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Time to Re-deregulate the Airline Industry
NTU Policy Paper No. 117
July 26, 2005
By Paul Gessing
"I'm not kow-towing to Washington or anyone else!" – Howard Hughes battling the government-sponsored Pan Am monopoly on European routes in the film The Aviator
Americans are justifiably proud of their nation's adherence to the tenets of capitalism and free enterprise, especially when they compare the U.S. economy with relative levels of socialism still found worldwide. Even so, our economy still contains hidden, significant pockets of government micromanagement, a behavior that distorts a given market to the point that it could barely be called "free." In some industries, particularly those that have never experienced anything resembling free market conditions, the negative impact of those rules and regulations is simply internalized and ignored by the general public.
Commercial air travel is the poster child for these industries. This paper explores and briefly analyzes the overwhelming federal role in the aviation industry and whether consumers are better served by continued government dominance or more responsive, market driven interests. Hopefully it will provide readers an understanding of just how little the industry resembles a free market and create a greater awareness of the impediments the industry faces.
U.S. airlines have lost more than $30 billion during the past four years, including an estimated $7.5 billion in 2004; the industry is expected to lose at least $2 billion more in 2005. The ongoing flow of red ink from the industry's balance sheets, and the decision by United Airlines to drop $9.8 billion in pension obligations onto the laps of federal taxpayers, leaves no doubt that the airline industry remains among the most troubled sectors in America's economy. However, that "trouble" is not universal within the industry. Although investors in so-called legacy carriers (and the balance sheets of those airlines) have fared poorly since deregulation took place in 1978, discount carriers like Southwest and JetBlue have gobbled up market share. Notably, the major problem in the industry has not been inadequate demand. As the chart below clearly shows, there has been a steady increase in the demand for airline flights over the decades and the number of airline passengers has far exceeded population growth, particularly since the industry was deregulated in 1978.
Under deregulation, passengers have benefited greatly from lower prices and service to new locations. The best estimates indicate that deregulated fares have been 10 to 18 percent lower, on average, than they would have been under the previous regulatory formulas. The total net benefit to travelers has been $20 billion per year. Unfortunately, the deregulation of 27 years ago was only the first step in creating a freer market in aviation. The limited scope of the original deregulation model and the rise of security as a major new cost component have preserved and extended the role of the federal government within the aviation sector, thus hindering efforts to turn a profit.
From the perspective of taxpayers who have been forced to spend billions of dollars bailing out failed airlines – and who may be on the hook for $8 billion more due to a funding shortfall in air traffic control – it is essential for Congress to create an environment that allows airlines to succeed or fail on their own merits in the closest thing possible to a free marketplace.
Problem One: Security Snafus
While it is undoubtedly in the government's (and our own) self interest to ensure that terrorists cannot easily board commercial jets and use them to commit 9/11-style atrocities again, the highly visible Transportation Security Administration (TSA) is the most obvious manifestation of government micromanagement of aviation. TSA is notoriously inefficient and incompetent. On multiple occasions, it has failed to stop teenagers from sneaking weapons and other dangerous items through security checkpoints. Less well known is that in forming its crack security team, TSA spent an absurd $12,000 per recruit, which is about 40 percent of each recruit's average annual salary of $29,500. The agency's operational missteps have also included a "no-fly" list that has mistakenly snared Senators, security screeners arrested for stealing from luggage, and uncomfortable passenger pat-downs.
After 9/11, a new tax of up to $5.00 per one-way trip (and $10.00 for flights with layovers) was levied on airline passengers in order to fund screeners, equipment, and other costs of the Transportation Security Administration.This tax alone costs the flying public about $1.7 billion annually. Unfortunately, yearly contributions of $300 million from the airlines are also required and another $3 billion each year is taken from the General Fund.
Recently, yet another tax increase was proposed by the House Aviation Subcommittee to provide TSA with funding for in-line Explosives Detection Systems and other equipment. The Subcommittee's so-called TSA High-Tech Proposal calls for a three-year, $6.02 billion hike in travel taxes and security fees. Although the fee increase was subsequently withdrawn, it is another sign of the ever-increasing burden on airline passengers.
During the last year alone, two other fee increases were proposed and one of them was enacted. Although the President's proposal to more than double the per-segment "9/11 Security Tax" – at a cost to passengers of $1.5 billion annually – was never enacted, a 61 percent "Passenger Inspection Fee" increase was put in place by the United States Department of Agriculture on January 1, 2005.
