Brave New Telecom World

Internet telephone communication is an exciting new prospect. Unless it's your job to regulate it.
by | April 2005

Area code envy is so strong in Manhattan that the TV show "Seinfeld" once devoted an episode to the pursuit of a desirable 212 phone number. Elaine meets a guy she's interested in dating, and gives him her number. He sees her 646 area code, figures she must live in New Jersey or something, and crumples the paper it's written on. In a dark turn of events typical to the show, Elaine is saved from area code stigma only when an elderly woman in her building--a 212--dies. She makes nice with the telephone guy and persuades him to give her the dead woman's number.

It's still tough to score a 212 area code in Manhattan, and maybe waiting out an aging neighbor remains a viable strategy. But something has changed since that show aired in 1998. If you want to be a 212 these days, you aren't just competing with New Yorkers. Now that phone calls are starting to go over the Internet using telephones hooked into computers, anyone in Chicago, Los Angeles, or for that matter, Beijing, can put his name on a 212 waiting list. And the benefits go beyond simple vanity: A Londoner who lands a 212 can ask his relatives in New York to call him direct--and it will be considered a local call.

Internet calling--technically known as "voice over Internet protocol," or VoIP--is the biggest revolution to hit telephone service since wireless became popular a decade ago. But in economic and regulatory terms, it's likely to be even more important. Internet calling promises to drive down the cost of phone calls closer and closer to zero. Over time, telephone communications will come more and more to resemble e-mail: available anywhere in the world, sometimes even for free, wherever it is possible to get online over a broadband connection.

VoIP is already a boon to the most tech-savvy consumers, and before long it will extend its benefits to millions more. For state and local governments, however, it threatens many traditional ways of doing business. Even now, with fewer than 1 percent of all Americans using the technology, VoIP is starting to turn state and local telecom regulation on its head. Some $18 billion worth of state and local tax revenues are tied to telecom services, and those may well vanish if states don't adapt their tax systems to fit the Internet era.

VoIP also is helping to reshuffle the decks of federalism. For most of the past century, states played a crucial role in setting telecom rates and rules within their borders. But it's not yet clear what role, if any, states will have in regulating something so seemingly placeless as VoIP. Recent decisions by the Federal Communications Commission already have begun moving authority over telecom away from the states and toward Washington. The biggest losers in this power shift are the state public utility commissions. They may find themselves evolving from a powerful force for industry to reckon with into something more like an ombudsman for handling consumer complaints.

States, cities and counties have seen these trends coming for a few years. In the broadband Internet era, all sorts of communications services are converging in a way that make the old means of categorization irrelevant. Cable companies are now selling phone service. The Baby Bells are angling into the video business. Satellite TV competes with cable TV. Mobile phones compete with landline phones. And consumers can buy broadband service, depending upon where they live, over phone wires, cable wires, fiber-optic lines, power lines or the airwaves.

VoIP is only one part of this competitive explosion. What makes it so disruptive, however, is that it is the first old-line utility that can be delivered over any broadband medium. "These technologies are no longer beholden to the platforms they travel on," says David Quam, director of federal relations for the National Governors Association. "Our entire regulatory and tax systems are set up on these silos--the infrastructure, as opposed to the service. But with VoIP, you don't have to lay lines, have facilities or physical plants. None of that is required. It's the poster child for the future of communications."

All of this, including key questions about the role of states and localities, is up for debate this year as Congress rewrites the 1996 Telecommunications Act. Industry leaders, joined by many members of Congress, are hoping to see 50 state telecom regimes migrate toward one in Washington. Some conservatives are jockeying to preempt states from taxing VoIP--much the way Congress preempted states from taxing Internet access. Meanwhile, others have an eye on wiping away state telecom taxes altogether.

For state and local leaders, the current struggle is largely about relevance: Is there a role for them in regulating telecom anymore? Or are consumers better off if the states just get out of the way? But what about taxation? Telecom taxes help fund schools and pay police officers in communities around the country. Who will pay if those revenues vanish? "There's a very real threat that Congress, in a political act, will take away these major sources of state and local revenues," says Virginia Governor Mark R. Warner. "That's easy for Congress to do. It's no skin off their nose."


The difficulties of taxing VoIP will sound familiar to you if you've followed the states' recent efforts to solve the problem of taxing sales on the Internet. Both issues turn in part on a similar dilemma: that a state can't collect taxes from a company that has no physical presence there.

That's why the sales transactions of businesses such as have so far gone mostly untaxed at the state level. And it's also why a company called Vonage, which is turning out to be the Amazon of the VoIP world, is enjoying the same exemption. Based in New Jersey, Vonage is the largest Internet phone company in the United States. It has a fast-growing base of 500,000 subscribers and charges $24.99 a month for unlimited calling to the U.S. and Canada (customers must pay for a broadband connection separately). Vonage customers make calls using their regular touch-tone phones, which connect to their broadband modem through an adapter. Because it uses the Internet, Vonage doesn't own any telecom infrastructure, at least not in the way that traditional phone companies do. Vonage has customers in all 50 states, but it charges its subscribers telecom taxes only in New Jersey.

