ATTACHMENT C

PRE TAX RETURN = 20.18% / (1 – 0.35) = 31.34%

RETURN TO INVESTORS AFTER TAXES = 31.34% - 31.34% x 0.35 = 20.18%

APPENDIX E

Major Tax Breaks for Investor-Owned

Telephone Companies in the Year 2000

Prepared by MSB Energy Associates, Inc.

On Behalf of the

American Public Power Association

December 2001

INTRODUCTION AND EXECUTIVE SUMMARY

This report analyzes the impact of various federal tax breaks available to the major investor-owned telephone companies (TELCOs) in the United States[1]. The tax breaks specifically are: (1) accelerated depreciation, and (2) investment tax credits. The report examines these questions:

1. How much higher would the costs and rates of TELCOs have been in 2000 if these tax breaks had not been available? and

2. How much do these tax breaks to TELCOs cost the U.S. Treasury?

The report analyzes the aggregate amount of tax breaks for all major investor-owned telephone companies[2], as well as those for each individual TELCO. The aggregate estimates are in the body of the report, while those for individual TELCOs are shown in appendices.

Major Findings:

1. Investor-owned TELCO costs of doing business would have been $5.7 billion higher in 2000 than they were had it not been for the benefits they received from the major tax breaks analyzed in this report;

2. The rates paid by investor-owned TELCO customers for local exchange service would have had to be 5.2 percent higher to pay for the $5.7 billion in increased costs;

3. The U.S. Treasury lost an estimated $4.0 billion in 2000 because of these TELCO tax breaks.

ASSUMPTIONS AND ORGANIZATION:

There are two major tax breaks which are provided to the investor-owned telephone companies. These are accelerated depreciation and investment tax credits.[3] Both of these tax breaks provide telephone companies with cost-free capital which they would otherwise have to raise in the capital markets at considerable cost. Replacing cost-free capital with market capital would entail both the issuance of new equity and debt. The cost of replacing cost-free capital with market capital would increase costs to the customers.

In addition, the U.S. Treasury loses a great deal because of these tax breaks. The Treasury loses both the direct cost of the tax breaks and the indirect taxes it would receive if the cost-free capital were replaced with market capital.

The body of the report contains a description of the major TELCO tax breaks and their impact. The appendices provide a detailed description of the methodologies used to derive the estimates, along with the tax break estimates for individual telephone companies.

It is important to note that, while many think of the telephone industry as being highly deregulated and market-driven, this is generally not the case with the provision of local exchange service. In almost all cases there is a single set of telephone wires serving an area, and a single provider of local service with rates for local exchange service based on cost-of-service. In those cases where there is competition for the provision of local service, that service is still provided over a single set of wires, with the use of those wires leased from the local owner. The cost-of-service drives the price for the use of those facilities, so even when there are competitive markets, the prices are highly affected by cost-of-service.

TAX BREAKS FOR INVESTOR-OWNED TELEPHONE COMPANIES

1. Cost Reductions from Accelerated Depreciation: Accumulated Deferred Income Taxes

Accelerated depreciation, which was introduced for U.S. corporations in 1954, is still available to telephone companies today. It allows corporations to "front load" the depreciation schedule for an asset. For example, a TELCO may be able to depreciate in the first year 10 percent of an asset expected to last 20 years. Under straight-line depreciation, the TELCO would depreciate one-twentieth or 5 percent of the asset in each year, including the first year. Under the rate-making approach used by most public utility commissions, the TELCO is allowed to use the straight-line method for rate making, and accelerated depreciation for tax purposes. Thus the income statement for rate making purposes will show a greater tax expense than the true amount of taxes paid by the TELCO, assuming all else is equal.

Put another way, the use of different depreciation schedules would allow a TELCO to tell its ratepayers that its taxes are say $1.0 million (and collect $1.0 million in rates), when in fact the actual taxes it paid might be only $0.8 million. The extra $0.2 million in reported, but not paid, taxes is recorded on the TELCO's books as a deferred tax. It represents capital available to the TELCO at no cost.

Because this capital is cost-free to the company, most utility commissions do not allow the company to collect a return on this zero-cost capital. Thus, the benefit of this tax break is passed through to the customers as reduced rates.

The tax is "deferred" in that for a particular asset the differences between accelerated and book depreciation will eventually reverse and the TELCO will report fewer taxes than it actually pays. This would draw down the deferred tax balance for that asset until the balance is zero at the end of the asset's life. Unfortunately, theory and fact don’t always match up. The problem with the asset-by-asset analysis is that new additions to plant usually outpace the depreciation associated with older assets, causing the net balance of deferred taxes to grow continually.

In other words, new assets generate more new deferred taxes than the reversals of the credits generated by the older assets. Therefore, the unamortized tax benefits to TELCOs from accelerated depreciation continue to grow over time. This has led some accounting professionals to suggest that deferred taxes are permanently deferred and may be more like an equity contribution than a liability. The merit of this argument is beyond the scope of this analysis. Whether one agrees or disagrees with this proposition has no effect on the empirical calculation of the benefit of deferred taxes in this analysis.

As of December 31, 2000, the estimated net deferred operating income tax balance for the major investor-owned telephone companies was $24.8 billion of cost-free capital. Of this, $23.3 billion was held by the group of 30 largest companies, while $1.5 billion was held by the 22 mid-sized companies.

If this cost-free capital were not available to the investor-owned telephone companies, this capital would have to be raised in the capital markets. The cost to the customers of these telephone companies would be the cost of capital (pre-tax) multiplied times the total amount of capital in question. The overall pre-tax weighted cost of capital for the TELCOs is 22.6%. The large TELCOs have a slightly higher cost of capital (22.64%), while the mid-sized TELCOs have a slightly lower cost of capital (22.26%).[4]

At a pre-tax, weighted cost of capital of 22.6 percent, the annual cost to replace the loss of the deferred income taxes is $5.6 billion. If the $5.6 billion were recovered through rates, prices to ultimate consumers would have had to increase by 5.1 percent. This breaks down to a cost for the large TELCOs of $5.3 billion and a rate increase of 5.2%, and a cost for the mid-size TELCOs of $0.32 billion and a rate increase of 4.7%.

