ELECTRONIC PAYMENTS for State Taxes and Fees

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1 Acceptance and Use of ELECTRONIC PAYMENTS for State Taxes and Fees Prepared for: The Council of State Governments Financial Services Working Group April 25, 2007

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3 Dwight V. Denison Merl M. Hackbart Juita-Eleana (Wie) Yusuf Jay H. Song University of Kentucky Martin School for Public Policy and Administration 419 Patterson Office Tower ß Lexington, KY Acceptance and Use of ELECTRONIC PAYMENTS for State Taxes and Fees Prepared for: The Council of State Governments Financial Services Working Group April 25, 2007

4 Foreword and Acknowledgements We would like to acknowledge the members of the Study Advisory Committee who were helpful in identifying the key issues for examination and in developing the electronic payments survey questionnaire. Our thanks also extend to CSG staff, especially Sujit CanagaRetna, for their assistance during this project. Members of the Study Advisory Committee were: ß Mr. Kenyatta Chandler (former Manager of epayment Services, Revenue Management Department, Ohio) ß Mr. Andrew Chang (Chief Deputy Director, Department of General Services, California) ß Mr. Robert Tetz (Department of General Services, California) ß Mr. Dennis Colling (Chief Administrator, Administrative Services, Department of Motor Vehicles, Nevada) ß Mr. Billy Hamilton (Deputy Comptroller, Executive Administration, Texas) ß Mr. Terry Straub (Division of Treasury, Department of Financial Services, Florida) ii The Council of State Governments Financial Services Working Group

5 Table of Contents Foreword and Acknowledgements... ii Executive Summary...1 Chapter 1: Introduction and Overview Research Objective Research Approach Report Structure...4 Chapter 2: Evolution of Payments and Growth in E-payments Evolution of Payments Growth in E-payments Non-cash Payment Instruments...6 Chapter 3: Electronic Payment of Government Taxes and Fees Benefits and Costs to State Governments of Accepting Electronic Payments Credit Card Payments for Government Services...10 Chapter 4: Findings of Previous Studies on Government Tax and Fee Electronic Payments Overview of Previous Studies How Extensive is the Acceptance and Use of Credit Card Payment for Taxes and Fees? What Taxes or Fees Can be (and Are) Paid by Credit Card? Why Should Government Agencies Allow Payment of Taxes and Fees by Credit Card? Who Pays the Transaction Fees Associated with Credit Card Payments? How are they Paid? What is Required for State Agencies to Accept Credit Card Payments?...19 Chapter 5: State Taxes and Fees E-payment Survey Findings Survey Overview and Methodology Acceptance and Use of Electronic Payments Benefits of and Challenges to Accepting Electronic Payments Electronic Payment Policies and Practices...26 Chapter 6: Summary and Conclusions...31 Endnotes...33 References...34 Appendix A: Survey Instrument...35 Acceptance and Use of Electronic Payments for State Taxes and Fees iii

6 List of Figures Figure 2.1 Number of Credit and Debit Card Transactions in the U.S. (in millions), Figure 2.2 Dollar value of Credit and Debit Card Transactions in the U.S. (in $ billions), Figure 2.3 Number of Credit and Debit Cards in the U.S. (in millions), Figure 3.1 Two Primary Credit Card Payment Systems for Government Agencies...11 Figure 4.1 Responsible Party for Paying Fees Associated with Tax Payments...16 Figure 4.2 Citizen Willingness to Pay for On-line Government Services...18 Figure 5.1 States that Responded to the E-payments Survey...22 Figure 5.2 Form of Electronic Payments Accepted for State Taxes...23 Figure 5.3 Initial Acceptance of Credit or Debit Card for Tax or Fee Payment...24 Figure 5.4 Average Credit Card Payment Transaction Amounts by Tax Category...26 Figure 5.5 Average Debit Card Payment Transaction Amounts by Tax Category...26 Figure 5.6 Fees Paid by States for Accepting Credit Card Payments...27 Figure 5.7 Criteria Cited by States as Basis for Awarding Third-Party Provider Contracts...27 Figure 5.8 States Satisfaction with Existing Credit Card Payment Programs...28 Figure 5.9 States Perceptions of Taxpayer Willingness to Pay Convenience Fees or Transaction Surcharges...28 List of Tables Table 2.1 Growth in Electronic Payment Transactions...7 Table 3.1 Transaction Fees by Payment Channels and Payment Types...10 Table 4.1 Trends in Credit Card Payments of Federal Income Taxes...14 Table 4.2 Credit Card Payment Transactions for State Taxes and Fees...19 Table 5.1 Forms of Electronic Payments Accepted for State Fees...22 Table 5.2 Percent of Tax Payment Dollar Volume by Different Payment Options...23 Table 5.3 Percent of Tax Payment Transactions Made by Different Payment Options...23 Table 5.4 Credit or Debit Card Acceptance by Tax Category...24 Table 5.5 Accepted Methods of Credit Card Payment...24 Table 5.6 Reasons for States Accepting Electronic Payments...25 Table 5.7 Cost Savings Realized from Accepting Credit and Debit Cards, by Tax Type...25 Table 5.8 Breakdown of Net Savings from Credit and Debit Card Acceptance...25 Table 5.9 Reasons for Not Accepting Debit Cards for Payment of Taxes and Fees...25 Table 5.10 Required Initial and Annual Investments in Infrastructure, Marketing, Staffing and Training: Examples from Three States...27 Table 5.11 States Use of Convenience Fees or Transaction Surcharges...28 Table 5.12 States Use of Third-Party Provider by Tax Type...28 Table 5.13 Proposed Changes to Credit and Debit Card Policies or Procedures...29 iv The Council of State Governments Financial Services Working Group

