Last month, leading long-distance telephone companies began making a hidden tax visible to their residential customers. The debate over the tax, which pays for a program to hook up libraries and schools to the Internet, is hampered by confused economics. The tax itself is probably unconstitutional.

The government’s new program to provide free or cut-rate computers and Internet connections to schools and libraries, established by the Federal Communications Commission under a provision of the Telecommunications Act of 1996, has recently leapt from bureaucratic obscurity to the forefront of congressional debate and editorial sermonizing.

The program—called the “e-rate” by its supporters (e for education) and the “Gore tax” by its opponents (it is a favorite of Vice President Gore)—presents many debatable issues of education policy and federal spending priorities. Proponents say the e-rate is essential to ensure that poor kids and communities are not left behind on the “information superhighway”; critics ask whether schools that cannot teach students how to read and write should be plugging them into the Internet instead. The program’s administration also appears to involve more than the usual amount of special-interest favoritism and political self-dealing.

A “Special Charge”

But those issues—standard fare for Washing-ton spending programs—are not the reason the e-rate has become such a hot political controversy. The reason is on the taxing side of the ledger. The costs of the program, amounting to several billions of dollars, are being funded by a special charge on the revenues of AT&T, MCI, Sprint, and other long-distance and wireless telephone companies. Most of them have been listing the charge, amounting to 4ÿ6 percent of their revenues, as a separate item on their bills to business customers since the beginning of the year—and began doing so July 1 on their residential bills. Politicians do not like to impose new taxes in election years, and many legislators who voted for the 1996 act are now denouncing the FCC and demanding a moratorium. E-rate enthusiasts, led by Sen. Bob Kerrey (D-Nebr.) and the editorial page of the New York Times, have responded by denouncing the telephone companies.

The long-distance companies, advocates say, should fund the e-rate program themselves rather than pass on the FCC charges to their customers. The reasons why they should do so are numerous. The long-distance companies’ regular businesses are very profitable. The companies lobbied for the 1996 act and have benefited from some of its other provisions. They should care about better schools and libraries. An FCC order recently reduced the companies’ “local access charges” (payments to local phone companies for connecting their long-distance lines to business offices and households)—so why not use the savings to pay for the new program? The New York Times—a profitable business that is entirely unregulated and does not routinely give away its newspapers to libraries and schools—says the telephone companies have a “public obligation” to fund the program and are driven by “company greed” to charge their customers instead. Senator Kerrey and other legislators, angered that the telephone companies should reveal the e-rate charges on residential bills, hint that new telephone regulation may be in the works.

The argument about who should pay the e-rate tax, unlike the arguments about spending priorities and program management, is not a matter of fair debate. It is based, at best, on a straightforward economic fallacy, at worst on sheer demagoguery. Either way, the argument threatens to undo such modest economic benefits as the partial deregulation of telecommunications has so far achieved.

Customers Pay the Costs of Supply

The economic fallacy is assuming that the long-distance companies have discretion over “passing on” the e-rate tax—or, for that matter, over passing on cost savings when local access charges are reduced. In an unregulated market (as interstate telephone service has been for several years now), those who purchase a service pay the costs of providing the service. Any market-wide increase or decrease in costs of supply is inevitably passed on to customers in the form of an increase or decrease in price. This is not a matter of how bills are itemized and it does not depend on whether suppliers are profitable or unprofitable.

When the long-distance telephone companies’ operating costs fall because of reduced access charges, they will reduce their rates from what the rates would have been otherwise. They will do so out of economic interest—without prompting from the government or newspaper editorials—because a firm that fails to pass on the cost reduction will lose valuable business to rivals that do lower their rates. Conversely, when the long-distance companies’ operating costs increase because of a charge on revenues to fund the
e-rate program, they will increase their rates—regardless of whether the charge is called a “tax” or a “contribution” and regardless of whether it is listed separately on customers’ bills. They will do so because a firm that fails to pass on the cost increase will find itself in a money-losing position, selling services for less than it costs to supply them.

These simple examples ignore a few wrinkles in the economics of “passing on” changes in operating costs, but the wrinkles do not alter the result. Interstate telephone service has been subject to active price competition among AT&T, MCI, Sprint, and other firms since the FCC finally abolished rate regulation in that market several years ago. Economists differ over how vigorous price rivalry has become and how much pricing power remains—but the extent of price competition does not affect the burden of the e-rate charges. A monopolist supplying an entire market will charge a higher price than competing firms would, but the monopoly price, like the competitive price, is a function of the firm’s costs of supply (in tandem with the level of market demand). The greediest monopolist will reduce its price in response to a cost decrease; otherwise, it would lose profitable new sales opportunities the cost savings make possible. The most statesmanlike monopolist will raise its price in response to a cost increase; otherwise, it would sacrifice profits, lose investors to other firms that are maximizing profits, and thereby increase its costs (in particular its capital costs) even further.

That changes in operating cost are passed on does not mean that the telephone companies are passive about such changes. E-rate charges—unlike, say, expenditures on improved transmission facilities—add to costs of supply without improving quality of service; vice versa for reductions in access charges. A business firm will always be more profitable when it can provide an identical service at a lower cost and a lower price. So the long-distance companies have a strong interest in keeping e-rate charges and access charges as low as possible. But that does not alter the fact that the long-distance customers pay the costs of the e-rate charges. The economic interests of producers and consumers often conflict, but they have the same interest in seeing that products of identical quality are supplied at the lowest possible cost.