2. Cost Reductions from Investment Tax Credits:

Investment tax credits (ITC) were direct tax reductions provided to industries in order to encourage capital investment. An industry was allowed to deduct 10 percent of the cost of new investment directly from tax payments. These tax breaks were available to TELCOs as well as other industries. The ITC is a permanent tax credit which is never repaid to the U.S. Treasury. New ITC is no longer available to TELCOs or any other industry, having been eliminated in the Tax Reform Act of 1986.

Under the ratemaking approach used by most utility commissions, customers pay returns on investment to TELCOs as though the investment tax credits had not been granted. In other words, the TELCO earns a return on money which it has not spent. In return, each year of the life of the investment, the TELCO returns to the customers (amortizes) a portion of the ITC. As a result, the TELCO has a zero cost source of capital from the unamortized portion of the ITC prior to the amortization of the credit to the customers.

In 2000 the unamortized investment tax credit balance for investor-owned telephone companies was $1.22 billion ($1.20 billion for the large TELCOs and $0.02 billion for the mid-size TELCOs). Under typical ratemaking methods, ratepayers do not receive a direct benefit from the unamortized balance. Instead, the benefit to the ratepayers comes in the amortization of the ITC.

In 2000 the ratepayers of TELCOs received an amortization of old investment tax credits as a credit against rates. If there had been no ITC, the rates in 2000 would have been higher. However, calculating the amount is difficult because the amortization is not reported in the Federal Comminications Commission (FCC) accounts. We used analytical methods to estimate what the ITC amortization for TELCOs in 2000 is likely to have been. We constructed a model to estimate the relationship between the current unamortized ITC, the amortization rate, and the total amount of amortization granted by the Internal Revenue Service (IRS). The model is based on work we have done analyzing investment tax credits for investor-owned electric utilities where the data series for unamortized ITC extends back to 1962, and where the annual amortization of ITC is a reported data item. This model is described in some detail in Appendix B. Using the model we estimated that in 2000 approximately 15% of the unamortized ITC balance was returned to customers in the form of ITC amortization. In other words, the ITC amortization fraction for 2000 was approximately 15%. This is a higher fraction than for electric utilities where the amortization rate is approximately 5%. But this is to be expected for telecommunications where the turnover rate of capital equipment is typically much higher than for electric utilities. A shorter equipment life means a shorter amortization period. The model also estimates that the total amount of ITC granted by the U.S. Treasury is about four times the current unamortized balance.

While the model we developed suggests that the ITC amortization fraction for telephone companies should be 15% and the ITC granted multiplier should be about four, we decided that, in order to be unquestionably conservative, we would use for the TELCOs the same low multipliers that we calculated for investor-owned electric utilities – 5% amortization fraction (instead of 15%) and multiplier of two (instead of four). We chose to use these multipliers because the ITC data is more complete for electric utilities, and the multipliers are lower leading to a more conservative result. The impact on the overall results is small. The calculations for both telephone companies and electric utilities are discussed in some detail in Appendix B.

Based on using the 5% amortization fraction as with the electric utilities, we estimated that the investment tax credit amortization in 2000 was approximately $61 million – $60 million for large TELCOs and $1 million for mid-size TELCOs. This amortization of ITC reduced customer rates by 0.06% (0.06% for large TELCOs and 0.02% for mid-size TELCOs). The impact of ITC on customer rates is obviously much less than the impact of deferred income taxes.[5]

3. Total Cost Reductions Accruing to Investor-Owned Telephone Companies from Major Tax Breaks

The aggregate impact in 2000 of the accelerated depreciation and investment tax credits was to reduce TELCO costs by $5.7 billion. If this amount were recovered through the prices charged ultimate consumers, the $109.0 billion they paid for local exchange service in 2000 would have increased by 5.2 percent. Of this $5.7 billion, $5.3 billion is for large TELCOs (rate impact of 5.23%) and $0.3 billion is for mid-size TELCOs (rate impact of 4.69%).

Table 1. Cost Savings from TELCO Tax Breaks ($billions)

Large Mid-Size Total

Accelerated depreciation $5.3 $0.3 $5.6

Investment Tax Credits $0.06 $0.001 $0.06

Total: $5.3 $0.3 $5.7

COST OF INVESTOR-OWNED TELEPHONE COMPANY TAX BREAKS TO THE U.S. TREASURY:

2000 Cost to the Treasury:

The annual cost to the U.S. Treasury in 2000 of TELCO benefits for accelerated depreciation and investment tax credits was $4.0 billion. Of this $4.0 billion, $3.9 billion comes from accelerated depreciation, and $0.1 billion comes from ITC.

There are two aspects to the costs related to accelerated depreciation. One is the direct cost to the Treasury to replace dollars lost from deferred income taxes and from investment tax credits; the other is the forgone taxes on income from capital – both equity and interest. Details of the calculations are shown in Appendix B.

The $24.8 billion of accumulated deferred income taxes cost the Treasury $1.3 billion in direct costs. This represents the cost to the Treasury of having to borrow money to replace the deferred income taxes.

In addition, the Treasury lost about $2.3 billion in revenues from the taxes they would have collected on increased equity income – $1.6 billion in corporate taxes on TELCO corporate income and $0.7 billion in individual taxes on dividend payouts.

About $0.26 billion was lost in taxes that would have been paid on the interest income from the debt capital component which would have been necessary to replace the $24.8 billion in accumulated deferred taxes.

The estimated $2.4[6] billion in investment tax credits granted cost the Treasury $0.13 billion in direct costs. This represents the cost to the Treasury of having to borrow money to replace the revenue lost to ITC.

These tax losses are summarized in Table 2 below. Of the $4.0 billion total cost to the U.S. Treasury, $3.8 billion comes from the large TELCOs and $0.2 billion comes from the mid-size TELCOs.