7 Executive Summary Rapidly expanding proportions of retail- and business-related payments, traditionally made by cash and check, are now being made electronically through Automated Clearing House (ACH) or using credit or debit cards. Increasingly, the shift to electronic payments is also occurring in the public sector. In fact, the economy-wide shift towards electronic payments continues to gain momentum. In December 2003, the Federal Reserve announced that e-payment transactions had, for the first time, exceeded the number of check payments (NECCC 2005). For the year 2003, e-payment transactions (credit cards, debit cards, and ACH transactions) totaled 44.5 billion, compared to 36.7 billion check transactions. In 2000, research by the Federal Reserve showed check payments exceeding electronic transactions by 42 billion to 31 billion. This change represents an average annual growth rate for electronic payments of 13.2% from 2000 to For the same time period, the use of checks for non-cash payments declined by 4.3% annually. Also, according to statistics published by the National Automated Clearing House Association (NACHA 2005), the distribution of payment transactions in the U.S. has shifted over the past 20 years, from 96% checks and 4% electronic to 49% check and 51% electronic. Electronic payments through ACH increased 14.5% from 2005 to 2006 to slightly under 16 billion transactions. Given these national trends, the principal purpose of this study was to determine current state government acceptance and use of electronic tax and fee payments. Related purposes included an analysis of policies and procedures implemented by the states to more effectively facilitate and manage electronic payment processes. Among such policies are alternative ways of financing transactions fees associated with electronic payments and policies designed to encourage electronic tax and fee payments. Such information is useful to state policy makers who might be considering changes in their states policy regarding the acceptance of electronic payments and/or initiating new programs and activities to encourage greater use of electronic payment processes and mechanisms. Among the findings of this study were first that citizens will take advantage of electronic payment options if state government agencies accept electronic payments and establish policies and procedures which encourage and facilitate such payments. Citizens appreciate the convenience, flexibility (including credit card payments to meet timelines of tax payments), security, and efficiency of these payment options. Second, there are major financial management benefits for states associated with accepting electronic payments including reducing processing costs, accelerating funds availability and reducing delinquent payments. Third, a potential barrier to expansion of electronic payments is managing the transactions costs associated with such payments. Currently, states have two principal options for addressing the issue of transaction fees including direct state payment for such fees or passing the fees to taxpayers via a convenience fee or surcharge (directly or through a third party). In addressing this issue, states may make the distinction between required payments such as taxes and payments for services. Be- Results of a 50-state survey suggest that states are becoming increasingly supportive of the use of electronic media for the receipt of payments from citizens. Acceptance and Use of Electronic Payments for State Taxes and Fees 1

8 cause states are typically required to collect 100% of the taxes owed, electronic transactions fees may have to be paid by the taxpayer while fees for services (such as licenses and registrations of various types) may be absorbed by the respective state agency. Innovative approaches to dealing with this important issue are summarized in this report. Following a review of previous federal, state and local government studies of electronic tax and fee payments, the research team administered a 50 state study of current state policies and practices regarding electronic tax and fee payments with the support and assistance of CSG staff and an advisory committee. Among the findings of the survey, responded to by 37 states, are the following: ß ACH was the most commonly used electronic payment option for business-related taxes while credit cards were the most commonly used electronic means for individual income tax payments as well as licenses or permits. ß Of the responding states, 95% indicated that they provided citizens the option of paying some form of state taxes or fees with a credit card while 54% permitted debit card payments. ß The major reasons cited for accepting electronic payments were to expedite fund deposits and to reduce the time it takes for funds to be available, and to reduce the costs of collecting and processing payments. ß Cost savings were identified as the major reason for accepting payment by credit or debit cards although estimated cost savings varied considerably among the states that responded to this inquiry. ß Issues surrounding the payment of transactions fees were one of the major challenges to accepting or expanding the use of electronic payments. ß The study indicated a high degree of satisfaction with electronic payments by the states responding to this study. These and other results of this study are summarized in the various sections of this report. It appears that states, like private businesses are becoming increasingly supportive of the use of electronic media for the receipt of payments from citizens. This trend is supported by citizens as well as state governments as they improve the efficiency of the collection and accountability associated with the various sources of state revenues. 2 The Council of State Governments Financial Services Working Group

