States Taxing Sports Betting: Lessons From Other Revenue Streams

May 23, 2018

The U.S. Supreme Court’s recent decision to allow states to legalize sports betting is being welcomed by many policymakers as a potential gateway to much needed revenue.

Putting aside opinions on whether sports betting should be legal, it makes sense that states would pursue taxation of new economic activity that isn’t covered by existing tax laws. The bigger question is what this tax treatment should end up being.

Preferably, it would go toward maintaining a fair, broad-based tax system that helps avoid rate hikes. However, previous experience suggests that states may consider a high-rate excise tax of some sort, which could invite unintended consequences for policymakers to consider. We discuss some of those potential issues below.

Revenue Volatility

As we’ve seen with marijuana, once a new good or service becomes part of the marketplace, states pursue different strategies on the tax treatment side. It’s been tempting in some states to apply very high rates, hoping to raise enough revenue to reduce the pressure on broad and more efficient – but less popular – tax types.

So-called “sin” taxes are an easier political sell. For instance, in the past several years states and localities have substantially increased taxes on cigarettes. Perhaps initially to offset externalities (health-care costs due to tobacco use), policymakers now regularly offer up cigarette taxes to fund core services. However, the data shows that cigarette tax rate hikes are met with a momentary bump in revenue, followed by a drop-off in collections in future years.

Any good economist will tell you that broad-based, low-rate taxes provide a more stable revenue stream. High taxes applied to smaller tax bases are much more volatile, making it difficult to adequately fund designated priorities. If states add sports betting to the latter category, they’ll have a harder time balancing their budgets.

Preventing Black Market Activity

Another consequence with excessive tax rates is continued untaxed black market activity. As with marijuana, a sports betting black market already exists. Imposing too high of a tax rate on gambling may deter some from shifting to the legal, regulated space.

In Colorado, the state’s effective tax rate on marijuana neared 30 percent, due to a 15 percent wholesale tax and a 10 percent retail tax, on top of state and local sales taxes. A state-sponsored study found that the high rate was a major reason that black market activity continued to flourish. As Gov. John Hickenlooper (D) noted, Colorado could reduce black market activity – and bolster its tax base – by “mak[ing] sure there is not as large a price differential.”

With sports betting, states may attempt to raise revenue based on gambling revenue (business activity), bets by consumers (retail purchases), or gambling winnings (consumer income). If a state attempts to tax multiple layers of sports betting activity, policymakers should consider the combined effective rate and whether that rate is appropriate or too exorbitant.

Nexus and State Taxing Authority

Another wrinkle is how these new sports betting markets would work in practice. Will states only authorize brick and mortar facilities, such as casinos? Daily fantasy sports betting is already quite popular online and has the backing of the major sports leagues. If online sports betting is allowed, policymakers will also have to consider whether the business has nexus, particularly if the state seeks to impose a tax on retail activity. The Court’s upcoming ruling in South Dakota v. Wayfair could impact what guidelines states must follow for taxation of online sports gambling.

Limited Demand

As with any new activity, states should take a cautious approach in their revenue estimates from taxing sports betting. An Oxford Economics study commissioned by the American Gaming Association estimates that sports betting could provide state and local governments with $3.4 billion in annual revenue. But the issues discussed above could mean a much smaller revenue impact.

Plus, legal gambling options have become far more prevalent in the past couple of decades. Atlantic City and Las Vegas are no longer the only options for gambling getaways. Not surprisingly, new casinos often haven’t generated the revenue or economic activity policymakers had hoped. Perhaps that market has become too saturated, or the excessive tax rates have made it more difficult for some casinos to turn a profit. Whatever the cause, sports betting may simply take the place of existing consumer spending, not complement it.

Integrity Fees

In West Virginia, in anticipation of the Court’s ruling, policymakers had already been discussing an “integrity fee,” which would divert a set amount of the proceeds to sports entities (NFL, NBA, etc.) as compensation for the licensing/use of their brands in these transactions (bets). Does that fee get taken out of the state’s revenue or the casino’s? Either way, these fees could reduce the number of potential market entrants and limit the ability of states to tax the sports betting market.

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