Table 2. Losses to the U.S. Treasury from TELCO Tax Breaks ($billions)

Large Mid-Size Total

Accelerated Depreciation

Replacement Cost: $1.2 $0.1 $1.3

Foregone Income Taxes

on Capital:

Net Income $1.5 $0.1 $1.6

Dividends $0.6 $0.04 $0.7

Debt: $0.3 $0.01 $0.3

Investment Tax Credit

Replacement Cost $0.13 $0.002 $0.13

Total: $3.8 $0.2 $4.0

CONCLUSION

This analysis demonstrates that the investor-owned telephone companies receive large benefits in terms of tax breaks granted by the U.S. Government. These tax breaks served to reduce the cost of local exchange service from investor-owned TELCOs by $5.7 billion in 2000. This is a reduction of 5.2% below the cost if the TELCOs did not receive these tax breaks. In addition these tax breaks cost the U.S. Treasury $4.0 billion in 2000.

The benefits are distributed unevenly among TELCOs. Some TELCOs receive little or no benefit from tax breaks, while others receive value much greater than the average 5.2 percent figure. The details of tax breaks for specific TELCOs are shown in Appendix E.

APPENDIX A

Method for Calculating the Cost Impact of

Deferred Income Taxes and Investment Tax Credits

The approach taken here is based on the assumption that investment tax credits and accelerated depreciation benefit TELCOs by displacing taxable equity or debt capital. If these tax breaks never existed, the TELCOs would have had to raise additional capital in equity or debt markets.

In calculating the dollar impact of eliminating the tax breaks, the following assumptions were made[7]:

1. The debt/equity fraction of the new issuances of capital would be the same as the present debt/equity ratio. The ratios are different for large TELCOs and mod-size TELCOs. For large TELCOs, the debt/equity ratio was in 39.5%/60.5% in 2000. For mid-size TELCOs the debt equity ratio was 35.7%/64.3%. Large TELCOs had a slightly more conservative capital structure than mid-sized.

2. The study used an embedded rather than a marginal cost of debt. This is because the study is intended to estimate the 2000 impact that would have occurred if the tax breaks had never existed. This approach assumes that in any year in which a tax break was granted, the TELCO would have had to issue private TELCO capital in lieu of the capital generated by the tax break. Thus debt would have been issued in each of the years from 1954 to 2000 to replace the capital provided by the tax breaks. The embedded cost of debt for a typical U.S. large TELCO in 2000 is estimated to be 9.7 percent, while the cost of debt for the typical mid-size TELCO was 6.6%.

3. The cost of equity poses a more difficult problem. Unlike debt costs, there is no "embedded" cost of equity. The obvious choices for estimating the 2000 impact associated with elimination of tax breaks over the 1954 to 2000 period are to use either the actual earned return on equity in 2000, or the marginal cost of equity in 2000. The 2000 earned return on common equity was used instead of the marginal cost because it is consistent with the embedded concept. The weighted average earned return on common equity for the large TELCOs was 20.18%, while the earned return for mid-size TELCOs was 20.13%. Since the TELCOs were assumed to be raising money in the same capital markets, the average earned return was used rather than the individual earned return for each company. However, because it is likely that the market would treat large and small TELCOs differently, the returns were calculated separately for each group. In fact, however, the average earned returns for each group were almost identical.

4. Capital raised through equity issuances will also generate a tax obligation. The 2000 statutory tax rate of 35 percent was used.[8]

5. Combining the debt/equity ratio, the debt and equity cost, and the tax rate yielded a pre-tax weighted cost of capital for large TELCOs of 22.64% and for the mid-size TELCOs of 22.26%. See Appendix C for a discussion and calculation of the pre-tax cost of capital. Use of the pre-tax cost of capital is appropriate because customers in regulated industries are responsible for paying the taxes which the company is assessed. The pre-tax cost of capital is the annual cost to the ratepayers for replacing the tax breaks with new issuances of capital.

6. The level of deferred income taxes is taken directly from Account 4340 in the Statistics of Common Carriers. The balance is $23.3 billion for large TELCOs and $1.3 billion for mid-size TELCOs. Multiplying these balances times the pre-tax weighted cost of capital gives a value for the deferred income taxes in 2000 of $5.3 billion for large TELCOs and $0.3 billion for mid-size TELCOs.

7. In 2000 the unamortized investment tax credit balance was $1.20 billion for large TELCOs and $0.02 billion for mid-size TELCOs. This comes directly from Account 4320 in the Statistics of Common Carriers. The study assumes that the ratable cost of service method was used to account for investment tax credits. This is the most common approach for dealing with investment tax credits. Under this approach the ratepayers pay the same cost of capital on the portion of ratebase financed with investment tax credits as they would on conventionally financed ratebase. Therefore, the cost of capital as seen by the ratepayers would be the same whether or not there had been investment tax credits (with the benefits going to the Telephone Company shareholders). The investment tax credit balance provides no rate reduction benefit to ratepayers. The benefit to the ratepayers comes in the amortization of the investment tax credit. In 2000 we estimated that the customers of investor-owned telephone companies received an amortization of $60 million for large TELCOs and $1 million for mid-size TELCOs[9]. If there had been no investment tax credits, the rates for local exchange service in 2000 would have been higher by $61 million.

8. The total benefit from tax breaks – $5.3 billion for large TELCOs and $0.3 billion for mid-size TELCOs is divided by the annual revenues to get the percentage rate impact. Revenues in 2000 were $102 billion for large TELCOs and $7 billion for mid-sized TELCOs. The rate impact is 5.23% for large and 4.69% for mid-size TELCOs.

APPENDIX B

Method for Calculating the

Revenue Loss to the U.S. Treasury in 2000

Table 2 in the body of the report shows the amount of money lost to the U.S. Treasury because of the existence of the tax breaks. There are five elements which total $4.0 billion. This appendix provides the details on how those losses were calculated.

Five Elements of Revenue Loss to the Treasury

1. The cost to the U.S. Treasury of borrowing money to replace the money lost in deferred taxes: While the money tied up in deferred taxes is intended to be repaid to the Treasury eventually, the fact remains that in 2000 there was a net of $24.8 billion tied up in deferred taxes which were owed to the Treasury by the investor-owned telephone companies.

