State Interchange Fee Regulation
TL;DR
Background: Payment cards generate significant benefits for both merchants and consumers. Consumers benefit from their convenience, security, and rewards. Merchants benefit from enhanced security, as well as higher throughput and larger per-ticket sales.
These benefits are made possible through the interchange fees retained by issuing banks, which go to fund network infrastructure, fraud prevention, and rewards programs, balancing payment networks’ two-sided markets (consumers and merchants).
But… Some state lawmakers have sought to enact laws limiting the retention of interchange fees on certain taxes. Illinois has passed legislation that covers both taxes and tips.
However… Such prohibitions would harm consumers, banks, and merchants.
Merchants would likely see a fall in card use, resulting in reduced throughput and lower revenue. Smaller merchants would lose out relative to larger merchants.
Banks and credit unions would lose revenue. Smaller local banks and credit unions would be hit worse due to their relatively constrained ability to distribute costs.
Consumers would likely see reduced card rewards and other benefits, as banks seek to compensate for lost revenue.
State and local governments might see an increase in the costs of enforcing sales tax and a fall in revenue due to reduced economic activity.
KEY TAKEAWAYS
The Importance of Interchange Fees to Card-Payment Networks
The ubiquity of card payments makes it easy to take them for granted. But ill-conceived regulation can serve to reduce or even eliminate the immense benefits of card-payment networks to both merchants and consumers.
Payment systems are an example of a two-sided market with cross-side network effects. To grow and maintain such a market, it is often necessary for one side to subsidize the other. In the case of payment networks, these cross-side subsidies can include collection, payment default, fraud monitoring, various kinds of insurance, and other account-related costs, as well as reward programs such as cashback and airline miles.
They also include fees to the network operator, which cover not just the network’s operation and maintenance, but also investments in such innovations as the EMV chip, contactless payments, and 3DS, all of which help to reduce fraud. In four-party networks, the card-issuing bank covers these costs by deducting an “interchange fee” from the amount remitted to the merchant’s acquiring bank.
Point-of-Sale Taxes Collected by Merchants
All but five of the 50 states charge state sales taxes. Economists generally find that sales taxes are superior to taxes on income or capital because they are less distortionary and can lead to more revenue over the long term.
In addition to state sales tax, other forms of taxation may also be applied at the point of sale. Most notably, excise taxes are applied to certain items, such as alcohol, tobacco, and gasoline.
Merchants are generally best-positioned to calculate how much in point-of-sale taxes is owed and to whom, since they know what they are selling, how much they charge, and where they are physically located. It would be practically infeasible to implement taxes at the point of sale without the cooperation of—and reporting by—merchants.
From the perspective of economic efficiency, electronic payments and electronic reporting together serve to minimize the combined costs of merchant compliance and government administration. Perhaps in part reflecting this, several state governments offer tax rebates or discounts to encourage electronic sales-tax reporting.
Illinois Interchange Fee Prohibition Act (IFPA)
Large merchants often argue that it is unfair for them to have to pay interchange fees on point-of-sale taxes and on tips to their employees. In June 2024, Illinois became the first state to pass legislation limiting the retention of interchange fees for taxes and gratuities. Under the IFPA, the merchant may determine whether interchange fees on taxes and gratuities are excluded or later rebated.
Whether it will be technically feasible for (especially smaller) merchants to exclude taxes and tips from interchange fees at the point of sale (POS) remains unclear. Doing so is likely to require significant changes to the way transaction information is collected within POS systems, and ultimately transmitted across payments networks.
Likely Effects of the IFPA
The IFPA will require banks to significantly modify how their payment systems work in order to separate transaction interchange fees from tips and taxes, resulting in a downstream effect on credit and debit-card transactions.
Prohibiting issuing banks from retaining interchange fees on taxes and other elements of a transaction at the point of sale would create significant market distortions. Specifically, it would:
- harm small- and medium-sized merchants at the expense of large merchants who can better afford to change their POS systems;
- result in a net reduction in business activity and profitability, due to longer times for processing cards with interchange fees;
- reduce the value of four-party payment cards to consumers, which would slow (and possibly reverse) the transition away from cash and toward electronic payments;
- reduce revenue to issuing banks and credit unions; and
- increase the costs of administering point-of-sale taxes and reduce the revenue generated by such taxes.
Legal Barriers to Enforcement
Recently, the U.S. District Court for the Northern District of Illinois granted a preliminary injunction staying implementation of the IFPA. The court noted that compliance for banks will be “extraordinarily expensive” since “[c]urrently, there is no system that separates out these fees.”
The court found the law is likely preempted by federal laws regulating national banks that allow for the collection of interchange fees.
For more on this issue, see ICLE’s issue brief “State Regulation of Interchange Fees” and the recent district court order in Illinois Bankers Ass’n v. Raoul granting a preliminary injunction against the IFPA.