9 Chapter 1 Introduction and Overview As states face what Osborne and Hutchinson (2004) call a permanent fiscal crisis, cash-strapped state governments are focusing on becoming more and more aggressive in searching for ways to maximize revenues without raising taxes. One way to maximize net revenues is to enhance the efficiency of tax and revenue collection. Such efficiency can be enhanced by reducing the cost of collecting and processing payments and/or ensuring that all revenues are collected. Revenues can also be enhanced by processing funds into interest-bearing accounts sooner to maximize investment revenue. Many government organizations are attempting to meet these financial management goals by taking advantage of the digital revolution, moving away from traditional collections and processing structures based on cash and check payments toward electronic-based payments using such means as ACH, credit cards and debit cards. Over the past decade or so, many government agencies have allowed businesses and individuals to pay their taxes and government fees electronically using ACH. Today, many states are providing taxpayers with expanded options for paying for government services, taxes and fees using credit or debit cards as well as other electronic means. For decades citizens have been using cash and checks to pay taxes and user fees or to reimburse states for services. More recently, as credit card acceptance has become virtually universal as a payment method within the private sector, state and local governments have also begun to accept credit card payments for services, taxes, and fees. Both governments and citizens have encouraged policy changes that permit greater acceptance of credit card payments by government agencies and encourage the use of credit cards by citizens for tax and fee payments. Studies suggest that citizens and businesses realize the benefits associated with electronic payments for products and services including the convenience and safety of such transactions. At the same time, governments, like businesses, are beginning to perceive the benefits associated with receiving revenues electronically. Such benefits include: (1) reduced transaction processing costs, (2) more immediate receipt and recording of revenue receipts, and (3) greater transparency and enhanced payment trails which can facilitate auditing and payment verification. 1.1 Research Objective There is little empirical evidence, other than anecdotal comments and suggestions, of the benefits that governments actually realize from accepting electronic tax and fee payments. As a result, states are making policy decisions to accept or encourage expansion of electronic tax payments (particularly taxpayer credit card payments) without the benefit of broad-based information about state experiences with credit cards and other forms of electronic payments. Therefore, the purpose of this research was to examine the use of electronic payments particularly credit and debit cards for the payment of state taxes and fees and to obtain evidence regarding the advantages and disadvantages of electronic payments. Specifically, the goal was to assess current and future state policies and practices regarding As credit card acceptance has become virtually universal as a payment method within the private sector, state and local governments have also begun to accept credit card payments for services, taxes and fees. Acceptance and Use of Electronic Payments for State Taxes and Fees 3

10 the use of electronic payments for state taxes and fees, along with financial implications for states of accepting electronic payment. The five key issues or questions addressed in this study regarding government acceptance of credit card payment for taxes and fees were: 1. How extensive is the acceptance of credit card payment for taxes and fees? 2. What taxes or fees can be (and are) paid by credit card? 3. Why should government agencies allow payment of taxes and fees by credit card? 4. Who pays the transaction fees associated with credit card payments and how are they paid? 5. What actions are required for state agencies to accept credit card payments. 1.2 Research Approach To answer the five questions discussed above, a twophased research approach was utilized. The first phase, completed in November 2006, involved identifying and analyzing previous studies regarding electronic payments for taxes and fees to determine trends in electronic payment acceptance, use, policies, and practices. The second phase involved conducting a survey of the 50 states to: 1. Determine acceptance of electronic payments; 2. Determine current policies and procedures; 3. Estimate financial implications of electronic payments; 4. Determine best practices regarding e-payments; and 5. Determine policy changes that might enhance use of electronic payments The survey was initiated in October 2006 and the analysis of survey data and compilation of survey findings were completed in March Thirty-seven states responded to the survey for a response rate of 74%. 1.3 Report Structure This report is structured to address the study s five key research questions in the following manner. Chapter 2 provides an overview and background of payment instruments available to consumers for reimbursements for private goods and services. It provides a discussion of the different payment options, paying particular attention to different forms of non-cash payment options. This is followed by a review of the growth trends in electronic payments. Chapter 3 shifts away from the consumer market to discuss payment instruments available to citizens and taxpayers for reimbursing government agencies for government services. Chapter 4 reviews the existing literature regarding electronic payment of government taxes and fees, and discusses their findings in terms of the extent of acceptance and use of credit card payments, benefits to be realized by government agencies from accepting credit card payments, transaction costs associated with credit card payments, and challenges to state governments in accepting credit card payments. Preliminary findings from the existing literature are then strengthened by the findings of the national state taxes and fees electronic payment survey. This national survey is discussed in Chapter 5 and key findings are highlighted in this chapter. Chapter 6 concludes the report with a summary of the study s findings. 4 The Council of State Governments Financial Services Working Group

