Turning the Lottery Loose

With Virginia struggling to pay for such pressing priorities as transportation and education and the legislature exhibiting its traditional lack of appetite for raising taxes,...
by | September 1, 2008 AT 1:00 AM

With Virginia struggling to pay for such pressing priorities as transportation and education and the legislature exhibiting its traditional lack of appetite for raising taxes, David Poisson, a Democratic member of the House of Delegates, thinks he knows where to find some easy money. There is gold, he says, to be mined in the state's lagging lottery. If the state would cut the lottery loose to perform to its maximum potential, Poisson thinks it could rake in far more than its flat-line gross revenues of about $1.3 billion in each of the past three years.

But to get the lottery there, Poisson also believes that some entity other than the state needs to be running the games. One idea is to let the private sector -- with its proven record of running casinos and other commercial gambling operations -- lease the lottery in return for $4 billion to $7 billion in up-front cash. Another is simply to turn the management of the lottery over to a private company to maximize revenues, an approach that Poisson figures would add about 50 percent to the $450 million or so that the lottery has been contributing annually to K-12 education over the past few years.

Virginia is hardly alone in its desire to milk more money out of what many states view as their under-performing state lotteries. Numerous states are now employing -- or at least considering -- a variety of new tactics aimed at pumping up lottery revenues, ranging from offering bigger and more frequent payouts (on the established theory that giving more prize money away boosts ticket sales), to expanding the number of outlets at which lottery tickets can be sold, in particular to big-box chain stores such as Kmart, Costco, Wal-Mart and Target. Meanwhile, there is increasingly serious discussion of selling tickets over the Internet, a lottery sales frontier that even the most free-wheeling legislatures have heretofore considered risky terrain.

But as states cast about for ways to drive up the lottery take -- state lotteries grossed nearly $54.5 billion in fiscal 2006, up from $52.6 million in sales the previous year -- a small but significant handful are trying to figure out how to get the cash out now. Three states -- Florida, Oregon and West Virginia -- already are using future lottery sales as collateral on bonds, paying debt service through the proceeds from ticket revenues. In general, those states have been fairly conservative in their borrowing against lottery receipts; they have used the money for capital investment and not for ongoing expenses or to fill budget gaps. But several besides Virginia -- including Indiana, Illinois and Massachusetts -- have been thinking about the much more radical approach of privatizing their lotteries altogether, through long-term leases that would involve up-front cash and an annual percentage payment to the state out of the overall take.

Golden Opportunity

If there is one state that symbolizes all the hopes and aspirations, pressures and problems related to lotteries as a miracle fiscal fix, it is California. In the past two years, the California lottery has become the focus of intense fiscal interest, not to mention fierce political warfare.

For the past two years, Governor Arnold Schwarzenegger has put the lottery on the table as a way to raise needed revenues. Last year, the idea was to bond the lottery to raise money to pay for the governor's ambitious universal health care plan. The whole plan crashed, mostly because of opposition to the health care plan itself, but a number of policy makers also couldn't help but point out that "monetizing" the lottery would have cost a huge amount in interest over the proposed 30-year life of the bonds -- as much as $30 billion.

This year, the governor started ogling the lottery for a different reason: to help the state cover its $15 billion-plus budget deficit. Rather than bond the lottery, though, the proposal this year was to lease the lottery for an up-front lump sum, letting a private company run it for the next few decades.

Schwarzenegger has good reason to ogle: Public officials are not the only ones whose attention has been captured by the potential found money represented by state lotteries. Financial-services companies including Morgan Stanley, Lehman Brothers, Goldman Sachs, UBS and JPMorgan have expressed strong interest in lottery privatization deals. "A private operator will pay a premium for the chance to improve profits above what the state can realistically achieve," Lehman Brothers asserted in an April 2007 report pitching the privatization of California's lottery.

Golden Goose

The whole question of a lottery's earning potential, though, is tricky and controversial. Setting aside the issue of whether the private sector might be more adept at running lotteries, the extent to which state lotteries are leaving too much money in the pockets of their residents depends to a large degree on the rules and regulations surrounding how each particular lottery operates. Most states have placed various constraints on lottery marketing and sales, such as requiring cash for ticket purchases and prohibiting sales via the Internet, so as not to appear to be encouraging irresponsible or underage gambling. Should state lotteries be cut loose to explore every market and every technologically feasible outlet for selling numbers? Should the games exist to maximize revenues or simply to supplement -- at some level -- state budgets?

Some states have made a very conscious decision: The lottery exists only to augment the state budget in a specific area. In South Carolina, that area is schools -- the formal name of the state's games is the South Carolina Education Lottery -- and the lottery wasn't created to squeeze the maximum revenue from South Carolinians. Each year in Columbia, lottery officials and the legislature get together with economic forecasters to come up with a sensible target for how much the lottery ought to aim to make in the next fiscal year, says Ernie Passailaigue, who is both director of the South Carolina lottery and president of the North American Association of State and Provincial Lotteries. The target is never one that would require that the state become an avaricious predator of citizens' hard-earned cash. The reason for the more laid-back approach is quite simple, says Passailaigue: South Carolina is a conservative place; neither the citizens of his state nor the legislature are all that comfortable with state-sponsored gambling.

Virginia's David Poisson is well aware of the dicey nature of this debate, but he sees hypocrisy in legislators squirming at the idea of a state aggressively angling for citizen's dollars by loosening up lottery rules. "We broached that debate when we voted to have the lottery in the first place. Yet when we get too successful at it, we pull back. We now have strong strictures about what you can do in the state lottery and what you can't. We don't permit selling the lottery on the idea that you can get wealthy by playing it, but that you should play because you're giving money to education." In other words, says Poisson, "We allow people to play the lottery, but we don't want it to look like anyone is having any fun doing it, so it won't smack of sin."

