The Communications Act of 1934 sets forth the nation’s telecommunications policy, including making communication services available “so far as possible, to all the people of the United States.” Early efforts by FCC, state regulators, and industry to promote universal service generally began in the 1950s. At that time, increasing amounts of the costs associated with providing local telephone service were recovered from rates for long-distance services. This had the effect of lowering local telephone rates and raising long-distance rates, which was intended to make local telephone service more affordable. Because American Telephone and Telegraph Company (AT&T) provided both nationwide long-distance service and local telephone service to approximately 80 percent of the nation’s telephone subscribers, universal service was largely promoted by shifting costs between different customers and services. Following the divestiture of AT&T’s local telephone companies in 1984, FCC made several changes to universal service policy. First, the costs associated with local telephone service could no longer be shifted internally within AT&T. FCC therefore implemented access charges—fees that long-distance companies pay to originate and terminate long-distance telephone calls over the local telephone network. Access charges were intended to not only recover the cost of originating and terminating long- distance telephone calls over the local telephone networks, but also to subsidize local telephone service. Second, FCC initiated several federal efforts that targeted support to low-income customers to bring the rates for basic telephone service within their reach. At this time, federal universal service was for the most part funded through charges imposed on long-distance companies. The Congress made significant changes to universal service policy through the 1996 Act. First, the 1996 Act provided explicit statutory support for federal universal service policy. Second, the 1996 Act extended the scope of federal universal service—beyond the traditional focus on low-income consumers and consumers in rural and high-cost areas—to include eligible schools, libraries, and rural health care providers. Third, the 1996 Act altered the federal mechanism for funding universal service. Every telecommunications carrier, and other entities, providing interstate telecommunications services were required to contribute to federal universal service, unless exempted by FCC; and their contributions were to be equitable, nondiscriminatory, and explicit. Contributions are deposited into the federal Universal Service Fund (USF), from which disbursements are made for the various federal universal service programs. Fourth, the 1996 Act established a Federal-State Joint Board on Universal Service (Joint Board). This Joint Board, which is composed of three FCC commissioners, four state regulatory commissioners, and a consumer advocate, makes recommendations to FCC on implementing the universal service-related provisions of the 1996 Act. The USF provides support through four different programs, each targeting a particular group of telecommunications users (see table 1). In 2007, support for the four USF programs totaled $7 billion. Among the four programs, the high-cost program accounted for the largest amount of support—$4.3 billion or 62 percent of USF support. The high-cost program provides financial support to carriers operating in high-cost—generally rural—areas in order to offset their costs, thereby allowing these carriers to provide rates and services that are comparable to the rates and services that customers in low-cost—generally urban—areas receive. Both federal and state governments play a role in implementing the federal high-cost program. FCC has overall responsibility for the federal high-cost program, including making and interpreting policy, overseeing the operations of the program, and ensuring compliance with its rules. However, FCC delegated to USAC responsibility to administer the day-to- day operations of the high-cost program. USAC is a not-for-profit corporation and a subsidiary of NECA, although NECA does not participate in the management of USAC. NECA, a not-for-profit association of local telephone carriers and the primary administrator of FCC’s access charge plan, collects cost and line count data from its members and validates this information. At the state level, state regulatory commissions hold the primary responsibility to determine carrier eligibility for participation in the program and to annually certify that carriers will appropriately use high-cost program support. Table 2 summarizes the general roles and responsibilities of the agencies and organizations involved in high-cost program administration. To be eligible to receive high-cost program support, a carrier must be designated as an eligible telecommunications carrier (ETC). Section 214(e)(1) of the 1996 Act requires that to be designated an ETC, the carrier must (1) offer the services that FCC identified as eligible for universal service support throughout the service area for which the designation is received, (2) advertise the availability of those services, and (3) use at least some of its own facilities to deliver those services. There are two types