Taxation by Telecommunications Regulation

Taxation by Telecommunications Regulation Author(s): Jerry Hausman Source: Tax Policy and the Economy, Vol. 12 (1998), pp. 29-48 Published by: The University of Chicago Press Stable URL: http://www.jstor.org/stable/20061854 Accessed: 15/11/2010 20:38 Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/action/showPublisher?publisherCode=ucpress. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org. The University of Chicago Press is collaborating with JSTOR to digitize, preserve and extend access to Tax Policy and the Economy. http://www.jstor.org TAXATION BY TELECOMMUNICATIONS REGULATION Jerry Hausman MIT and NBER EXECUTIVE SUMMARY Telecommunications has become an increasingly important area of atten tion by policymakers as new services such as cellular telephone and Internet services become increasingly important to businesses and con sumers. Rapidly changing technology has led to these new services as well as the realization that market-based competition may replace much outdated regulation which has led to considerable consumer harm (e.g. Hausman, 1997).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 the field of public finance have in the analysis of telecom munications policy? Telecommunications regulation in the U.S. is replete with a system of subsidies and taxes, in part because of the dual system of regulation in which the federal government (FCC [Federal Communica tions Commission]) and each state has regulatory jurisdiction over local telephone companies.1 Public-finance analysis demonstrates how to Susan Dynarski and Hyde Hsu provided research assistance. Jim Poterba and Tim Tardiff provided helpful comments. 1 Broadly speaking, the FCC has jurisdiction over interstate calls and about 25% of the capital base of local telephone companies, while state regulation does intrastate calls and the remaining 75% of the capital base. Numerous exceptions exist with respect to interstate versus intrastate calls, and some services have aspects of both interstate and intrastate calls. 30 Hausman evaluate the costs and benefits of tax and subsidy systems.2 Indeed, it demonstrates how to measure the distortions to economic efficiency that tax and subsidy systems create.3 Furthermore, it has determined rules for optimal taxation that can be applied to telecommunications regulation.4 A potentially important application of public-finance analysis to tele communications regulation is the financing by regulation of telephone companies' fixed and common costs. Because of significant economies of scale and scope, the first best prescription of setting price equal to mar ginal cost would require government subsidies or would lead to bank ruptcy of local telephone companies.5 In the U.S., government subsidies have not been used, and 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 residen tial service. Here Ramsey optimal tax theory would suggest how prices should exceed marginal costs to minimize the efficiency losses to the economy.6 Although Ramsey theory was devised for the purpose of raising revenue in just the situation that regulators face, it has found little acceptance in telephone regulation, perhaps for the reason that most of the tax burden would fall on local telephone service, which actually receives the highest subsidy of any telephone service. Another potential application for public finance analysis in telecommu nications regulation, and the main topic of my paper, is the marginal cost to the economy of the new Congressional legislation which leads to taxation of telecommunications services. Because of budgetary spending limits, Congress is increasingly unable to increase general taxes to pay for social programs.7 Thus, Congress increasingly funds social programs from taxes on specific sectors of the economy. In this paper I consider the Congressional legislation which established a program so that all schools and libraries in the U.S. will receive subsidized access to the Internet. 2 Some Washington lawyers might quibble about the use of "tax" here, since the FCC is only allowed to assess "fees," not taxes. However, public-finance economists know a tax when we see one. 3 See e.g. Auerbach (1985). 4 For optimal taxation analysis see e.g. Diamond and Mirrlees (1971), and for an applica tion of Diamond-Mirrlees theory to telecommunications regulation see e.g. Hausman (1995). 5 This point has long been recognized. See e.g. Kahn (1988). 6 For recent recommendations using Ramsey theory in the context of price-cap regulation see e.g. Laffont and Tir?le (1996). 7 The 1990 Budget Enforcement Act includes a pay-as-you-go restriction on tax changes and changes in entitlement programs other than Social Security. Poterba (1997) discusses the budget experience under this act. Taxation by Telecommunications Regulation 31 The cost of the program is currently estimated to be $2.25 billion per year.8 Rather than increasing general taxes to fund this program, Con gress passed legislation that directed all users of interstate telephone service to pay for the program. Congress left it to the FCC to decide how to tax users of telephone services to pay for this new subsidy.9 In this paper 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 addition to the $2.25 billion of tax revenue), so that 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 be yond the money raised for the Internet discounts.12 This cost to the economy is extraordinarily high compared to other taxes used by the federal government to raise revenues. There are three reasons for the high cost to the economy of this increased tax on interstate long distance 8 This subsidy is only a small part of a much larger framework of universal service subsi dies. Congress passed the legislation establishing the subsidies, but the FCC determined the $2.25-billion-per-year amount. 