At the same time, the extent to which legislatures and governors are willing to see state-sanctioned gambling unleashed is central to the privatization issue, and for intertwined reasons. First, private firms aren't going to want to run lotteries if they're constrained by lengthy contracts detailing what they are not allowed to do to market and sell the games. "Unless you expand the lottery, they're not going to be interested," says California state Senator Leland Yee, a Democrat from San Francisco who strongly opposes the Schwarzenegger lottery-privatization plan. "These Wall Street guys aren't going to come in and dump money on us because they're nice guys; they want a good return on their investment."

Second, those states that have loosened -- or are willing to loosen -- strictures on how their lotteries are run will be valued more highly by companies looking to lease. This is a particularly relevant discussion in California, whose lottery has long been considered an anemic underachiever.

Indeed, on every important metric by which state lottery performance is judged, California's lags badly. The state has fewer lottery sales outlets than the national average: one per 1,800 residents compared with one per 1,400 for the 10 most populous states. It generates less than $100 per capita in annual gross revenues, compared with a national average of nearly $200. And when adjusted for inflation, the California lottery brought in less money last year than it did in its first year of operation in 1984.

Given its weak performance, the asking price for the California lottery as currently configured is billions of dollars less than some in the legislature might once have thought it was potentially worth. This was driven home when estimates of the lottery's value, which at first had been hovering toward the $20 billion range, were drastically cut back to what experts considered a much more realistic $7 billion to $10 billion, based on the state lottery's underwhelming past performance.

Which is why some in the California legislature have been calling for the lottery to be cut loose and allowed much more freedom to sell tickets in new places and new ways, a strategy that legislators such as Senator Yee also oppose. He is afraid that lottery expansion will only mean digging deeper into the pockets of current players, many of whom he believes are on the low end of the economic scale and can ill afford to spend more money on lottery tickets.

Gold Rush

To some veterans of the lottery wars, however, the debate about taking more money from people already playing the numbers misses the point. Michael Jones, a former director of the Illinois lottery who is now a consultant to lotteries -- and a suitor seeking to lease them, as well -- says the goal of flexibility isn't to try to sell more tickets to the same demographic but to dramatically expand the market to younger, better educated, more affluent players, the kind who typically head to casinos when they want to gamble.

Jones says he took the Illinois lottery from ringing up a modest $300 million to $400 million a year to one that started raking in close to $1 billion a year not by trying to extract more money from people who were already playing but by attracting new players.

But, says Jones, the key to cracking that new demographic is allowing Web-based sales, something that legislatures have been hesitant to do because it raises the specter of under-age and addictive gambling. And there remains the issue of a federal law that bans the use of credit cards for playing games of chance across state lines (or internationally).

According to research conducted by eLottery, a Stamford, Connecticut, company that is angling to handle Web-based lottery sales, Illinois could add 10 percent to its 2007 sales of just over $2 billion by going the online route. In aggregate, eLottery claims that the 17 states that it analyzed are leaving nearly $4 billion in potential players' pockets by prohibiting Internet sales.

Jones argues that worries associated with Web-based lottery sales can be easily alleviated, given new technology for screening and tracking credit cards. And he is making that case to Illinois, where dueling privatization proposals include one by Governor Rod Blagojevich aimed at leasing the lottery for the next half-century or so in return for $10 billion and an 80/20 private/state split of future revenues.

The Blagojevich plan passed in the Senate this past session, but was killed by the House, thanks largely to a rift between the Democratic governor and Democratic House Speaker Michael Madigan, who characterizes the governor's plan as "selling the state's future."

Meanwhile, a plan has been floated on the Senate side that would call for a smaller initial lease amount and a 50/50 split of revenues, an alternative that the governor opposes but that Democratic Senator John Cullerton, who serves on the Senate revenue committee, thinks makes much more sense given the lottery's out-years earning potential. Cullerton says support for the 50/50 plan is strong in the Senate and that some form of lease plan will be back before the legislature in the next session.

Golden Handcuffs

While the privatization debates so far have led to stalemate everywhere, South Carolina's Ernie Passailaigue figures that it's just a matter of time before some state goes private. His personal position on the subject is straightforward (the association he represents has no official position on the subject of privatization): He doesn't place any great faith in the private sector when it comes to running lotteries. "We turned over unfettered power to the private sector to offer home loans and they maximized profits for a while, and look where that got us," he says. Besides, he thinks anyone can significantly boost lottery revenues if they are handed the freedom and the incentives to extract the maximum dollars from the maximum number of players.

Which is to say that at the end of the day, the whole issue is probably less about who would be better at running state lotteries -- government or the private sector -- than it is about what a state wants out of its lottery. If the idea is to maximize profits, then governors and legislators are going to have to make the political decision to loosen strictures on marketing and sales -- no matter who ends up running the games -- and perhaps even work to modify the federal ban on using credit cards to pay for interstate gambling.

Some elected officials, such as Senator Cullerton in Illinois, are all for such an approach, and all for allowing Internet lottery sales. "Every dollar we bring in that way means we don't have to increase property, income or sales taxes," he says.

On the other hand, if a state decides that its lottery isn't meant to substitute for taxation to the greatest extent practicable but simply to supplement budgets at some steady level, then state officials need look no further than South Carolina and the Passailaigue path: View the lottery as a way to raise a helpful chunk of change for education or some other specific need with games that offer willing players a little diversion from day-to-day life -- not as a mechanism for turning every possible resident of the state upside down and giving each of them a good shake.