TSA and the broader aviation security apparatus are costly and inefficient, but security is essential. Reform of security can be done in ways that limit costs while increasing effectiveness, such as implementing innovative procedures to create a "registered traveler" system that would allow certain frequent fliers to be expedited through security. Aside from procedural changes within TSA, allowing private contractors to manage a larger share of the day-to-day security operation at airports would also improve flexibility and save money, as Aviation Subcommittee Chairman John Mica recently pointed out. The good news is that five airports have already been allowed to opt out of the federally-operated screening system in favor of private screeners. That practice is likely to become far more common once TSA completes remaining policies and procedures sometime in 2005.
Problem Two: Induced Overcapacity
The days of Howard Hughes, TWA, and Pan Am have long passed, yet most airlines have been unable to kick the subsidy habit (several discount carriers including Southwest and JetBlue being notable exceptions). Since 9/11, the federal government has provided no less than $9.5 billion to the airline industry in the guise of grants, loan guarantees, and tax waivers. Although one could argue over the "fairness" of such a bailout given what occurred on 9/11 and the ensuing fallout, the reality is that industry analysts cite excess capacity caused by too many airlines competing for the same routes as being among the industry's major problems.
Although some short-term actions may be justified on both moral and economic grounds, by keeping inefficient competitors in the air over the long term, the federal government has made it very difficult for the industry to achieve balance and thus profitability. Elizabeth Bailey, Professor of Business and Public Policy at Wharton University, believes that reducing capacity is essential. She argues, "If one airline goes under it will strengthen the others. There are too many carriers and too much capacity. This industry hasn't been in equilibrium as long as I have been watching it." If laggards like United and US Airways were allowed to stop flying, more efficient competitors would step in quickly in most markets, thus preserving and improving overall airline service.
While Congress induces airlines to overcapacity through cash payments, other problems have surfaced. Even when airlines act to reduce overcapacity and save costs, federal regulators often stand in their way. The proposed pre-9/11 merger between United and US Airways is just one example. In July of 2001, the airlines were forced to call off their planned merger after the U.S. Justice Department threatened to block the deal. Then-Attorney General John Ashcroft's statement that "while some mergers can further competition, this one does not," shows that micromanagement of the airline industry knows no ideological or party boundaries. The fact is that in the months leading up to 9/11, the airline industry was already suffering from the nation's economic slowdown in the wake of strong growth and relative stability throughout the 1990s. Although 9/11 itself may have made the deal unworkable in the end, this episode clearly shows the tendency for federal officials and politicians toward encouraging excess capacity.
The latest announced airline merger between US Airways and America West is yet another industry attempt to restructure itself. It represents the first merger bid among the top-ten domestic airlines since the 9/11 terrorist attacks, but this deal will likewise face federal scrutiny that could force the industry to once again retain excess capacity.
Problem 3: Out-of-Control Air Traffic Control
In both 2000 and 2003, I addressed the issue of how the nation's federally-managed air traffic control system burdens airlines and taxpayers with unnecessarily high costs and inefficient service. The major funding source for air traffic control in the U.S. is a 7.5 percent tax on airline tickets. Due in part to rampant inefficiency spanning several decades as well as the ongoing decline in the average ticket price for airline passengers, the ticket tax is not expected to produce adequate revenue in coming years to fund air traffic control operations under the current model. According to Russell Chew, Chief Operating Officer of the Air Traffic Organization within the FAA, air traffic control is facing an $8.2 billion gap between revenues and spending over the next five years. Given the past unwillingness on the part of organized labor and Congress to tackle needed reforms, a crisis may be the catalyst needed for reform.
Although the measure is strongly opposed by labor unions and some in the general aviation community, the impending financial meltdown can be resolved if Congress acts to commercialize air traffic control operations. As of March 2005, 38 nations had taken this step in an effort to create a more efficient, technologically modern, and appropriately financed air traffic control system. In an April 2005 publication called Preliminary Observations on Commercialized Air Navigation Service Providers, the Government Accountability Office (GAO) studied the pros and cons of commercialization efforts overseas. After evaluating air traffic control services in Australia, Canada, Germany, New Zealand, and the U.K., the GAO determined that overseas services have been able to reduce operating costs, improve efficiency through modernization, and reduce unit costs (in turn reducing passenger and taxpayer costs). Throughout this process, safety has not been compromised.
