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Capitol Comment 288 – Universal Service Subsidies Constrain Local Telephone Competition

For most of this century, regulators and legislators have considered cheap local phone service akin to a basic human right, nearly as important as free speech itself. Phone companies cashed in on this political preference by promising “affordable” service for all in exchange for monopolies. But now that competition in local service is legal, new competitors in the residential market find themselves up against established firms that are required by regulation to sell service at prices well below cost.

Telephone subsidies take three forms: business customers subsidize residential customers, urban service subsidizes rural service, and long-distance service subsidizes local service. A new book published by the Brookings Institution documents the effects of these cross-subsidies. On average, the price of local residential service is currently between $5 and $13 per month below its actual cost; rural rates are even further below cost.1 Since the average local residential phone bill is about $20, a new competitor has to offer a price 20 percent to 40 percent below the established company’s cost if it wants to attract residential customers.

“An obvious explanation exists for the lack of competition in residential lines: regulated flat rates are so low that no new entrant is interested in pursuing such customers,” conclude the Brookings study’s authors, Robert Crandall and Leonard Waverman.

The Telecommunications Act of 1996 was supposed to remedy this competitive disadvantage by creating portable subsidies that would be available to any company offering local residential telephone service. Regulators, however, have had trouble designing a politically acceptable system that offers subsidies large enough to adequately compensate new entrants. Once such a system is in place, it will forever be vulnerable to shifting political winds. Few new competitors are likely to make big investments in residential service when those investments could quickly lose their value if the subsidy program changes.

Defenders of local service subsidies usually offer two arguments: poor and rural customers would not have telephones in the absence of the subsidies, and it is just plain fair to give these disadvantaged groups a break on local phone rates. Neither argument can justify the current system.

Affordability is not an issue. Numerous studies show that demand for local telephone service is not very responsive to the monthly charge. As a result, few people would drop their service even if local rates were deregulated. Americans who forego telephone service usually do so because they cannot afford installation charges or because they cannot afford to pay off past bills with large long-distance charges. In other words, removal of local rate subsidies would throw virtually no one off the telephone network.

Even for Americans with annual incomes below $10,000, local phone service accounts for only 2 percent of the household budget – less than half the amount spent on entertainment (or tobacco and alcohol).2 Even if the subsidy is as high as $13 per month, most poor families could afford subsidy-free local service simply by giving up drinking, smoking, or cable TV.

Universal service is an extremely inefficient form of income redistribution. The people currently paying below-cost prices would of course pay more if local rates were deregulated, but that fact does not provide a fairness argument for subsidies. Current local subsidies are not targeted based on need; rich and poor alike benefit. Inner-city single parents pay higher long-distance rates so that wealthy executives can have cheap local phone service at their hunting lodges.

The subsidies do not even always help the intended beneficiaries. A big chunk of the subsidy is funded through excessive long-distance rates, and so rural customers who make a lot of long-distance calls are actually net losers under current arrangements. Even for households with incomes below $10,000, long-distance charges account for 40 percent of the average phone bill. Poor families who use a lot of long-distance service are worse off with the subsidies than without.

Crandall and Waverman estimate that local service subsidies transfer $340 million to $425 million to low-income households; but because the subsidies distort prices and reduce purchases of other services, all other telephone customers are worse off by as much as $7 billion. Universal service subsidies clearly qualify as one of the least efficient government attempts to redistribute income.

When a normal business gives away its product at a price below cost, it is accused of “predatory pricing.” When a local phone company does the same thing, it is praised for promoting “universal service.” Ironically, the government-mandated subsidies for universal local phone service constrain competition more than most alleged cases of predatory pricing. Policymakers who wonder why local competition is slow in coming should remember the words of Pogo, the comic-strip possum: “We have met the enemy, and they is us.”

1 Robert W. Crandall and Leonard Waverman, Who Pays for Universal Service? Washington: Brookings, 2000. All data in this Capitol Comment are from this book.
2 Ibid., 38.

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Citizens for a Sound Economy Foundation
Capitol Comment 288:
Universal Service Subsidies Constrain Local Telephone Competition
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