11 Chapter 2 Evolution of Payments and Growth in E-payments In the non-barter world, cash was the dominant form of payment for goods and services up to the middle of the 20 th century. Paper checks then entered the payment landscape and became dominant in the 1960s. 2.1 Evolution of Payments Beginning in the 1950s, credit cards became more and more accepted as a payment media, particularly for personal travel. The Automated Clearing House (ACH) joined the mainstream payment system in the 1970s. The ACH network developed in response to the rapid growth of check payments, and was perceived to be an efficient, electronic alternative to checks. The use of debit cards began in the 1980s and has recently gained popularity. The most recent electronic payment option is the electronic check or e-check, an ACH payment option that is used for consumer payments. 2.2 Growth in E-payments As noted, many payments traditionally made by cash and check are now being made electronically through ACH or by using credit or debit cards. Between 2000 and 2003, the use of checks for non-cash payments declined by 4.3% annually, while ACH, debit card and credit card transactions exhibited average annual increases of 13.4%, 23.5%, and 6.7%, respectively (Gerdes et al. 2005). A summary of electronic payment transactions for 2000 and 2003 are shown in Table 2.1. According to statistics published by the National Automated Clearing House Association (NACHA), the distribution of payment transactions in the U.S. has shifted over the past 20 years, from 96% checks and 4% electronic to 49% check and 51% electronic. As a general proposition, this evolution from traditional methods to electronic alternatives has been mirrored in the public sector. However there is still plenty of room for continued movement away from paper and towards alternatives (NECCC 2005, p. 1). The migration towards electronic payments continues to gain momentum in the U.S. In December 2003, the Federal Reserve announced that e-payment transactions had, for the first time, exceeded the number of check payments (NECCC 2005). For the year 2003, e- payment transactions (credit cards, debit cards, and ACH transactions) totaled 44.5 billion, compared to 36.7 billion check transactions. In 2000, similar research by the Federal Reserve showed check payments exceeding electronic transactions by 42 billion to 31 billion. This change represents an average annual growth rate for electronic payments of 13.2% from 2000 to 2003, and a corresponding average annual decline in check payments of 4.3%. The 44 billion electronic payment transactions in 2003 had a dollar value of $27 trillion, and included consumer, busi- The distribution of payment transactions in the U.S. has shifted over the past 20 years, from 96% checks and 4% electronic to 49% check and 51% electronic. National Automated Clearing House Association (NACHA) Acceptance and Use of Electronic Payments for State Taxes and Fees 5

12 Source: CPSS (2006), Table 7 (p. 157). ness, and government-initiated electronic payments. Figures 2.1 and 2.2 show the trends in credit and debit card use over the past 5 years. Figure 2.1 summarizes the number of transactions by credit and debit cards from 2001 through Figure 2.2 summarizes the total value of credit and debit card transactions for the same period. Combined, they show that while almost equal numbers of card transactions take place for credit and debit cards, the total payment value for cred- Figure 2.1 Number of Credit and Debit Card Transactions in the U.S. (in millions), ,000 20,000 15,000 10,000 5,000 0 $2,000 $1,800 $1,600 $1,400 $1,200 $1,000 $800 $600 $400 $200 $ Debit card Credit Card Figure 2.2 Dollar Value of Credit and Debit Card Transactions in the U.S. (in $ billions), Source: CPSS (2006), Table 8 (p. 158). Debit card Credit Card it card transactions were between two- and three-times higher than the value for debit card transactions. 2.3 Non-cash Payment Instruments Until the emergence of electronic payments, cash payments accounted for most small transactions and checks were used for larger value items and were the dominant method for non-cash transactions. However, the use of paper checks is increasingly being replaced by electronic payment media, made possible by the development of the Automated Clearing House (ACH) and e-check, and credit and debit card payment networks. The various non-cash payment instruments and trends in their use are briefly discussed next. Paper Checks. Paper checks are the most frequently used non-cash payment instrument in the U.S., with an estimated 42.5 billion checks (valued at $39.3 trillion) written during However, the number of check payments and the number of check payments as a share of non-cash payments have declined over time, with data indicating a decline in check payments since 1995 (Gerdes & Walton 2002). Over the past decade, private and public sector efforts to shift away from paper check payments to electronic media, such as ACH and credit or debit cards, appear to be gaining ground. The expansion of online point-of-sale terminals and the widespread acceptance of debit and credit cards at retail establishments have presented consumers with significant payment alternatives to traditional paper checks. The use of checks was further decreased by the Debt Collection Improvement Act of 1996 which mandated that most federal government payments be made electronically starting in As a result, the U.S. federal government made 262 million check payments in 2000, a 40% decline in check volume from the 436 million checks the government wrote in 1996 (CPSS 2003). Automatic Clearing House (ACH). The ACH network is a processing and delivery system that provides for the distribution and settlement of electronic credits and debits among financial institutions. It is a batch processing, store-and-forward system with transactions received by the financial institutions during the day being stored and processed later in a batch mode. ACH transactions are a common form of electronic funds transfer used to make both recurring and nonrecurring payments. Depository institutions originated 6.8 billion ACH transactions during 2000 for themselves and their customers, twice as many as were initiated during 1995 (CPSS 2003). ACH has typically been used for payroll direct deposits, government benefit payments, corporate payments to contractors and vendors, mortgage and loan payments, insurance premium payments, corporate cash concentration transactions, and payments to and from the state or federal government. Pricing for ACH transactions is typically negotiated between the originator and the originating financial 6 The Council of State Governments Financial Services Working Group

