How Pending State Legislation on Interchange Fees Threatens Digital Payments Nationwide

In a Nutshell: Merchant-acquiring banks pay interchange fees to credit card issuers to fund payment network operations and innovations. New research from Julian Morris, Senior Scholar at the International Center for Law and Economics, shows how pending legislation in Illinois to exempt sales taxes and tips from interchange fees threatens the incentives consumers and merchants have to use and accept cards. As a 2025 court battle looms and other states contemplate taking similar action, Morris argues that allowing legislators rather than the market to regulate interchange fees will add costs, increase administrative burden, and ultimately reduce participation in the digital payment system.

People tend not to concern themselves with how things work until something goes wrong. But we think you need to make an exception in this case and learn how credit card interchange fees make the convenience of card payments possible.

That’s because legislation passed in Illinois in June 2024 — the Interchange Fee Prohibition Act (IFPA) — threatens the delicate market balance between card-issuing banks and the merchant-acquiring banks that accept payments from them, according to Julian Morris, Senior Scholar at the International Center for Law and Economics (ICLE).

The Center is a nonprofit, nonpartisan global research and policy center with a mission to promote the use of law and economics methodologies to inform public policy debates. The Interchange Fee Prohibition Act prohibits card-issuing banks from retaining interchange fees on sales taxes and tips. It will go into effect on July 1, 2025, if it survives a pending battle in the U.S. District Court for the Northern District of Illinois.

In his white paper, “State Regulation of Interchange Fees,” Morris argues the law should not survive. Not only is it unconstitutional, he argues, but it would also place unprecedented administrative burdens and extra costs on issuers and merchants doing business in Illinois, especially smaller businesses, banks, credit unions, and financial technology companies.

The consequences will compound if more states follow the Illinois example and replace market dynamics with what Morris considers arbitrary political judgment — as some are currently considering.

Increased costs will reduce rewards and other consumer benefits from using cards. The resulting decline in card use will reduce overall sales volume and card usage as a percentage of sales, putting a damper on a system that has evolved over decades to incentivize the maximum number of consumers and merchants to participate.

The court will likely rule on the legislation before the close of 2024. No matter how it rules, Morris’s white paper stands as a justification for continued vigilance against antimarket legislative action related to the card payment system.

“Illinois is the first place anywhere in the world to have attempted to impose this carve-out for interchange fees on sales tax and tips,” Morris said. “Why would a state government want to do something that ends up distorting the cost basis for transactions?”

It may come as a surprise to many for whom cash is a relic of the past, but credit cards don’t just materialize out of thin air. Instead, card networks like Visa and Mastercard work with thousands of issuing banks, credit unions, and financial technology companies to innovate and invest in the kind of infrastructure and best practices that have made boundless eCommerce purchasing routine for billions globally.

Indeed, in his white paper, Morris describes the modern payment card system as having “transformed the way we pay for goods and services.”

Answering Morris’s question above requires understanding the regulatory motivations of Illinois and other state governments. And that requires understanding how interchange fees facilitate the innovation we consumers see around us but take for granted every day.

In a standard four-party payment-card network like those operated by Visa and Mastercard, the issuing bank earns compensation when it retains an interchange fee for remitting a consumer payment to a merchant-acquiring bank. The acquirer then charges the merchant a merchant discount fee to earn back that interchange fee and more.

Morris said card issuers and merchant acquirers have each been fighting for a bigger slice of the pie since the modern card payment system emerged in the 1950s and 60s. He suggests that after the legislature capped a sales tax rebate it had previously based on an open-ended percentage, a quid pro quo existed to repay merchants by passing the IFPA.

Morris said it’s not just that states are contemplating regulating interchange fees. It’s how they’re going about it by exempting specific categories of transactions.

“Illinois is basically trying to transfer the merchants’ costs to the issuing banks,” he said. “What happens when you then start messing with that by carving it out? You potentially also cap the amount you can deduct.”

That Illinois and other states even have sales tax rebate programs to compensate merchants for the cost of doing business with the card companies speaks to the level of animus merchants and issuers traditionally hold against each other. It also reveals how politicians involve themselves in people’s business in ways that make them seem like they’re looking out for the little guy.

Justifying the Illinois action, Interchange Fee Prohibition Act supporters argue it’s improper to compel merchants to pay for tax collection. Morris, the International Center for Law and Economics, and others join national and state banking and credit union advocacy groups to counter that the pending legislation violates the National Bank Act and other federal laws designed to protect the financial system.

Beyond that, it’s a substitution of arbitrary political judgment as part of a dealmaking process for the modulation of billions of supply and demand inputs today’s market-based system provides.

It’s known as perfect competition. Card issuers don’t want to preserve the current system because they’re evildoers out to exploit the defenseless. They want the market to remain in control because the continual push and pull of supply and demand naturally creates the most mutually beneficial environment for all stakeholders to thrive.

The market is where investments, incentives, and obligations cohere to create the greatest possible synergy.

That’s because markets like today’s payment system require scale on both sides of the transaction — between merchant-acquired and card issuers, in this case — to sustain themselves and grow. Morris calls them “two-sided markets with cross-side network effects.”

“To grow and maintain a two-sided market, it is often necessary for one side to subsidize the other,” Morris writes. Just as advertisers subsidize content production, which leads to more readers and viewers consuming advertisements, merchants also subsidize issuers for the costs of collections, defaults, fraud monitoring, insurance, and rewards that make cardholding attractive to consumers and easy for merchants to adopt.

A portion of those fees also accrues to the network operators (Visa, Mastercard, etc.) to cover the cost of their enormous networks and innovations such as EMV chips, contactless payments, and the 3DSecure standard.

Taking a portion of those fees away through arbitrary state action substitutes political will for market dynamics and hurts issuers, Morris argues.

“The law imposes costs in quite a concentrated way on credit unions and smaller Illinois-based banks,” Morris said. “They won’t be able to spread the cost over cardholders in multiple states  as national entities will.”

Since its founding in 1973, the International Center for Law and Economics has operated under the belief that “intellectually rigorous, data-driven analysis will lead to efficient policy solutions that promote consumer welfare and global economic growth,” according to the organization’s website.

The Center’s publications and resources cover antitrust and consumer protection, data security and privacy, and financial regulation and corporate governance. They also deal with innovation and the new economy, intellectual property and licensing, and telecommunications and regulated utilities.

Global academic affiliates help ground the next generation of scholars in the essential traditions of law and economics. International Center for Law and Economics events promote information exchange and institutional cooperation.

Morris writes that advocates of the Interchange Fee Prohibition Act assume incorrectly that any fee relief for merchants must translate into savings and is therefore a net benefit. Morris’s white paper argues convincingly that arbitrary interchange reductions through state regulations will depress the market.

Consumer costs will rise as rewards and other benefits wane. Smaller banks and credit cards may not handle the fallout. States will carry a heavier burden to manage the increased complexity.

“Based on my analysis, this is net harmful and would be harmful in other states,” Morris said. “It would also be good more generally because it would set a precedent nationwide that states can’t come and do this really odd carve-out.”

United against the Interchange Fee Prohibition Act’s position are influential legislators, including Dick Durbin, U.S. Senator from Illinois and author of the 2010 Durbin amendment that puts interchange fees for debit cards under federal control. Morris hopes for an outcome that will put the issue in the states to rest once and for all.

“The extent to which the major card networks have been important for the development of commerce in the states is phenomenal,” Morris said. “It’s worrying that the states may undermine it through regulation of interchange fees of this kind.”