A Macdonald-Laurier Institute Publication Punishing Rewards How clamping down on credit card interchange fees can hurt the middle class Julian Morris, Geoffrey A. Manne, Ian Lee, and Todd J. Zywicki NOVEMBER 2017 Board of Directors CHAIR Brian Flemming Rob Wildeboer International lawyer, writer, and policy advisor, Halifax Executive Chairman, Martinrea International Inc., Robert Fulford Vaughan Former Editor of Saturday Night magazine, VICE CHAIR columnist with the National Post, Ottawa Pierre Casgrain Wayne Gudbranson Director and Corporate Secretary, CEO, Branham Group Inc., Ottawa Casgrain & Company Limited, Montreal Stanley Hartt MANAGING DIRECTOR Counsel, Norton Rose Fulbright LLP, Toronto Brian Lee Crowley, Ottawa Calvin Helin SECRETARY Aboriginal author and entrepreneur, Vancouver Vaughn MacLellan DLA Piper (Canada) LLP, Toronto Peter John Nicholson Inaugural President, Council of Canadian Academies, TREASURER Annapolis Royal Martin MacKinnon CFO, Black Bull Resources Inc., Halifax Hon. Jim Peterson Former federal cabinet minister, DIRECTORS Counsel at Fasken Martineau, Toronto Blaine Favel Executive Chairman, One Earth Oil and Gas, Calgary Barry Sookman Senior Partner, McCarthy Tétrault, Toronto Laura Jones Executive Vice-President of the Canadian Federation Jacquelyn Thayer Scott of Independent Business, Vancouver Past President and Professor, Cape Breton University, Sydney Jayson Myers Chief Executive Officer, Jayson Myers Public Affairs Inc., Aberfoyle Dan Nowlan Research Advisory Board Vice Chair, Investment Banking, National Bank Financial, Toronto Janet Ajzenstat, Vijay Sappani Professor Emeritus of Politics, McMaster University Co-Founder and Chief Strategy Officer, Brian Ferguson, TerrAscend, Mississauga Professor, Health Care Economics, University of Guelph Jack Granatstein, Historian and former head of the Advisory Council Canadian War Museum Patrick James, John Beck Dornsife Dean’s Professor, President and CEO, Aecon Enterprises Inc., Toronto University of Southern California Erin Chutter Rainer Knopff, Executive Chair, Global Energy Metals Corporation Professor Emeritus of Politics, University of Calgary Vancouver Larry Martin, Navjeet (Bob) Dhillon Prinicipal, Dr. Larry Martin and Associates and Partner, President and CEO, Mainstreet Equity Corp., Calgary Agri-Food Management Excellence, Inc. Jim Dinning Christopher Sands, Former Treasurer of Alberta, Calgary Senior Research Professor, Johns Hopkins University David Emerson William Watson, Corporate Director, Vancouver Associate Professor of Economics, McGill University Richard Fadden Former National Security Advisor to the Prime Minister, Ottawa Table of Contents Executive Summary ............................................................................................................................... 2 Sommaire .............................................................................................................................................. 3 Introduction .......................................................................................................................................... 5 PART I – The Rise of Credit Card Use: Benefits, Investments, Incentives, and Fees ............................ 6 PART II – The History and Development of Reward Programs ............................................................ 8 The purpose and function of reward programs .............................................................................. 9 Credit card reward programs ......................................................................................................... 10 Effectiveness of credit card reward programs................................................................................ 11 PART III – Criticisms of and Challenges to Reward Programs ............................................................ 13 Putting the costs of credit card transactions in perspective .......................................................... 14 Do credit card rewards result in higher levels of debt? ................................................................. 17 PART IV – The Potential Effects of Interchange Fee Caps on Rewards and Credit Card Fees: Lessons from Australia ........................................................................................................................ 19 PART V – The Effect of Interchange Fee Regulation on the Middle Class in Canada ......................... 24 Case studies of the effects of interchange fee caps on middle class households .......................... 25 The differential effect of interchange fee caps on middle class, higher income, and lower income consumers ........................................................................................................ 27 PART VI – The Economic Effects of Interchange Fee Regulation in Canada ...................................... 28 PART VII – Estimates ........................................................................................................................... 28 Conclusions ......................................................................................................................................... 30 About the Authors ............................................................................................................................... 31 References ........................................................................................................................................... 32 Endnotes ............................................................................................................................................. 37 The authors of this document have worked independently and are solely responsible for the views presented here. The opinions are not necessarily those of the Macdonald-Laurier Institute, its Directors or Supporters. Copyright © 2017 Macdonald-Laurier Institute. May be reproduced freely for non-profit and educational purposes. Merchants, however, are less happy with the Executive Summary higher interchange fees. Apparently assuming that all of the benefit of rewards cards accrues ver the past 20 years, credit cards have to users, while merchants bear the added in- become an increasingly popular means terchange cost, these merchants say that the O of paying for goods and services in Can- increase has negatively affected their profitabil- ada. Today nearly 90 percent of Canadian adults ity. Of note, however, the number of merchants own a credit card and approximately 65 percent who accept credit cards, after falling in the early of all point of sale payments are made using 2000s, has increased in the past decade – and credit cards. appears to have risen more rapidly following the The rise of credit cards has been driven by the introduction of more generous rewards cards, in benefits that accompany their use, including spite of a rise in accompanying interchange fees. convenience, security, insurance, and warran- ties on purchases. But arguably the biggest driv- er has been the rewards that cards offer, such as cash back, Air Miles or Aeroplan rewards, or merchant-specific rewards. About 80 percent of “Middle class consumers are Canadians with credit cards have at least one card that offers rewards for use, and owners of the major beneficiaries of credit credit cards with rewards say that the rewards card rewards.” are the primary reason they use their rewards card for purchases. The benefits provided by credit cards are paid for by the issuing bank through a combination of annual fees charged to cardholders and trans- Some merchant groups have, in fact, called for the action fees charged to merchants. In closed-loop government to impose caps on interchange fees; three-party card systems (primarily American Ex- in February 2016, a private member’s bill was in- press, as well as international cards issued by Dis- troduced in Parliament seeking to do just that. cover), the payment card provider charges both Interchange fee caps, like other price controls, merchants and consumers directly. In four-party card systems (Visa and Mastercard), card issuers tend to have predictable effects: as a rule, they charge cardholders directly but the fees from result in other prices increasing, leading to a merchants come via the acquirer (such as a mer- redistribution, but not a reduction, in overall chant’s bank), which charges merchants a ser- costs. Several other countries have introduced vice charge. The largest portion of the merchant caps on interchange fees, including, of particu- service charge is the interchange fee, which is lar relevance, the caps introduced in Australia passed on to issuing banks. in 2003. These caps resulted in a significant in- crease in the annual fees charged to cardholders In spite of the higher annual fees on cards with and a substantial reduction in the rate at which more benefits, the vast majority of consumers re- card use earned rewards. port that they receive more benefits from their cards than the cost of the fees they carry. Middle Using data on and analysis of the effect of Austra- class consumers are the major beneficiaries of lia’s interchange fee caps, combined with pub- credit card rewards. A consumer or household licly available and proprietary data on Canadian earning $40k might expect annual rewards val- credit card use, household income and expendi- ued at $450, while paying fees of $75, providing ture, and other economic variables, the authors a net benefit of $375. Meanwhile, a consumer or of this report modelled the likely