Any trained economist or person of reasonable intellect would naturally assume that commercialization would create cost savings by freeing air traffic management from federal control, but the GAO report's finding on safety is critically important. Opponents of commercialization, particularly labor unions, have repeatedly used the threat of a "corporate" air traffic control organization placing profits above "safety" in their campaigns against reform. Now we have objective findings that safety is maintained or even improved under a commercial model. Commercialization is the key to resolving the air traffic control funding gap without burdening taxpayers and passengers or compromising security.
Problem 4: Aviation Protectionism
Many Americans mistakenly believe that protectionist laws are designed only to "protect" farmers, textile producers, and automobile manufacturers from cheap imports, but the level of protectionism in aviation is stunningly high. In 1926, Congress enacted legislation known as the Air Commerce Act, which restricted combined foreign ownership of any U.S. airline to 49 percent or less. By 1938, protectionist impulses were further deepened to the point that Congress mandated that U.S. citizens control at least 75 percent of the voting interests of all U.S. airlines. That standard is still in place today. In 2003 President Bush proposed loosening the ownership restrictions to lower the foreign ownership threshold back to 49 percent, but Congressional opposition scuttled that effort.
Most major U.S. airlines would like to see an influx of foreign investment; the problems are the labor unions and Congressional protectionist impulses standing firmly in the way. Opponents cite supposed national security interests, safety, and the possibility that U.S. jobs could be put at risk. Of course, what opponents fail to mention is that the airlines themselves could dramatically improve their financial conditions and allow for innovative ideas and services from foreign nations that might otherwise take years to get here or never get here at all.
Although President Bush's proposal was obviously a step in the pro-taxpayer, free market direction, the greatest benefits would come from true free trade. That means ending these absurd and restrictive ownership laws and allowing foreign ownership and operations to occur within the U.S. Studies have shown that American workers overall – and in the aviation industry itself – are more productive than their European counterparts. Allowing greater freedom of investment and operation to foreigners would be a huge boon for aviation employees whose jobs – and even pensions – are threatened.
Problem 5: Federal Micromanagement
In addition to the industry-wide issue areas highlighted in this paper, the federal government imposes restrictions on specific airports around the country that warp the marketplace and cost passengers time and money in the process. First and foremost, in a misguided effort to use command and control techniques rather than market tools – like pricing – to reduce congestion at certain major airports, the FAA has since 1969 limited the number of takeoffs and landings that can occur at Chicago O'Hare, Washington National, and New York's LaGuardia and Kennedy airports. Although most passengers would question whether these federal restrictions have really alleviated congestion at the aforementioned airports, there is no question that such restrictions have served to keep discount carriers out of the nation's busiest airports and most important cities. In fact, the GAO has repeatedly pointed out that these slots were used by established carriers to build upon the favorable positions they inherited as a result of grandfathering. Predictably, little new entry has occurred at these airports, which are crucial to establishing new service in the heavily traveled Eastern and Midwestern markets.
The four major airports are of course by no means the only places in which Congress has exercised significant micromanaging. Having achieved the status of being a major (and profitable) player in the airline industry, Southwest Airlines is taking aim at repealing the so-called "Wright Amendment" that restricts flights into and out of Love Field near Dallas. The cities of Dallas and Fort Worth, and the Dallas/Fort Worth airport (DFW), which opened in 1974, tried unsuccessfully to force Southwest (a tiny three-plane airline at the time) to move its operations from close-in Love Field out to DFW, arguing that the new airport depended on this.
Although they failed to force Southwest to move, the other carriers convinced House Majority Leader Jim Wright, from Fort Worth, to push through Congress a measure designed to stifle the growth of Southwest and punish it for not moving out to DFW. The Wright Amendment restricted interstate service from Love Field to cities in just four states – Louisiana, Arkansas, Oklahoma, and New Mexico. In 1997 Senators wanting to bring Southwest's low fares to their constituents altered the Wright Amendment to allow flights to Alabama, Kansas, and Mississippi. Still today, however, if you want to fly Southwest from Love Field to Los Angeles, you must buy a ticket to Albuquerque, collect your baggage there, buy another ticket, go through security again and board another plane. The Wright Amendment and the near-monopoly status of that region's aviation market are two primary reasons that residents of North Texas are forced to pay an average business fare that is 48 percent higher than at other airports across America.
There are dozens of other ways in which the federal government intervenes in the marketplace, usually to the detriment of passengers and airlines alike, but one program of note is the Essential Air Service (EAS). EAS was created as part of the Airline Deregulation Act of 1978 to ensure continued air service to small communities that airlines might otherwise abandon. The program subsidizes air service to a community if it's located more than 70 miles from the nearest medium or large hub airport and if the per passenger subsidy is $200 or less. In 2005, total EAS subsidies totaled more than $100 million. Although there is no question that EAS allows some cities to receive airline service that would not otherwise be served, it is arguable that many smaller cities would remain served if Congress reduced the number of market distortions throughout the industry.
