Our last ConsumerGram analyzed the hidden telephone fees that consumers pay as a result of an outdated system of regulated payments between telephone companies. We concluded then that these payments represent subsidies that hurt consumers, are inefficient, and are not sustainable in the face of increasing competition. Moreover, the subsidy scheme works to discourage investment in new technologies in all parts of the country, including high-cost rural areas. Beyond the problem of how cross-subsidies can misallocate resources, this ConsumerGram provides evidence that this subsidy scheme encourages manipulation that defrauds the public, raises the cost of phone service generally, and increases telephone prices on every long distance consumer.

Hidden Taxes Must Go
Survey research has shown that consumers abhor hidden charges and subsidies. However, while the Telecommunications Act of 1996 sought to end hidden subsidies, long distance service prices are still laden with hidden fees that provide a subsidy to many telephone companies at the expense of other companies that pass these fees along to consumers. The senselessness of the current regulatory scheme is clear from the stark differences in fees charged to terminate calls between telephone company providers. As the chart below shows, small telephone companies often charge more to terminate a telephone call on their network than they are required to pay when their calls are terminated on other networks. This has the effect of raising other network costs, while artificially boosting the earnings of these small telephone companies, thereby discouraging wireline (labeled CLEC) and wireless competition in the rural areas they typically serve and effectively maintaining rural monopolies. Likewise, short toll calls (labeled in the chart as intraLATA) often have terminating rates that are several times higher than long distance calls (labeled interLATA), even though these longer calls require more resources, costs and investment. Similarly, terminating traffic onto advanced wireless and broadband (labeled ISP) networks permits old technology providers to overcharge new technology providers, discouraging investments in newer technology, while funneling dollars into antiquated technologies.

As we stated in our last ConsumerGram, a consumer making a 30-mile call may well generate five times the charges of a 1,300 mile call. The cost of the call between two cities, while using the identical telecommunications facilities, can incur vastly different rates depending on which city the call terminates. While the consumers do not explicitly see these fees on their telephone bills, the telephone companies that lose money on these schemes offset their losses by charging higher rates to every consumer that makes long distance telephone calls.

Incentives for Fraudulent Schemes
These inter-company payments were initially designed by policymakers to help small rural companies provide service in lightly populated areas, which are often more expensive to serve. Universal service programs now support service to high-cost areas, but the old subsidies buried in long distance charges still remain. The variation in costs on terminating telephone traffic, encourages some telephone companies to “game the system” by increasing the volume of terminating traffic and collecting even more fees from other telephone companies without any benefit to consumers or universal service.

How Sex Chat Rooms Boost Consumer Prices On October 4, 2007, the Wall Street Journal reported that rural companies were entering deals with sex and chat line operators who would advertise and attract callers (of any age), generating millions of long distance calls to these rural telephone companies. Because of artificially high rural terminating rates, these deals have permitted rural telephone companies to reap millions of dollars of subsidies, which the rural companies split (as part of the deal) with the sex and chat line operators. For example, the Journal article mentioned Farmers’ Telephone of Riceville, a very small rural provider, which entered a deal with a firm promoting an “all male chat line” service. Because terminating rates are so overpriced in this rural town, Farmers’ Telephone of Riceville collected generous fees (subsidies) that were shared with the sex chat line company. Meanwhile, the company whose lines carried the originating call pays the higher fees, which are then passed along to all of its customers, including the vast majority who had nothing to do with the sex chat rooms. These sorts of deals have popped up across the U.S, accounting for millions of calls and minutes, while funneling money away from network investment to scrupulous businesses. One Federal Communications Commission filing (12/2007) noted:

“… one such agreement provides for payments from the LEC to the calling service partner of $0.007 for the first two million minutes generated by the scheme and directed to the LEC’s exchange, and $0.013 for every minute above 2 million generated by the scheme. Another such agreement provides $0.005 for the first million minutes, then $0.007 up to 4 million minutes, and $0.01 minute for every minute above 4 million.”

BusinessWeek (April 12, 2007), USAToday (June 6, 2008) and others have written about similar telephone scams. In fact, ex parte filings with the FCC have reported dozens of examples of telephone companies gaming the system, effectively funneling money from some telephone companies to others with sex chat lines. Some of these small companies have seen their traffic increase by hundreds of percentage points and even a few by thousands of percentage points.

While long distance rates have plummeted in recent decades, rural access termination rates remain so out of alignment that they have encouraged some providers to offer cheap international calling, not based on competitive pricing, but the arbitrage of rates. For example, when a consumer calls a phone number that promises cheap international calling, their call is treated as a terminated call and a second dial tone is initiated that permits the caller to make a cheap international call. In this instance, the rural telephone company collects more money for terminating the domestic call than it pays for completing the international call. Essentially, other phone companies are bilked into paying the rural company. While a handful of consumers benefit from the cheap calling scheme, the vast majority of consumers unwittingly pay higher long distance rates in order to finance the scheme and cover these excessive (and hidden) terminating fees. As a result, most consumers are worse off and a system that defies rational market pricing is kept alive so that manipulative phone carriers can line their pockets with extra profits they’ve done nothing to earn.

In sum, the lure for subsidies has meant that consumers are unwittingly subsidizing adult entertainment, party, sex, chat line services, free conference bridge services, free International Long Distance Calls, free voicemail, VoIP gateways, and missed call/remote call forwarding. In other words, consumers who had nothing to do with these schemes are paying higher prices.

Stop Hidden Charges; Encourage Investment
Policymakers need to eliminate the hidden fees that raise costs for all consumers and slow investment in broadband and other new technologies. Lowering these fees and making them uniform across all geographies, services and technologies would provide telephone companies the right incentives to invest in new technologies and would give consumers greater choice among these technologies. In turn, providing the correct incentives to invest would benefit rural consumers by reducing prices and encouraging competition in rural service. If some rural telephone companies truly require subsidies, the universal service fund should be used to identify and explicitly support these companies and their rural consumers. As Milton Friedman once said – “there’s no such thing as a free lunch.” Policies that bilk consumers with hidden fees must stop.