
The
Massachusetts Scratch Card Lottery:
A TruthinAdvertising Travesty
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version
By
Vincent A. Fulmer and David G. Tuerck
If
you are lucky enough to win a million dollars or more in a scratch
ticket through any of the 7,500 retail outlets of the Massachusetts
Lottery, your prize is worth far less than you might imagine. In
fact, it is worth less than half of the face value of the advertised
amount.
It
all comes down to timing and to taxes. The state is up front when
it informs lottery ticket buyers that milliondollar prizes will
be paid in 20 installments of $50,000 each for 20 years. But that’s
where truthful advertising ends. The state gives no indication what
the present value of the future stream of annual aftertax payouts
is worth in terms of today’s dollars. And, it does not tell
the purchaser, except by remote reference, that 30% will be withheld
each year for federal and state income taxes.(1)
The
present value of a stream of future payments is always less than
the sum of those payments. Suppose Josephine tells Joe she’ll
pay him $5,000 to paint her house but that she won’t pay him
until a year from today. If Josephine paid him now and he put the
same $5,000 in the bank today at 5% interest, the $5,000 would accumulate
to $5,250 a year from now (ignoring income taxes). By the same token,
$5,000 received a year from now is worth only $4,761.90 (= $5,000/1.05)
today: At 5% interest, Joe would have to deposit only $4,761.90
in the bank today in order to have $5,000 a year from now. Joe should
discount Josephine’s offer in this manner in order to decide
whether to take on the job.
Likewise,
Joe has to consider the fact that he must pay taxes on his income.
If the tax rate on $5,000 of income is 30%, he gets to keep only
$3,500. If he is paid next year, the same $3,500 is worth only $3,333.33
in presentvalue terms.
While
the average person will ordinarily take these details into account
when making a business decision, he or she will be far less inclined
to do so when tempted by a milliondollar lottery prize. Because
gambling winnings seem like “free money,” there is a temptation
to leave logic behind in plunking down money for a major prize.
There is a temptation to ignore the principles of discounting and
the inevitability of taxes in deciding whether to gamble and how
much to gamble.
Yet,
the decision to gamble is – or should at least be treated as
– a business decision. Given similar odds, a gambler should
skip a milliondollar lottery and risk his or her money, instead,
on gambles that pay out immediately, for example, the slots and
horse races. Yet, the marketing behind milliondollar prizes does
everything possible to discourage this kind of rational thinking.
Table
1 shows how compound interest and taxes shrink the prize actually
received by a milliondollar scratchticket winner. We apply a discount
rate of 4.22%, based on assumptions about the winner’s investment
strategy, detailed below in the Appendix. We also reduce the annual
payout by $15,142.51
to account for an estimated combined federal and state tax rate
of 30.29% on the winnings. The third column of Table 1 shows the
Net Present Value (NPV) of the resulting annual aftertax payout
of $34,857.49 over the 20year payout period. The present value
of the combined 20 payments is $484,310.01, less than half the advertised
milliondollar prize.(2)
TABLE
1
There
can be only one motive for spreading the winnings out over 20 years:
The cost to the state of paying out later is less than the cost
of paying out now. If the state pays out now, the cost (taking into
account the taxes it collects on the winnings) is $947,000. If it
pays out over 20 years, the cost is $657,881 in presentvalue terms.(3)
In
the corporate world, chief financial officers are never deceived
by the high cost of factoring their accounts receivable. They understand
the time value of money and the high cost of waiting for customers
to pay. Consumers on the other hand are largely unaware of the compound
interest factor and the devastating effect of the time value of
money.
Consider
the rentorbuy decision as it affects housing. It seems unlikely
that home buyers seriously consider the fact that they will end
up paying two times the purchase price of a house by the time they
finish paying principal and interest. Rather, they commit themselves
to 30 years of mortgage payments in the (perhaps illusory) hope
that their house will appreciate in value.
