OF CREDIT CARD REWARDS: A RESPONSE TO WHO GAINS AND WHO LOSES FROM CREDIT CARD PAYMENTS? THEORY AND CALIBRATIONS F Steven Semeraro* or two decades, economic and legal academics have speculated about the impact of the fees that merchants pay for credit card acceptance. Since all customers pay the same price, the theory goes, everyone pays for the benefits that go only to credit card users. A recent Federal Reserve Bank of Boston (FRBB) policy paper written by economists Scott Schuh, Oz Shy, and Joanna Stavins entitled Who Gains and Who Loses from Credit Card Payments? Theory and Calibrations 1 has taken the argument a step further, contending that credit card programs reduce consumer welfare by transferring money from low-income households that purchase goods and services with payment * Professor of Law, Thomas Jefferson School of Law. The author thanks the American Bankers Association for its generous support for this paper, and economists Scott Thompson and Eric Emch of the Bates, White economic consulting firm for their valuable assistance. During the late 1990s, the author was the lead attorney on an investigation of Visa and MasterCard when he served as a trial attorney with the United States Department of Justice, Antitrust Division. The views expressed herein are exclusively those of the author. 1 Scott Schuh, Oz Shy & Joanna Stavins, Who Gains and Who Loses from Credit Card Payments? Theory and Calibrations (Federal Reserve Bank of Boston, Public Policy Discussion Papers No , 2010) [hereinafter FRBB]. A revised version of the paper by the same authors expands their wealth transfer analysis beyond card rewards. Scott Schuh, Oz Shy & Joanna Stavins, Who Gains and Who Loses from Credit Card Payments? Theory and Calibrations, at 26 (May 4, 2011) [hereinafter Schuh et al. 2011]. This version, which has apparently not been published by the Federal Reserve Bank of Boston, is cited throughout to highlight relevant differences with Paper No 2012 Assessing Credit Card Rewards 31 mechanisms other than credit cards to high-income households that pay with cards. Although recognizing that their analysis does not yield precise policy recommendations that would necessarily optimize social welfare, 2 the authors nonetheless offer suggestions for improvement. 3 Specifically, they suggest that regulators could increase consumer welfare by (1) eliminating card system rules that prohibit merchants from surcharging credit card transactions, and (2) directly regulating merchant fees and reward rates. 4 Both proposals would likely reduce or eliminate reward programs. This article shows that the FRBB economists policy recommendations would be more likely to harm consumers than to help them. First, the authors welfare claims are narrower than a casual reader might assume. They do not argue that any reward program constitutes a bad deal for a cardholder who takes advantage of the program. On the contrary, they show that, regardless of a cardholder s income level, reward cards benefit those who use them and collect rewards. 5 Like all credit cards, they provide spending flexibility, a no-cost float period for those who do not run balances, and accounting benefits. In addition, reward cards effectively lower the price that card users pay for all goods and services purchased with the card through a bonus that suits the cardholder s own market preferences. Any regulatory steps that reduce the value of reward card programs would unquestionably reduce the welfare of those consumers regularly receiving card rewards. The FRBB authors do claim that reward programs harm those consumers who do not use credit cards because merchants increase prices to cover card acceptance costs. The FRBB authors data demonstrates that high-income households use reward credit cards more often than low-income households. 6 This disproportionate use, the authors claim, transfers wealth from poorer to wealthier consumers. Importantly, however, the welfare transfer that they predict occurs, if at all, only because low-income households on average choose to use reward credit cards for a lower percentage of their purchases than do higherincome households. 2 Id. at Id. 4 Id. 5 See infra Part II.A. 6 FRBB, supra note 1, at 7. 32 Loyola Consumer Law Review Vol. 25:1 The FRBB authors proposals would certainly reduce the value of reward card programs and thus the welfare of all reward card users. Any consumer welfare gains from implementing those proposals, however, would be quite speculative. To support their welfare predictions, the FRBB authors claim that one can draw meaningful conclusions about consumer welfare effects by assuming that: (1) merchants pass on the marginal cost of card acceptance through their retail prices to all consumers on a dollar-for-dollar basis 7 ; and (2) the only relevant benefit in assessing the consumer welfare impact of payment system choice is the reward paid to credit card users. 