Those who contend that the long-distance companies “saved” the access-charge reductions, and now (therefore) should spend the savings on e-rate charges, actually end up in the same position as if they had understood both matters correctly. If the phone companies failed to lower their rates when their access charges fell and are now to use the proceeds to fund the e-rate program, then the long-distance ratepayers are still the ones who will have paid for the program! It is telling that even the advocates of “making the companies pay” cannot describe how that might be accomplished.

For there is only one way the phone companies might have absorbed the savings in access charges and now might absorb the costs of the e-rate charges: a return to government price controls. If a government authority required all long-distance companies to hold their prices constant in the face of the increased operating costs of the e-rate charges, those costs would indeed be paid “by the companies”—that is, by their shareholders and employees—rather than by their customers. Although some e-rate advocates appear to be contemplating such a course, it is difficult to imagine a more retrograde policy than imposing price regulation on a competitive market just to shift a tax burden. Past efforts to force businesses to sell services at less than their costs have typically led to deterioration in service quality, to eventual price increases (by increasing producers’ costs, especially capital costs, and by facilitating price collusion), or both. In all events, the shareholders of the telephone companies—consisting in significant part of institutions investing the savings of small investors and pensioners—are not obviously a more attractive, or even a very different, source of funding for the e-rate program than the businesses and households that use long-distance and wireless telephone services. The difference in the populations is not social or economic but political: when a business fails to cover its costs, its shareholders and employees do not receive a bill itemizing their losses.

Rate Subsidies and the Constitution

Reregulating the telephone companies in an effort to shift the burden of the e-rate program would run into another difficulty—the U.S. Constitution. Telephone rates, in common with those of other regulated utilities, have traditionally featured a profusion of “cross-subsidies” among consumer groups: some consumers (generally business and city customers and long-distance callers) have been charged rates substantially above costs of supply, while others (generally residential and rural customers and local callers) have been charged rates below costs. This sort of implicit “taxation by regulation” has been shaped by the Constitution’s
due process and takings provisions, which have required regulators to leave the owners of regulated firms with a “reasonable rate of return” on their investments. As a result, rate subsidies to favored consumer groups have been funded from above-cost rates charged to other consumers—not from below-market returns to shareholders.

One of many flaws in the Telecommunications Act of 1996 is that it relaxes or abolishes rate regulation (in response to the increasingly competitive nature of the industry) yet attempts to retain subsidized rates for certain customers (a practice that had been accomplished through rate regulation). In the case of the e-rate program, the FCC has attempted to square the circle by making the taxes and subsidies explicit—by establishing its own separate charge on long-distance revenues and spending the proceeds on cash grants to schools and libraries. But this approach violates another provision of the Constitution: the one vesting the power to tax in Congress, and specifically in the House of Representatives, and not in regulatory agencies such as the FCC. So Congress will be revisiting the e-rate program regardless of the outcome of the current debate (a constitutional challenge is already underway), and the program’s supporters will be obliged to find a new approach. Congress is unlikely to fix the delegated-taxation problem by reviving across-the-board rate regulation and building the e-rate subsidies into the rate structure. But if it should, those who object to charging long-distance customers the costs of the e-rate subsidies will be disappointed once again—this time courtesy of the due process and takings clauses.

Political Accountability and Economic Efficiency

What Congress should do when it reconsiders the e-rate program is to step up to its constitutional responsibility: fund the program, if at all, from direct taxes it enacts itself, and let the e-rate sink or swim in competition with hundreds of other causes clamoring for federal largess. That would have large economic benefits in addition to (and related to) those of political accountability. A new study by Jerry Hausman of the Massachusetts Institute of Technology¹ shows that the e-rate tax, like more traditional regulatory taxes, is extraordinarily inefficient. Long-distance telephone service is very price sensitive, is already heavily taxed, and is still sold at prices well above marginal costs of supply; as a result, the higher long-distance rates produced by the e-rate tax suppress a large volume of beneficial transactions that would otherwise occur. Indeed, Hausman finds that the e-rate tax produces more than one dollar of sheer waste—“dead-weight” economic loss that benefits no one—for every dollar transferred from long-distance ratepayers to schools, libraries, and their suppliers. Almost any general tax that Congress would enact in the light of day, including current federal taxes (which are hardly a model of economic efficiency), would be vastly less costly than this.

In the meantime, the long-distance companies that are listing the e-rate charges on their bills deserve our praise and admiration. It is a fact of democratic life that politicians aggressively claim credit for the benefits of spending programs while attempting to obscure the costs of those programs and the identity of those who pay the costs. The legislators, FCC commissioners, and editorial writers who are denouncing the long-distance companies for disclosing the e-rate charges are saying, pure and simple, that those who are paying for the program should be kept ignorant of that fact. The telephone companies’ resistance to those pressures is strong evidence that they are finally breaking free from the mentality of the regulated utility—and managing their businesses with an eye on the interests of consumers rather than politicians.

Note

1. Jerry Hausman, Taxation by Telecommuni-cations Regulation: The Economics of the E-Rate (AEI Press, forthcoming 1998).

Christopher DeMuth is president of AEI.