Merchant internalization and tax evasion

Highlights

• Theoretical links between tax evasion and merchant card acceptance

• Merchant tax evasion is modeled as exogenous and as a strategic reason under the card industry framework

• Under exogenous tax evasion, the tax benefit of accepting cash reduces the cardholder benefit per card payment

• Under the strategic case, the merchant’s decision to evade taxes affects the cardholder benefit per card payment

Abstract

Merchant internalization has been used to explain why merchants may accept high fees to accept card payments. However, merchants seem to be more resistant in some economic activities or countries; in particular, when the shadow economy is sizeable. Cash payments are usually associated with tax evasion, and therefore the analysis of card industry should take it in to consideration. This paper explores the role of tax evasion in the merchant internalization condition; first, considering it as exogenous, and then, as a strategic reason.

Introduction

Over the last decade of the twentieth century, it was common to say that merchants accept payment cards only if the merchant discount (the fee that the retailer pays to the acquirer in each card transaction) is not higher than the net convenience cost of cash; i.e. the cost savings from accepting card instead of cash (Baxter, 1983). However, this proposition did not help to understand the “must-take card” phenomenon in which retailers may accept high merchant fees, even if they are above their net convenience cost of cash, in order to attract new consumers (Rochet, Tirole, 2011, Vickers).

The “must-take card” phenomenon or merchant internalization refers to the merchants’ ability to increase the retail price in order to obtain the net cardholder benefit of paying by card instead of cash, without losing market share (Rochet, Tirole, 2002, Rochet, Tirole, 2011).¹ As a result of the merchant internalization, merchants are less resistant to accept high fees, and thus induces a card network to set inefficiently high merchant fees (Rochet and Tirole, 2002). The merchant internalization holds under different competition models: monopoly retailing, perfect retailing competition and Hotelling-Salop-Lerner differentiated products competition (Rochet, Tirole, 2002, Rochet, Tirole, 2011); the Perlof-Salop competition model (Ding and Wright, 2017) and the general discrete choice model and the representative consumer model (Ding, 2014).

However, there are some situations where the merchant internalization does not hold. For instance, if consumers are not aware of whether merchants accept cards, or if the retail prices are capped (Ding, 2014). This paper explores another reason where the merchant internalization cannot hold: tax evasion through cash payments.

According to Madzharova (2014) and Immordino and Russo (2018), cash payments are strongly associated with VAT evasion since they are not traceable and eases the under-reporting and its usage in illegal activities. In addition, Medina and Schneider (2018) show that in those countries with a high degree of shadow economy, cash is the most used payment instrument. Therefore, this feature of cash payments associated with tax evasion should be included into the analysis of the card industry; in particular, when the shadow economy is sizeable.

Aurazo and Vasquez (2020) include the government in the model setup of Rochet and Tirole (2011) to take tax evasion into consideration. In their model, merchants benefit from tax evasion through cash payments since they do not provide a receipt when the consumer pays by cash instead of card, and thus, they have an additional benefit per cash payment which reduces the net convenience cost of cash. The authors, however, focus on the role of tax evasion in the tourist test (also called the merchant indifferent test)² rather than in the merchant internalization condition. This paper aims to fill gaps in this analysis.

We develop two cases for tax evasion. In the exogenous case, merchants benefit from tax evasion since it reduces the net convenience cost of cash while in the strategic case, merchants can increase the retail price by evading taxes in cash payments because the cardholder values the receipt received in card payments.

The rest of the paper is structured as follows. Section 2 describes a standard model of payment card platform to explain the merchant internalization condition. Section 3 incorporates tax evasion in the model setup when consumers do not ask for the receipt in cash payments or it is determined by some country variable (exogenous tax evasion). Section 4 explores tax evasion for strategic reasons since the net cardholder benefit per card payment is affected by the merchants’ decision to provide receipts in cash payments. Section 5 summarizes the key insights.