It's More Than a Safe Bet That State Lotteries Bring About Considerable Costs

A couple of days ago was the announcement of the lottery numbers for the Powerball game. That jackpot of $1.5B was the largest jackpot in world history. Many frantically bought tickets in the hopes that their lives would change for the better if they had all that money, even with post-tax earnings of $561M. One could do a lot with $561M. It's amusing to think what you can do with all that money, although the odds of winning were 1 in 292,000,000. I briefly wondered the same thing, but my mind wandered in a different direction. First, I thought how hypocritical it was for the government to historically restrict casino gambling on the grounds that it gambling is a moral hazard, while various state governments allow for government-run lotteries to exist. After realizing that the lottery is another example of "do as I say, not as I do," I asked myself whether the lottery caused net benefits, and whether the government should be in the lottery business.

One of the more obvious reasons that the government allows for such double standards in the first place is because the lottery is such a tempting form of generating revenue for state governments. The lottery has been a net revenue generator for state governments for quite some time. In 2014, lotteries generated about $62B (Census), which exceeded the $37B from the casino industry. In 2013, state governments collectively made a profit of $20.3B. For 2014, the North American State Provincial Lottery (NASPL) found that lottery sales were $70B, and profits were over $19B. That is a 28 percent profit margin! That profit margin is much higher than the 7 percent profit margin of the average company, and is presently even higher than the banking industry (see Yahoo! database here). On average, state governments derive 2 percent of their revenues from lotteries. As nice as it might be to expediently tap into a source of revenue through the lottery system, what's the cost?

A survey of the academic literature of the economics of lotteries (Grote and Matheson, 2011) sheds some light on the question. The first interesting finding is that in most cases, the price elasticity is -1 or less, which is to say that people are relatively responsive/sensitive to lotto ticket price changes. Paradoxically enough, the lower the odds of winning, the more likely one is to buy a ticket. The reason isn't that people care about the odds of winning, but are attracted by the size of the jackpot. I also found it interesting that the income elasticity for lotto tickets is relatively low, which is to say that a greater percentage of income is spent on lottery products at lower income levels.

Although the lottery is a voluntary activity, these findings help explain why the lottery is sometimes referred to as a "tax on stupid people" or a "tax on people who can't do math." The findings also explain why the lottery disproportionately affects the poor, in no small part due to the fact that the poor are more likely to purchase lottery tickets than those who are not (Kearney et al., 2010; McAuliffe, 2006). For those making less than $10,000 per annum, they annually spend $597 on lottery tickets, which is about six percent of their income. 15-20 percent of individuals believe that the lottery is the [only] way they'll be able to accumulate a significant amount of wealth (see here, here, and here). For the typical ticket purchaser, the costs exceed the benefits.

Lotteries don't have averse effects for the vast majority who lose, but also potentially for those who win, and that's not just in terms of the tax rates on the lottery winnings. There is enough anecdotal evidence about how the lottery makes matters worse. At least for smaller jackpot winnings (i.e., the equivalent of 6-8 months of salary), a study from University of California-Santa Barbara shows that it doesn't have positive effects (Kuhn et al., 2008). The Swedish experience shows that lottery winnings don't have statistically significant effects on one's health or that of their children (Cesarini et al., 2015). Ultimately, it depends on how the lottery winners approach their winnings. Planning for the windfalls is important because if you simply decide to spend (instead of doing something like saving or investing), you'll be in for a world of hurt. One study showed that at least with smaller winnings (i.e., $50-100K), the lottery winnings seem to postpone financial ruin instead of avoiding it (Hankins et al., 2010). Lotteries don't seem to exaggerate one's current situation, which is to say that if you were living a happy life pre-lottery, you should be fine. If not, then the lottery is going to exacerbate your current state of well-being (Mochon et al., 2007). These findings make sense. After all, happiness is relative. But at the same time, poverty does not bring about happiness. Poverty can be quite stressful and deleterious. That is why money buys happiness, but only to a certain point. The benchmark for happiness used is $75,000, although that changes a bit based on cost of living. Beyond making $75,000 annually, the marginal rate of return for earning an additional dollar does very little to nothing to add to one's happiness.

One of the points that state governments try to use is that the revenues are used to fund schools. The Illinois Association of School Boards found that the lottery provides no additional funds to school coffers, and that it acts as nothing more as an accounting maneuver. North Carolina also found out this lesson the hard way. The North Carolina government promised a boost to education revenue, but the Tax Policy Center (TPC) found that North Carolina actually experienced a decline in education funds. The TPC also found that lottery revenues never covered more than 5.5 percent of expenses. The fact that lotto revenues cannot fund education, certainly to the extent which proponents promise, is because in state budgets, money moves around a lot, and it's hard to securely appropriate the funds for just one aspect of the budget.

Ironically enough, the lottery doesn't help state governments to the extent to which they think it does. Since the odds of winning the lottery are so low, the lottery de facto acts similar to a hidden, implicit tax at a rate of 38 percent. While it is highly expedient for the government to collect lottery revenues, the revenue collected via the lottery creates a relatively high deadweight loss for a few of reasons (Grote and Matheson, p. 20). One is that states tend to levy the amount too high. Second, the administrative costs are higher compared to other taxes. The third is the high advertising costs and retailing commission. Granted, pooling resources with other jurisdictions helps make it more efficient with economies of scale, but advertising is still a considerable cost that is not problematic with other forms of taxation. In terms of efficient collection of government revenue, there are better ways than what the lottery system has to offer. The Nelson A. Rockefeller Institute (Dadayan and Ward, 2009) also found that the lottery has a tendency to create greater imbalances in state budgets.

One policy alternative is to have prize-linked savings accounts as an alternative to state lotteries. However, I don't think the government could handle that competition, which is why the ultimate jackpot in this scenario is simply to do away with state lotteries all together, regardless of what one's view of gambling is. State-sponsored lotteries are bad for losers, often bad for winners, and doesn't even help with state revenues or education funding nearly to the extent intended. Getting rid of these lotteries means that people don't have to succumb to the false hope that is known as Lotto.