Do Rural Telecom Subsidies Slow Broadband Growth?

Published December 1, 2007

After a day at the annual Rural Telecom Conference, or Rural TeleCon, advocates of free-market policies had reason to emerge downcast.

The 2007 conference, held in October in Springfield, Illinois, brought together lawmakers, regulators, executives, and technicians from rural phone companies around the country, many of whom seem ready to accept, unquestioned, that market forces have somehow failed and large-scale government intervention is required to ensure universal broadband, especially in rural markets.

Conventional wisdom says rural areas cost so much to build out, and offer so little return, that enterprises beholden to shareowners will see no profit in extending broadband infrastructure to remote towns and regions.

Rural Broadband Growing Fast

Penetration is indeed higher in urban and suburban areas than rural areas. But while rural penetration lags, it’s not declining or even flatlining. From 2001 to 2007, according to the Pew Internet and American Life Project, rural broadband penetration increased from 5 percent to 30 percent.

Hence rural broadband penetration increased sixfold–from 1 in 20 households to 6 in 20. Over the same period, city and suburban broadband grew fivefold, from 1 in 10 to 5 in 10.

Broadband penetration in rural areas could be better. But it could be that rural penetration is at only 30 percent because of government programs, not due to a lack of them.

Numerous Federal Programs

If you listen to those who suggest we adopt broadband subsidy programs similar to those in Europe and Asia, you’d believe the federal government is doing nothing. That’s not true. There are numerous government programs, run by several cabinet-level agencies, aimed at funding telecommunications infrastructure and applications in high-cost areas.

The federal effort starts with the $6.8 billion Federal Universal Service Fund (FUSF), amassed from a federal surcharge on all wireline, wireless, and Internet phone lines. There are numerous other programs, including the Department of Agriculture’s Rural Utilities Services, loans and block grants from the Departments of Commerce, Education, Homeland Security, and Housing and Urban Development, and several federal-state partnerships.

How well are those programs being administered? Economist Thomas Hazlett calculated you could take the $7 billion the FUSF spends in one year and buy a satellite phone for every household without a phone … and have plenty of money left over.

The FUSF is an easy target, but it’s not the only program that raises questions. The core problem is that huge subsidies are flowing to large rural companies with a vested interest in maintaining expensive, older facilities in order to extend depreciation periods. This is leading to a dangerous dependence on a business model that requires subsidies, as opposed to real equity, to bolster company value.

Subsidizing Equity?

The accompanying table shows some of the top telephone holding companies serving rural areas. The biggest, Embarq, a spin-off from Sprint, did $6.3 billion in revenues in 2006. Of those revenues, $228 million came from the state and federal USF funds. Embarq had net earnings in 2006 of $784 million.

Do the math and you’ll see 29 percent of Embarq’s profit came from government USF receipts. Move down the list and you see how the USF simply pads the bottom line for most of these companies. Is the government subsidizing broadband or shareowner equity?

Holding Companies

With the exception of one company in the chart (Consolidated Communications Holdings, a situation that raises questions in itself), if the subsidies were taken away these firms would still be profitable. Maybe not as profitable, but profitable. And then, maybe, they would start looking for ways to grow revenues in line with the actual market appeal of their services.

And therein lies the point. Government subsidies are inherently misallocated capital. Generally, the rationale for a subsidy comes when the government decides an essential product or service can’t be delivered by market mechanisms. It is an intentional diversion of capital to fill a gap between what a service costs to provide and what an average citizen can afford to pay.

Productivity Trade-Off

In doing so, the government takes available capital away, either as tax or as loan at below-market interest, from investments that, in a totally free market, would yield more productive returns in the long term. That’s the societal trade off,-but the loss in productivity gain is often not calculated into the subsidy equation.

Policymakers should think about it, however, especially in telecommunications, where the pace of technological change makes business models particularly prone to disruption.

By all signs, in three to five years the market stands to deliver much greater value from the investor dollars government leaves alone, than what it can deliver from tax dollars it takes.

Technologies such as WiMax and delivery of broadband over power lines aren’t commercial yet, but established patterns suggest these technologies will eventually eclipse the cost and capabilities of conventional wireline and DSL in rural areas–and deliver profit for investors. But government must be careful not to confuse the protection of rural consumers with the protection of rural holding companies.

Market Power

If, as the worriers say, the U.S. is at risk of losing global leadership in broadband growth, then less government, not more, is the answer. In the IT and telecom sector, only transport companies are regulated and subsidized. All other segments compete freely.

In each of the competitive areas, the leader is a U.S. company–software: Microsoft; search engines: Google; IP infrastructure: Cisco; e-commerce: eBay; Web-based media: Apple; Internet servers: HP, Sun, Akamai, and IBM.

Look at what this industry, when left unregulated and driven only by the need to attract willing investors, has accomplished. Isn’t it time we extended the same freedom to the service provider sector?

Steven Titch ([email protected]) is The Heartland Institute’s senior fellow for telecom and information technology and managing editor of IT&T News. This article is adapted from a presentation Titch made at The Heartland Institute’s 2007 Emerging Issues Forum in October.