2. Lost corporate taxes on the equity returns which would be generated if the TELCO had to raise capital now provided from deferred income taxes through the issuance of new debt and equity. The portion raised from new equity would generate taxable income which would generate a tax payment to the Treasury. These payments are lost due to the tax breaks.

3. Lost individual taxes on dividend payout to equity holders of the equity returns on the new equity required to replace the capital now provided from deferred income taxes.

4. Lost taxes on interest paid out by the TELCOs to debt holders on the new debt required to replace capital now provided from deferred income taxes.

5. The cost to the U.S. Treasury of borrowing money to replace the money lost to investment tax credits. The money lost to the Treasury in investment tax credits is lost forever, since there is no repayment to the Treasury of ITC.

Method

In order to calculate the total impact of these elements it is necessary to make some careful assumptions. This analysis is a snapshot view which does not include the long-term cost of interest on prior tax breaks.

1. The ten-year U.S. Treasury rate of 5.26 percent was used as the cost to the Treasury of funding the tax breaks.[10]

2. The total of deferred taxes lost to the Treasury in 2000 from telephone company operations was $24.8 billion. The annual borrowing cost on $24.8 billion, at the 5.26 percent U.S. Treasury rate, is $1.3 billion per year.

3. The lost taxes on the equity returns which the TELCO would have if it had to raise the deferred taxes through debt and equity issuance are calculated as follows. The amount to be raised would be the $24.8 billion calculated previously. Using the equity fraction in the capital structure (60.85 percent) and the pre-tax cost of equity (31.0 percent) yields a pre-tax equity return of $4.7 billion. At a corporate tax rate of 35 percent, the taxes on this return are $1.6 billion.

4. The lost individual taxes on the dividends which would have been paid out by the TELCO from the after-tax equity returns are calculated as follows. The after tax equity return is $4.42 billion minus $1.55 billion in corporate taxes, or $2.87 billion. Since the Statistics of Common Carriers data series did not include dividend payouts, we used a typical utility figure of 80%. Using 80%, the payout to stockholders on the additional after tax equity returns which there would be without the tax breaks would be an additional $2.4 billion in dividends. Assuming a 28 percent individual tax rate, the taxes on the dividend payout would be $0.68 billion.

5. The lost taxes on the interest which would have been paid out by the TELCO on the additional debt are calculated as follows. The deferred income taxes which would be replaced by debt is $24.8 billion times the 39.15% debt fraction, or $9.7 billion. The interest rate is 9.49 percent, yielding interest payments of $0.92 billion. At the individual tax rate of 28 percent, the taxes on this interest would be $0.26 billion.

6. In order to determine the cost to the Treasury of investment tax credits, it is necessary to determine how much the Treasury has lost in investment tax credits (ITC). This is not directly obtainable from the FCC data series since those only show the net investment tax credit balance. The net ITC balance shown in the data series represents the credit taken by the TELCOs, minus the amortization of that credit. However, the amortization of the credits goes to the ratepayers, not to the Treasury. The Treasury is never reimbursed for these

credits.

Assuming that the ITC never existed involves accounting for both the unamortized and the amortized portions to the Treasury. Therefore it is necessary to estimate the total investment tax credit balance which would include the portion already flowed back to the ratepayers.

The problem is that there is no standard source for the investment tax credits claimed by the TELCOs. It was necessary to estimate this series from available data. The starting point is the net cumulative ITC credits of the TELCO. This series extends back to the initial creation of investment tax credits in 1962. However, the data to construct this series is not available. The following assumptions were made:

a) the credits are amortized to the ratepayers over the life of the equipment being financed with the assistance of the tax credits;

b) a book life for these assets of 25 years, a typical life for TELCO assets. Thus, each year's new ITC is amortized to the ratepayers over 25 years.

c) There is an initial granting of investment tax credits in 1962 with each additional year’s investment tax credit increasing at a geometric rate.

d) Since the level of telephone company investment (net book value) is approximately half the level of electric utility investment (net book value), we assumed that the initial year’s investment tax credit was approximately half that for electric utilities (for which the data were available).

e) Using these assumptions we construct a series which provides the correct level of unamortized investment tax credits in 2000.

The result of this analysis is that the total ITC granted over the years 1962 to 1987 is about $5.4 billion or about 4.5 times the current level of unamortized ITC. The same model shows that the amortization in 2000 is about 15% of the unamortized balance, or $183 million.

Having gone through this exercise in model development, we decided that the uncertainties built into the model due to the lack of data called for conservatism. Therefore, we went back to the calculations which were done for investor-owned electric utilities for which better data were available on investment tax credits. The model developed for electric IOUs is shown in Schedule 2 below. This model shows that the amortization factor for 2000 is 6.7% while the “ITC Granted” multiplier is 2.34.

For additional conservatism we rounded the multiplier down to 2.0 and the amortization factor down to 5%. The 5% amortization factor is the one used in Appendix A. The 2.0 multiplier gives an estimate of $2.44 billion in ITC granted.