In fact, however, VoIP isn't a national phenomenon, it's a global one. Americans can now get voice services from abroad, too. One outfit based in London and Estonia, known as Skype, offers a way to speak over the Internet that is a lot like instant messaging, only using a microphone and speakers. It gives the service away for free. The tax issue Skype poses isn't just that states can't tax a company based in Europe. It's also that without a monthly bill, there's nothing to tax.

This isn't just a problem for states and localities. It's trouble for the big telecom companies, too. Under the existing system, they are the tax collectors for states and localities, and at rather lofty rates. Their burden--as high as 17 percent in New York--is a legacy of the days of AT&T's service monopoly, when it was easy to tax telephone infrastructure because it ran through just about every community in America. Vonage represents the opposite of the old system in almost every possible respect. "It's hard to apply a tax to something beyond your reach," says Deborah Bierbaum, director of external tax policy at AT&T. "If you can live in California and get a New York phone number, and be anywhere in the world to receive that call, then who has the right to tax that?"

Big Telecom is trying to get into VoIP, too--AT&T switched to marketing Internet phone service a year ago. And AT&T and other big telecoms do levy taxes on VoIP in states where they have a physical presence. So a certain percentage of telecom tax money will continue to roll in for the foreseeable future. Still, telecom's momentum toward the Internet has state and local leaders searching for a better way to tax. Should the tax system really care whether your mother calls you over copper wires, airwaves or the Internet? "There's a growing understanding from the governmental side that we have to have a rational approach here," Governor Warner says. "Trying to tax exactly the same service just because of the way technology delivers that service doesn't make sense."

Warner, who made a fortune in the telecom business himself before entering politics, is leading high-level discussions aimed at adapting state and local taxes for the new era. All of the state and local government associations represented in Washington are involved, as are spokesmen for the telecom, wireless, cable, satellite, Internet and VoIP industries. The industries want tax collection streamlined, and they want tax rates generally to come down. The governmental side wants any reform to come out revenue-neutral. Cities and counties are especially adamant that they keep control over their rights-of-way, particularly when companies cut up roads to lay cabling in the ground. "We'll have several cuts in the same road," says Michael Guido, mayor of Dearborn, Michigan, who has been in on the talks. "People drive down the street yelling at the mayor."

But tax simplification is always easier said than done. This past January, Warner's home state of Virginia rejected exactly the sort of restructuring he envisions on a broader basis. The Virginia plan aimed to convert a hodgepodge of communications taxes into a single statewide flat tax. The rate would have been 5 percent--the same as Virginia's current sales tax. Levies on local and mobile phone calls would have gone down. But satellite TV and long-distance calling, currently untaxed in Virginia, would have had to start paying. By broadening the tax base while lowering rates overall, the package was meant to be revenue-neutral. "There's so much overlap in what they do from one venue to another," says state Senator Jay O'Brien, a Republican who sponsored the plan. "My feeling is we want to treat all equally from a tax perspective."

O'Brien's bill never got out of committee. The reason had little to do with VoIP. Instead, it was pressure from the satellite TV industry, which didn't want to give up its tax advantage over competitors in cable TV. Local governments were also apprehensive about the plan, although many grudgingly supported it in the end. They stood to lose their ability to set and collect their own tax rates--and feared that once their money was funneled through state government, they would never see it again.

If the Virginia plan was about trying to rationalize telecom taxes in order to save them, there is a broader current of anti-tax thought in some states. To some fiscal conservatives, VoIP isn't a threat. It's an opportunity to right past wrongs. In Colorado, state Representative Matt Knoedler wants to specifically exempt VoIP from state taxes. As he sees it, Colorado taxed the hell out of landline phones, and then chose to do it again when wireless came around. "This is the third opportunity since Alexander Graham Bell invented the telephone for us to look at a new technology that everyone will use to talk to their families," Knoedler says. "The question is, should it be taxed? I say no."


If you ask Ronda Hartman Fergus whether VoIP spells doom for state public utility commissions--at least as far as telecom goes--she'll say that she's heard that line before. Fergus is a PUC commissioner in Ohio. In 1984, when a federal judge broke up AT&T, she was a staffer at the commission. "We thought we'd have nothing more to do," Fergus says. "Competition was coming and we wouldn't need regulation anymore. But since 1984, our lives just got more complicated, with more and more work to do."

This time may be different. Competition's Round One took place over the old circuit-switched telephone network. Rather than one company using that network, there were many. The situation required a referee, and the PUCs were perfectly situated to set rates and rules, at least for calls that stayed within their states. Round Two, however, will increasingly take place over the Internet. And on the Internet, it's not so easy to track whether a VoIP user is calling his neighbor down the street, or his cousin in Delhi.

