The funds are hidden in the access charges that long distance carriers pay for the use of local telephone channels.
This system was intended for a regime of monopoly local phone service, but the 1996 Telecommunications Act has ended that regime. The current system is broken: it fails to target the neediest subscribers, it rewards inefficient phone companies and it is inconsistent with the goal of competition for local phone service. Recognizing these problems, Congress told the FCC to fix them. But the incumbent monopoly local phone companies are resisting change.
The Universal Service Fund is a pot of nearly $1 billion dollars that is collected as a tax from telephone ratepayers; the funds are disbursed to local phone companies that can show they have costs that are substantially above average. The subsidy funds go to high-cost phone companies, not directly to needy subscribers. As such, the subsidies diminish these companies' incentives to become more efficient and lower their costs.
The money comes in part from hidden fees within the access charges that are paid by long distance carriers for the use of local channels supplied by the local phone companies. This is one reason access charges are so high. The Fund is administered by the National Exchange Carrier Association. The FCC has no real responsibility to make sure that the funds are disbursed to those who really need them.
The new law requires the FCC to adopt changes to the universal service support mechanisms within 15 months. These new rules will decide which services should be supported, who should receive the subsidies and how this program will work in the new competitive regime.
Today, the monopoly local exchange carriers are the only ones eligible to receive subsidies from the Universal Service Fund, not competing carriers. But in the future, the FCC believes that any competing carrier should be eligible to receive these funds. The problem is how to decide who gets them. One solution is to set up an auction and let them bid against one another. The carrier that is willing to provide service with the lowest amount of subsidy per line wins the auction and gets the subsidy funds. I didn't make that up; it's in the FCC proposal. But it sounds like a good idea to me. Of course, the incumbent local exchange carriers hate it.
One major problem with these universal service subsidies is not that customers in high cost areas receive them, it's that somebody must pay them. Because these subsidies are paid by the long distance companies that use the local channels supplied by local telcos, it creates incentives for long distance companies and other entrants to build their own local channels. It creates this incentive even if the local phone company is the most efficient supplier of this service. It creates the incentive for entry by inefficient competitors, who may have higher costs but can nonetheless undercut the price charged by the local phone company because they don't have the subsidy burden.
The FCC should not protect local exchange carriers against fair competition from new local communications service providers. But it may feel that they should be protected against unfair competition, where the incumbent telco bears the burden of subsidies, while the new entrant does not. This was exactly the situation in the late 1970s: AT&T's long distance charges included subsidies to cover local phone service, while MCI did not pay these subsidies. The FCC created access charges to level the playing field for long distance competition, but built new subsidies into those access charges to benefit high cost areas. In a competitive local exchange marketplace, those subsidies now have to be revised.
But these universal service subsidies should not be used to protect incumbents in high cost areas against more efficient new entrants. If local phone service can be provided more efficiently in these areas by new wireless or cable-based carriers, the high cost incumbent telcos might not survive. Too bad. Universal service policies should not be used to protect those guys against more efficient competitors.Targeted subsidies
Here's another problem with the current Universal Service Fund. It creates broad subsidy flows that, while supporting some who need the subsidies, also support many who do not. Today, heavy phone users subsidize light users, and urban users subsidize rural users. Never mind that the rural estates of northern Virginia are owned by some of the wealthiest people in the world. Never mind that the lowest telephone penetration rates are in low income urban areas. The urban poor of Richmond subsidize the riding stables of Middleburg.
Will lowering the price of phone service in high cost but wealthy rural areas result in increased penetration? Nobody asks if the benefits of the current policies are received by those, and only those, who need them.
Competition can help. If suppliers of phone service are allowed to compete for the subsidies, it would create the incentive to provide subsidies only to those with the greatest need. The incumbent local phone companies are fighting these changes. They'll try to show how competition will harm, rather than benefit, universal service. Never mind that competition usually results in more efficient, lower cost service to all customers. The FCC faces a challenge as it tries to promote both competition and universal service, both requirements of the new telecommunications law. The incumbents can be expected to use every tactic they can to slow or limit competition, and universal service will be one of their weapons.