Pros and Cons of the Maryland Slots Proposal, from a Tax Policy Perspective

November 03, 2008

Tomorrow Marylanders will vote on a constitutional amendment to allow slot machines—also know as video lottery terminals, or VLTs—in five locations around the state to raise money for public education.  Slots opponents and advocates have been fighting bitterly for years, and the issue will finally be decided.

Many opponents of this plan argue that VLTs are more likely than traditional lottery games to lead to compulsive gambling. Some call them "video crack" because they allow players to bet repeatedly in a short period of time, providing the fast-paced, instant gratification that other lottery games generally don't provide. Others oppose the games, and gambling generally, on moral grounds.  Still others talk of voting for the slots plan to bolster Maryland's horse-racing industry. However, there are tax policy considerations that most of these discussions overlook. Below are two opposing-yet-not-so-different sides of the slots argument, from a tax policy perspective.

Reasons to Support the Slots Plan, by Gerald Prante

The question surrounding government-run slots in Maryland is similar to many policy debates that come down to questions of second best and baselines. Under an ideal fiscal system in Maryland, slots would be permitted to operate freely and the rate of return in the marketplace would be close to competitive (or close to a normal rate of return). Price, as measured by the "take" of the slot owner, would not greatly exceed marginal cost (including opportunity cost). Policymakers could then internalize any negative externality of gambling by levying a proper Pigouvian tax (based, perhaps, on the amount gambled).

Unfortunately, such a policy isn't up for discussion and so we are left with two alternatives: prohibition (status quo) and a government-run monopoly that earns economic rents (and is likely inefficient relative to a privately-run monopoly, and definitely less efficient than a free market due to X-inefficiencies of monopolies in general).

The first point that needs to be made is that the current policy of prohibition is actually an implicit tax whereby the tax equals the expected fine of being caught gambling and providing gambling services. This "tax" raises very little revenue, and its benefits are largely viewed as paternalistic and/or protecting the property of others in society (i.e. the negative externalities are so great that it justifies an exorbitant tax that is essentially equivalent to prohibition). I personally see little justification for a prohibition tax that is levied at such an exorbitant rate. The optimum tax is obviously less than the status quo; and in fact, government revenue will actually increase if this tax is decreased. This is one of the rare cases in which we are indeed on the right side of the Laffer Curve. Those who oppose such a policy by arguing that it amounts to an increase in tax burden are ignoring the fact that there are two components to a tax burden: the revenue portion and the excess burden. While revenues may increase, that doesn't mean the overall burden has increased because consumer choice has actually been expanded, which means that well-being can only increase assuming a rational consumer (and absent externalities).

Even if one wants to justify the existence of an externality (such as higher crime rates, etc.), the current Pigouvian tax that is set at a level of prohibition is likely far in excess of the tax level that would reflect the true externality (how bad is it in Nevada?). With regard to the internality argument that says people are acting irrationally by gambling (and could become addicted) and therefore that a barrier to gambling improves their well-being, it becomes less clear. The main problem with gambling from a paternalistic perspective is the lost income that results from it, and therefore a government-run monopoly that has a higher "take" than the free market could actually make the problem worse. Therefore, under an assumption of a high degree of irrational economic actors, it is possible that a government-run monopoly is inferior to prohibition. But, a priori, I find this argument especially weak given that other options for gambling already exist for Maryland residents, such as internet gaming, lotteries and out-of-state gambling.

One final possible justification for opposing the current Maryland initiative is the existence of a public choice problem. If government becomes involved in operating slots, does that make it more likely for government to take existing free-market industries and convert them to government-run enterprises that earn rents? Similarly, it is possible (yet in my view highly unlikely) that absent this initiative, Maryland would have eventually let a free market for slots play out. On the contrary, it could even be a stepping stone for a free market end that at least raises tax revenue in a more efficient method.

In summary, the arguments that have been made in opposition to the slots initiative have not only failed to convince me that the optimum policy is prohibition, but they have failed to convince me that even a second best policy is prohibition compared to a government-run monopoly.

Reasons to Oppose the Slots Plan, by Alicia Hansen

Many people on both sides of the debate fail to realize that video slot machines would be run by the State Lottery Commission and, for all intents and purposes, would constitute a significant expansion of the state-run lottery. Therefore, to evaluate the slots plan, we need to examine the merits of the lottery as a whole in addition to the specifics of adding VLTs. Here are some reasons that I consider the slots plan—and any expansion of the state-run lottery—poor tax policy.

Transparency

Sound tax policy requires transparency, which means that policymakers should not try to hide the true nature and cost of taxes, and taxpayers should be aware of the types and amounts of taxes they pay. State governments keep a portion of lottery revenue after they award prizes and cover operating costs, and that portion is used to fund programs entirely unrelated to lotteries or gambling (public education in many states). If this revenue were simply put back into the lottery agency and used to continue providing lottery games, then it would be a user fee; however, since this revenue is used for other government programs, or put into the general fund in some states, it is tax revenue, plain and simple.

However, most people are unaware that they are paying taxes when they play the lottery. They reason that since playing the lottery is voluntary and taxes are mandatory, lottery revenue cannot possibly be tax revenue. But they're confusing the purchase of a product, which is always voluntary, with the payment of a tax on that product, which is mandatory. A lottery player cannot buy a ticket or play a VLT without paying the full purchase price—including the portion kept by the state—just as one cannot voluntarily buy a bottle of wine without paying the mandatory excise taxes or a book without paying the mandatory sales tax.