7. The annual borrowing cost on $2.44 billion, at the 5.26 percent U.S. Treasury rate, is $0.13 billion per year.

8. The total cost to the U.S. Treasury in 2000 of the investor-owned telephone company tax breaks is $4.0 billion.

	Cumulative	Annual	New ITC		Cumulative
	Net ITC	Change in	From IRS in	ITC Amortized	ITC Received
	Balance	Net ITC	This Year	to Ratepayers	From the IRS		Amortization
	(1)	(2)	(3)	(4)	(5)	Multiplier	Factor
--------	-----------------	----------------	-------------------	----------------------	---------------------	--------------	--------------------
1962	24.0	24.0	25.0	1.0	25.0	1.042	0.042
1963	50.4	26.4	28.6	2.1	53.6	1.062	0.042
1964	79.6	29.2	32.6	3.4	86.2	1.083	0.043
1965	112.0	32.4	37.3	4.9	123.5	1.103	0.044
1966	148.0	36.0	42.6	6.6	166.1	1.123	0.045
1967	188.1	40.1	48.7	8.6	214.8	1.142	0.046
1968	232.9	44.8	55.7	10.8	270.5	1.161	0.046
1969	283.2	50.2	63.6	13.4	334.1	1.180	0.047
1970	339.6	56.4	72.7	16.3	406.8	1.198	0.048
1971	403.0	63.5	83.0	19.6	489.8	1.215	0.049
1972	474.5	71.5	94.9	23.4	584.7	1.232	0.049
1973	555.2	80.7	108.4	27.7	693.2	1.248	0.050
1974	646.5	91.2	123.9	32.7	817.1	1.264	0.051
1975	749.7	103.3	141.6	38.3	958.7	1.279	0.051
1976	866.7	117.0	161.8	44.8	1,120.5	1.293	0.052
1977	999.4	132.7	184.9	52.2	1,305.4	1.306	0.052
1978	1,150.0	150.6	211.3	60.7	1,516.7	1.319	0.053
1979	1,321.1	171.1	241.4	70.3	1,758.1	1.331	0.053
1980	1,515.6	194.5	275.9	81.4	2,034.0	1.342	0.054
1981	1,736.9	221.3	315.2	94.0	2,349.2	1.353	0.054
1982	1,988.8	251.9	360.2	108.4	2,709.5	1.362	0.054
1983	2,275.6	286.8	411.6	124.8	3,121.1	1.372	0.055
1984	2,602.3	326.7	470.4	143.7	3,591.5	1.380	0.055
1985	2,974.6	372.3	537.5	165.2	4,129.0	1.388	0.056
1986	3,399.1	424.5	614.2	189.7	4,743.2	1.395	0.056
1987	3,883.1	484.1	701.9	217.8	5,445.0	1.402	0.056
1988	3,666.3	-216.8	0.0	216.8	5,445.0	1.485	0.059
1989	3,450.7	-215.7	0.0	215.7	5,445.0	1.578	0.062
1990	3,236.3	-214.4	0.0	214.4	5,445.0	1.682	0.066
1991	3,023.5	-212.9	0.0	212.9	5,445.0	1.801	0.070
1992	2,812.3	-211.2	0.0	211.2	5,445.0	1.936	0.075
1993	2,603.1	-209.2	0.0	209.2	5,445.0	2.092	0.080
1994	2,396.1	-207.0	0.0	207.0	5,445.0	2.272	0.086
1995	2,191.7	-204.4	0.0	204.4	5,445.0	2.484	0.093
1996	1,990.2	-201.5	0.0	201.5	5,445.0	2.736	0.101
1997	1,792.0	-198.2	0.0	198.2	5,445.0	3.039	0.111
1998	1,597.5	-194.4	0.0	194.4	5,445.0	3.408	0.122
1999	1,407.5	-190.1	0.0	190.1	5,445.0	3.869	0.135
2000	1,222.3	-185.1	0.0	185.1	5,445.0	4.455	0.151

Schedule 2. ITC Calculations for Investor-Owned Electric Utilities (millions of dollars)

	Cumulative	Annual		New ITC		Cumulative
	Net ITC	Change in		From IRS in	ITC Amortized	ITC Received		Amortization
Year	Balance	Net ITC		This Year	to Ratepayers	From the IRS	Multiplier	Factor
	(1)	(2)		(3)	(4)	(5)	(6)	(7)
-------	---------------	---------------	-	----------------	--------------------	--------------------	-------------------------	---------------------
1962	35.3	35.3		36.3	1.0	36.3	1.029	2.9%
1963	88.3	53.0		55.6	2.6	91.9	1.042	3.0%
1964	147.1	58.8		63.3	4.4	155.2	1.055	3.0%
1965	208.9	61.8		68.2	6.4	223.4	1.069	3.1%
1966	267.7	58.7		67.0	8.3	290.5	1.085	3.1%
1967	348.7	81.1		92.0	10.9	382.5	1.097	3.1%
1968	429.6	80.9		94.5	13.6	477.0	1.110	3.2%
1969	496.3	66.6		82.6	16.0	559.6	1.128	3.2%
1970	522.9	26.6		43.9	17.2	603.5	1.154	3.3%
1971	613.3	90.3		110.7	20.4	714.2	1.165	3.3%
1972	769.3	156.0		181.6	25.6	895.8	1.165	3.3%
1973	1,004.9	235.7		269.0	33.3	1,164.8	1.159	3.3%
1974	1,160.8	155.9		194.7	38.8	1,359.5	1.171	3.3%
1975	1,732.8	571.9		628.7	56.8	1,988.3	1.147	3.3%
1976	2,831.4	1,098.6		1,189.4	90.8	3,177.6	1.122	3.2%
1977	4,074.6	1,243.3		1,373.3	130.0	4,551.0	1.117	3.2%
1978	5,245.0	1,170.3		1,338.6	168.3	5,889.6	1.123	3.2%
1979	6,318.4	1,073.4		1,278.2	204.8	7,167.8	1.134	3.2%
1980	7,094.0	775.6		1,009.2	233.6	8,177.0	1.153	3.3%
1981	8,352.1	1,258.1		1,535.6	277.5	9,712.6	1.163	3.3%
1982	10,552.0	2,200.0		2,550.3	350.4	12,262.9	1.162	3.3%
1983	12,309.7	1,757.7		2,170.1	412.4	14,433.0	1.172	3.3%
1984	14,393.5	2,083.8		2,569.6	485.8	17,002.6	1.181	3.4%
1985	16,177.0	1,783.4		2,335.9	552.5	19,338.5	1.195	3.4%
1986	16,993.2	816.2		1,409.0	592.8	20,747.5	1.221	3.5%
1987	17,275.5	282.3		900.3	618.0	21,647.8	1.253	3.6%
1988	16,657.5	618.0		0.0	618.0	21,647.8	1.300	3.7%
1989	16,039.5	618.0		0.0	618.0	21,647.8	1.350	3.9%
1990	15,421.5	618.0		0.0	618.0	21,647.8	1.404	4.0%
1991	14,803.5	618.0		0.0	618.0	21,647.8	1.462	4.2%
1992	14,185.5	618.0		0.0	618.0	21,647.8	1.526	4.4%
1993	13,567.5	618.0		0.0	618.0	21,647.8	1.596	4.6%
1994	12,949.5	618.0		0.0	618.0	21,647.8	1.672	4.8%
1995	12,331.5	618.0		0.0	618.0	21,647.8	1.755	5.0%
1996	11,713.5	618.0		0.0	618.0	21,647.8	1.848	5.3%
1997	11,095.5	618.0		0.0	618.0	21,647.8	1.951	5.6%
1998	10,477.5	618.0		0.0	618.0	21,647.8	2.066	5.9%
1999	9,859.5	618.0		0.0	618.0	21,647.8	2.196	6.3%
2000	9,241.5	618.0		0.0	618.0	21,647.8	2.342	6.7%

