NYU Tax Policy Colloquium, Edward Fox on banks vs. credit unions and corporate tax incidence

Yesterday, in the last session of the 2023 NYU Tax Policy Colloquium, Edward Fox co-presented his paper (co-authored by Benjamin Pyle), Who Benefits From Corporate Tax Cuts? Evidence from Banks and Credit Unions Around the TCJA. (I'm not linking it here because it's a preliminary draft that the authors plan to post when it's a bit further along.)

But just as initial background first, I've now completed 28 (!) years of running the colloquium, which for the first 25 years I always did with a co-convenor. Next year I'll be doing it solo again, and also with just 6 rather than 13 public sessions, but there is going to be a time change. Owing to NYU Law School's changing around the course scheduling blocks for reasons that are not germane here, it's highly likely that we will be meeting on Mondays, rather than Tuesdays. The time of the sessions will also change, either to 4:45-6:45 pm or to 2:35-4:35 pm, depending in large part on feedback that I am seeking from people who are on my email distribution list, or indeed from any prospective attendees. (If that includes you, please feel free to email me about your scheduling preferences.) BTW, if I had my choice, I'd still use the old time slot (going back a few years) of 4-6 pm, but that unfortunately is not available, as law schools need as a practical matter to coordinate their class meeting times across the curriculum.

Okay, enough of those not so fascinating prelims, on to the paper. It is motivated by the quest for a natural experiment that would offer insight regarding what one could broadly call the "incidence of the corporate tax" - or, more narrowly and carefully, as the paper recognizes, on the short-term incidence of the particular corporate tax cuts that Congress enacted in 2017. The natural experiment that it finds is in the small to medium-sized banking sector, in which taxable C corporations (among other taxable players) appear to compete with credit unions. The point of the comparison being: the taxable banks that meet this description are subject to the corporate tax, the rate of which was lowered in 2017 from 35% to 21% (among other changes adopted in 2017). Whereas, credit unions are federally tax-exempt, whether you look before or after 2017. So there is presumably some sort of competitive equilibrium in the sector, which then gets disrupted by the tax change for wholly exogenous reasons. One can then pursue a difference-in-difference analysis to see what happened, after duly checking on what else might have been happening at the same time (including, but not limited to, elsewhere in the TCJA), and with the look forward running only through 2019, given the pandemic's disruption of everything. With all that said, I'll offer responsive comments in 3 buckets.

1) Credit unions versus banks: The paper, while noting relevant literature, doesn't attempt to deeply theorize the competitive equilibrium between banks and credit unions, for a logical reason. However it works, why would the 2017 tax act change it? But this equilibrium is peculiar enough that I think it's worth a brief look.

Credit unions and similarly-sized banks have similar business models, except that the latter make relatively more business as opposed to consumer loans. That said, each tries to make money by holding deposits that pay comparatively low interest, and making investments (chiefly loans) that earn comparatively high interest. The spread, of course, reflects the payment and other services that they provide. Depositors typically get fixed returns on their deposits, and these are generally insured by the FDIC for banks, and the NCUA for credit unions. But the business inevitably has a variable return, depending on how well it does (including via pertinent legal changes, such as the 2017 corporate tax rate change for banks). For banks these variable returns go to shareholders. For credit unions, they at least in principle (but often not so proximately in practice) go to depositors, such as through patronage dividends or eventual liquidation claims.

One big difference, therefore, is that only the banks have shareholders. The second is that credit unions are tax-exempt, rather than facing (in the case of C corp banks) the federal income tax rules for C corporations. Let's briefly further consider each of these two differences:

     a) Why have shareholders? Normally, shareholders in a business supply a cushion that protects debt-holders against downside risk, thus benefiting the latter (who might be averse to such risk if they are seeking fixed returns). But in the case of banks and credit unions, FDIC/NCUA deposit insurance may substantially mitigate this downside risk. So, what are the shareholders "for"? Or, to put it more clearly, how do debt-holders, such as depositors, benefit from ceding both upside and downside variability to someone else, when the downside is already covered by another institutional arrangement. Or, if two otherwise identical financial institutions were offering prospective depositors otherwise identical terms, how would the institution with shareholders compensate the depositors for having taken away the variable upside risk? (Note that, with complete markets, the depositors could simply sell this upside variable return for a fixed amount reflecting its expected value, to counterparties whose preference for such variability exceeded their own - but this may be unfeasible in the credit union setting.)

Possibly, shareholders "pay" for themselves by improving corporate governance, which can be an especial problem for credit unions if the depositors are less able than shareholders to monitor management. And even with NCUA protection, credit union default might be a tough blow for depositors if that process is costly, protracted, unpredictable, etcetera. But still, it is not as obvious as it would be in the absence of deposit insurance why an equity tier is commercially useful and valuable.

