By Joyce Beebe, Ph.D.
Fellow in Public Finance
Covid-19 has created a large revenue shortage for state governments. On average, states’ sales tax revenue plummeted 21% in May 2020 compared to May 2019. High unemployment is also expected to negatively affect states’ personal income tax collection. At the same time, there is no consensus regarding whether the federal government should provide additional financial help to states. Some believe that the federal government has a moral, ethical and economic obligation to help, whereas others argue that state governments need to make difficult but financially responsible decisions instead of relying on the federal government.
With reduced collection from major revenue sources and limited federal assistance, states are caught between a rock and a hard place. Although many states experienced budget shortfalls prior to Covid-19, the pandemic has intensified the magnitude of the revenue shortage, and states have been exploring different approaches to secure additional revenue. This blog post reviews the recent developments of one such measure — imposing excise taxes on sports betting and on a closely related activity, daily fantasy sports (DFS). This blog post also discusses key issues states should consider if they decide to impose these taxes during the Covid-19 pandemic.
The Changed Sports Betting Landscape and the Rise of Daily Fantasy Sports
Excise taxes encompass a wide variety of taxable targets with different attributes. States have been levying excise taxes on gasoline, cigarettes and alcoholic beverages for decades. In recent years, a number of jurisdictions tried to add soda and sugary beverages and vaping products to the list of taxable items. Others attempted to impose excise taxes on emerging economic activities such as streaming services. When excise taxes are levied on potentially harmful goods and activities, such as cigarettes, gambling and alcoholic beverages, they are often called “sin taxes.” Over time, what constitutes “sinful” products varies as a result of evolving cultural, health and social perspectives. Although “sin taxes” arguably focus on goods and activities that aren’t overly controversial, the public debate is no less intense, because the tax is imposed, in part, to change people’s behaviors.
A fairly new consideration in the excise tax arena is sports betting and DFS. In 2018, the U.S. Supreme Court overturned the Professional and Amateur Sports Protection Act, a federal law that prohibited sports betting under state rules. This decision gave states an opportunity to set their own rules on sports betting. Since then, many states legalized sports betting out of the motivation of getting additional tax revenue. As of June 2020, sports betting is legal in 23 states plus Washington D.C. Several states, including Ohio, Louisiana, Florida, Kansas, Kentucky, Massachusetts and Missouri, proposed to legalize sports betting in the current legislative session. Some bills were stalled, whereas others are still pending.
A recent addition to the general sports betting landscape is DFS, which develops out of traditional fantasy sports. Traditional games involve participants assembling “fantasy” teams with rosters of actual players from real sports teams, including players from associations like the National Basketball Association, Major League Baseball and the National Football League. These games are typically played among a group of family members, friends or coworkers over the course of a team’s whole season, and participants earn points based on the selected players’ actual game performances.
The accessibility of high speed internet and the ease of obtaining instant statistics from actual sports competitions enable companies to offer new forms of fantasy sports that can be played online. These new fantasy sports, known as DFS, expand the participant pool beyond small circles of friends and relatives, and can take place on a daily basis instead of during the sport’s season.
Instead of the traditional draft process, the online DFS operators consider players’ past performances and assign “salaries” where participants can pay to assemble their fantasy teams. The DFS operators collect entry fees from participants to play the game. Upon paying the entry fees, participants are given a fictitious amount of capital to pay player salaries. Operators typically retain a portion of the fees as commission (typically 6% to 14%, a “rake”) and pay out the rest to the winner. For bookkeeping purposes, the operators’ revenue follows a net contest revenue method, calculated as the participants’ entry fees minus payouts. The DFS industry generated an estimated $3.2 billion in entry fees and about $335 million in total revenue in 2018, implying an average “rake” of 10%.
Tax and Legal Considerations of DFS
Some observers believe that the popularity of DFS helps to enhance people’s acceptance of sports betting, which has a close link to gambling. Despite the close relationship between sports betting and DFS, the list of states that allow sports betting does not always overlap with the states that allow DFS. Some states allow DFS but not all allow sports betting, while others allow sports betting in general but are silent about DFS.
The distinction generally lies in whether the fantasy sports are considered a “game of chance” or a “game of skills” under state law, where the former falls in the definition of gambling and the latter is generally authorized. As such, some DFS industry groups maintain the distinction between DFS and sports betting by emphasizing the skill element of DFS, hoping to increase the chance of legalizing DFS — although their goal is to ultimately legalize both.
Attorney generals in several states, including New York and Texas, view DFS as a form of illegal gambling under state law. In February, an appellate court in New York ruled that DFS constituted illegal gambling, and the case is with the Court of Appeals. In Texas, the attorney general’s 2016 opinion stated that traditional fantasy sports are legal if nobody takes a “rake” to run the game, but he also indicated that DFS is illegal. A DFS operator subsequently filed a lawsuit to challenge this opinion, and a trial is set for April 2021.
In the 2019 Texas legislative session, a proposed bill that would legalize DFS passed the House but did not move in the Senate. Supporters of the bill claimed that over 4 million Texans played DFS despite the attorney general’s disapproval; as a result, the bill would allow what was already taking place to gain legal status. They argued that if an activity continues despite it being banned, it is better to regulate and monitor the activity instead of ignoring it. In addition, they view DFS as similar to day trading stocks, except the former is illegal but the latter is legal.