Lottery
prize winners display the same indifference to discounting scratch
tickets; they do not seem to know, or even care, that milliondollar
scratch cards are subject to compoundinterest shrinkage. The dominant
attraction of these scratch cards is that they offer “instant
winnings” to players. The cards emphasize this feature. Players
don’t have to wait to find out whether or not they have won.
And the possibility of striking it rich for a “million dollar
prize” is part of the package and becomes a powerful psychological
motivator.
There
is a further anomaly that characterizes the decision to bet on a
milliondollar prize. Prizes below a million dollars are paid out
instantly. Because there is no waiting to collect those prizes,
there is no compound interest shrinkage. Further, prizes below $5,000
are subject to less withholding or no withholding.4
There
is a fundamental mistruth in a card that promises instant winnings
but pays off instantly only for lessthanone million dollar prizes.
The million dollar prizes are illusionary. They merely heighten
the getrichquick aura of the scratch cards without delivering
on the psychologicallyinduced perception of an immediate milliondollar
prize.
Where
are all the consumer advocates to protest these subtle features
that betray truthinadvertising? Why aren’t they accusing
the state of false advertising? To begin with, gaming is already
on shaky moral grounds, despite its acceptance in ? of all places
? church basements where bingo and $1,000 clubs provide an often
meager revenue stream. The social costs of gambling addiction are
large and poorly documented. What is known is that gambling losses
impose a larger burden on low income recipients than on more affluent
players. Little wonder that casino gambling stirs passions on both
sides of the issue.
There are three defenses of the lottery and other forms of legalized
gambling. First, criminal enterprise is removed by granting the
state power to control and regulate gaming. Second, lottery revenues
in Massachusetts go to support schools, and gambling revenues in
general lessen the burden of government on taxpayers. Third, there
is a principled, libertarian argument that people should be permitted
to gamble or not, as they choose.
People
have the right to gamble with their own money and are, by the same
token, responsible for informing themselves about the true worth
of the advertised prizes. It is a longsettled principle of government,
however, that private sector businesses must adhere to certain standards
for truth in advertising. It is particularly troubling, therefore,
for the very government that is charged with administering the truthinadvertising
laws to engage in its own brand of deceptive advertising. Indeed,
we view the practice as a travesty.
A
reported 42 states now have state lotteries. Most, if not all, also
sell scratch cards at retail establishments. It is a strange policy
to rely on misinformed and gullible gamblers for revenue that smart
gamblers avoid in the first place. This kind of asymmetrical information
would not be allowed in most commercial transactions.
Despite
the need for revenue, government is supposed to represent the people’s
interests not exploit the gullibility of a few. This exposes a grand
irony. Elected officials often demonize the denizens of Wall Street
who by sleight of hand mislead and defraud investors. In Massachusetts,
it makes for great theater to go after Wall Street. But when it
comes to the lottery, many politicians are no different from unsavory
investment bankers. The theft takes place off stage. Massachusetts
scratch card patrons deserve better.
To
make its advertising more truthful, the Massachusetts Lottery Commission
should speed up the payouts on its milliondollar prizes. One easy
reform would be, for example, to pay out winnings over five to seven
years, rather than 20. That would send out the signal to scratchticket
patrons that the value of their winnings would be worth more. And,
in a state plagued with one widelyperceived political scandal after
another, our elected officials could upgrade their moral standing
with the voters.
Appendix:
Methodology
Because
of time preference – the preference for a dollar now over a
dollar later – and inflation, the calculation of the discount
rate is necessary.5 Consider the example
of Josephine, the homeowner, and Joe, the painter, in the example
above. When Josephine offered Joe $5,000 a year from now to paint
her house, Joe had to discount her offer by 5%, which was the rate
of interest paid by his bank. That discount rate reflected time
preference and expected inflation. Suppose that expected inflation
was zero and that bank depositors expected to be paid 5% interest
in order to be willing to keep their money in the bank for a year
(i.e. their rate of time preference was 5%). The bank would have
to pay them 5% to get them to deposit their money. Now suppose that
expected inflation was 3%. Then the bank would have to pay 8% in
interest in order to get depositors to deposit their money. That
8% is the sum of the depositors’ time preference and the expected
inflation rate. With a 5% rate of time preference and 3% inflation,
it is the appropriate discount rate.