of carriers. Incumbents. When the Congress passed the 1996 Act, existing telephone carriers that were members of NECA were designated as incumbent carriers for their service areas. These incumbents subsequently received ETC status. These incumbents are further classified as either “rural”— generally small carriers serving primarily rural areas—or “nonrural”— generally large carriers serving both rural and urban areas. Competitors. Carriers competing against incumbents—both wireline and wireless—also are eligible to receive high-cost program support. Just like incumbents, these companies must apply for eligibility and receive ETC status before they can receive support; these carriers are referred to as competitive eligible telecommunications carriers (CETC). Competitors can provide service without receiving CETC status or high-cost program support. Carriers that receive high-cost program support may use this support only for the “provision, maintenance, and upgrading of facilities and services for which the support is intended.” The high-cost program consists of five components, each with different eligibility criteria and different methods to determine the level of support. Four of the components provide support to carriers to offset the costs of the network, including local loops (primarily, the equipment that runs from the carrier’s facilities to the customer’s premises). The four components are high-cost loop, high-cost model, interstate access, and interstate common line. The fifth component, local switching support, provides support for very small carriers to offset the cost of their switching equipment. For incumbent carriers, eligibility for the components depends on the carrier’s size (as recognized by their classification as rural or nonrural) and the type of regulation the carrier is subject to—either rate-of-return or price-cap regulation. In 2007, USAC reported that there were 1,250 rural carriers subject to rate-of-return regulation, 105 rural carriers subject to price-cap regulation, 5 nonrural carriers subject to rate-of-return regulation, and 81 nonrural carriers subject to price-cap regulation. Based on the components for which they qualify, rural carriers receive support based on the costs they incurred, whereas based on the components for which they qualify, nonrural carriers receive part of their support based on projected costs using an FCC model. Table 3 summarizes each of the five high-cost program components, which carriers are eligible for each, the qualification criteria for each component, and the amount of support provided in 2007. For example, a rural carrier with less than 50,000 customers and subject to rate-of-return regulation could receive support through the high-cost loop, local switching, and interstate common line components. Unlike incumbents, competitors do not directly receive funds based on their costs or FCC’s model. Rather, once a competitor receives CETC status, it qualifies for the identical per-line level of support that the incumbent receives for the area it serves; this is known as the identical support rule. Since its inception in 1998, the high-cost program has increased nearly 153 percent, from $1.7 billion in 1998 to about $4.3 billion in 2007. This significant growth has raised concerns about the program’s long-term sustainability, efficiency, and effectiveness, as well as the adequacy of the oversight of carriers’ need for and use of support. Figure 1 illustrates the growth in the high-cost program, including both incumbents and competitors. Several factors have contributed to the growth in the high- cost program. In the early years of the program, support grew as FCC reduced access charges (a form of implicit support for carriers) to incumbents and offset those reductions with greater high-cost program support (a form of explicit subsidy). However, in recent years, the high- cost program has grown because of support provided to competitors, especially wireless companies. In response to concerns about the long-term sustainability of the high-cost program, FCC issued several Notices of Proposed Rulemaking (NPRM) in January 2008, seeking comment on proposals for comprehensive reform of the program. These NPRMs represent the culmination of efforts by FCC and the Joint Board to reform the program. FCC released an NPRM seeking comment on a Joint Board recommendation that the high-cost program be divided into three separate funds: broadband service, mobility (or wireless) service, and traditional provider of last resort service. FCC also released an NPRM seeking comment on changing the current funding mechanism for CETCs, namely eliminating the identical support rule and requiring CETCs to submit cost data. Finally, FCC released an NPRM that sought comment on implementing reverse auctions to determine the amount of high-cost program support to be given to an ETC; with reverse auctions, support generally would be determined by the lowest bid to serve the auctioned area. In this report, however, we will not assess or discuss the merits of the reform proposals; instead, we will review the high-cost program in its current state and discuss best practices that are critical for the future of the fund, regardless of which reform efforts are adopted, if any.