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Warning: Credit Card Use May be Harmful (to Your Country’s Income Distribution)

Ah plastic. What’s not to love?

  • Convenient? Check.
  • Light in the pocket? Check.
  • Monthly bill summaries? Check.
  • Free short-term credit? Check (provided you pay your bills in full, on time).
  • Benefits (free car rental insurance, points, cash back etc): Check


  • Take from the poor and give to the rich? err… wait a minute.

Unfortunately, credit cards — especially those feature-laden cards that we have grown increasingly attached to — do that too.  But how? Well, to see the mechanism at work, it’s important to understand that credit cards entail costs over-and-above the ones we’re all familiar with (i.e., annual fees (where applicable) and interest costs on unpaid balances).

Every time you use a credit card, merchants pay something called the ‘merchant discount rate‘ (MDR) — which varies anywhere from say 1.5% to 3% of your purchase — to a third party called an ‘acquirer’ who then hands over a share of this amount called the interchange fee — set by VISA or Mastercard — to the issuing financial institution (Royal Bank, Bank of Nova Scotia, and so on). In the last year or two, VISA and Mastercard have done two things to the interchange fee (which they do not receive but set on behalf of the issuers):

  • First, they’ve started engaging in price discrimination — charging different rates for the same service depending on the sector.  Until recently, they charged a single flat percentage (with a minimum fee) to everyone.   The fees for grocery store and gas station purchases for example are now relatively low because profit margins in these businesses are thin and credit card usage limited; interchange fees for higher-profit margin retailers are higher.
  • Second, VISA and Mastercard have set higher interchange fees for feature-laden cards.  Paying with your Visa Gold or Platinum entails a higher interchange fee than a plain old vanilla Visa card.

The net effect of these changes is that the interchange fees have gone up, marginally in some cases, in a big way elsewhere.   Since interchange fees are a floor for the merchant discount rate (ah, cost+ pricing strikes again — when will marginal pricing theorists ever learn?), these two have increased in lockstep.

So what’s a merchant to do? Well, logically they can do one of three things: (a) they can pass the entire increase in the form of higher prices; (b) suck up the entire increase in the form of lower profit margins, or (c) some combination of the two.   There is very little empirical evidence to settle this question decisively — some firms have more pricing power than others — but the limited evidence suggests that merchants probably end up doing a bit of both.

Which, finally, brings us to what is for now, a simmering policy debate, but which could heat up soon.  Both the Retail Council of Canada (RCC) and the Canadian Federation of Independent Business (CFIB) have mounted lobbying campaigns to have the federal government step in and regulate interchange fees, as has been done in Australia (who woulda thunk it?!?) and other countries with the predictable effects — interchange fees are down but other costs are up, i.e., annual fees, shorter grace periods, and fewer benefits.   In other words, credit card users pay for what they get and don’t foist those costs on others. Sounds about right to me.

On its website, the RCC notes that it’s lobbying effort has born fruit in that two committees — one in the House and the other in the Senate — are gearing up to study the issue.  But don’t hold your breath. It’s unlikely that distributional issues will figure prominently in either study — after all, it’s merchants who are driving the bus, which is a shame because the distributional question is crucial here.

As Adam Levitin points out, to the extent that rising interchange costs get passed through to consumers, it’s low-income individuals who pay the price for all those fancy benefits because they are far more likely to rely on cash than your average middle or higher income person.  And if you think merchants can just charge different prices depending on whether you use credit or cash, think again: Visa and Mastercard expressly forbid surcharging (“discounting” is allowed but as Levitin rightly points out, the behavioural evidence suggests that surcharging is a far more effective method of discouraging credit card use, which is why Australia also banned “no surcharge” provisions).

Worse yet, rising interchange fees probably account for some of the willingness on the part of issuers to foist credit cards on people who can’t afford them (hello financial crisis!!) and on those who can (but shouldn’t) — it’s a lot easier to absorb higher-than-average default rates from sub-prime card users when you’re assured a steady stream of interchange profits. And finally, let’s not forget that the credit card companies in the U.S. (but not here, mercifully, not yet anyway) lobbied successfully to reform bankruptcy provisions to make it that much more difficult to escape the yoke of credit card debt.

Where is all this going?  Will the government regulate?  Seems unlikely to me given the balance of political power right now but then again, it’s been a long time since we’ve had two business groups — merchants and financial firms — going at it so openly (in his book The Predator State, Jamie Galbraith argues that most progressive legislation gets through when consumer groups and NGO’s can ally themselves for a cause).  And given the general disfavor shown to financial firms of late, maybe just maybe people have some room to hope that the right policy decision will be made. And that, truly, would be priceless.


Comment from Chrystal Ocean
Time: March 21, 2009, 9:09 am

Interesting post. But if the desired new regulations are created, how confident would anyone be that prices will come down? Cuz they won’t. Cuz there’s that other matter of sticky pricing.

Comment from Arun Dubois
Time: March 21, 2009, 9:36 am

You’re right — there’s no clear evidence that I can see on price effects — prices are indeed, and often, sticky — BUT they clearly won’t go up any further, which is something. Moreover, allowing surcharging means that at least some prices will come down, especially for big-ticket purchases where 2% or 3% means a lot.

Comment from Stephen Gordon
Time: March 21, 2009, 2:19 pm

Nice post. It appears to be a pretty clear example in which current policy induces externalities with regressive effects. Un dossier à suivre.

Comment from Rev Dave
Time: March 21, 2009, 7:40 pm

“Moreover, allowing surcharging means that at least some prices will come down, especially for big-ticket purchases where 2% or 3% means a lot.”

OK, but it seems to me that that, too, has the effect of making permanent a form of inequality. As someone who is very low income, I’m not really making any big-ticket purchases.

If prices are only going to come down on big-ticket purchases, then the people who benefit from that policy will be the people making a lot of big-ticket purchases. Basically, for those of us who can only afford small tickets, it would seem the damage is already done.

Comment from Jim Patterson
Time: March 23, 2009, 8:51 pm

The really unfair aspect of the “discount rate” is that many Visa and Mastercard users are now effectively getting kickbacks (cash back plans) for using their credit cards. For example Scotiabank is offering users 2% on grocery and gas purchases. So, not only are the cash users subsidizing the credit card users, but they’re often paying more money for the same goods because they don’t get the same discount that some cardholders get.

Comment from Arun Dubois
Time: March 24, 2009, 3:18 am

Hi Rev Dave
You’re right — probably won’t see a lot of price reduction pass through (in the event of regulation) in most non-big-ticket products.

That said, I can think of a few services where you probably would, such as taxi companies (I’ve had quite a few experiences where they’ve tried to surcharge even though they’re not allowed to). Maybe hair cutting services. And so on.

Comment from Colleen Moore
Time: November 16, 2009, 1:35 pm

Cash is where it is at. It is disappointing the best governments and the banking industry have come up for the credit fiasco is charge it. And although I understand the importance of governments engaging in job creation (unemployment continues to climb) many Canadians are heavily reliant on credit. And while real estate prices climb and home purchases rise thanks to government incentives to purchase real estate isn’t this like a bit of the hair of the dog that bite you?

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