American Express has famously touted that “membership has its privileges.” For wealthy consumers today, those benefits total $9.2 billion each year, subsidized by middle- and lower-income households.

As inflation-weary businesses raise prices to cover credit card interchange fees, the pain isn't universal, says research by Harvard Business School Professor Mark L. Egan. Because merchants charge everyone the same price regardless of how they pay, those fee costs are factored into prices for all shoppers. However, credit card users get that money back and then some through rewards, while cash and debit users get little or nothing.

The result: People paying cash face the equivalent of a 26% higher sales tax than premium credit card users shopping at the same store.

Collectively, interchange fees shift an estimated $30 billion from those paying with cash and debit cards to credit card users at similar merchants annually, Egan and his fellow researchers estimate in the April working paper “Who Pays for Payments?” That windfall is as “economically significant” as government policies that support low- and middle-income Americans, such as the Earned Income Tax Credit and unemployment insurance.

“It's just the way the market was set up,” says Egan, the George E. Bates Professor. “It turns out to be unfavorable to people who use cash and debit, and those who happen to be people with low incomes.”

Egan’s research shows how consumer policies, banks’ need for fees, and buying behaviors have converged to facilitate a massive wealth transfer. The findings arrive amid a widening schism between the country’s richest and poorest residents, as wealthy households gain from surging stocks and many lower-income families struggle to afford basic necessities.

Egan coauthored the paper with Gregor Matvos and Lulu Wang, professors at Northwestern University, Stanford University Professor Amit Seru, and Georgia State University Professor Vincent Yao.

How did this system evolve?

One factor stems from an amendment to the Dodd-Frank Wall Street Reform and Consumer Protection Act passed in 2010 at the crest of the global financial crisis. The law includes a provision known as the Durbin Amendment that caps debit card interchange rates charged by large banks.

The law, which went into effect in 2011, aimed to protect consumers and merchants from excessive interchange fees on debit cards. However, the policy ended up hurting debit card users, who lost rewards and perks like free checking as banks made up the lost fee revenue. And while cash users benefited, the biggest winners were credit card users: lower debit interchange fees reduced the prices merchants charged, and credit card users enjoyed those lower prices while their rewards remained untouched.

Ultimately, the policy proved regressive, benefiting affluent consumers while middle-income debit card users lost the most.

“It's just unfortunate,” says Egan, a professor of business administration in the HBS finance unit. “No one wanted this outcome from the Durbin Amendment.”

Parsing payments at 1.8 million merchants

To study how interchange fees impact consumers, the authors partnered with financial transaction firm Fiserv, owner of the popular Clover payment platform. The partnership allowed the researchers to examine card payments across roughly 1 million merchants—about one-fifth of all US card volume—plus data from 800,000 Clover merchants that captures notoriously hard-to-track cash transactions.

The analysis assumed that retailers pass interchange fees to customers through higher prices, but the results held even after relaxing that assumption. Tallying who receives card rewards versus who effectively pays the fees that fund them, the researchers found:

• Premium card users reap 43% of rewards, but pay 30% of interchange fees.

• Cash users receive no rewards, but pay about 10% of fee-related costs.

• Users of debit cards issued by large banks covered by the Durbin Amendment receive about 13% of rewards but pay 23% of the fees.

Because credit card use rises with income, this redistribution translates into a $9.2 billion annual transfer to households earning more than $150,000 from lower-income households—a gain of about $390 a year for high-income households, while lower-income households lose about $88.

The authors found two factors that mitigated the transfer. First, cash, debit, and credit card users tend to shop at different merchants, which limits cross-subsidization. Second, the merchants with more overlap—large grocery stores, gas stations, and big retailers—tend to pay the lowest interchange fees, thanks to sector discounts and the negotiating clout of major chains. Together, these forces shrink the transfer by about 25%.

“Because there's this consumer sorting, and places like Target and Walmart negotiate lower fees, [the redistribution is] not quite as bad as you might think,” Egan says.

Managing the shifting fee landscape

Interchange fees have grown with rising card use, raising strategic questions for any business that sells to consumers, from big box stores to small gas stations. Among the factors they will likely grapple with:

• Premium card use will likely grow. When forecasting interchange fee costs, it’s fair to assume that premium card use will expand, especially as more middle-income consumers embrace them and stop carrying cash. “More expensive payment methods are just going to drive out cheaper ones,” Egan says.

• Sound forecasting will require more granularity. A business with multiple sites might need to consider customer behavior at each location, rather than relying on averages. “Card type, merchant sector, and merchant size play fundamental roles in determining merchant-level interchange fees,” the authors write.

• Squeezed merchants have few easy solutions. Rejecting premium cards or adding surcharges, for example, might undermine competitiveness and alienate customers. “People like to pay with fancy credit cards,” Egan says. “You certainly see that in the data.”

Where do we go from here?

In trying to rein in bank fees, the Durbin Amendment ended up being a regressive transfer from middle-income consumers to high-income consumers. Policymakers weighing future reforms to fees should keep in mind that:

Consumers “self-sort” by income

Wealthy people tend to shop at retailers that anticipate premium card use and price accordingly, the researchers find. And businesses that cater to cash and debit customers might not need to raise prices as aggressively to cover rewards. For that reason, more targeted reforms might be more effective.

Large merchants have more options to manage costs

Big-box stores, for example, have more leverage to negotiate interchange fees than small businesses, Egan says. Niche merchants that serve a variety of customers might be most vulnerable.

Middle-income households often suffer most

After the Durbin Amendment, credit card users enjoyed lower prices while keeping their rewards, and cash-reliant shoppers benefited from lower prices too. Middle-income shoppers—most likely to use debit cards—lost free checking and other perks that outweighed any price relief.

“We find that low-income consumers were relatively unaffected, middle-income consumers were hurt the most by the Durbin Amendment, and higher-income consumers benefited,” the authors write.

Photo credit: Adobe Stock/Lenny.