Jose Aurazo, Central Reserve Bank of Peru & Jose Vasquez, Central Reserve Bank of Peru
What is the maximum fee that merchants should pay when they accept card payments instead of cash? Rochet and Tirole (2011) address the issue by developing a “tourist test” based on the merchant discount (fee that merchants pay to acquirers when a card payment is done) and the interchange fee (the component of the merchant discount that goes to the card issuer). Due to the two-sidedness of the market (customer and merchants), the interchange fee plays a crucial role by providing incentives to each side to use and accept card payments. The interchange fee passes the “tourist test” if it does not increase the merchant’s net cost of accepting card payments. This implies that the merchant is indifferent between accepting cards or cash from a non-repeat customer (a tourist) because cards are not more expensive than cash. When the interchange fee satisfies the tourist test, merchants do not complain about excessive fees when they accept card payments instead of cash.
The approach is designed based on the stylized facts in developed countries where the major costs involved for accepting different means of payments for merchants are operating costs (handling cash, attending cash or card payments, etc.). The situation is however different in developing countries where the shadow economy tends to be large, the share of cash payments high, and merchants usually evade taxes by using cash transactions.
Our paper extends the tourist test model proposed by Rochet and Tirole (2011) to the situation of emerging countries. We incorporate the government in order to take into account informality (i.e. tax evasion in cash payments) and the net social cost of cash usage, two elements that are relevant in developing countries. In the presence of informality, the tax gap between card and cash payments reduces merchants’ net operating benefit of accepting card sales. The main idea is that although retail prices include taxes (i.e. VAT), merchants usually do not provide an invoice for cash payments and so pocket the VAT. Merchants then perceive cash as less expensive than cards. We adjust the concept of the tourist test to this environment, and show that the maximum interchange fee that merchants accept now internalizes this tax gap between card and cash payments. Therefore, ceteris paribus, the interchange fee compatible with the tourist test is lower in the presence of informality than in the baseline setting.
We also analyze the interchange fee that maximizes the government’s payoff, defined as the sum of the government’s net income (tax revenues minus the net social cost of cash usage) and the final user’s surplus (cardholders plus merchants). This interchange fee exceeds the tourist test threshold because it internalizes the positive externality to the government whenever cardholders make a card payment. The higher level of the interchange fee aims to incentivize cardholders to use their cards, thereby allowing the government to avoid the net social cost of cash and receive the VAT. However, this higher level of the fee increases merchants’ net operating costs which in turn reduces their willingness to accept card payments.
Our extension of the tourist test model is a useful tool for estimating a cap on interchange fees in developing countries. Unlike developed economies, these countries are characterized by high shadow economy and high tax evasion through cash payments. Therefore, the application of the tourist test must consider the tax gap between card and cash payments. It can be expected that, interchange fees resulting from the tourist test are higher in developed countries than in developing ones.
Rochet, Jean-Charles, and Jean Tirole (2011), “Must-take cards: Merchant discounts and avoided costs”, Journal fo the European Economic Association.