The Problems with Rural Telecom Subsidies

Published October 25, 2007

In October 2007 I had the privilege of attending the annual Rural Telecom Conference, or Rural TeleCon, held this year in Springfield, Illinois.

As I sat in on some of the proceedings at the conference, which brings together lawmakers, regulators, and executives and technicians from rural phone companies around the country, I grew more dismayed that many of them were ready to accept, unquestioned, the notion market forces have somehow failed and that a large-scale government intervention is required to assure universal broadband, especially in rural markets.

That would be unfortunate. For one, it’s debatable whether market forces have indeed fallen short. Second, any debate about the effectiveness of private capital in rural telecom needs to take into account current government programs designed to foster universal service. Finally, when considering government intervention in telecom development, it is appropriate to consider the consequences this might have on investment and innovation over the long term.

But let’s address the most common assertion head-on: that when it comes to rural areas, there is market failure.

Market Failure in Rural Areas?

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. Hence, large portions of rural America will miss the broadband revolution.

It is true penetration is higher in urban and suburban areas than rural areas. But while rural penetration lags, it’s not declining. It’s not even flatlining.

From 2001 to 2007, according to the Pew Internet and American Life Project, rural broadband penetration went from 5 percent to 30 percent. (See Figure 1.) If we break that down, we see that rural grew six times–going from 1 in 20 households to 6 in 20. Over the same period, cities and suburbs grew five times going from 1 in 10 to 5 in 10. Again, there are more users in cities and suburbs, but plenty of real growth in rural areas, too.

But I’m going to take a page from the other side. I’m going to agree that, despite this growth, broadband penetration in rural areas could be better. Thirty percent penetration is too low for where we are in terms of broadband technology.

Yet, I would say the reason we are at 30 percent is because of government programs themselves. My question to those who propose greater government involvement in rural telecom is, given all the government programs already in place to spread broadband, why are we only at 30 percent?

Government Programs Aplenty

If you listen to some of my opponents, you’d believe the federal government is doing nothing about the gap between urban and rural penetration. That’s not true.

Figure 2
Federal Funding Programs for Rural Telecom
and Broadband Infrastructure and Applications
Federal Communications Commission
USF High Cost
USF Schools and Libraries
USF Rural Health Care
Department of Agriculture
Rural Utilities Service Rural Telephone Loans and Loan Guarantees
Rural Utilities Service Community Connect Broadband Grant
Rural Utilities Service Distance Learning and Telemedicine Program
Department of Housing and Urban Development
Community Development Block Grants
Indian Community Development Block Grants
Department of Commerce
Grants for Public Works and Economic Development Facilities
Public Telecommunications Facilities Program
Department of Health and Human Services
Telehealth Network Grants
Department of Education
Education technology programs
Department of Homeland Security
Interoperable Communications Equipment Grants
Federal-State Partnerships
Appalachian Regional Commission
Delta Regional Authority
Denali Commission
Other Sources
Institute of Museum and Library Services
National Institute of Health/National Library of Medicine
Source: Len Kruger, Congressional Research Service

As Figure 2 shows, there are numerous government programs, run by several cabinet-level agencies, aimed at funding telecommunications infrastructure and applications in high-cost areas. The Federal Universal Service Find (FUSF) is at the top–more on that a little later.

For now, note the FUSF in 2005 paid out $6.8 billion. Beneath that we have the Department of Agriculture’s Rural Utilities Services program, which this year has $500 million banked for broadband grants and loans, rural development.

Then we can go down the list: programs run by the Department of Commerce, HHS, Homeland Security, and even some federal-state partnerships. There’s no dearth of programs or funding, either in the form of grants or low-interest loans.

The real question, then, is how well those program are being administered.

FUSF Failures

Here’s where I take on an easy target, the FUSF.

Economist Thomas Hazlett has calculated that you could take the $7 billion FUSF spends in one year and buy a satellite phone for every household without a phone and have plenty leftover.1

But there is more to the problem than that. FUSF primarily addresses plain-old dial-tone service, much of it wireline. But for wireline narrowband, usage has peaked and is in decline. Hazlett notes that 95 percent of the population had at least one phone line as of 2004. Of that group, 89 percent used a wireline connection. The balance was wireless-only users.

More recently, a Mediamark Research survey found the share of households with wireline phones has fallen to 84.4 percent. The same survey found that wireless-only households had moved ahead of wireline-only households, 14 percent to 12.25 percent.2

So here we have a $7 billion program dedicated to expanding a service people find less and less desirable. What would Groucho Marx say if he were charge of the FUSF? “First prize, one landline phone; second prize, two landline phones.”