1. Cumulative Net ITC Balance from Federal Energy Regulatory Commission (FERC) Form 1s.

2. Annual Change in Net ITC calculated from Column 1.

3. New ITC From IRS in This Year is the sum of Column 2 and Column 4.

4. ITC Amortized to Ratepayers is each year's amortization of all the previous New ITC.

5. Cumulative ITC Received from the IRS is the cumulative total of Column 3.

6. Column 5 divided by column 1.

7. Column 4 divided by column 1.

APPENDIX C

Pre-Tax Cost of Capital

To allow the TELCO to earn a particular after-tax return on equity, the TELCO must be allowed to collect more than that return on equity from the ratepayers. The reason: equity returns are taxable. After-tax and pre-tax returns on equity were calculated using the following formulae:

AFTER TAX RETURN = PRE TAX RETURN – TAXES ON PRE TAX RETURN

= PRE TAX RETURN – TAX RATE x PRE TAX RETURN

= (1 – TAX RATE) x PRE TAX RETURN

PRE TAX RETURN = (AFTER TAX RETURN) / (1 – TAX RATE)

So if regulators thought the TELCO deserved to earn 20.18 percent after-tax on its equity capital, assuming a 35 percent federal tax rate, the TELCO would have to have its rates set in such a way that it could expect to earn 31.34 percent on a pre-tax basis as is shown below.

The 31.34 percent figure is the one that is relevant to the ratepayers. This return will generate the desired 20.18 percent return to investors as is shown below.

The difference, i.e., 31.34 percent minus 20.18 percent or 11.16 percent, is the U.S. Treasury's share of the pre-tax equity return.

A similar adjustment is not required for debt costs. The reason is that debt costs are tax deductible to the issuing corporation. So if TELCO bond holders expect to earn 9.5%, regulators must simply allow an 9.5% return on debt.

Combining the debt and equity costs yields the following weighted, pre-tax cost of capital:

Capital Item	Percent of Capital Structure	Pre-Tax Marginal Cost	Pre-Tax Weighted Cost
Equity	60.85%	31.34%	18.88%
Debt	39.15%	9.49%	3.72%

Total			22.60%

The 22.60 percent figure is the cost of capital used in estimating the costs if tax breaks had never existed for U.S. investor-owned telephone companies.

APPENDIX D

Accumulated Deferred Income Taxes and Income Tax Credits for

Individual Investor-Owned Telephone Companies

The table shows the accumulated deferred income taxes and investment tax credits in place in 2000 for each of the major investor-owned telephone companies.

Table D-1. Deferred Income Taxes and Investment Tax Credits by Investor-Owned Telephone Companies as of 2000

(thousands of Dollars)

	Accumulated Deferred	Accumulated Investment
Company	Income Taxes	Tax Credits
----------------------------------------------	------------------------------	---------------------------------
Bell South	$3,952,914	$170,833
Qwest	$2,839,423	$234,618
Ameritech/Illinois	$1,013,541	$41,681
Ameritech/Indiana	$319,739	$13,124
Ameritech/Michigan	$611,044	$32,119
Ameritech/Ohio	$559,090	$29,710
Ameritech/Wisconsin	$359,372	$13,867
Nevada Bell	$41,849	$4,856
Pacific Bell	$2,645,271	$203,184
Southern New England	$236,729	$13,884
Southwestern Bell	$1,699,687	$159,864
Verizon/California	$1,140,352	$6,168
Verizon/Delaware	$78,205	$2,352
Verizon/Florida	$471,476	$0
Verizon/Hawaii	$339,257	$32,313
Verizon/Maryland	$513,532	$14,190
Verizon/Mid-States	$31,802	$931
Verizon/Midwest	$126,696	$1,290
Verizon/New England	$595,862	$43,224
Verizon/New Jersey	$858,252	$32,587
Verizon/New York	$531,309	$84,677
Verizon North	$1,268,956	$272
Verizon/Northwest	$445,165	$0
Verizon/Pennsylvania	$937,441	$34,205
Verizon/South	$439,565	$1,213
Verizon/Southwest	$358,232	$367
Verizon/Virginia	$587,652	$23,390
Verizon/DC	$194,588	$3,228
Verizon/West Virginia	$122,799	$3,012
Puerto Rico Telephone Company	$9,884	$0
Aliant	$17,100	$47
ALLTEL/Carolina	$34,996	$38
ALLTEL/Georgia	$67,078	$9
ALLTEL/Pennsylvania	$38,805	$38
Western Reserve	$26,810	$15
Cincinnati Bell	$126,287	$9,227
Citizens/New York	$20,806	$0
Commonwealth	$44,024	$0
Frontier/Rochester	$72,348	$3,271
Carolina Telephone & Telegraph	$99,730	$0
Central Telephone Company	$174,156	$484
Central/Texas	$27,536	$52
Central/Virginia	$56,460	$275
Sprint/Florida	$279,549	$7,373
Sprint/Missouri	$63,756	$0
United/Indiana	$17,519	$0
United/New Jersey	$35,063	$0
United/Northwest	$32,144	$0
United/Ohio	$57,612	$0
United/Pennsylvania	$56,164	$0
United/Southeast	$64,405	$0
United/Texas	$23,405	$0
United/Southeast	$64,405	$0
United/Texas	$23,405	$0

Schedule 1:

Calculation of Investment Tax Credits for Investor-Owned Telephone Companies

Actually Received from the U.S. Treasury

(in millions of dollars)

Tax Breaks for Individual Investor-Owned Telephone Companies

Data from the 2000 FCC data series were used to calculate the 2000 tax breaks for each of the major investor-owned telephone companies. The data series provided the necessary information on deferred taxes and investment tax credits. The FCC data series also provide the necessary information to calculate individual TELCO debt and equity costs. In this report, however, the overall average investor-owned TELCO debt and equity costs were used rather than the individually calculated costs.

