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To Avoid Massive Tax Hikes, Privatize State Lotteries

An innovative new lottery privatization model is emerging.

As states continue to grapple with ongoing fiscal pressures, some are beginning to explore an innovative new lottery privatization model with the hopes of increasing revenue. To the extent that this trend could prevent tax hikes or cuts in core programs, it is worth applauding.

Earlier this month, New Jersey began seeking bidders for a lottery management contract that could generate $120 million in upfront revenues and higher net annual revenues to the state. Indiana and Pennsylvania have likewise launched similar efforts in recent months.

The pioneer driving this trend is Illinois. It handed over its lottery operations to Northstar Lottery Group, a private manager, last year. The result? A $36 million boost in net lottery revenues to the state in the first year with hundreds of millions of additional dollars expected over the next five years.

Why is Northstar doing so much better than the government? It's not by scamming customers or cheating. State authorities continue to exercise control and oversight over all of Northstar's significant business decisions because Northstar has to submit its annual business plans for state approval.

What privatization does is recognize that lotteries are essentially businesses that are better run by professional firms that have the right mix of incentives, skills and technology to maximize the value of this ultimately state-owned asset. It hands over to the private operator management of day-to-day operations, marketing and other functions in exchange for a portion of revenues (subject to an overall cap).

The upshot is not just increased efficiency but expanded product lines, improved marketing to attract new types of players, and new outlets for lottery ticket purchases across the state, all of which boost the bottom line.

Lotteries are lucrative businesses that generate profits even when not run super efficiently. Hence, even state-run lotteries produce revenues. However, public agencies face very few incentives to maximize efficiency since they don't have to focus on a bottom line and, are rarely held to performance standards.

Privatization critics assert that governments are doing a fine job on their own, as evidenced by historic lottery returns in a number of states. But like any business, the amount of net revenue generated is a direct function of what portion of gross revenues is spent internally to run the operation. Given that public sector labor and employee benefit costs tend to be far higher than those in the private sector, a private manager - even assuming the same level of gross revenues - is more likely to contain operating costs far better than a government agency and return more revenue to the state.

But private lottery management delivers better returns not only because it can run the business more cost-effectively, but also because it grows the business - or increases net revenues. In fact, the Illinois deal and the others currently being explored tie the lottery manager's compensation to its performance at enhancing lottery revenues, subject to a cap. In Illinois, Northstar receives an annual $15 million management fee with performance incentives for extra profits, but the contract includes a 5% total net income cap on the potential profits for the contractor, as well as penalties if the company fails to hit pre-determined revenue targets.

Where exactly this revenue target should be set has been a bone of contention between Illinois and Northstar and will be an issue that other states should handle with care. After all, a revenue target is an aspiration that is subject to a variety of factors, including external economic forces affecting consumer spending, not to mention a state's unwillingness to approve (or approve with conditions) the vendor's own annual business plan. Putting a hard target in the contract could end up penalizing the vendor for factors that it might not be able to control and could ultimately undermine the whole venture.

But Illinois' experience with Northstar is encouraging. Although Northstar fell short of its $825 million revenue target in the contract, it returned a historic $726 million to the state in the first year. This represents a record profit, given that the state had generated only $690 million in net revenue the year before, according to the Chicago Tribune. Northstar expanded ticket sales to over 1,000 new retailers and introduced new or revamped games, all of which prompted a 27 percent spike in instant ticket sales last year.

Every state lottery is a bit different, with state constitutions directing proceeds to specific uses such as K-12 education. In Illinois' case, enhanced lottery revenues are targeted for education funding and new capital projects included in a legislatively approved infrastructure program. By contrast, lottery proceeds in Pennsylvania are directed to programs to benefit the elderly population.

Although every state has something different to gain from privatizing lottery management, to the extent that money is fungible, by relieving fiscal pressure on some programs, lottery revenues can relieve the overall pressure for tax increases. And its far better that the state pursue new revenue from people voluntarily playing lottery games instead of taking more of taxpayers' income involuntarily through tax hikes and the like.

What's more, many states are saddled with debt and legacy obligations (pension and retiree healthcare costs) that they don't have the funds to pay for. Many of these promises were reckless and should never have been made. But the fact is that governments can't write them all off. They'll have to find a way to pay for some of them. And lottery and other privatization efforts offer one such way without massive tax hikes.

Implementing privatization, like any policy tool (and like playing the lottery itself), is inherently risky. But all risk is not created equal, and ongoing fiscal woes suggest the risk of maintaining the status quo in government may be far greater.

It seems far more sensible for policymakers to avail themselves of every opportunity to maximize the return from the state's existing revenue-generating assets through more efficient management, creating another option for cash-strapped states beyond just higher taxes and cuts in core services. Thus far, Illinois' experience partnering with the private sector to increase lottery revenues suggests that maybe privatization isn't such a risky gamble after all.

Leonard Gilroy is the director of government reform and Harris Kenny is a policy analyst at Reason Foundation (www.reason.org), a Los Angeles-based think tank.

Leonard Gilroy is Director of Government Reform

Harris Kenny is Policy Analyst






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