Although the total cost of these and other misguided federal policies may not be calculable, there is no doubt that billions of dollars annually are lost to taxpayers and the economy because the lessons of "deregulation" that took place in 1978 have not been learned. Nearly 30 years after a growth spurt introduced innovation and competition into the industry and brought the convenience of flying to the masses, Congress refuses to release its iron grip. Only when that occurs will the creative energies of the next Howard Hughes or Herb Kelleher once again be released to the benefit of travelers and the global economy alike.
 Joel J. Smith, "Airlines Pushed to the Brink Over Low Fares," Detroit News, January 24, 2005, http://www.detnews.com/2005/business/0501/24/A01-67893.htm.
 Sam Pelzman and Clifford Winston (2000) Deregulation of Network Industries: What's Next?. AEI-Brookings Joint Center for Regulatory Studies. Washington DC: Brookings Institution Press. p. 2, http://www.aei.brookings.org/admin/authorpdfs/page.php?id=109.
 Sara Kehaulani Goo, "Air Security Agency Faces Reduced Role," The Washington Post, April 8, 2005, http://www.washingtonpost.com/ac2/wp-dyn/A35333-2005Apr7?language=printer.
 U.S. Department of State, "Taxes and Fees Associated with Air Travel," January 2003, http://www.state.gov/ofm/resource/imp/tax/20129.htm.
 Kenneth M. Mead, "Statement Before the Committee on Commerce, Science, and Transportation, Subcommittee on Aviation, United States Senate," February 5, 2003, http://dorgan.senate.gov/newsroom/extras/020503mead.pdf.
 Chairman John Mica, House Aviation Subcommittee, "Continued Air Security Failures Need A Dramatic High Tech Overhaul," statement regarding the public release of the Department of Homeland Security's Inspector General report on the quality of airport security screening since the September 11th terrorist attacks, April 19, 2005, http://www.house.gov/transportation/press/press2005/release45.html.
 Government Accountability Office, "Preliminary Observations on TSA's Progress to Allow Airports to Use Private Passenger and Baggage Screeners," November 2004, www.gao.gov/cgi-bin/getrpt?GAO-05-126.
 Joel J. Smith, "Airlines Pushed to the Brink Over Low Fares," Detroit News, January 24, 2005, http://www.detnews.com/2005/business/0501/24/A01-67893.htm.
 Wharton Strategic Management, "Few Survivors Predicted: Why Most Airlines Are Caught in a Tailspin," February 9, 2005, http://knowledge.wharton.upenn.edu/article/1124.cfm.
 Interview with Russell Chew, Chief Operating Officer, Air Traffic Organization, Federal Aviation Administration, July 14, 2005.
 Gerald L. Dillingham, Ph.D, Director, Physical Infrastructure Issues, "Preliminary Observations on Commercialized Air Navigation Service Providers," Government Accountability Office, April 20, 2005, http://www.gao.gov/cgi-bin/getrpt?GAO-05-542T.
 Michael Buckley, "Transportation Labor Criticizes Irresponsible Call to Privatize Air Traffic Control," Transportation Trades Department – AFL-CIO, February 22, 2001, http://www.ttd.org/pressrel/feb01/pr022201.htm.
 JayEtta Z. Hecker, Director, Physical Infrastructure Issues, "Issues Relating to Foreign Investment and Control of U.S. Airlines," Government Accountability Office, October 30, 2003, http://www.gao.gov/new.items/d0434r.pdf.
 Thomas Firey, "Nothing to Fear from Open Skies with European Union," Cato Institute, September 24, 2003, http://cato.org/research/articles/firey-030924.html.
 John H. Anderson, Jr., Director, Transportation Issues, Resources, Community, and Economic Development Division, "Barriers to Entry Continue to Limit Benefits of Airline Deregulation," Government Accountability Office, May 13, 1997, http://www.gao.gov/archive/1997/rc97120t.pdf.
 George Will, "The Wrongs of the Wright Rule," The Washington Post, June 5, 2005, http://www.washingtonpost.com/wp-dyn/content/article/2005/06/03/AR2005060301461.html.
 Douglas Clement, "Regional Airports: Fear of Not Flying," FedGazette, January 2001, http://minneapolisfed.org/pubs/fedgaz/01-01/airports.cfm.