The proliferation of DFS even led the Internal Revenue Service’s (IRS) Office of Chief Counsel to issue a memorandum in July 2020 to clarify its position about taxing DFS. In the memorandum, the Office of Chief Counsel states that it considers the DFS entry fee as “wager,” and the DFS operators are liable for paying the federal excise tax on wagers. The tax rate will be dependent on whether or not the wager is accepted in a state where the activity is legal. If a wager is accepted in a state where it is legal, the federal excise tax rate is 0.25% of the wager amount. On the other hand, if DFS is not authorized and the operator accepts a wager, it is subject to a rate of 2% of the wager amount.
Although the memorandum only states the IRS’ view about the issue and has no precedential value in court, it may have significant revenue and operational implications for operators. Besides the difference in tax rates based on whether the wagers are legal in the states where they are accepted, the tax is levied on the amount of the wager instead of the revenue. Specifically, the wager is the gross amount of entry fees an operator collects from participants and can be as much as 10 times the amount of net proceeds retained by the operator after paying the rewards. In addition, some observers are concerned that if the IRS determines an operator should pay a 2% excise tax rate and the company subsequently makes the tax payment, it will essentially be admitting to accepting illegal wagers. Although the IRS may not care about other legal implications beyond collecting the accurate amount of excise tax revenue, there may be enforceable consequences from other federal or state authorities.
Key Issues to Consider
From both operational and legal perspectives, Covid-19 has provided an unexpected environment for DFS to flourish. Although the seasons for several professional sports were truncated in March, many sports leagues have decided to return without a live audience. Several industry analysts believe these social distancing measures will fuel the popularity of online sports betting, and the pandemic will motivate more states to accelerate its legalization. Despite lawmakers’ interest in discussing these measures, there are several important issues states should consider.
First, it is important to carefully assess the revenue estimate at the individual state level. In general, excise taxes target specific sets of activities; therefore, the tax base is inherently narrow, and the amount of tax revenue can vary significantly. Because of the diverse nature of taxable goods and services, each service or good that is subject to an excise tax can also have different revenue potentials.
In addition, even the same type of excise tax may have different revenue implications across states. As such, each state needs to account for the unique dynamics of existing revenue sources when adding another excise tax to the picture. In aggregate, the relative importance of excise taxes has decreased as a portion of state tax revenues. In 2008, states collected 15% of revenue from excise taxes, whereas in 2018, this declined to 11%. However, excise tax revenues are also less affected by economic fluctuations than those of income taxes, sales taxes or property taxes. During the Great Recession, excise tax collection showed modest reduction in comparison to personal and corporate income taxes, which were down by as much as 10% and 30%, respectively.
In Texas, the big three “sin taxes” — taxes on cigarettes and tobacco (2.4% of total tax revenue), alcoholic beverages (2.3%) and state lottery tickets (2.6%) — accounted for about 7.3% of tax revenue in 2018, which was lower than the national average. The importance of these three taxes as a share of total state revenue for Texas also demonstrates a different trend from that of national average: the share of tax revenue has been fairly stable since 2000, consistently accounting for 7% to 8% of Texas’ total tax revenue.
Despite its uncertain legal status in about half of states, sports betting black markets exist, and illegal activities are taking place. These activities are especially hard to detect when happening online. Widely cited statistics publicized by the American Gaming Association (AGA) show Americans spend $150 billion on illegal betting annually. A study commissioned by the AGA estimates that, if all 50 states allow sports betting in both retail and online forms, state and local governments could collect $3.4 billion in revenue per year; the federal government could collect a separate $4.9 billion.
The additional revenue is appealing; however, some studies caution that the lack of credible revenue estimates remain an important obstacle when it comes to legalizing sports betting. In addition, preliminary evidence from several states that recently legalized sports betting show these tax revenues are not only unpredictable, but also smaller than anticipated. There could be many reasons for this. For instance, it is hard to predict whether or not people who have been participating in sports betting illegally will change their behaviors by moving to legal platforms. The tax revenue collection also depends on the type of games, the establishments authorized and the portion of gaming revenue going to the state government. Therefore, many observers believe that in the grand scheme of Covid-19 revenue needs, the modest sports betting revenue will not have a meaningful impact on budget shortfalls.
Second, if a state plans to legalize sports betting, they should also address online sports betting and DFS. Although recent movements by DFS and sports betting industrial groups seem to diverge, states should discuss all issues comprehensively.
States have been struggling to fit new business models created by the digital economy, such as cloud computing, streaming services and various digital products, into their existing tax systems that were created decades ago. The emergence of DFS provides an opportunity for states to design up-to-date rules and include new economic activities that have not been previously addressed.
Finally, for states that are considering legalizing sports betting, they should focus on the benefits of being able to regulate the activity. The federal government’s concerns about sports betting include that it would be used as a money generating tool for organized crime, participants might be addicted to the games and it could influence the outcomes of professional sports or compromise their integrity. Although many have been shut down, online sports-books that operate offshore have also given sports betting a shadowy reputation and have deprived the U.S. government of tax revenue.
States should be mindful that legalizing sports betting and DFS involves substantial social and moral considerations that need to be deliberated, and the implications go beyond tax revenue. When debating whether to legalize sports betting, the real gain is that states can regulate the activities and provide a legitimate environment that protects consumers from disreputable operations and limits the risk of addiction. Although it is important to have robust revenue estimates so states can have a constructive debate about the issue, revenue should be viewed as the means but not the end; using tax revenue as the sole factor to justify legalizing sports betting would be a tricky proposition.