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vi CONTENTS
APPENDIX D: MARGINAL EFFICIENCY LOSS
FROM AN INCREASE IN THE SLC 29
NOTES 31
REFERENCES 37
ABOUT THE AUTHOR 41
vii
Foreword
R
egulated industries such as telecommunications,
transportation, and electric power have always had
numerous “cross-subsidies” embedded in their rate
structures. To promote “universal service” or just to sat-
isfy the demands of politically influential consumer groups,
state and federal regulatory agencies have set rates for
some services at levels below the costs of supplying them
and other rates at levels commensurately higher than costs
of supply. As a result, some consumers have paid what
amounts to a tax on their telephone and electricity bills to
finance subsidized service to other consumers. The pat-
tern of cross-subsidies has generally been from business
customers to residential customers and from urban to ru-
ral customers—but the subsidies have often been highly
complex as well as oblique, with numerous exceptions,
anomalies, and departures from the general pattern built
into regulated rate structures.
This “taxation by regulation” has drawn heavy criti-
cism from academic students of regulation. Political sci-
entists have noted that it is a form of public finance
operating outside the usual legislative and executive pro-
cedures of taxing, appropriation, and budgeting—proce-
dures that promote political accountability and restrain
the influence of narrow interest groups in most areas of
government spending. Economists have noted that cross-
subsidies are usually highly inefficient: taxing customers
of a particular service (say, business users of long-distance
viii FOREWORD
telephone service) to fund subsidized service to others pro-
duces far greater economic distortions than if a broad-based
general tax funded the subsidized service.
The academic criticisms have had very little influ-
ence on practical policy; indeed, they have provided a pow-
erful explanation of why cross-subsidies are so pervasive
despite being so wasteful. Precisely because the source of
tax revenues is obscure and “stealthy”—invisibly embed-
ded in the prices large numbers of utility customers pay—
taxation by regulation is an attractive means of subsidizing
politically influential groups—including some customers,
such as the well-to-do who own vacation homes in the coun-
try, who would be unlikely candidates for public largess if
the subsidies were a matter of open legislative debate.
In recent years, however, cross-subsidization has
come under pressure from a different, more powerful
source: technological and economic developments that have
generated new entry and price and service rivalry in regu-
lated markets, thereby undermining the private monopo-
lies and public regulation that had been the source of the
cross-subsidies. In the typical case, new competition has
first emerged in the “taxed” segments of the regulated rate
structure, such as urban and business telephone service
and industrial electric power, which have presented at-
tractive targets for new entrants precisely because of their
artificially high rates. Price competition, with its usual
result of compressing prices to costs of supply, has obliged
regulators and legislators to search for other revenue
sources—such as other regulated services where competi-
tive entry remains difficult—to fund continued below-cost
service to favored customers. Where industries have been
completely deregulated, legislators have occasionally
turned to explicit general taxes to continue subsidizing
those who had benefited from cross-subsidies. The Airline
Deregulation Act of 1979, for example, which entirely abol-
ished federal and state regulation of airline fares, estab-
lished a grant program for “essential air service” to certain
FOREWORD ix
rural communities that is funded by general tax revenues.
The Telecommunications Act of 1996 provides an im-
portant case study in the tensions between deregulation
and “universal service” subsidies. The Telecommunications
Act did not go nearly so far as the Airline Deregulation
Act in lifting government controls from an increasingly
competitive industry. It did, however, relax or remove sev-
eral of those controls, including price controls that had
long been employed to “tax” many telecommunications
services. At the same time, the act instructed the Federal
Communications Commission to continue promoting uni-
versal service—but without access to explicit federal tax
revenues such as those provided by the Airline Deregula-
tion Act.
How, if at all, this circle might be squared is the sub-
ject of the present study by Jerry Hausman of the Massa-
chusetts Institute of Technology. Using economic
techniques he pioneered in other contexts, Professor
Hausman examines one of the FCC’s most striking and
controversial “universal service” policies under the Tele-
communications Act of 1996. This is the so-called e-rate
program, under which certain schools and libraries are
receiving subsidized computer facilities, Internet hookups,
and telecommunications services funded by a special
charge on the long-distance revenues of AT&T, MCI, Sprint,
and other suppliers of long-distance and wireless services.
As one would predict, the commission’s e-rate scheme
abandons the old and now infeasible technique of embed-
ding subsidies within the rate structure and instead makes
the taxes and subsidies explicit. Long-distance carriers,
and through them their customers, are taxed the costs of
the program, and the commission pays out the tax rev-
enues in cash grants to qualifying schools and libraries.
