Progress Snapshot 1.26 December 2005

Kent Lassman *

Local franchise issues have seemingly emerged from out of the blue to perplex state lawmakers across the nation. Early this year, legislatures in New Jersey and Virginia considered changes to their franchise laws. Texas adopted a new statewide franchise system and the Federal Communications Commission has opened a fact finding enquiry on the issue. Already, legislators in Florida , Missouri and California have discussed potential changes to the franchise system for 2006.

Franchises are a regulatory tool. Like all regulatory tools, an assortment of reliance interests has developed around the use of franchises. However, unlike most regulatory tools, franchises can have large and clearly identified public finance implications.

My purpose today is to help you identify the broad regulatory and public finance issues at stake. The interests - both those who rely on the current system and those who seek changes - will readily enough identify themselves to you through their lobbying efforts.

The first point that you should know about franchise reform is that franchise regulation is independent of right of way regulation. The two issues are distinct in at least four ways. Franchises were originally designed to limit market power. The regulatory basis for right of way management has nothing to do with economics. Rather, it is rooted in the public safety and welfare of the community or what we traditionally call the police powers of a state.

The two types of regulation are also differentiated by their legal pedigree. Franchise regulation is found in Title VI of the federal act, the cable or video section of the law, while right of way is found in Title II which is the communications section of the law. As a result, the standard used to determine revenues is also different. Franchise fees are limited to 5 percent of gross revenues while right of way fees are linked to a reasonableness standard and are typically related to the costs associated with access to the right of way. Finally, the economic rationales of the two types of regulation are also different. Franchises primarily exist today as a source of revenue for local governments. By contrast, right of way fees serve as a proxy congestion price to manage access to rights of way. The price mechanism helps allocate the resource because like all common resources, rights of way are subject to capacity limits and exhaustion.

Representatives from local government argue that these two regulatory issues cannot be disentangled. This is not true. If a single contract can be written to cover both franchises and rights of way, then a contract that would only cover right of way is certainly possible.

In many localities the two issues must be disentangled because historically one agreement has covered both issues. Severing the issues may cause short term difficulty but is eminently practical. Franchise reform does not necessarily imply any change to the traditional powers of local government to manage their rights of way.

The second major idea that is often misunderstood in the franchising debate is that regulation is a close substitute for taxation. Government can raise revenue and spend its funds on goods and services. Alternately, through regulation of a firm, government can induce expenditures on similar goods and services. Current video franchises raise this issue in two ways.

• Approximately $2.4 to $3.0 billion is collected by local government every year in franchise fees.

Setting aside the taxation by regulation that is endemic among franchise regulation, the straightforward revenue stream that results from franchise fees poses significant problems for public finance. As a general rule, revenuers tend to tax inelastic goods and stable markets and apply the tax across a broad base. Each trait has a corresponding benefit. Taxes on inelastic goods create less distortion among producers and consumers. Low elasticity of demand means people buy the good even if an incremental tax is put on top of the price. Similarly, it makes sense to tax a market that is relatively stable. Low volubility allows budget officials to plan for the likely revenue stream with confidence. In this way, revenue officials do not like change or surprises. Finally, good tax policy tends to tax a broad base in order to achieve equity.

Unfortunately, the people not yet consuming video services are by definition the most price sensitive in the market. The average demand sensitivity, taken from four GAO studies conducted between 2000 and 2005, is -2.37. These consumers are highly sensitive to incremental price changes and therefore most affected by the imposition of franchise fees.

Secondly, the communications marketplace is anything but stable. Tremendous innovation is taking place. New entrants from other sectors as well as entrepreneurs are now in the mix. VoIP, IPTV, video tiering and a rash of triple-play, even quadruple-play bundles, are all available. To wrap up the public finance problems of franchise fees, it should be clear that the base is narrow and narrowing. Currently, approximately 2/3 of American households subscribe to a pay video service. Of that figure, approximately 20 percent are DBS subscribers and therefore not subject to franchise fees. As a result, barely half of American households pay all of the explicit franchise taxes.

It is clear that the current franchise system is an anachronism. Franchises were born as a medieval grant of the Crown; they came of age before changes to federal law in 1984 and 1992 and are now sustained as a result of benefits derived by reliance interests. Franchise regulation is far removed from its purpose and exists in spite of the substantial costs it imposes.

Statewide franchises or a federal system may be more efficient. Unfortunately, it would be a more efficient way to do something with high costs and low benefits. Undoubtedly, as franchise regulation recedes the revenue streams it supports must be addressed. Nonetheless, the best alternative is to eliminate franchise regulation altogether.

But until franchises fade into history, your job as policymakers will be to make sure that incumbents and new entrants alike have access to the benefits of whatever policy regime replaces today's franchise regulation.

* Kent Lassman is a research fellow at The Progress & Freedom Foundation. On December 7, and then on December 10, 2005 he gave testimony to the National Conference of State Legislatures and the American Legislative Exchange Council at their respective annual meetings. This essay is adapted from his testimony.