How should payment services be taxed?

Abstract

This paper considers the design of taxes on real money balances and bank payment services, when realistically, the household can use either cash or a bank payment account for the purchase of different varieties of goods. These taxes, plus a consumption tax, fund a government revenue requirement. We find that generally, real money balances and bank transaction fees should be taxed, and at different rates, i.e. the tax system should not leave the choice of payment services undistorted. For a wide class of time transactions cost technologies, including the Baumol-Tobin case, fees should be taxed at a lower rate than real money balances, and the tax on real money balances should be positive. However, it is possible that fees should be subsidized. The rate of tax on fees has no simple relationship to the optimal consumption tax, and can be higher or lower. A Corlett-Hague type intuition for these results is also developed, which relies on the concept of a virtual time endowment.JEL Classification G21 · H21 · H25 ) which consider a transactions cost theory of money demand, or Chari et al. (1991, 1996), where some goods can be bought on costless credit. More recent models include a more micro-founded search theoretic demand for fiat money e.g. Aruoba and Chugh (2010), but existing models of this type do not include a banking sector. The literature is surveyed in Kocherlakota (2005) and Schmitt-Grohe and Uribe (2010). 2 As a result of these trends, the provision of payment services is an increasing source of both activity and profit for banks and payment network operators, such as VISA and Mastercard. For example, in the United States, the fee averages approximately 2% of transaction value. This is giving rise to large and growing revenues and profits for both banks and the operators. For example, DeYoung and Rice (2004) estimate that in the US in 2003, non-interest income accounted for half of all bank income, and 52% of non-interest income was generated by fees associated with payment accounts. Visa, the largest payment network operator, had gross income and profit of $18.36 bln. and $11.69 bln. in the 2017 financial year. 4 On average, in the EU, consumption is about 70% of GDP. Also, as a rough approximation, about 50% of total transactions are non-cash. So, the percentage is 1%/(0.7 × 0.5)=2.8%. 5 So, a payment account is what is known as a checking account in the USA, and a current account in the UK. 6 These fees are known as merchant discount fees. The bulk of this is made up of a change for card use by the card-issuing bank, known as the interchange fee, and the reminder of the merchant discount fee goes to the card company and the acquiring bank. 7 This is discussed formally in Sect. 3.4.