New Approaches to Universal Service

Published January 1, 2005

I approach this topic with a healthy skepticism about the utility of universal service policy as we know it, but with a concession that it will remain with us in some form or another. The task at hand is to make it do as little damage to the market and technological innovation as possible, while if we are lucky serving a positive social goal of attaining greater societal connectivity.

I start with what should be the fundamental fear for all those professionally concerned with universal service policy–escapability. Technology, and the inability of law to keep up with it, makes escape from the current universal service structure not just possible, but inevitable.

Let’s be plain about what universal service is: a tax assessed by regulation. This type of tax works only in a “closed” industry. Thus regulation must prevent entry into the regulated market and, just as important, prevent escape into substitutable services or to other technological platforms.

One might say the closed system of telecommunications ended with the break-up of AT&T in 1984. The competitive dynamics unleashed by the Modified Final Judgment, which gave rise to the competitive local exchange carriers (CLECs) and in turn the 1996 Telecom Act, made it possible for payers into the universal service system to escape onto less-taxed platforms. And as this escape route grows, particularly through means such as Voice over Internet Protocol (VoIP), the ability to employ the various explicit and implicit taxation mechanisms that constitute universal service is lost.

The Federal Communications Commission’s (FCC) Vonage decision in November bestowed VoIP with interstate status, allowing it to escape a portion of the universal service system. If VoIP achieves information service status, it will escape almost completely.

Then there are services like Skype and Free World Dial-Up, which not only bypass the conventional public network, but also the North American numbering system. They are harbingers of the end of the closed regulatory universe, no matter what the states or the FCC do.

If you accept that this is the era of regulatory escape from the closed world of taxation by regulation then let me proceed, as best I can, to rebuild a system of universal service from both the contribution and distribution side.

Principles of Contribution

On the contribution side, there are three principles for competent tax policy that universal service must adhere to:

  • First, it must be minimal, because all taxes upset the market equilibrium and excessive taxes encourage inefficient substitution.
  • Second, it must be non-bypassable; that is, it cannot admit escape very easily.
  • Third, it must be neutral, so as not to distort the price system or choices of technologies.

A connections-based universal service tax has the quality of being non-bypassable. Any connection to a network, be it a data or telephone network, is taxed and the raised revenue can be used for “universal service” purposes. It is also neutral in that it hits all network connections. The “minimization” criterion is arguably not met, however, because you are expanding the tax base to collect your revenue.

A numbers-based system has the benefit of minimizing the tax, but its bypassability and neutrality are in doubt. As Skype, Voice IM, and my Xbox Live conversations with my son demonstrate, the numbering system is not necessary for voice communications. As voice call set-up mechanisms move toward IP-based signaling protocols, bypassability and neutrality become acute because number-based connections apply only to conventional telco voice networks.

Principles for Distribution

On the distribution side, a new universal service scheme should meet the criteria of sound fiscal policy. Distribution should be transparent and equitable, minimize distortion in the market, and lessen the burden on taxpayers.

You are left with three possibilities: traditional regulatory costing methods (embedded or forward-looking), vouchers, or reverse auctions.

The first solution suffers from all of the current problems with regulatory cost-setting: information asymmetries, gaming, rent-seeking, and so forth. The incentive to innovate and achieve scale also is harmed if you aren’t using a forward-looking model. And a forward-looking model suffers from blackboard economics disease–solutions that are right in theory but undoable in practice. Finally, as exemplified by the non-rural universal service fund (USF) funding methodology, these decisions will inevitably be driven as much by political advantage and favoritism as legitimate cost considerations.

The second solution, vouchers, holds only superficial appeal. It makes USF competitive and puts consumer preferences and sovereignty at the forefront, but the problem of determining the amount of the voucher brings you back to the problems of the first distribution method. The biggest objection, in the end, is that the voucher method doesn’t match up with the cost characteristics of networks.

Reverse Auctions

Thus, my suggestion is that we explore reverse auction methods. Reverse auctions, properly designed, could give you some of the benefits you want, so long as the auction outcomes are competitive.

First, providers will reveal their true costs, thus minimizing the subsidy level and creating incentives to innovate and cost economize.

Second, you should get competitive benefits of innovation, and if you design the auction right, you can get them with as few as two players.

Finally, you avoid the traditional regulatory cost and price-setting problems, which are intractable and upset any “true” market equilibrium.

Again, my support for reverse auctions is tentative, mainly because there is still considerable work to be done on this issue. That said, properly designed auctions hold promise as a way to minimize cost and bring competitive innovation to USF distribution and rural markets.

Raymond Gifford ([email protected]) is president and senior fellow with the Progress and Freedom Foundation. This article is adapted from remarks to the KMBVideojournal Conference, Tampa, Florida, September 29, 2004. The full text is available at