More surprising, perhaps, is that the commission is using
the new subsidies not just to maintain but to expand—
quite substantially—traditional regulatory cross-subsidies.
No one received free or cut-rate computers when FCC rate
regulation was in full flower; now, however, schools and
libraries will spend a large share of e-rate grants (which
analysts project will total several billion dollars annually)
to purchase sophisticated computers and to build or refur-
bish facilities to accommodate them. Yet one critical ele-
ment of the traditional cross-subsidy approach remains:
the program’s revenue source is a usage-sensitive tax on
certain regulated services. The commission selected that
source, of course, not out of considerations of economic ef-
ficiency, political fairness, or legislative logrolling, but sim-
ply because the taxed service falls within its regulatory
jurisdiction. The FCC appears to be transforming itself
from an architect of cross-subsidies and promoter of uni-
versal service within telecommunications markets to a tax
collector for funds to subsidize other markets and purposes.
The e-rate program has been the subject of lively and
sometimes heated controversy since the commission first
imposed the e-rate taxes at the beginning of 1998. Advo-
cates say that the program is essential to ensure that poor
communities and schoolchildren are not left behind on the
“information highway.” Opponents say that schools that
cannot teach their students to read and write should not
be plugging them into the Internet instead—and that
Washington should not, in any event, be determining school
and library spending priorities. Some say that the pro-
gram, regardless of its merits, is unconstitutional because
it establishes, calibrates, and collects taxes—functions the
Constitution vests in Congress.
Professor Hausman’s study focuses on a separate and
more analytically tractable issue, but one that has impor-
tant implications for the broader political debates. He asks
whether the e-rate tax is an efficient tax, in the sense of
raising a sum of public revenue with minimum disruption
to private economic activity. He finds that the tax is
appallingly inefficient, causing more than one dollar of
sheer waste—deadweight economic costs that produce no
benefits for anyone—for every dollar of revenue raised.
x FOREWORD
Tax distortions of that magnitude are exceptionally high
compared with broad-based general taxes and even with
the implicit taxes embodied in traditional regulatory cross-
subsidies. The result leads Professor Hausman to ask
whether the FCC has actually maximized, rather than
minimized, the cost to economic welfare of its e-rate pro-
gram and to suggest several alternatives that, even with-
out resort to general federal tax revenues, would be far
less harmful.
Congress intended the Telecommunications Act of
1996 to reduce regulatory costs and improve consumer
welfare in one of America’s most rapidly growing and so-
cially important industries. Professor Hausman’s study
demonstrates that one critical component of that act is
instead increasing regulatory costs and harming consumer
welfare. No one ever said that the transition from regu-
lated to competitive markets would be easy or free of po-
litical controversy, compromise, and false steps—but the
e-rate tax appears to be a step backward rather than a
partial step forward. One hopes that the FCC and Con-
gress, as well as business executives, professionals, and
academics will pay due attention to this cautionary tale.
C
HRISTOPHER DEMUTH
President
American Enterprise Institute
for Public Policy Research
H
AROLD FURCHTGOTT-ROTH
Commissioner
Federal Communications Commission
FOREWORD xi
JERRY HAUSMAN 1
1
Introduction
1
P
olicy makers have paid increasing attention to tele-
communications as new features such as cellular
telephones and Internet services have become
widely available to businesses and consumers. Rapidly
changing technology has led to these new services along
with the realization that market-based competition may
replace much outdated regulation, which has harmed con-
sumers (see, for example, Hausman 1997). Congress passed
the Telecommunications Act of 1996, the first major change
in telecommunications legislation since 1934, in response
to these changes.
What role does public finance have in the analysis of
telecommunications policy? Telecommunications regula-
tion in the United States is replete with a system of subsi-
dies and taxes, in part because of the dual system of
regulation in which the federal government (through the
Federal Communications Commission) and each state have
regulatory jurisdiction over local telephone companies.
1
Public finance analysis demonstrates how to evaluate the
costs and benefits of tax and subsidy systems.
2
Indeed,
public finance analysis demonstrates how to measure the
distortions to economic efficiency that tax and subsidy
systems create.
3
Furthermore, public finance analysis has
determined rules for optimal taxation that can be applied
to telecommunications regulation.