But the FUSF is an easy target. Even won’t defend it. So why do we have it?

Subsidies to Old Technology

At the risk of sounding a bit like, let’s look at the subsidies that flow to the large rural telephone companies. (See Figure 3.) This is a veritable picture of corporate welfare.

Figure 3
Telephone Holding Companies Serving Rural Areas

Analysis of 2006 Revenues and Profit
Company 2006 Revenues Revenue from Fed and State USF Revenues from access Net Income USF as percentage of profit Access Lines
Embarq $6.3b $228m Not disclosed $784m 29% 6.9m
Windstream $3b $240m1 $860m2 $545m 44% 3.2m
CenturyTel $2.4b $163.1m $879m $370m 44% 2.1m
Citizens Communications $2b $165m $263m $345m 48% 2.5m
Consolidated Communications Holdings $320.8m $47.6m $68.1m $13.3m 358% 233,689
FairPoint Communications $270m $20m (FUSF only) $110m $31m 65% 311,150
Iowa Telecommunications Services $228.1m $3.3m $95m $14.2m 23% 252,000
Qwest $13.9b $80m3 $550m $593m 14% 13.8m
1 Based on statement that 8 percent of revenues come from Federal and State USF (page 18)
2. Based on statements on page F-12
3. FUSF only
Sources: 2006 10K Annual Reports for Respective Companies

The table shows some of the top telephone holding companies that serve rural areas.

Now, the rural telco lobby paints a picture of rural areas served by small mom-and-pop phone companies and village co-ops. Such operations do exist, but to much less a degree than even in the recent past. In the past two years there’s been a spate of consolidations by a small a number of companies, mostly spin-offs, specifically targeting rural operations.

The biggest is Embarq, a spin-off from Sprint (incorporating the former wireline holdings of Sprint and Centel). Embarq did $6.3 billion in revenues in 2006. Of those revenues, $228 million came from state and federal USF funds.

I don’t have time today to address the column on access charges: That’s a presentation in and of itself. But those familiar with the issue of intercarrier payments can note these numbers.

Looking at the profit column, we see Embarq had net earnings in 2006 of $784 million. Do the math and you’ll see 29 percent of its profit came from USF receipts. You move down the list and you see how USF simply pads the bottom line for most of these companies. This isn’t a subsidy–this is shareowner equity, courtesy of the USF tax we all pay on our phone bills.

Worse, these companies are becoming addicted to these subsidies. Income from USF and access charges are part of the way rural holding companies push their stock on Wall Street. Then they come back to Washington and they say, “don’t cut our subsidies.”

However, with the exception of one company in the chart (Consolidated Communications Holdings), take the subsidies away and they still will be profitable. Maybe not as profitable, but profitable. And then, maybe, they will start looking for ways to organically grow revenues in line with proper market mechanisms.

Misallocated Capital

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.

In diverting capital through subsidies, the government takes available capital away, either as tax, or as a loan at below-market interest, from investments that, in a totally free market, would yield more productive return in the long term. That’s the societal trade off.

That loss in productivity gain is often not calculated into the subsidy equation. But policymakers should think about it, especially in telecommunications, where the pace of technological change makes every business model prone to disruption.

You must ask if, three to five years down the line, the market stands to deliver much greater value from the investor dollars you leave, versus what a government program can deliver from the tax dollars you take.

Relying on the Market Is Low Risk

I don’t think reliance on market mechanisms poses a tenth of the risk to rural consumers that regulators and rural telcos believe. On the contrary, today it’s only the transport portion of the network, especially in rural areas, that’s regulated and subsidized.

If, as the worriers say, the U.S. risks losing global leadership in broadband growth, I don’t think more government is the answer.

Look to the segments of the IT, telecom, and Internet industry that are unregulated and unsubsidized. In each one you find the leader is a U.S. company–software: Microsoft; search engines: Google; IP infrastructure: Cisco; e-commerce: eBay; Web-based media: Apple; PCs: Dell; 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 IT and telecom policy.

1 Thomas W. Hazlett, “Universal Service Telephone Subsidies: What Does $7 Billion Buy?” Analysis Group, June 2006, page 7.

2 Frank Barbetta, “More U.S. Households Are Now Wireless-Only than Wireline-Only,” Info Tech & Telecom News, The Heartland Institute, November 2007, page 1.