Tax Money From Sports Betting May Not Be the Windfall States Are Expecting

When Ohio Gov. Mike DeWine signed legislation in December making Ohio the 33rd state to legalize sports gambling, the talk locally was less of opening up the joys of betting on who’ll score the Cleveland Browns’ first touchdown than of the flood of new money it would bring to state coffers.

“It’s going to benefit education and veterans groups in a really substantial way,” promised the bill’s co-sponsor, state Rep. Adam Miller, envisioning tens of millions of fresh dollars pouring into the state treasury.

As states have moved one after another to legalize betting on the outcome of sporting events (betting on fantasy sports has been legal in most of the U.S. since 2006), there has been an air of “get rich quick” about the projections. Legalized sports books, according to advocates, could tap into a potential $10 billion-a-year industry, boosting public coffers at a time when the ravages of the pandemic economy have left states with massive budget shortfalls.

But economists warn that state officials may want to hold off before planning how to spend their sports-book boodle. Those who’ve studied the real-world impact of the burgeoning sports-gambling legalization wave – and earlier expansions of other forms of gambling, like lotteries and racetrack casinos – say that the numbers are as yet uncertain and rife with confounding factors. If all goes well, they say, legalized sports gambling could be, if not a huge cash windfall for states, at least an easy way to collect taxes on an otherwise-underground economy. If not, it could end up just substituting new taxes for old ones – or even costing states money in the long run.

“The one thing that states should be aware of is not to count on it as a cash flow,” says Lucy Dadayan, a gambling tax researcher at the Urban-Brookings Tax Policy Center at the Urban Institute in Washington, D.C. In the long run, she cautions, betting revenue grows at a slower rate that other state tax revenues, or even declines, so states need “to be mindful about how they use the revenues generated from gambling activities” – or else risk leaving themselves with unexpected budget holes.

From Illegal to Lucrative

The sports-gambling gold rush was set off by a 2018 Supreme Court decision in a case brought by the state of New Jersey against the Professional and Amateur Sports Protection Act of 1992, federal legislation that had outlawed sports betting as a “national problem” that inflicted harm “beyond the borders of those States that sanction it.” (Notwithstanding this conclusion, Congress allowed Nevada’s existing sports books to remain open.) In a 6-3 ruling in the case of Murphy v. National Collegiate Athletic Association, Justice Samuel Alito wrote for the conservative majority that PASPA violated the 10th Amendment’s guarantee that states can set their own laws for anything not mentioned in the Constitution.

States were now free to legalize sports gambling if they wanted – and, figuring that their residents were already betting on games with Las Vegas sports books without paying any local taxes where they lived, legislators launched a wave of legalization that is continuing to spread across the U.S. At first, this largely spread geographically: As was the case with the previous introduction of lotteries, gambling experts note, state governments were more likely to jump into legalized sports gambling if they were worried about seeing their citizens taking their money across state lines to neighbors that had already passed legalization. (Miller, the author of Ohio’s legalization bill, touted it as necessary to “keep up with other states and to ensure that Ohio wasn't left behind”; two neighboring states, Indiana and Michigan, already allowed sports bets.)

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At the same time, states smelled big money at the prospect of gaining the ability to tax sports books. Victor Matheson, a College of the Holy Cross economist who has studied sports gambling and edited a special issue of the Eastern Economic Journal on the topic in January 2021, points to the United Kingdom, where betting on sports has been legal since the 1960s and where, he says, “there’s a Ladbrokes on every corner just like a 7-Eleven.” British per-capita sports betting, mostly on horse racing and soccer, is about $1,000 per person, notes Matheson, which would translate into “potentially $300 billion of bets being made a year in the United States – and that kind of matches with the estimates of there being somewhere like $300 billion of illegal betting prior to legalization.”

The busiest U.S. state so far for sports betting is New Jersey, which reached the $1 billion-a-month mark in September. That figure, however, represents bets placed – the “handle” or “drop” in gambling lingo. Most of that money goes right back to bettors as winnings; only about $82 million was kept by sports betting operators as net revenue. After applying various taxes – New Jersey taxes in-person sports wagers at 8.5% of net revenues, and online bets at 13% – the state cleared about $10.2 million in sports gambling revenue.