For
the lottery payments, we determined a discount rate by determining
the expected rate of return to a hypothetical, typical investment
portfolio. We assumed that 50% of the amount to be invested would
go into stocks, 25% into bonds and 25% into a money market fund.
Taking an average of the annual return of the NASDAQ Stock Market,
the S&P 500 and the DJIA over the last 20 years, we calculated
an expected return on stocks. Using the average rate of 10year
and the 30year U.S. Treasuries, we determined the expected, tax
free, return on bonds. Finally, we took the average annual return
of a TIAA Money Market fund since inception to determine the expected
return on a money market fund. Using the weighted average of the
three, we calculated a discount rate of 4.22%.
We
calculated the tax liability on lottery winnings for an average
Massachusetts taxpayer, who would pay income taxes on his or her
income, inclusive of the lottery payments, for the next 20 years.
We first determined the incremental state tax liability on each
year’s payout of $50,000. This comes to $2,650, given that
Massachusetts imposes an income tax at a flat rate of 5.3%. We then
determined the incremental federal tax liability on the prize winner
by estimating the federal tax liability on the mean annual income
of a Massachusetts taxpayer before and after the $50,000 payout.
The mean annual income in Massachusetts is $50,990(6)
Therefore, we calculated the incremental federal tax liability by
subtracting the federal taxes on $50,990 from the federal taxes
on $100,990. That came to $12,492.51.(7)
Adding this to the state tax liability of $2,650, we got a total
tax take of $15,142.51, which comes to 30.39% of the annual payout.
Thus, the annual aftertax payout became $34,857.49.
Vincent
A. Fulmer is a consultant for early stage companies in New England
and former Chairman of the Board of Trustees of Suffolk University.
David G. Tuerck is the executive director of the Beacon Hill Institute
at Suffolk University. They can both be reached at bhi@beaconhill.org.
*Various scratch tickets offer different payment schedules and lump
sum options. http://www.masslottery.com/games/instantwin.html.
1
It merely points out that “all holders, tickets and transactions
subject to Lottery Commission rules as published in the Massachusetts
Register and the administrative Bulletin issued thereunder.”
2 There is one advantage to the winner of having his prize winnings
stretched out over 20 years, and that is the progressive nature
of the federal income tax (though not the Massachusetts state income
tax). If the winner gets all the money now, he ends up in a much
higher federal tax bracket than if he gets it over 20 years. Even
so, the prize is less than advertised. If a Massachusetts taxpayer,
in an example developed in the Appendix, received the entire million
dollars now, he would end up paying $390,524 in additional federal
and state taxes, leaving him with $609,476 in net winnings. This
is still 39% less than the face value of the ticket.
3 We assume that the winner is a Massachusetts resident. The state
tax rate is 5.3%. If the state pays out now, the cost is the $1,000,000
payout minus the $53,000 (= .053 X $1,000,000) it receives in taxes
on the payout. If it pays out over 20 years, the cost is the present
value of the stream of $50,000 payouts minus the stream of taxes
(= .053 X $50,000) it receives back on each payout. See the Appendix
for additional details.
4 For prizes of $601 to $4,999, the state withholds 5% in state
taxes. For larger prizes it withholds 5% in state taxes and 20%
in federal taxes.
5 Anthony E. Boardman, et al., CostBenefit Analysis: Concepts and
Practices, 3rd ed.(Upper Saddle River, NJ: PearsonPrentice Hall,
2006), 14.
6 U.S. Bureau of Labor Statistics, “May 2008 State Occupational
Employment and Wage Estimates,” http://www.bls.gov/oes/2008/may/oes_ma.htm#b000000
(accessed December 1, 2009).
7 Internal Revenue Service, “2009 Tax Table,” http://www.irs.gov/pub/irspdf/i1040tt.pdf
(accessed December 8, 2009).