4
2 TAXATION BY TELECOMMUNICATIONS REGULATION
A potentially important application of public finance
analysis to telecommunications regulation is the financ-
ing by regulation of telephone companies’ fixed and com-
mon costs. The technological characteristics of the local
telecommunications industry with its large fixed costs
generate significant economies of scale and scope. The first-
best prescription of setting price equal to marginal cost
would require government subsidies or would lead to bank-
ruptcy of local telephone companies.
5
The United States
has not used government subsidies; instead, regulators
have set price in excess of marginal cost for some services
to allow regulated telephone companies to cover their fixed
and common costs and to provide a subsidy to basic resi-
dential service. Here Ramsey optimal tax theory, which
explains how taxes on different goods or services cause
different amounts of economic efficiency loss depending
on the elasticity of demand for the good or service being
taxed, would suggest how prices should exceed marginal
costs to minimize the efficiency losses to the economy.
6
While Ramsey theory was devised for the purpose of rais-
ing revenue in just the situation that regulators face, it
has found little acceptance in telephone regulation, per-
haps because most of the tax burden would fall on local
telephone service, which actually receives the highest sub-
sidy of any telephone service. Estimates of the different
relevant elasticities of demand necessary for Ramsey
theory to be applied appear later in this discussion.
Another potential application for public finance analy-
sis in telecommunications regulation, and the main topic
of this volume, is the marginal cost to the economy of the
new congressional legislation that leads to additional taxa-
tion of telecommunications services. Because of budget-
ary spending limits, Congress is increasingly unable to
raise general taxes to pay for social programs.
7
Thus, Con-
gress increasingly funds social programs from taxes on
specific sectors of the economy. Here, I consider the con-
gressional legislation that established a program to pro-
JERRY HAUSMAN 3
vide subsidized Internet services to all schools and librar-
ies in the United States. The cost of the program is cur-
rently estimated to reach $2.25 billion per year in 2007.
8
Instead of increasing general taxes to fund this program,
Congress passed legislation that directed all interstate tele-
phone service providers to pay for the program. Congress
let the FCC determine the appropriate rate of the new
subsidy.
9
In this volume, I calculate the efficiency cost to the
economy of the increased taxation of interstate telephone
services to fund the Internet access discounts to schools
and libraries.
10
I do not attempt to measure the benefits,
but for reasoned policy decisions the cost estimates are
useful.
11
I estimate the cost to the economy of raising the
$2.25 billion per year to be at least $2.36 billion (in addi-
tion to the $2.25 billion of tax revenue) or the efficiency
loss to the economy for every $1 raised to pay for the
Internet access discounts is an additional $1.05 to $1.25
beyond the money raised for the discounts themselves.
12
This cost to the economy is extraordinarily high compared
with other taxes used by the federal government to raise
revenues. Three reasons exist for the high cost to the
economy of this increased tax on interstate long-distance
services: (1) the price elasticity of long-distance services is
relatively high; (2) the taxation of interstate long-distance
services is already quite high; and (3) the price-to-
marginal-cost ratio of long-distance services is high. Thus,
the FCC’s choice of a tax instrument to finance the Internet
discounts imposes extremely high efficiency costs on the
U.S. economy.
Next, I propose an alternative method by which the
FCC could have raised the revenue for the Internet dis-
counts that would have a near zero cost to the economy,
beyond the revenues raised. Econometric research has led
to wide agreement on the relative size of telephone ser-
vice price elasticities, and the FCC could have chosen to
increase taxes already in place, which would have led to
4 TAXATION BY TELECOMMUNICATIONS REGULATION
much lower costs to the economy of funding the Internet
discounts. Indeed, economic theory and public finance
analysis establish the goal of using taxes that minimize
the cost to the economy of raising government revenue.
The FCC, to the contrary, chose the taxation method ap-
plied to interstate telephone service that likely maximizes
the cost to the economy of raising the revenue to provide
the Internet discounts.
Taxpayers can hope that the FCC will begin to take
heed of economic analysis in the future as it continues to
modify the tax and subsidy system for telecommunications.
The Telecommunications Act of 1996 calls for further modi-
fications to regulation in the future. Telecommunications
regulation at the federal level has always recognized the
“public interest standard” as one of the main bases for regu-
lation. The public interest standard should recognize eco-
nomic efficiency as one of its primary goals. Economic
efficiency implies not assessing unnecessary costs on U.S.
consumers and firms. The FCC’s current policies are cost-
ing the U.S. economy billions or tens of billions of dollars
per year. The goal of the Telecommunications Act of 1996
was to decrease these regulatory costs to the United States,
not to increase them as the FCC has done in its imple-
mentation of provisions of the 1996 act.