For that matter, might governance concerns go both pro- and anti-credit union? For example, absent the shareholder class, might credit unions be actually and/or perceptually less likely - despite defects in managerial oversight - to play little tricks such as using hidden fees to extract $$ from depositors? 

     b) Tax exemption: Suppose that a bunch of depositors could band together (or pay an entrepreneur to assemble them) in such a way that the banking business they could fund by pooling their deposits could be either taxable or tax-exempt. Obviously, they would prefer the latter, so that the business's pretax returns, which presumably are expected to be positive (and even if negative, there are issues of nonrefundability) would not be reduced by payments to the federal income tax authorities. Thus, if being classified as a tax-exempt "credit union" was purely an election - requiring neither a lack of shareholders nor that one qualify under relevant legal criteria, such as those which generally require a "common bond" between members - then presumably all banks would happily elect to be called credit unions. So the existence of taxable banks reflects limits on (or costs to) the practical availability of the undoubted benefit of being tax-exempt rather than taxable. Credit unions have in theory a competitive advantage in attracting depositors, but practical factors, including both the (comparative) governance issue and the other legal requirements, apparently prevent them from conquering the field.

The bottom line here is that this is a complex, interesting, and distinctive business sector. How banks and credit unions ought to and do compete with each other is not pellucid, and will depend in practice on matters of institutional detail, although it is true that the 2017 tax act did not obviously change or disrupt any of this, other than via the C corporation rate changes (along with its other changes, which the paper argues tend not to have enormous, or at least direct, implications here).

2. The paper's main results: There are two principal ones. First, credit unions were paying depositors higher interest rates both before and after the 2017 act. But after the act, the gap narrowed, with banks increasing relative interest rates paid to depositors by 0.8 basis points.

Second, 74% of the banks' gain from the tax cut went to capital holders - 52% to shareholders, and 22% to depositors. The paper recognizes that it is ambiguous how we should classify the depositors, given that they are both capital holders and customers. But other players, such as borrowers (another class of customer) and employees, apparently don't gain anything. There is also some evidence of the tax cuts' leading to increased physical capital investment, such as in real estate, although with too low a confidence interval to support reporting this as a "result."

3. Interpreting the results (including as evidence regarding the broader incidence of the U.S. corporate tax): I find both of these results intriguing, but their import is not entirely clear. Starting with the first, as noted above it is challenging to try to understand the competitive equilibrium between banks and credit unions. How does one compete when offering lower interest, especially given the deposit insurance in both cases? Do the banks offer more in other ways, such as ATM availability and other payment services? If so, then why? Does this relate to governance? But, in any event, why would the banks increase the relative interest paid just because the equity tier has gained from a tax cut? True, the depositors are literally capital-holders, in that the $$ they deposit are then lent out to yield profits from the positive interest rate spread. But if they just have a fixed $$ stake that they can easily move from one bank to another at any time, without this depending on the business's distinctive features or variable returns, then why wouldn't the "customer" relationship predominate economically?

As for corporate tax incidence more generally - or even just the incidence of gain from a very particular corporate tax rate cut that was embedded in a complex system and combined with other (on balance, unfunded!) tax law changes - we clearly have a relevant datum here, pertaining to the banks within the survey. But I wonder about generalizability, even just as to the 2017 act.

One point is that (as I discussed here in re. Kim Clausing's paper earlier this semester), the presence or absence of rents seems likely to play an important role in corporate tax residence. Small to medium-sized banks seem unlikely to have significant rents - although, I suppose who knows if they hold market power in geographically segmented local markets?

A second point is that this is pretty much a snapshot story, looking only through 2019 given the pandemic's motivating curtailment of the study period. There may often be a significant gap between transition and long-term incidence, and we may have reason to care about both. As an example, suppose one believed that workers bore the incidence of the corporate tax, via its affecting investment levels that in turn affect productivity that in turn affect wages. This effect might take years to emerge. In such a case, the surprise enactment of a corporate rate cut (which itself is not exactly what happened in 2017) would be expected to give shareholders a transition gain, dissipating only over time as capital deepening lowered marginal pretax rates of return and increased wages.

As transition versus long-term incidence goes, maybe banks versus credit unions would settle out relatively fast? E.g., if it is mainly a matter of deposits moving around (at least, assuming attentive depositors!). Certainly, it might perhaps operate a bit faster than a mechanism in which big new factories are being built or a lot of fancy machines acquired and placed in service. But again, one needs a lot of knowledge about institutional detail in order to game all this out. So, while this is a valuable and informative case study in any event, the question of its broader relevance requires greater reflection and knowledge than I was able to bring to its being one of this semester's colloquium papers.

As a final word, thanks to my students, who were great and very much involved and committed at all times, and to the authors plus the public sessions' attendees. The NYU Tax Policy Colloquium is an institution that I care about, but insofar as it succeeds my efforts can only be a very small piece of the reason why.