13 Table 2.1 Growth in Electronic Payment Transactions Number of Value of Average Number of Value of Average payments payments value payments payments value Type of payment (billions) (trillions) of payment (billions) (trillions) of payment ACH 6.1 $18.2 $2, $24.6 $2,766 Debit card 8.3 $0.3 $ $0.6 $40 Credit card 15.6 $1.3 $ $1.7 $89 Source: Gerdes et al. (2005) from the 2001 and 2004 electronic payment surveys (Dove Consulting 2004). institution. Individual transaction origination and receipt fees can vary from $0.029 to $0.10, depending on volume and compensating balances (NECCC 2005). While the costs of ACH payments compare favorably with credit and debit cards and checks, ACH does not afford citizens and consumers the same protection from fraud as are afforded credit card users. Total ACH consumer debit volume (both commercial and government) increased by 53% between 2000 (2.7 billion transaction) and 2003 (4.2 billion). This growth rate is slightly higher than the overall 45% growth rate for ACH volume (6.9 billion in 2000 and 10.0 billion in 2003), and also represents just under half of the total ACH transaction volume increase (Nelson 2004). NA- CHA recently announced, in its Payments 2007 conference, that 16.0 billion ACH payments were made in the U.S. in 2006, representing a 14.5% increase from 14.0 billion payment transactions in Electronic Check (e-check). More recently, electronic checks (e-checks) have become a popular ACH transaction. An e-check is an electronic debit to a checking account that can be initiated at the point-ofsale, on the internet, over the telephone, or via a bill remittance sent through the mail. An e-check is processed using the ACH network. If payment has been negotiated (i.e. the check is presented for payment), the process of changing the paper check document into an electronic transaction is referred to as truncation. Otherwise, the electronic transaction is referred to as check conversion. Check truncation is covered by check law while check conversion is covered by Regulation E, which was issued by the Federal Reserve as part of the Electronic Funds Transfer Act and contains more explicit consumer protection that is stronger than the check law (NECCC 2002). ACH operating rules limit e-check transactions only to consumer payments. Between 2000 and 2003, e-check transactions account for nearly all the growth in ACH consumer debit volume. The cumulative 1.9 billion consumer debit transaction increase from 2000 to 2003 is more than accounted for by the 2.0 billion e-check transactions over that period (Grant 2004). Credit Cards. The credit card industry began in 1914, when Western Union, department stores, oil companies and hotels began offering cards for customers to pay for their services. Since then, the industry has grown rapidly, and consumers today can pay for a wide range of goods and services, from major purchases like cars and appliances to everyday requirements like food and gasoline. Originally, credit cards were used by consumers to spread payments on large ticket items. In the mid 1990s, however, the pattern of credit card use has changed such that credit and debit cards are used for all types of purchases. This accelerated use of credit and debit cards can also be attributed to the rise in mail order and internet purchasing. Credit cards are the most frequently used electronic payment instrument in the U.S. They combine a pay- Figure 2.3 Number of Credit and Debit Cards in the U.S. (in millions), ,400 1,200 1, Source: CPSS (2006), Table 6 (p. 156). Debit card Credit Card Acceptance and Use of Electronic Payments for State Taxes and Fees 7

14 ment instrument with a credit arrangement. Bank credit cards are generally issued by a bank under a license from a national organization, such as Visa or MasterCard, and typically involve a revolving credit agreement. In addition to bank-issued cards, other credit cards are issued directly to businesses and consumers such as Discover Card, American Express, and limited-use proprietary cards (e.g. those issued by retail stores and oil companies). A 1998 survey of consumers indicated that 68% of U.S. households had at least one general purpose credit card, a 21% increase since In 1998, limited-use cards issued by retail stores and oil companies were held by 50% of U.S. households compared to only 19% of U.S. households in 1989 (CPSS 2003). Debit Card. Debit cards are also known as check cards. They look like credit cards or automated teller machine (ATM) cards, but operate like cash or personal check. Debit card transactions involve the transfer of funds from a cardholder s transactions account (typically a checking account) at an issuing bank. There were 9.5 billion debit card transactions processed during 2000, valued at $419 billion. Cardholders authorize debit card transactions either by entering a personal identification number (PIN) directly into a merchant s online terminal or by a written signature. An estimated 2.8 million online debit terminals were available at U.S. retail locations in 2000 and involving approximately 4 billion PIN-based transactions and 5.5 billion signature-based transactions (CPSS 2003). Unlike a credit card, funds are withdrawn directly from the purchaser s checking or savings account at a bank when a debit card is used. While a credit card is a way to pay later a debit card is a way to pay now. Because debit card transactions are directly subtracted from the consumer s related bank account, debit card transactions are limited to the amount in the bank account. Figure 2.3 summarizes the total number of debit and credit cards held by consumers in the U.S. from 2001 through This chart shows that the number of credit cards has reached a plateau at just under 1.3 billion. The number of debit cards has seen steady growth over the past five years, but the total amount still comprises less than a quarter of the number of credit cards. 8 The Council of State Governments Financial Services Working Group