9 Supposedly Gladstone, while Chancellor of the Exchequer, asked Michael Faraday about the usefulness of electricity. Faraday responded, "Why Sir, there is every possibility that you will soon be able to tax it." 10 Thus, this paper demonstrates how to answer the question raised by Posner (1971) of the cost of subsidy programs arising from regulation. 11 The question of benefits is worthy of further study. For instance, all public schools (and some private schools) and all public libraries receive a subsidy for their purchase of In ternet access. While the subsidy scheme is progressive, over 97 percent of schools receive at least a 40 percent discount and over 67 percent of schools receive at least a 50 percent discount. One might question why communities such as Weston, MA, with a 1990 median family income of $95,134, and Hillsborough, CA, with a 1990 median family income of $123,625, require a subsidy, especially given the high proportion of high-technology related job holders in both towns. Given the likely outcome that these towns will not change their purchase behavior even with the subsidy, the subsidy represents a pure transfer from long-distance users to taxpayers of these communities. 12 This estimate is an approximation, because the funds will be raised from all interstate telecommunications services, e.g. cellular telephone, not just regular long distance. The FCC estimates that about 1.5 percent of end-user wireless revenues will be used in the tax. Thus, I base my estimate of the efficiency loss to the economy on the assumption that $1.89 billion will be raised through a tax on long-distance calls. I do not include the additional efficiency loss to the economy from the tax on wireless services. Given my estimate of the cellular demand-price elasticity (Hausman, 1997), the tax on wireless will also lead to a significant additional loss in economic efficiency to the economy. Including the efficiency loss from the tax on wireless services would increase my estimate of the efficiency loss from $2.36 billion to $2.53 billion. Also, taking account of general equilibrium price effects would lead to a further increase in my estimates. 32 Hausman 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 imposed 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 discounts, which 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 service price elasticities, and the FCC could have chosen to increase other taxes, already in place, which would have led to much lower costs to the economy of funding the Internet discounts. Indeed, economic theory and public finance analysis establish the goal of using taxes which minimize the cost to the economy of raising government revenue. The FCC, to the contrary, chose the taxation method applied to interstate telephone service which likely maximizes the cost to the economy of raising the revenue to provide the Internet discounts. Hopefully, the FCC will begin to take heed of economic analysis in the future as it continues to modify the tax and subsidy system for telecom munications. 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 regulation. The public interest standard should recognize economic 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 costing the U.S. economy billions or tens of billions of dollars per year. The goal of the Telecommu nications Act of 1996 was to decrease these regulatory costs to the U.S., not to increase them. 1. REGULATION OF TELECOMMUNICATIONS IN THE U.S. Regulation of telecommunications in the U.S. is unique among all coun tries in that two levels of government regulate telephone service: the federal government through the FCC and each of 51 state (including the District of Columbia) regulatory commissions. In broad principle the FCC is in charge of interstate telecommunications while the state regulatory commissions are in charge of intrastate telecommunications. While the FCC has periodically attempted "power grabs" to attain more control over regulation, these activities have been resisted by the state commissions, Taxation by Telecommunications Regulation 33 which have been upheld by the courts in two notable decisions, the Louisi ana decision (1986) and recently in the interconnection decision by the Eighth Circuit Court of Appeals in July 1997.13 Both times, the Appeals Courts have narrowly circumscribed the ability of the FCC to intervene in intrastate telecommunications regulation. However, as most users of a telephone realize, the same telephone wire which connects a residence to the local central office switch, the switch itself, and the fiber-optic cable which connects the switch to other switches carry both intrastate calls and interstate calls. Thus, no natural boundary exists to demarcate spheres of regulation. In an earlier era of telephone regulation (about 15 years ago), when cost of service, i.e. rate of return regulation, was used, the rate was arbitrarily separated into an intrastate portion and an interstate portion, primarily on the number of calls of each type. Thus the separations system was put into place, and over time it has achieved an increasingly complicated level of detail that only a regulatory accountant could love and perhaps no living person can under stand completely. The separations system, if it ever made sense, has no basis in economic reality today, since rate-base regulation is no longer used by the FCC and has disappeared from use by a majority of the states. The end result of the separations system is that the FCC interstate regulation is responsible for about 25 percent of the local exchange compa nies' assets, and state