The outlook for VoIP: Regulatory battles and new competition

The ongoing debate about how and whether to tax voice services is growing louder as the number of VoIP users surges.

During his four years as chairman of the Federal Communications Commission, Michael Powell championed the idea that new communications technologies should not be subject to federal and state regulations. But as Powell prepares to step down in March, Voice over Internet Protocol (VoIP) -- the technology that allows telephone calls to travel over the Internet -- faces a push by several states to regulate it as a traditional telephone...

service, a move that many fear would stifle its potential.

After a fitful start in the late '90s, VoIP has grown into a more reliable product offered at rates as much as 50% lower than traditional phone service. Such savings are cause for concern among state officials who worry that as consumers drop highly taxed and regulated landline service for VoIP, they will no longer contribute to tax and surcharge revenues that the states rely upon to meet important social needs.

These social obligations -- supported by required contributions to the Universal Service Fund -- are a collection of subsidy programs for telecommunications services in rural and high-cost areas, including, for example, broadband connections for schools and libraries as well as 911 emergency calling. The Universal Service Fund is supported partially by surcharges on certain communications services and partially by fees embedded in the rates companies pay each other to exchange telephone traffic.

'Let market forces work'

"VoIP promises to be pretty scary for anybody invested in traditional wireline phone," such as the state regulatory commissions, says Gerald Faulhaber, Wharton professor of business and public policy, and chief economist at the Federal Communications Commission from 2000 to 2001. "There's a lot of money here, not by Defense Department standards, but about $5 billion to $8 billion sloshing around," part of which has always gone to the states.

Fear of losing this revenue source has mobilized more than two dozen states to regulate VoIP. A ruling in November by the FCC only heightened states' concern when the federal agency declared that Internet telephony service "is not subject to traditional state public utility regulation" and that the FCC "has the power to preempt state regulations that thwart or impede federal authority over interstate communications." The FCC ruling, however, did call for the states to "continue playing a vital role in protecting consumers from fraud, responding to complaints, and enforcing fair business practices."

In the meantime, many states are refusing to be sidelined. The California Public Utilities Commission (PUC) and the Minnesota Public Utilities Commission have filed separate petitions to the United States Court of Appeals. Ohio has also appealed, according to James B. Ramsay, general counsel for the National Association of Regulatory Utility Commissioners. In addition, regulators in New York state are appealing a federal court that temporarily barred them from regulating Vonage, a leading independent VoIP service provider. "Other states are interested in the outcome," says Ramsay. "To the extent that these VoIP services terminate on the public switch network and they don't pay the same rates as other carriers, they are being subsidized by those other carriers. VoIP [customers] are also being subsidized by those who use the traditional phone carriers." The goal of any state regulator, he adds, "is to let market forces work."

The Senate Commerce, Science and Transportation Committee entered the fray last year by proposing the VoIP Regulatory Freedom Act of 2004, which continues to wind its way through Congress. If Congress signs the bill into law, it would exempt VoIP services from state regulations. But an amendment added in late December by Byron Dorgan, a Democratic senator from South Dakota, watered down the protection offered to VoIP providers. The amendment noted that "nothing in the bill would exempt providers of a VoIP application from requirements imposed by a state commission on all providers of telecommunications services."

The Institute for Policy Innovation, a Washington, D.C.-based advocacy group that seeks lower taxes and fewer government regulations, called the addition "a disappointing amendment that would allow states to continue requiring VoIP providers to hand over cash for state Universal Service programs," a requirement it says could "smother the vast potential of VoIP."

According to telecommunications experts, the main group that the FCC and VoIP providers must stave off is Congress. By themselves, the states have little clout in reversing the FCC's decrees. "But you can't tell a senator from Nebraska that we are going to cut the Universal Service Fund from which your constituents have been getting hundreds of millions of dollars a year," says Faulhaber. "Politically, it just will not fly."

An "Economic Distortion"

The issue of jurisdiction -- which is at the core of the conflict -- has been vigorously debated for almost a decade. Under the 1996 Telecommunications Act, how a communications service is regulated depends largely on whether it is classified as a telecommunications service or an information service. Generally, information services, or enhanced data services, are subject to minimal, if any, regulation in order to foster innovation. The law, however, required telecommunications services to be heavily regulated for calls traveling from one state to another as well as for all intrastate telecommunications services. "The idea of enhanced services in a totally unregulated space became an arbitrage opportunity, for example, for people to develop Internet telephony completely outside the realm of traditional telephone regulation," says Faulhaber. "The states are saying, 'This is a local telephone service, and we are the local telephone regulators.'"