15 Chapter 3 Electronic Payment of Government Taxes and Fees Electronic payments offer government agencies the opportunity to automate accounting, banking and reconciliation functions and processes. Electronic payments can also speed up the receipt of tax and fee payments from citizens and taxpayers. 3.1 Benefits and Costs to State Governments of Accepting Electronic Payments Citizens have, for decades, been using cash and check to pay taxes and registration fees and to reimburse states for services. Meanwhile, ACH transactions have primarily been used for payment of state taxes and fees, especially large payment amounts made by corporations and other major employers. Credit and debit cards, while being a payment option for some government agencies, are still not as prevalently accepted as other payment media. Electronic payments for government taxes and fees whether in the form of ACH, credit card, or debit card offer many benefits to government agencies and citizens. These include: ß Reduced processing costs associated with cash and check payments; ß Reduced transaction processing time and costs; ß Improved payment verification and auditing through real-time authorization and verification; ß Reduced accounts receivables and payment delinquencies, and fewer need for debt collection activities; ß Improved fund availability by reducing check float and enhancing cash flow; ß Added convenience for citizens. Beyond these benefits, electronic payments offer government agencies the opportunity to automate accounting, banking and reconciliation functions and processes. Electronic payments can also speed up the receipt of tax and fee payments from citizens and taxpayers. While electronic payments provide several benefits and cost savings, the acceptance of electronic payments also involves several costs. If decisions are made to accept electronic payment, policies must be established to address how and by whom such costs will be covered. The costs associated with electronic payments include: ß Equipment expenses including specialized software, keypads, computers, etc.; ß Administrative expenses including employee training, process streamlining, and marketing activities and user education programs; and ß Social costs associated with electronic payment media such as lack of access to electronic payment options by certain categories of citizens or misuse of electronic payment options such as increased debt burden due to increased use of credit cards. The costs associated with electronic payments vary both according to the type of payment media and the Electronic payments for government taxes and fees offer reduced processing costs for government agencies and added convenience for citizens. Acceptance and Use of Electronic Payments for State Taxes and Fees 9

16 payment channel. These payment channels are: ß Point-of-sale. Point-of-sale systems allow the public to pay for government services with debit cards and credit cards, checks and cash over the counter at walk-in service centers. It provides citizens with a cost-effective and convenient way of paying for government services while allowing for quick and efficient updates to payment records. For credit card transactions, the point-ofsale is a location where the credit card payment is performed with the cardholder present. The credit card is read magnetically, and the cardholder s signature is generally obtained as insurance against the transaction. This is the most secure form of credit card payment. ß Pay by Telephone. Interactive voice response (IVR) is a telephony technology in which consumers use a touch-tone telephone to interact with a database to acquire information from or enter data into the database. IVR or pay-by-phone systems eliminate the inconvenience and costs associated with postage and check-writing. Studies have shown that electronic bill payment reduces these costs by 60% by eliminating the cost of stamps and paper checks and by reducing consumers exposure to late fees and bounced checks (NECCC 2005). The costs associated with a pay-by-phone system will depend on the hardware and software needed to implement the system. ß Pay by Internet. Internet payment systems allow government agencies to accept electronic payment via the web. An internet payment system reduces the costs associated with traditional (and often inefficient) paper-based payment methods, and allows citizens to pay taxes and fees when and where it is convenient for them. This significantly improves access to government services and increases the potential for on-time payments and fewer delinquent payments. The many costs associated with developing and maintaining an internet payment system include software, hardware, licenses, and maintenance costs. Acceptance of electronic payments through the different payment channels offers a variety of benefits to government agencies and citizens. The combinations of electronic payments and payment channels have different costs associated with them and some types of electronic payments are even limited to certain payment channels. Table 3.1 provides a matrix of payment channels and payment types and describes the level of transaction fees that are faced by the government agency for each combination of payment type and payment channel. 3.2 Credit Card Payments for Government Services While credit and debit card acceptance as a payment method has become virtually universal within the private sector, credit card use for payment for government services has lagged behind credit card usage in the consumer market. To allow government agencies to benefit from the cost advantages of electronic payments and to permit citizens to realize the benefits of credit card payments, government leaders and citizens have encouraged policy changes that permit greater acceptance of credit card payments by government agencies and encourage greater use of credit cards by citizens to pay their taxes and fees. The system or structure for credit or debit card payment of government taxes and fees are not very different from that of the private sector. Government agencies have two primary options for accepting credit card payments, as shown in Figure 3.1. The primary difference between the two systems is the use of a financial intermediary a third party service provider that can perform multiple functions for the government agency, including accepting and processing the credit card transaction. In the first option (top panel of Figure 3.1) the credit card transaction begins with payment accepted directly by the government agency. The bank issuing the credit card transfers funds to the Table 3.1 Transaction Fees by Payment Channels and Payment Types Transaction fees Payment Channels charged to Type of payment government agency Point-of-sale Telephone Internet Cash or check None Credit card High Signature debit card High to Moderate PINless debit card 2 Moderate Varies PIN-based debit card Low ACH Low Source: National Electronic Commerce Coordinating Council s E-Payments Primer (NECCC 2005). 10 The Council of State Governments Financial Services Working Group