The overall average TELCO costs were used rather than the individual TELCO costs for the following reason. The individual costs are reflective of the current state of investment by each TELCO and the package of loans and equity issues which it has undertaken. This analysis, however, is attempting to calculate the cost of raising additional capital which would be needed to replace capital now raised through tax breaks. This additional capital would need to be raised at the margin, and each company would need to compete with all the other companies. Therefore it is appropriate to use the overall average cost of capital for the individual calculations.

Table E-1. Summary of Results by Company

(all values in thousands of dollars)

	Benefits of Tax Breaks to Telephone Company Customers				Cost of Tax Breaks to the U.S. Treasury

	Benefit of	Benefit of	Total
	Deferred	Investment	Benefit to	Rate	Interest Cost	Interest Cost	Lost Taxes on	Lost Taxes on	Lost Taxes on	Total Cost to the
Company	Income Taxes	Tax Credits	Customers	Impact	on Lost DIT	on ITC Given	Equity Return	Dividend Payout	Debt Interest	U.S. Treasury
--------------------------	----------------	---------------	---------------	----------	----------------	------------------	----------------------	-------------------------	-----------------------	---------------------------
All ILECs	$5,598,142	$61,099	$5,659,241	5.19%	$1,302,662	$128,553	$1,637,324	$681,127	$257,620	$4,007,287

Large ILECs		$5,281,436	$60,058	$5,341,494	5.23%	$1,227,141	$126,362	$1,534,460	$638,336	$251,234	$3,777,533
	Bell South	$911,425	$8,542	$919,967	5.48%	$207,923	$17,972	$268,437	$111,670	$40,450	$646,451
	Qwest	$604,850	$11,731	$616,581	5.65%	$149,354	$24,682	$167,405	$69,640	$35,434	$446,515
	Ameritech/ Illinois	$280,750	$2,084	$282,834	6.63%	$53,312	$4,385	$92,827	$38,616	$4,349	$193,488
	Ameritech/ Indiana	$82,265	$656	$82,921	6.19%	$16,818	$1,381	$26,069	$10,845	$2,179	$57,292
	Ameritech/ Michigan	$165,318	$1,606	$166,924	4.86%	$32,141	$3,379	$53,954	$22,445	$3,126	$115,044
	Ameritech/Ohio	$153,319	$1,486	$154,804	6.63%	$29,408	$3,125	$50,415	$20,973	$2,597	$106,519
	Ameritech/ Wisconsin	$93,234	$693	$93,928	7.21%	$18,903	$1,459	$29,695	$12,353	$2,350	$64,759
	Nevada Bell	$10,642	$243	$10,885	5.80%	$2,201	$511	$3,348	$1,393	$301	$7,754
	Pacific Bell	$581,428	$10,159	$591,587	5.98%	$139,141	$21,375	$165,105	$68,684	$30,715	$425,021
	Southern New England	$54,358	$694	$55,052	3.49%	$12,452	$1,461	$15,961	$6,640	$2,451	$38,965
	Southwestern Bell	$376,600	$7,993	$384,594	3.44%	$89,404	$16,818	$107,622	$44,771	$19,351	$277,965
	Verizon/ California	$226,609	$308	$226,918	7.46%	$59,983	$649	$58,916	$24,509	$16,318	$160,374
	Verizon/ Delaware	$19,013	$118	$19,130	6.60%	$4,114	$247	$5,811	$2,417	$675	$13,264
	Verizon/Florida	$98,269	$0	$98,269	6.71%	$24,800	$0	$26,693	$11,104	$6,161	$68,758
	Verizon/Hawaii	$76,076	$1,616	$77,692	16.61%	$17,845	$3,399	$21,944	$9,129	$3,746	$56,063
	Verizon/ Maryland	$117,729	$710	$118,439	5.34%	$27,012	$1,493	$34,528	$14,364	$5,341	$82,738
	Verizon/ Mid-States	$8,690	$47	$8,737	6.66%	$1,673	$98	$2,852	$1,186	$152	$5,961
	Verizon/ Midwest	$37,920	$65	$37,985	8.81%	$6,664	$136	$13,045	$5,427	$182	$25,453
	Verizon/ New England	$131,293	$2,161	$133,454	3.02%	$31,342	$4,547	$37,356	$15,540	$6,878	$95,662
		Benefits of Tax Breaks to Telephone Company Customers				Cost of Tax Breaks to the U.S. Treasury

		Benefit of	Benefit of	Total
		Deferred	Investment	Benefit to	Rate	Interest Cost	Interest Cost	Lost Taxes on	Lost Taxes on	Lost Taxes on	Total Cost to the
Company		Income Taxes	Tax Credits	Customers	Impact	on Lost DIT	on ITC Given	Equity Return	Dividend Payout	Debt Interest	U.S. Treasury
--------------------------		----------------	---------------	---------------	----------	----------------	------------------	----------------------	-------------------------	-----------------------	---------------------------
	Verizon/ New Jersey	$195,749	$1,629	$197,378	5.34%	$45,144	$3,428	$57,192	$23,792	$9,056	$138,612
	Verizon/New York	$110,827	$4,234	$115,061	1.46%	$27,947	$8,908	$30,125	$12,532	$6,931	$86,444
	Verizon North	$287,331	$14	$287,345	10.19%	$66,747	$29	$83,494	$34,734	$13,657	$198,661
	Verizon/ Northwest	$107,708	$0	$107,708	9.82%	$23,416	$0	$32,814	$13,651	$3,907	$73,787
	Verizon/ Pennsylvania	$212,722	$1,710	$214,432	6.18%	$49,309	$3,598	$61,914	$25,756	$10,031	$150,609
	Verizon/South	$96,085	$61	$96,146	6.77%	$23,121	$128	$27,165	$11,301	$5,172	$66,886
	Verizon/ Southwest	$81,880	$18	$81,899	5.60%	$18,843	$39	$23,961	$9,968	$3,758	$56,568
	Verizon/ Virginia	$133,795	$1,170	$134,965	5.87%	$30,910	$2,461	$39,040	$16,241	$6,231	$94,882
	Verizon/DC	$50,577	$161	$50,739	7.89%	$10,235	$340	$16,127	$6,709	$1,260	$34,671
	Verizon/ West Virginia	$29,020	$151	$29,170	4.59%	$6,459	$317	$8,699	$3,619	$1,166	$20,260
	Puerto Rico	$1,598	$0	$1,598	0.15%	$520	$0	$324	$135	$188	$1,167