The issue of jurisdiction aside, the prospect of taxing VoIP suddenly looms larger after the Congressional Joint Committee on Taxation issued a report on January 28, 2005, stating that an excise tax on telephone service passed in 1898 to finance the Spanish American War could be applied to all new Internet and data services as early as this year. The report, titled "Options to Improve Tax Compliance and Reform Tax Expenditures," describes a number of proposals to help reduce the size of the tax gap by shutting down tax shelters, closing unintended loopholes and generally reforming tax law.

The report states that taxing voice services, but not data and Internet services, creates an "economic distortion." The most aggressive proposal that could affect VoIP suggests taxing all voice and data services because the two are becoming "interchangeable and integrated parts of modern communications."

While the report admits that taxing new services and technologies "makes them more expensive" and may "slow their development," it also eyes the potential tax revenue. It notes that the IRS raised about $5.8 billion in 2003 from the excise tax and could generate even more if the tax is also applied to data and Internet services.

Becoming mainstream

While the number of VoIP subscribers is minuscule compared to residential phone lines subscribers, VoIP's growth is likely to accelerate, driven largely by lower prices that are the direct result of light regulation. Forecasters expect the number of VoIP subscribers to increase from about one million subscribers in the U.S. now to 18 million by 2008.

Some telecommunications experts note that while there have been predictions for several years that VoIP would cut tax revenues and the Universal Service Fund program, the reality has been vastly different thus far. In fact, the opposite has occurred in some cases where VoIP services indirectly contribute to both taxes and the Fund. "Even if VoIP services are not classified as regulated communications services that contribute to the Universal Service Fund, VoIP providers still purchase communications capacities that have those subsidies embedded," says Kevin Werbach, a professor of legal studies at Wharton and the FCC's counsel for new technology policy from 1994 to 1998. "So it's not that all the money goes away."

But concerns over lost tax revenues and subsidies are likely to grow as VoIP services expand into the mainstream -- both in terms of greater consumer adoption and the number of companies providing the service. "What's important to keep in mind is that VoIP is not just some new service that is growing adjacent to the telecom industry; it is the future of the telecom industry," says Werbach. "So the question is not just whether upstarts like Vonage can be brought into the regulatory system, but what happens as companies like Comcast and Verizon and SBC increasingly deploy a VoIP-based service."

Indeed, Verizon supported the FCC's November 2004 ruling – stating that Vonage should not be subject to traditional state public utility commission regulations -- after it began offering its own VoIP service, VoiceWing, in July. SBC is now preparing to launch Internet telephony service during the first half of 2005. These traditional telecommunications providers are offering VoIP services despite the very real possibility of cannibalizing their own landline business. The reason, telecommunications experts note, is the industry's growing realization that the landline phone business is now dwindling because of displacement by wireless services and the growing adoption of cable broadband services which come at the expense of dial-up phone lines.

But leading VoIP providers -- including Vonage, cable operators like Comcast and Time Warner, and some regional bells -- face a threat from players using innovative technologies that skirt the need for telephones or telecommunications networks at all. Services like Skype and Free World Dialup allow consumers to use software for free to connect to others over peer-to-peer networks. The companies hope to generate revenue by charging for added services, like video conferencing or calls placed to traditional phone numbers.

Another nascent technology is even further out on the fringes of VoIP but carries an enviable pedigree because its creator, Jeff Pulver, is a Vonage co-founder and an Internet telephony pioneer. His new Bellster Network, however, is not yet ready for prime time due to technical installation difficulties that currently limit its general appeal. Whether any of these forms of VoIP can out-muscle traditional landline services remains doubtful largely because of the technical restrictions on Internet telephony. After all, to place a telephone call over the Internet, consumers must first have a computer connected to the Internet via a broadband connection. "I think VoIP will get a sizable piece of the market, but I don't think it will become dominant," says Faulhaber. "If anything is going to [displace] traditional wireline, it is going to be wireless because that technology is not limited to homes that have broadband."

Such a prospect is likely to soothe the states. As Faulhaber notes: "Wireless services pay into the Universal Service Fund."


To read more articles like this one, visit Knowledge@Wharton, an online source for business analysis, information and research.

All materials copyright © 2004 of the Wharton School of the University of Pennsylvania.

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