17 government agency s processing bank. Subsequently, funds are deposited into the government agency s account. Note that the issuing bank must transfer payment to the processing bank prior to collecting payment from the taxpayer. In this first option, the government agency is typically responsible for the fees associated with the credit card transaction. The same process is mirrored in the second option (bottom panel of Figure 3.1). However, depending on the functions undertaken by the third party service provider, the payment for government services can be made either to the government agency or to the third party service provider. In addition to possibly accepting the credit card payment, the third party service provider also replaces the functions of the processing bank. Government agencies have two primary options for accepting credit card payments, as shown in Figure 3.1. The primary difference between the two systems is the use of a financial intermediary a third party service provider that can perform multiple functions for the government agency, including accepting and processing the credit card transaction. In the first option (top panel of Figure 3.1) the credit card transaction begins with payment accepted directly by the government agency. The taxpayer transfers funds to the bank issuer of his/her credit card, which in turn transfers the funds to the government agency s processing bank. Once the payment is settled, funds are deposited into the government agency s account. In this situation, the government agency is typically responsible for the fees associated with the credit card transaction. The same process is mirrored in the second option (bottom panel of Figure 3.1). However, depending on the functions undertaken by the third party service provider, the payment for government services can be made either to the government agency or to the third party service provider. In addition to possibly accepting the credit card payment, the third party service provider also replaces the functions of the processing bank. Benefits of Accepting Credit and Debit Card Payments for Government Taxes and Fees Many of the benefits credit and debit cards offer government agencies are the same as those offered by other electronic payments. However, credit cards offer an additional benefit to citizens and taxpayers in the form of short-term credit. This credit option offers additional taxpayer relief by providing the opportunity Figure 3.1 Two Primary Credit Card Payment Systems for Government Agencies Credit Card Issuing Bank Processing Bank Citizen/Taxpayer Transaction Government Agency Credit Card Issuing Bank Third-Party Service Provider Citizen/Taxpayer Transaction Government Agency Source: Developed by the research team. Acceptance and Use of Electronic Payments for State Taxes and Fees 11

18 for payment spreading and cash flow management for those who may otherwise face difficulties in paying large tax or fee payments at a particular point of time but who could otherwise manage payments spread over time. Debit cards also offer further advantages over credit cards. Because anyone with a checking account can obtain a debit card, accepting debit cards as a payment option serves a larger pool of potential users. In addition, canceling services or returning goods paid for with a debit card is typically treated as if they were made with cash or check, allowing for a less complicated and less costly return or cancellation process. Challenges to Accepting Credit and Debit Card Payments for Government Taxes and Fees However, accepting credit and debit card payments also poses several challenges to government agencies. These include legal and legislative challenges, cost challenges and technology challenges. From a legal or legislative perspective, issues that affect the acceptance of credit and debit card payments include: ß Credit and debit card transactions impose certain costs (transaction fees), which may conflict with legislation requiring that government agencies collect 100% of the amount due; ß Credit card transactions may violate public funds handling laws; and ß Legislative issues regarding protection of financial data from public records laws and technology issues related to data and information security need to be addressed. The primary costs associated with credit and debit card payments are the start-up costs (initial equipment, training, marketing and education) and the recurring per transaction fees. The fees paid by government agencies for credit card processing are determined by their contractual relationship with their bank and/or service provider, and are based on a number of factors, including total and average volume, total and average dollar amount, association fees, processor fees, card types, and processing timeframe. States have used two principal ways to pay for such fees associated with credit and debit card transactions including the use of surcharges and convenience fees. Transaction Surcharge. A transaction surcharge is an additional charge that is added to the transaction amount by the merchant if the customer chooses to pay by card, either credit or debit. The surcharge tends to be a fixed amount but varies with the transaction amount. Use of surcharges is strictly prohibited by Visa, Master- Card and Discover. However, a very small number of merchants were grandfathered by the debit networks to surcharge on PIN debit transactions (Webster 2005). Convenience Fees. A convenience fee is an additional charge that is added to the transaction amount by the merchant if the customer chooses to pay the merchant in a non-traditional environment, such as via a website or an interactive voice response (IVR) telephony system. The convenience fee amount can take the form of a flat fee or a percentage-based fee, but the type of fee varies widely across government entities and third party service providers. American Express allows convenience fees if the transaction is related to: (1) federal, state, provincial or municipal government mandatory revenue payments; (2) public utility payments; and/or (3) mandatory fees at public higher education institutions. Furthermore, under the American Express convenience fee policy, convenience fees (1) can only be charged when the payment is made through a more convenient payment method; and (2) cannot be higher than the fees imposed on other payment instruments. For Visa and MasterCard, the convenience fee must be applied equally to all payment types offered through the same environment. However, Visa also states that the convenience fee cannot be charged for over-the-counter or face-to-face transactions. The merchant must also state up-front that a convenience fee will be charged to the cardholder, specify the fee amount, and allow the cardholder to either decline or proceed with the transaction and the assessed fee. 12 The Council of State Governments Financial Services Working Group