8 The data on which the FRBB authors rely do not confirm these assumptions. On the contrary, those assumptions are almost certainly wrong. Credit card acceptance benefits merchants, banks, and even consumers using other payment mechanisms in ways that impact the net prices paid by all customers. Merchants would not mark up their retail prices by the full marginal cost of credit card acceptance costs over other means of payment if, for example, card acceptance (1) increases sales by enabling consumers to shop more efficiently alleviating the need to predetermine the amount of cash needed or knowing ones checking account balance enabling a merchant to spread its fixed costs over more sales or (2) reduces other costs such as the risk of unpaid checks, late payment, default, and collection expenses. 9 In addition, banks may use reward card system profits to innovate and expand products that benefit all consumers, such as more effective fraud protection, enhanced security, and systems that speed up transactions at the point of sale. 10 Moreover, although consumers who choose not to use rewards credit cards by definition do not receive credit card rewards, they may still benefit from their payment choice in other ways. First, reward card use creates spillover effects such as faster checkout times benefiting all customers. Second, overwhelmingly consumers choose to use non-credit-card payment mechanisms for some purchases and reward credit cards 7 More specifically, the authors assume that credit card use increases retail prices by precisely the amount that credit card use exceeds the cost to the merchant of alternative means of payment. See infra Part IV.A. The authors analysis ignores the extent to which merchant s benefit from card acceptance in ways that may lower prices. See infra Part IV.B. 8 See infra Part IV.A. 9 See infra Part IV.B. 10 Id. 2012 Assessing Credit Card Rewards 33 for others, necessarily benefitting themselves in ways not fully accounted for in the FRBB policy paper. 11 As a result, the FRBB authors welfare calculations are at best overstated and potentially entirely inaccurate. Even if one irrationally ignored the non-reward benefits of payment system choices, the FRBB authors welfare calculations would remain suspect. Important aspects of their consumer welfare calculation most importantly, the strength of the preference consumers have for reward cards or other means of payment and the negative consumer welfare effect of transferring money from low- to high-income households rest on assumptions that are entirely independent of the data on which the authors purport to rely. 12 These assumptions are critical to the magnitude of the consumer welfare effect that they predict, and the uncertainty with respect to these factors undermines the reliability of their analysis. Regulatory intervention is also suspect because if the FRBB authors predicted wealth transfers from credit card programs existed, they would be indistinguishable from a myriad of other reward programs and retailing strategies that have the same impact. 13 That these practices are so widespread indicates that they are generally accepted as legitimate competitive options supporting economic vitality. Finally, the FRBB authors specific policy proposals encouraging surcharging and regulating fees could have serious, negative unintended consequences. 14 The ubiquitous nature of rewards programs and other retailing strategies that benefit those who spend heavily suggests that these programs have economic benefits. Rather than undermining card rewards, any regulatory activity in credit card markets should focus on expanding the availability of consumer-welfare enhancing reward programs to those consumers who currently choose not to use them. 15 The FRBB authors proposals, designed to reduce reward card availability, thus point in precisely the wrong direction. This article begins by explaining the role of merchant fees 11 See infra at (reference to charts showing that two thirds of households have both credit and debit cards; nearly all have checking accounts in addition to cards; and they use these payment mechanisms in different percentages for different categories of purchases). 12 See infra Part V. 13 See infra Part VI. 14 See infra Part VII. 15 See infra Part VIII. 34 Loyola Consumer Law Review Vol. 25:1 in credit card systems. Part II summarizes the history of the literature recognizing that credit card programs may theoretically transfer wealth from low-income to high-income households. This part also examines the FRBB policy paper in this context. Part III demonstrates that the FRBB economists conclusions are suspect because the assumptions underlying their analysis underestimate the benefits of current payment system choices accruing to merchants, card issuing banks, and non-credit card users. In Part IV, this paper shows that even if an individual irrationally ignored non-reward benefits, the author s consumer welfare predictions would depend on assumptions that are independent of the