regulators are responsible for the other 75 percent. Under rate-of-return regulation, the regulated telephone companies' prof its in each regulatory regime were meant to be large enough to allow them to earn their regulated cost of capital on these regulatory-determined rate bases. Prior to the breakup of AT&T in 1984, local residential service was cross-subsidized by long-distance service through intra-company trans fers, the result of an earlier agreement with regulators and the Ozark Plan of 1971.14 After the AT&T divestiture, an explicit subsidy flow had to be established to continue the cross subsidy of local residential ser vice.15 The FCC established a per-minute-of-use access fee that long distance companies were required to pay local telephone companies for 13 Louisiana Pub. Sew. Comm'n v. FCC, 476 U.S. 355 (1986) and Iowa Utilities Board et al. v. FCC, Eighth Circuit, July 18,1997. 14 In its antitrust suit against AT&T, the Department of Justice claimed that AT&T used its local access revenues to cross-subsidize its long-distance competition with MCI. This theory was incorrect: the cross subsidy flowed in the opposite direction, as subsequent events demonstrated conclusively. Indeed, the Department of Justice recognized its mis take in a court filing in 1987. 15 By the term cross subsidy, I mean setting price less than long-run incremental cost. 34 Hausman the use of their networks to originate and terminate long-distance calls.16 The access fees were initially set quite high, about 17.3 cents per minute for both origination and termination. The access fees had the same effect as a tax on long-distance calls, because the access fee is paid for the subsidy on local residential service as well as paying for some of the fixed and common costs of the local exchange companies which were included in the FCC's 25 percent share of the local exchange companies' rate bases that the FCC held charge over.17 These access charges were not a very economically efficient set of taxes, since studies funded by AT&T Bell Laboratories had consistently demonstrated an interstate long-distance elasticity of about -0.7.18 Fur thermore, policymakers did not seriously analyze the fundamental ques tion of whether every residential telephone customer should receive a cross subsidy, no matter what the income of the customer. Cross subsi dies of local telephone service were discussed under the rubric of "uni versal service" which was contained in the Telecommunications Act of 1934. However, by 1984 telephone penetration in the U.S. was about 91.5 percent with additional targeted subsidies in place for low-income customers. Current telephone penetration is about 93.9 percent. Econo metric studies which I conducted did not show any significant "network effects" at this level of penetration; I am unaware of any econometric studies which did show a significant network externality.19 Thus, the replacement of a universal cross subsidy with targeted subsidies (e.g. telephone stamps) would have been more economically efficient than access charges for long distance, but such a rational policy was never seriously considered by policymakers. 16 AU the taxes on long distance which I discuss were established by the FCC, although Congress does exercise oversight on the FCC. 17 Many other cross subsidies and distortions arise from state regulation, such as the subsidy to rural telephone subscribers, who are generally significantly higher cost to serve, but who pay the same rates as urban customers when served by a common local exchange provider. 18 See e.g. Taylor (1994). These estimated elasticities were based on times-series data, which led to very precise estimation given the significant decrease in long-distance prices which occurred in the 1970s. More recent estimates also lead to very precise results. Thus, a one-standard-deviation change in the elasticity estimate would not affect the results of my calculations by a significant amount. A quite interesting finding is that the price elasticity for long-distance service did not change and remained at much the same value up through the 1990s, as I discuss later. Thus, the onset of long-distance competition did not affect the price elasticity; nor did competition significantly affect the position of the de mand curve over time (no outward shift of the demand curves due to competition has been estimated). 19 Taylor (1994, pp. 236-238) summarized the size of the estimated network externality effects. He concludes that they are quite small. Taxation by Telecommunications Regulation 35 In 1984 the FCC adopted a framework which did allow for a significant decrease in long-distance access charges. It adopted a subscriber line charge (SLC), which reached $3.50 per line per month for residential households and $6.00 per line per month for businesses. Access rates for long distance decreased from about 17 cents per minute to about 9.5 cents per minute, primarily as a result of the advent of the SLC. The FCC considered a higher SLC which would have decreased long-distance access rates even more, but Washington lobbying groups such as the Consumer Federation of America (CFA) made apocalyptic forecasts of 6 million households stopping their telephone service, which would have decreased telephone penetration below 85 percent. As with much of the policy debate over telephone regulation during the past 20 years, the CFA's forecasts were based on little real economics and proved to be vastly inaccurate. Indeed, telephone penetration increased because of the SLC and lower access prices, as demonstrated by Hausman, Tardiff, and Belinfante (1993). The SLC was quite unlikely to lead to large decreases in telephone penetration, since an increase in the SLC leads di