'The Substitution Effect'

Whether that money should be considered a windfall or not depends heavily on what you think Garden Staters would have done with that money if not for legalized sports betting. If they otherwise would have spent the same amount placing illegal bets, that’s fresh money much as cannabis legalization has allowed states to tax economic activity that would otherwise be off the official books. But if legalization ends up cannibalizing other local spending that was previously taxed – known in economics as the “substitution effect,” because one form of spending is substituted for another – that could cause state tax revenues to go down.

“The substitution effect is a real thing,” says Matheson. “As you have more different types of gambling coming in, the question is: Is that new revenue for the state, or does it just mean you’re making less money from this other kind of gambling you have?”

One of the journal articles edited by Matheson provided a clue to just how much new forms of sports gambling can cannibalize older betting habits. West Virginia University economist Brad Humphreys looked at gambling spending in his state after it legalized sports betting in 2018, and he found that it brought in $2.6 million in new revenue in the first 18 months after legalization – but at the same time, the state coffers lost $45.4 million in taxes from video slot machines, which plummeted over the same period.

West Virginia was hit especially hard by substitution because video slots – formally known as video lottery terminals, or VLTs – are taxed at an extremely high rate, 53.5% of net revenues. Sports betting, by contrast, faces only a 10% tax, meaning the state was effectively creating a huge tax dodge for the gambling industry by allowing a low-tax wagering option.

This should be a common concern for states hoping for a sports-betting bonanza, says Matheson. For example, he notes, “there’s almost no good you can think of that gets taxed higher than lottery tickets.” After the payment of winnings and administrative costs, he says, about 30% of all lottery spending ends up going back to the issuing state, on average. “So every $100 of lottery tickets you stop selling and replace with $100 of sports bets almost certainly is a loss to the state.”

Matheson cautions that West Virginia’s situation can’t be directly extrapolated to other states. Still, there are worrying signs elsewhere of sports betting substitution. Betting on dog racing and horse racing has cratered in recent years, he notes, and there’s reason to suspect that this is related to other, more accessible forms of wagering. “There’s a lot more easy ways to gamble than to spend your day at the track,” he says.

Will Sports Gambling Stay Popular Indefinitely?

At the same time, states can cannibalize sports betting revenue from each other, as gamblers drift across state lines to make their wagers – but this, too, comes with potentially diminishing returns, as a state’s gains may soon be siphoned off by the next state to legalize. Dadayan, the gambling tax researcher, notes that most recent growth in gambling at casinos and “racinos” (gambling hubs at racetracks, meant to boost those sites as horse racing has seen much of its audience disappear) has been in states that only recently legalized that form of betting, seemingly cannibalizing bets that otherwise would have been placed in their early-adopter neighbors.

Neither Matheson nor Dadayan opposes legalized sports betting, but both warn that states should be tempering their expectations of how much new revenue will result. Sports gambling, Dadayan acknowledges, could bring more new customers into the gambling world, especially in its online variants that could appeal to younger bettors who wouldn’t be caught dead at a racetrack. (While this would potentially reduce cannibalization, gambling economists note, it also runs the risk of creating a fresh explosion of gambling addiction, a problem that currently affects an estimated 1 million to 10 million Americans.)

“It might be more attractive to a wider range of demographics and age groups, and it might be lucrative for quite some time,” says Dadayan. “But I think the history of gambling shows that at the end of the day it’s just a matter of time until the popularity of any given type of gambling wears out and we see steep declines in revenues.”

Matheson offers a personal anecdote that illustrates one reason to beware of initially gaudy sports gambling figures. A colleague of his, he says, was able to make a living as a professional online poker player when online poker first debuted, but the colleague eventually found it harder and harder to find easy money.

“Every single 21-year-old male who was an econ major, an accounting major, or a finance major lost a thousand bucks,” Matheson recalls. “But once that pool of dumb players dried up, he couldn’t make it anymore. He had to eat up a couple of players a week to keep up his lifestyle. And I would expect a lot of the same thing will be happening with sports gambling.”