hard data and are thus essentially arbitrary. Part V shows that similar wealth transfer effects are pervasive throughout the economy. Part VI explains why permitting merchants to surcharge card transactions or regulating merchant fees would be unwise responses to any wealth transfer that may exist. And finally, this article offers alternative steps that could combat the potentially negative effects of transferring wealth without the risks associated with permitting card transaction surcharges or regulating acceptance fees. I. PRICING IN CREDIT CARD MARKETS This section explains how the stream of payments flows in a credit card transaction and how banks participating in the card system earn revenue. The process begins with a cardholder purchasing a good or service using the card, thus generating a receipt for payment. The card-purchase receipt flows from the merchant to its card acceptance bank (CAB) and then to the bank, such as Citibank, that issued the Visa, MasterCard, American Express, or Discover card (issuer). For example, when a customer makes a $100 purchase with a credit card, the merchant s CAB would pay the retailer approximately $98. The difference is the merchant s fee ($2 in this case) for card acceptance. This fee is commonly called the merchant discount because it amounts to a discount from the full purchase price that compensates the credit card system. 16 Next, the issuer would typically pay the CAB 16 In many cases, the merchant fee would include a small fixed amount per transaction as well as a percentage of the total. The fixed fee is ignored in the illustration in the text to demonstrate more clearly the flow of funds. 2012 Assessing Credit Card Rewards 35 approximately $98.50 for the receivable 17 and bill the cardholder for the entire $100, plus interest if the account has a balance. From the $2.00 fee paid by the merchant, the CAB would typically keep about $.50 or 25%. The remaining $1.50, approximately 75% of the revenue from the merchant, constitutes the fee that a merchant effectively pays to the issuer. 18 This fee is often referred to as the interchange fee. 19 Both the level of the merchant discount and the percentages of the purchase price retained by the issuer and the CAB will vary depending on the industry, type of card, and a variety of other factors. In all cases, however, the issuer will receive a substantially larger percentage of the merchant fee than the CAB. 20 Although merchant fees are an important source of cardissuer revenue, approximately 70% of a typical card issuer s revenue comes from interest paid by cardholders for financed purchases. 21 In addition, a recent survey by Phoenix Marketing International shows that some credit cards, and particularly reward cards, also carry an annual fee paid by the cardholder. 22 Issuers also charge cardholders a variety of other fees for services provided as well as for violations of the cardholder agreement, such as late payments, that raise the cost of the system for all participants. 17 In practice, a small percentage of the merchant fee compensates the card network rather than either the CAB or the issuer for the network s costs of processing transactions. 18 Alan S. Frankel, Monopoly and Competition in the Supply and Exchange of Money, 66 ANTITRUST L. J. 313, 340 (1998). 19 The term interchange was used in the Visa and MasterCard systems because it constituted the fee that a bank acquiring card transactions from a merchant paid to the bank that had issued the card. Unitary systems such as American Express, Diners Club, and Discover did not technically have interchange fees. Nevertheless, they have always charged more to merchants than the cost of providing merchant services. As a result, merchant fees were used by these systems to support the card issuing business, just as they were in the Visa and MasterCard systems. Steven Semeraro, Credit Card Interchange Fees: Three Decades of Antitrust Uncertainty, 14 GEO. MASON L. REV. 941, 947 (2007). 20 Id. 21 DAVID S. EVANS & RICHARD SCHMALENSEE, PAYING WITH PLASTIC: THE DIGITAL REVOLUTION IN BUYING AND BORROWING 223 (2d ed. 2005). 22 Appendix I.F. This article relies on data produced by Phoenix Marketing International through a broad survey of consumers about credit card and other payment methods. This survey data is cited throughout this article and is on file with the Consumer Law Review. 36 Loyola Consumer Law Review Vol. 25:1 II. THE LIMITED SCOPE OF THE FRBB AUTHORS CONSUMER WELFARE ANALYSIS The FRBB authors do not contend that (1) card use reduces the welfare of any consumer who receives card rewards; or (2) the banks business model sacrifices profit from highincome card users in order to increase revenues earned from lowincome households. A. Reward Card Holders Benefit From the Current Credit Card System The FRBB authors data shows that reward credit cards are generally available to consumers in both low- and highincome groups, those who use reward credit cards to collect air travel, discounts, or cash, experience substantial welfare gains. 