The FCC is already starting to re-draw jurisdictional lines. A big decision came last November. The Minnesota PUC had asked Vonage to file papers with the state, just as any traditional telephone company would. The FCC preempted Minnesota from doing that, stating its philosophy about VoIP and hinting at its approach to the Internet in general. In a statement accompanying the order, then-Chairman Michael K. Powell said, "To subject a global network to disparate local regulatory treatment by 51 different jurisdictions would be to destroy the very qualities that embody the technological marvel that is the Internet."

Minnesota is appealing the order, along with California, New York and Ohio. The states point out that even a Vonage phone call made through the Internet, if it is directed to or from someone using regular phone service, hits the old circuit network under their purview somewhere. They also make the point that if states lose the ability to regulate Internet telephone communications, emergency 911 service may essentially become unregulated as well. Suppose a VoIP customer in Las Vegas makes a 911 call using a Manhattan 212 area code. Where will that call be routed? To a firehouse off the Las Vegas Strip? To a police station in Manhattan? If state PUCs aren't able to impose some rules on these communications, who will protect the consumer?

The FCC has mentioned a few duties for states in the VoIP era, such as protecting consumers from fraud and responding to public inquiries and complaints. The commission is likely to spell these out more clearly in the next month or two, in a broader proceeding about Internet-based services. "I don't know what we'll be left with in the voice landscape," Ohio Commissioner Fergus says. "It's a big concern. Because if you set up a regulatory framework based totally on the technology you use, and some technologies get a completely unregulated landscape and other technologies get what they have, then it won't take long for other telephone companies to say, gee, maybe we should switch to unregulated technology and forget this other stuff."


The irony is that states, with or without the FCC, were already on a deregulatory path. The big telecoms have been lobbying legislatures and state PUCs to let retail prices find their own market levels, arguing that under the current system of regulation, competition from wireless, cable and now VoIP is eating them up.

Qwest, the predominant Baby Bell in the West, is leading the deregulatory charge in about a dozen states. Qwest argues that it is being strangled by pricing rules designed for telephone's monopoly era. "Look at if Qwest wants to offer a new discount package," says Steve Davis, the company's senior vice president of public policy. "In some states where we operate, we have to file that with the state commission 30 to 60 days in advance--notifying our competitors of what we're doing. Plus, there's always some risk that it won't be approved. Then our promotional and advertising materials have to specify that the offer is only available in these states, and not these states. It increases the cost of marketing and administering the programs."

Qwest's arguments for price deregulation are finding receptive ears in Iowa. There's a sense among legislators that real competition in telecom, long hoped for, has finally arrived. VoIP's arrival is only the latest sign of that, says Democratic state Senator Steve Warnstadt. "We think we're seeing a lot of competition," Warnstadt says. "Less than a year ago there wasn't much agreement that VoIP was going to be a viable option. Now it's available in 16 communities in Iowa. When I pulled up Vonage's Web site, it noted that Des Moines phone numbers were temporarily out of stock. That tells me they're getting usage."

John Perkins, Iowa's consumer advocate, isn't convinced. Competition in Iowa, as in every state, is more fierce in some places than in others, he points out. Consumers in cities have seen their communications choices expand dramatically in the past couple of years. But in the rural areas, where cell phone coverage can be spotty and anyone on the Internet is most likely using a slow dial-up modem, the choices don't look much better than they did in the 1990s. Those choices may diminish further once SBC's acquisition of AT&T and Verizon's purchase of MCI are completed. "There's very little competition," Perkins says. "Voice over Internet isn't a reality to most people in Iowa."

Much of Iowa's discussion is focusing on what has come to be known as the "Aunt Tillie" problem. Aunt Tillie is not a real person. She's a type of person, one everybody knows: technology phobic, computer illiterate and unsure which buttons to press to make a cell phone work. Aunt Tillie thinks broadband is something you use to tie hair in a bun. Iowa's concern is that as all the young whippersnappers move to VoIP, Aunt Tillie will have to pay more and more to keep using her standard land-based phone.

Iowa's solution so far has been to keep prices on all customers with just a single phone line regulated for another three years. Qwest can raise Aunt Tillie's rates by one dollar a month each year. After that, the Iowa Utilities Board will decide whether competition is stiff enough to leave pricing to the free market. If it's not, the board can extend regulation for two more years. Qwest's Davis says Aunt Tillie has nothing to worry about. "No one's getting rich jacking up prices for Aunt Tillie," Davis says.

Still, the times ahead are a leap of faith for policy makers in Iowa, as they are around the country. "Maybe in three to five years when there's better broadband deployment, there'll be a reason for people like myself to use voice over Internet," says Perkins. "But my mother will never own a computer. It'll never do her any good."


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