Lawmakers are quite happy to allow lottery players, taxpayers and voters to hold onto this inaccurate view of the lottery, and refuse to correctly label the revenue "tax revenue," instead calling it "miscellaneous revenue" or "profits." They know that if they call it tax revenue, voters will be less accepting of the lottery. Hiding the true nature of lottery revenue allows policymakers to have their cake and eat it too: they get to claim credit for raising more money for worthy causes without having to admit to raising taxes.

The lack of transparency is bad enough with traditional lottery games, such as lotto and Powerball. But it's even worse with VLTs, which often resemble casino games so closely that players probably don't even realize they're playing a game that's run by the state, let alone that they're paying implicit taxes on that game. When we think of playing the lottery, we think of buying a ticket at the convenience store and scratching off a few circles or waiting days to find out if we won; we don't think of going to the racetrack to play slots.

Regressivity

The implicit lottery tax is a regressive one, meaning that the poor pay a disproportionate share of their income in implicit lottery taxes.  While it is true that the poor spend a disproportionate amount of their income on many recreational activities and goods, those goods are not provided and heavily marketed by the state. There is less research on the regressivity of VLTs than on traditional lotteries, and it's possible that VLTs will prove somewhat less regressive. However, we must still ask whether the state should be in the business of providing, advertising and heavily taxing a good on which the poor are known to spend a disproportionate amount.

Neutrality

Another reason to oppose state-run lotteries is their lack of neutrality. Since taxes provide government services enjoyed by everyone, taxes should also be paid by everyone. They should be levied at the same rate on all goods and services, not at higher rates on goods deemed unnecessary or unhealthy to the consumer ("sin taxes"). The implicit tax rate on lotteries, however, is extremely high—much higher than any state's sales tax rate. While it is true that Maryland VLTs would have a lower implicit tax rate than the state's other lottery games, there is still no reason for the rate to be any higher than the state's sales tax. And, since VLTs will simply be part of the state lottery, although they will lower the overall implicit tax rate of the lottery, it will still remain much too high, violating the principle of economic neutrality. The very fact of the government monopoly inherently makes the lottery non-neutral.

What's Next?

In 1963, no state allowed lotteries, Today, 42 states and the District of Columbia have them, and they're all run by the state. Many states enacted them in large part to prevent residents from spending money on neighboring states' lotteries. This domino effect has now created a game of one-upmanship in which states compete for revenue not only by selling lotto tickets, but also by exempting lottery agencies from some of the regulations that other government agencies must follow, joining multi-state lottery games, raising their ticket prices to exorbitant levels, creating digital lottery tickets, installing VLTs, attempting to sell lottery tickets on the internet, and so on. We must wonder where the competition will end.  Competition among private companies in a free market is healthy; competition among state governments for the most revenue spent by residents on gambling is not.

Maryland's HB17 contains the following assumptions regarding the slots revenue predictions:

Other Assumptions
VLTs will operate 365 days a year, once operational.
Virginia and Washington, DC do not authorize VLT gambling.
West Virginia and Delaware do not expand VLT operations, either by adding additional VLT facilities or authorizing casino-style gambling.
Pennsylvania does not expand gambling beyond VLT facilities authorized in 2004.

What will happen if these assumptions are unfounded? In five years, if West Virginia and Delaware have expanded VLT operations, and DC and Virginia have indeed installed VLTs, and Maryland residents are spending large sums of money in those states, how will Maryland policymakers up the ante to bring that money back into the state? A lottery in every town? Roulette wheels on every street corner? Half-price lottery tickets for schoolchildren? At some point the state must say enough is enough and turn to transparent, honest methods of taxation for additional revenue, such as the state income tax or sales tax.

Unreliability of Earmarking

The slots plan is being sold to voters as a way to finance public education. But there's no guarantee, no matter what legislators say, that all the money raised from VLTs will be spent on education.  Since earmarked money is fungible, policymakers can simply shuffle finds and spend the lottery revenue on whatever they please.  Even in states with "lockboxes" to safeguard lottery revenue for education, there's nothing to prevent legislators from spending less non-lottery revenue on education than they otherwise would have; as long as the education budget exceeds available lottery funds, the use of the earmarked revenue cannot be guaranteed. Some voters, however, might support the slots plan simply because they believe the education funding predictions they hear. "We must do this for the children" is a common refrain among lottery supporters, but often the children benefit far less than promised.

The Role of Government

It is true that the slots plan will increase consumer choice by providing another type of gambling in Maryland and another recreational activity. While consumers are generally better off when they have more choices, government involvement is not necessary to provide this choice. If the goal is to give consumers choice and end the prohibition on certain types of gambling, the solution is very simple. Policymakers can get the state out of the lottery business (they can even earn a large sum by selling the lottery to the highest bidder), allow private companies to compete to offer both traditional lotteries and video lotteries, and impose the state sales tax on the profits. It doesn't need to be anymore complicated than that, or damaging to the tax code. 

State-run lotteries and state-run video slot machines make the tax system more complex, more bureaucratic, less transparent, more regressive, and less neutral. And they're simply unnecessary. If Maryland policymakers need more money in state coffers, then they can explicitly and honestly increase the rates of broad-based sales, income or property taxes.

Conclusion

Despite the differences in these two points of view, both authors conclude that the ideal solution would be free competition in the gambling industry, with the state's involvement limited to levying explicit, transparent taxes.

Read more Tax Foundation studies and blog posts on state-run lotteries.

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