State lotteries as a source of revenue: a re-examination.

• Author: Szakmary, Andrew C.

1. Introduction

   Most of the academic literature that has examined state lotteries has had a negative assessment of them. Studies of lotteries as a source of revenue have reported that even under the best circumstances, they generate only a tiny proportion of a state's revenues, and the lottery revenues are so volatile that states cannot and should not be dependent on them. In addition, the general consensus is that lotteries have high administrative costs, and that they may reduce other sources of state revenue.(1)

   In contrast to this negative view prevalent in the academic literature, lotteries have been exceedingly popular with policymakers in state capitals and among the general public. Most of the literature which casts a negative light on lotteries as a revenue source looked at data through the mid-1980s. Since then, the number of states operating lotteries has grown from 17 in 1985 to 33 in 1992. In only one state (North Dakota) during the past 30 years has a lottery referendum failed to achieve a majority of votes.(2) Why are lotteries so popular? Is it because voters are ill-informed and unsophisticated? Do proponents mistakenly believe that they will help cure government revenue shortfalls? Or is it possible that lotteries really do have a significantly favorable fiscal impact, that lottery revenues are not as small and destabilizing as the academic literature maintains?

   A reexamination of lotteries as a source of revenue is warranted for two reasons. First, previous studies that have examined this issue [13; 3] have used data only through the mid-1980s, when lottery sales consisted primarily of instant and numbers games and lotto was in its infancy. Several studies [4; 6] have found that lotto has become enormously popular, and that revenues generated by lotto are "new money," that is in addition to revenues from the other games. Also, lotto seems to attract a different clientele than the other games: instant and numbers sales are primarily to lower income, less-educated consumers, while participation in lotto is much more apt to include middle and high income groups. Thus, it is reasonable to surmise that as lotto sales have surged, both the magnitude and the stability of lottery revenues over time may have changed.

   Another, more crucial reason lottery revenues merit further analysis is that previous studies have all examined the volatility of this revenue on a stand alone basis, rather than in terms of the contribution of lottery revenue to the stability of overall state revenue. As a consequence of this failure to examine lottery revenue in a portfolio context, the earlier studies imply that lottery revenues, being highly volatile, destabilize overall revenue. In fact, given the likely low correlation of lottery revenue with non-lottery revenues, it is entirely possible that lotteries provide states with an attractive diversification vehicle and, on balance, help to stabilize overall revenues. If so, this could at least partly account for their popularity.

   The balance of the paper is organized as follows. Section II contains a review of the literature on the fiscal implications of lotteries. In section III, we discuss sources of data and the methodology used to examine the contribution of lotteries to the size and variability of overall state revenues. The results are presented in section IV, and section V concludes the paper.

2. Literature Review

   Proponents of the lottery, according to Mikesell and Zorn [13], believe it is an outstanding state revenue source for a number of reasons. Participation is voluntary, unlike payment of taxes. It generates enough revenue to relieve pressure on the fiscal system, and provides an alternative to illegal gambling through legal games that have been virtually scandal-free.

   Clotfelter and Cook [2] report that per capita sales in lottery states have grown from $23 in 1975 to an average of $88 in 1985, measured in 1985 dollars. This represents a per capita sales growth of 14 percent a year. By 1986, lotteries in the United States were selling $12 billion worth of tickets per year, and generated $4.7 billion of net income to states after prizes, commissions and administrative costs had been subtracted. Sales growth has slowed somewhat since then, but more states adopted lotteries and, by 1992, aggregate lottery net income was nearly $7.8 billion.

   Opposition to lotteries in the academic literature is extensive. Critics assert that lotteries provide only a negligible proportion of state revenues, that lottery revenues are highly volatile, that lotteries have much higher administrative costs than alternative revenue streams, and that lotteries can reduce other sources of state revenue such as taxes on parimutuel wagering and sales taxes.

   Previous studies find that despite their rapid growth, lotteries still represent only a small percentage of revenues in states that have them. Mikesell and Zorn [13] report that in the 17 states with lotteries operating in 1984, net revenues from lotteries averaged just 1.95 percent of own-source revenues (which they define as general revenue less intergovernmental revenue). In only two states, Pennsylvania and Maryland, did lotteries account for more than 4 percent of own-source revenue.

   In addition to the low yield, Mikesell and Zorn [13] and Clotfelter and Cook [3] find that lottery revenues are highly volatile and unpredictable.(3) This volatility has been attributed to the introduction of new games, changes in consumer preferences, variations in the intensity and effectiveness of marketing efforts, the startup of competing lotteries in neighboring states, and rollovers in lotto jackpots. DeBoer [9] and Clotfelter and Cook [4] both find that lotto sales are highly sensitive to the size of the jackpot. When a state is "unlucky" and most lotto drawings produce a winner, lottery sales will be much lower than in periods when winners are infrequent and jackpots build to high levels.

   A number of studies focus on the difficulty of making accurate revenue forecasts of lottery proceeds. Stover [14] concludes that for a state to make accurate forecasts on lottery revenues, the effects of substitution from competing games both inside and outside the state must be taken into account. Mikesell [11, 252] found that "States without lottery competition from any neighbor enjoy higher per capita sales than do those with such competition, other influences held constant." He also reported evidence that new states' lotteries significantly reduce the expected yields of existing lotteries. The age of the lottery was also found to affect sales. Over time, games lose their appeal to customers and new ones must be found by the lottery management. Summing up the consensus view that has emerged in the literature, Mikesell and Zorn [13] conclude that "Clearly, a state cannot rely on its lottery to be a stable, reliable source of net revenue."

   The cost of administering lotteries is much greater than for other revenue sources, and a wide variation exists in administrative costs as a percentage of revenues across states. For example, Mikesell and Zorn calculate that in 1984 administrative costs ranged from 4.8% in Illinois to 76.8% in Maine [13]. They note that these costs are underreported, as commissions to vendors are not...