19 Chapter 4 Findings of Previous Studies on Government Tax and Fee Electronic Payments The analysis included in this chapter is based on five major studies and research efforts. These other studies include an assessment of the acceptance of credit card payment by a federal agency, a survey of state and local government agencies, a survey by the Federation of Tax Administrators (FTA), and a public opinion survey regarding internet-based government services. While some studies have examined the acceptance and management of electronic tax and fee payments, there have been limited empirical studies that focused on the broader issues relevant to state governments accepting electronic payments for state taxes and fees. Combined, however, information from existing studies can be used to develop preliminary answers to the following research questions: 1. How extensive is the acceptance of credit card payment for taxes and fees? 2. What taxes or fees can be (and are) paid by credit card? 3. Why should government agencies allow payment of taxes and fees by credit card? 4. Who pays the transaction fees associated with credit card payments? How are they paid? 5. What is required for state agencies to accept credit card payments? 4.1 Overview of Previous Studies The analysis included in this chapter is based on five major studies and research efforts. These other studies include an assessment of the acceptance of credit card payment by a federal agency, a survey of state and local government agencies, a survey by the Federation of Tax Administrators (FTA), and a public opinion survey regarding internet-based government services. These are discussed below. Credit Card Survey of State and Local Government Acceptance by the District of Columbia Treasurer s Office and the Office of the City Administrator. In 1991, staff from the District of Columbia Treasurer s Office and the Office of the City Administrator contacted treasury and finance officials in the 20 largest U.S. cities, the 17 jurisdictions making up the Washington metropolitan area, and the seven states known to accept credit cards. Altogether, 45 state and local governments were surveyed, along with 23 federal-level government agencies (Kuhn 1992). The purpose of this survey was to determine the prevalence of credit card payment acceptance among state and local governments. One reason driving government acceptance of tax and fee payments by credit card is citizen preference for credit card payment. Acceptance and Use of Electronic Payments for State Taxes and Fees 13

20 Table 4.1 Trends in Credit Card Payments of Federal Income Taxes Dollar volume of Number of payment transactions Average Year payment transactions ($ in million) transaction value ($) ,300 $184 $3, , , , , , , , ,569 Source: Mitchell (2004) from IRS data. Case Study of the U.S. Postal Service (USPS) Acceptance of Credit and Debit Cards for Payment of Postal Services (GAO 1994, Green 1997, Beyer 1999). The USPS first began accepting credit card payments at some post offices in In 1991, then Postmaster General Anthony Frank established a task force to make recommendations on the future direction of credit card acceptance. The task force arranged for Arthur D. Little to undertake a feasibility study in 1991 of the extent of market demand for credit and debit cards at postal retail windows and vending machines. Postmaster General Marvin Runyon then decided in 1992 that USPS should begin accepting credit and debit cards and soon as possible. Implementation of the credit card acceptance program, to be launched in three phases, began in June 1993 with 550 pilot test sites. The only restriction on credit card acceptance was that money orders and collect-on-delivery services could not be paid for via credit card. Later, the USPS added the policy that credit cards could not be used for payment of bulk mailings. Texas Electronic Government Survey (Strover & Straubhaar 2000a, 2000b). The Texas Electronic Government Survey is a public opinion survey to assess a variety of issues related to public access necessary to use e-government service. Research addressed specific questions: (1) Would people use government services if they were available on the internet? How much would they pay? (2) What are the privacy and security concerns of Texans with respect to e-government application? (3) What are citizen opinions with respect to financially supporting e-government services? Federation of Tax Administrators (FTA) Credit Card Survey (FTA 2003). A survey conducted by the FTA in 2003 on how states use credit cards to facilitate the payment of taxes or fees. Thirty-three states (including the District of Columbia and New York City) responded to the survey. The survey also focused on the use of debit card and e-check for payment of taxes or fees. The survey examined issues such as: (1) acceptance of credit card, debit card or e-check for tax or fee payment, (2) types of taxes or fees that can be paid by credit card, debit card or e-check, (3) transaction volume, (4) payment of the merchant discount fee, (5) satisfaction with electronic payment processing programs, and (6) proposed changes to these programs. While these studies may be somewhat dated mostly from the mid-1990s and early 2000s the information they provide remain useful as starting points for the current investigation into policies and practices regarding state government acceptance of electronic payments for taxes and fees. The studies findings may no longer be current or relevant in today s environment, but they do provide interesting insights into how government agencies have dealt with the issues and challenges of accepting electronic payments. 4.2 How Extensive is the Acceptance and Use of Credit Card Payment for Taxes and Fees? Acceptance of Credit Card Payment for Taxes and Fees. There is evidence, as far back as the early 1990s, that federal, state, and local government agencies have been accepting credit card payments for taxes and fees. In the 1991 survey by the District of Columbia government, 65% of the government organizations surveyed accepted credit card payments, with another 20% having recently issued RFPs for credit card programs or conducting feasibility studies (Kuhn 1992). In addition, a Public Investor survey conducted in 1993 found that 30% of state and local governments in the U.S. accepted credit card payment for user fees, parking tickets, utility bills and taxes (Michel & Carter 1996). Mitchell (2004) cites a 2003 survey of 419 counties by the National Association of Counties which found that 28% and 29% of respondents indicated that their agencies had enabled residents to pay taxes and fees with credit cards on-line and over the telephone, respectively. This represented an increase from 18% and 26% of respondents the previous year. A 2003 survey by the National Center for State Courts (NCSC) of 84 courts in 30 states found that 77% of the responding courts accepted credit card payments. Most of these courts had begun accepting credit card payments within the previous five years. Of the state revenue agencies responding to the 2003 FTA survey, all but one had the necessary legal authority to accept credit cards for payment of taxes or other fees. Results of this survey showed that 91% (30 out of 33) of the responding states had programs in place to accept credit card payments. They further found that most states were planning to expand their electronic payment programs. These included adding more payment types via the Internet, expanding the program to include more types of taxes or fees, and adding direct debit or e-check capabilities. 14 The Council of State Governments Financial Services Working Group