23 The FRBB policy paper thus confirms that reward cards are a good deal for those who use them to collect rewards, regardless of the cardholder s income level. 24 As the authors conclude, even low-income credit card buyers benefit from those cards, receiving a subsidy ($613) annually as a result of their reward card use. 25 B. High-Income Card Users Generate Substantial Bank Profits The FRBB policy paper focuses entirely on the fees that merchants pay for card acceptance. The authors primary model takes no account of the impact of revolving credit, annual fees, or other fee revenue earned by banks issuing credit cards. 26 Yet, this 23 FRBB, supra note 1, at 38 (Table 11) (showing that reducing card rewards alone would reduce consumer welfare). 24 Id. at (Table 6). 25 Id. at In a draft revision of their paper, the authors purport to take account of revolving debt. Schuh et al. 2011, supra note 3, at 9-10, 15-16, Although they recognize that high-income households revolve more often and pay more interest (albeit at a slightly lower interest rate), the authors conclude that on average taking account of revolving debt increases the transfer somewhat. Id. at 9. Their revised analysis, however, is driven by the their assumptions about the distribution of profits through stock ownership. Id. at 27 (calculating that nearly two-thirds of the transfer between low- and high-income households persists even when the two groups are assumed to shop at entirely different merchants because of the authors assumptions about interest payments, float, and redistributed profits ). Id. Transfer effects resulting from interest 2012 Assessing Credit Card Rewards 37 revenue exceeds merchant fee revenue collected by card-issuing banks, and low-income households do not pay more than their proportional share of it. Over the past decade, Phoenix Marketing International surveyed over 21,000 households about their payment system choices. 27 The data generated by this survey confirmed that reward card accounts contribute more to total market performance than non-rewards accounts, particularly at high-income levels from all three sources (financing, cardholder fees, and merchant fees). 28 A rarely used account, by contrast, is unprofitable. High-use cardholders, a disproportionate percentage of which are high-income cardholders, thus subsidize low-income cardholders who use their credit cards only rarely. 29 The FRBB authors do not dispute this conclusion, recognizing that (1) the propensity to revolve credit card spending is surprisingly similar across income groups ; 30 (2) high-income households carry about twice as much revolving debt as lowincome households ; and (3) high-income households pay on average almost twice as much interest. 31 High-income households also generate more annual fee revenue than low-income households. 32 The FRBB authors do not dispute this, recognizing that all cardholder income groups pay more than enough out of their own pockets to cover the credit card rewards earned by the group. 33 payments occur because they are assumed to fund the float period enjoyed by convenience users, a transfer that impacts high-income households as often as low-income households, (See Table 3), and is purely a matter of household choice. Id. at 9, The assumptions about redistribution of bank profits are criticized. See infra at IV.C. 27 Appendix at I.A. (providing background on data produced by the Phoenix Marketing International survey of consumers about their payment system choices). This survey data is cited throughout this article and is on file with the Consumer Law Review. 28 Id. 29 Id. 30 FRBB, supra note 1, at 4. Reward credit cards often have a slightly higher interchange fee than non-reward cards, but this increment amounts to only about 25% of a typical reward payment and accounts for an even lower percentage of the more generous reward programs. 31 Id. at 42 (low income households average $788 in interest per year while high income households average $1,316). 32 Id. at 43 (low-income households pay an average of $5.7 while highincome households pay $7.7). The FRBB authors nevertheless conclude that interest income is unlikely to play a major role in the [wealth] transfers. Id. at 4, Id. at 42. 38 Loyola Consumer Law Review Vol. 25:1 This data and analysis shows that the FRBB authors predicted wealth transfer from low- to high-income households cannot be attributed to any inherent flaw in the card systems. They do not point to any data suggesting that reward cards are unavailable to low-income households, and the authors make clear that they have no reason to believe that banks have designed card systems to transfer wealth. 34 The most recent Phoenix Marketing data confirms the wide availability of reward cards, showing that they outpace non-reward card ownership across income groups. As a result, if high-
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