Midsize ILECs		$319,533		$1,041	$320,575	4.69%	$75,521	$2,191	$100,000	$41,600	$9,469	$228,781
	Aliant		$5,145	$2	$5,147	2.81%	$899	$5	$1,786	$743	$11	$3,445
	ALLTEL/ Carolina		$6,542	$2	$6,544	5.03%	$1,841	$4	$1,883	$783	$325	$4,836
	ALLTEL/ Georgia		$16,007	$0	$16,008	6.52%	$3,528	$1	$5,152	$2,143	$361	$11,185
	ALLTEL/ Pennsylvania		$9,158	$2	$9,160	6.17%	$2,041	$4	$2,935	$1,221	$216	$6,417
	Western Reserve		$5,559	$1	$5,560	4.36%	$1,410	$2	$1,686	$701	$208	$4,007
	Cincinnati Bell		$25,310	$461	$25,771	3.70%	$6,643	$971	$7,553	$3,142	$1,045	$19,352
	Citizens/ New York		$2,885	$0	$2,885	1.40%	$1,094	$0	$673	$280	$269	$2,317
	Commonwealth		$10,317	$0	$10,317	5.68%	$2,316	$0	$3,297	$1,372	$251	$7,235
	Frontier/ Rochester		$21,116	$164	$21,280	6.31%	$3,806	$344	$7,269	$3,024	$97	$14,540
	Carolina T&T		$21,707	$0	$21,707	2.88%	$5,246	$0	$6,729	$2,799	$695	$15,469
	Central		$43,523	$24	$43,547	7.45%	$9,161	$51	$14,248	$5,927	$788	$30,175
	Central/Texas		$5,663	$3	$5,666	3.78%	$1,448	$5	$1,711	$712	$217	$4,094
	Central/Virginia		$11,578	$14	$11,592	5.80%	$2,970	$29	$3,493	$1,453	$447	$8,392
	Sprint/Florida		$58,959	$369	$59,327	4.83%	$14,704	$776	$18,023	$7,497	$2,090	$43,090
	Sprint/Missouri		$12,478	$0	$12,478	6.15%	$3,354	$0	$3,680	$1,531	$550	$9,114
	United/Indiana		$3,735	$0	$3,735	2.38%	$921	$0	$1,147	$477	$128	$2,674
		Benefits of Tax Breaks to Telephone Company Customers					Cost of Tax Breaks to the U.S. Treasury

		Benefit of		Benefit of	Total
		Deferred		Investment	Benefit to	Rate	Interest Cost	Interest Cost	Lost Taxes on	Lost Taxes on	Lost Taxes on	Total Cost to the
Company		Income Taxes		Tax Credits	Customers	Impact	on Lost DIT	on ITC Given	Equity Return	Dividend Payout	Debt Interest	U.S. Treasury
--------------------------		----------------		---------------	---------------	----------	----------------	------------------	----------------------	-------------------------	-----------------------	---------------------------
	United/ New Jersey		$7,626	$0	$7,626	5.85%	$1,844	$0	$2,363	$983	$245	$5,435
	United/ Northwest		$6,825	$0	$6,825	5.95%	$1,691	$0	$2,093	$871	$237	$4,891
	United/Ohio		$12,541	$0	$12,541	2.82%	$3,030	$0	$3,888	$1,617	$401	$8,937
	United/ Pennsylvania		$12,144	$0	$12,144	4.74%	$2,954	$0	$3,754	$1,562	$397	$8,667
	United/ Southeast		$13,100	$0	$13,100	5.80%	$3,388	$0	$3,937	$1,638	$518	$9,481
	United/Texas		$4,839	$0	$4,839	3.63%	$1,231	$0	$1,466	$610	$182	$3,489

[1] These companies are providers of local exchange service, and are also known as “Incumbent Local Exchange Companies,” or ILECs.

[2] The companies are classified into two categories – large ILECs and midsize ILECs – and the data collected by the Federal Communications Commission is separated accordingly. Thus, in this report we are able to identify where there are differences in the amount of tax-saving benefits received by these two groups. According to the FCC’s Common Carrier Bureau, these two categories together provide local exchange service to over 90% of all telephone customers. The overwhelming majority of telephone service provided by the large and mid-size companies (94%) is actually provided by the large companies, all regional Bell operating companies.

[3] New accelerated depreciation is still available to telephone companies. Granting of new investment tax credits ended in 1987, but companies still continue to receive significant residual benefit from investment tax credits granted prior to that year.

[4] Calculation of the pre-tax weighted cost of capital is detailed in Appendix C.

[5] If we had used the 15% amortization fraction, the rate impact of ITC amortization would have been 0.17% for all TELCOs (0.18% for large TELCOs and 0.05% for mid-sized TELCOs).

[6] See Appendix B for a detailed discussion of the source of the $2.4 billion figure. The discussion is found under the part of Appendix B which discusses the cost to the Treasury of investment tax credits. This figure represents the total amount of investment tax credit given to the TELCOs during the period when investment tax credits were offered by the Treasury. Since investment tax credits are never paid back to the Treasury, the total amount granted over the years is the appropriate amount to include here.

[7] All the underlying data calculations are based on FCC Statistics of Common Carriers (SOCC) Tables 2-9, 2-10, and 2-11.

[8] Source: United States Internal Revenue Service, Instructions to Form 1120. The 35% figure applies to most income categories.

[9] The model which was used is described in Appendix B.

[10] Source: Economic Report to the President.