GG06 - Increase Lottery Sales and Funding to Public Education

The state's fiscal crisis and the public's reluctance to increase taxes requires that the state consider all available sources of additional funding for our public schools. The Lottery is one of these sources. Even though the Lottery generates about $1 billion a year for public education, it ranks at the bottom of the list in per capita sales when compared to the other large state lotteries in the nation. [1] This is because state laws prevent the lottery from offering the best lottery products.

California's lottery was created in 1984 when 58 percent of the electorate approved Proposition 37—The California State Lottery Act (The Lottery Act). The Lottery is the only forprofit business run by the state. All of the Lottery's funding is derived from the sale of lottery tickets, not the state General Fund. The Lottery has two basic products; computer generated draw games like SuperLOTTO Plus™ and instant scratch-off games known as Scratchers®.

The lottery's purpose is to provide supplemental funding for public education. The Lottery Act states that the Lottery must be run in a manner that makes the most money for education. In other words, the mandate of the voters is for the lottery to operate at maximum profitability. That mandate has yet to be fully realized.

A February 2004 analysis conducted by the world's largest provider of lottery systems concluded that: "The general consensus among national lottery experts is that California operates an under-producing lottery which currently grosses approximately $3 billion in annual revenues, when it should be earning twice that much or $6 billion annually." [2]

Lottery sales have been flat since Fiscal Year 2000-2001. Lottery officials believe that the only way to bring the lottery up to its full revenue generating potential and to ensure that revenues do not go down, is by changing state laws that prevent the lottery from increasing prize payouts, operating banked games and selling games with popular themes.

A proven strategy for lotteries across the country to generate additional funding for their beneficiaries has been to increase prize payouts. Higher payouts generate more winning experiences for players. This makes the games more entertaining and increases sales dramatically. Every lottery in the U.S. that has increased prize payouts has increased sales. [3] The most successful lotteries in the country have one major thing in common, a prize payout of at least 60 percent. There are 39 state lotteries, 36 of which allocate 60 percent or more of ticket sales to prizes. Two of the poorest performing lotteries, California and Louisiana, have a limited prize payout of only 50 percent of ticket sales. [4]

The Massachusetts State Lottery is the most successful lottery in the nation. It also has the highest prize payouts in the nation ranging from 60 percent to 79 percent of ticket sales. With a population of only 6.4 million, compared to California's population of over 35 million, Massachusetts out-produced California in 2002 total revenues by approximately $1.3 billion. [5]

In New York, the payout for their instant games was increased to 65 percent in 1999. After the fourth year of the program, contributions to education increased by more than $500 million a year with higher payouts a major contributing factor. In 2002, Florida increased instant game payouts from 56 percent to 67 percent. Revenues from these products increased 62 percent in the first year, thereby increasing annual contributions to education by $49 million the first year. In Texas, sales sharply declined from $3.7 billion to $2.5 billion after prize payouts were capped in 1998 at 52 percent. Four years after the cap was restored to its prior level, revenues have steadily increased to $3.1 billion. [6]

Top lottery officials from Massachusetts, New York, Florida, Texas and Georgia have recently stated that higher payouts were instrumental in increasing revenues and generating additional funds for their beneficiaries. [7]

The Lottery Act does not give the lottery the flexibility to increase prize payouts. The Lottery Act requires that education receive at least 34 percent of gross lottery revenues, that 50 percent be allocated to prizes and no more than 16 percent to administration. Given these restrictions, the only way the lottery could increase prizes above 50 percent is to spend less on administration and put the savings into the prize fund.

In 1997 the lottery did just that. It streamlined its business processes and cut its workforce by nearly 30 percent. The result was a reduction in administrative expense from 16 percent to 13.5 percent. The Lottery took those savings and put them into the Scratchers® prize fund. This relatively small increase in payouts more than doubled revenues in 20 months from just under $10 million per week in the fall of 1997 to more than $20 million per week in the summer of 1999. [8] Total contributions to public education increased by $191 million after three years, primarily due to this program. [9]

Over the last three years, the lottery has managed to keep its administrative budget at about 13.5 percent and Scratchers® sales have leveled off at about $30 million per week. Although the lottery could increase sales more, it cannot afford to do so because it does not have the necessary prize funds. Lottery officials believe that further cuts in administrative expense to increase prize payouts are not possible without seriously jeopardizing the lottery's operations and security. [10]

In 1996, the California Supreme Court issued an opinion in Western Telecon v. California State Lottery 13 Cal.4th 475 that forced the lottery to eliminate banked games and become the only lottery in the nation that cannot offer games with fixed prizes. [11]

In a banked game, players always know how much they will win for matching a given combination of winning numbers. The prize amount is predetermined or "fixed." For example, players who match five out of six numbers will always win $100,000 regardless of whether or not there is enough money in the prize pool to cover that amount. Accordingly, in banked games, "the house" stands to make or lose money depending on the number of winners for any given drawing. As a result of the California Supreme Court's decision, all lottery games must be pari-mutuel. In a pari-mutuel game all of the money in the prize pool is divided equally among all of the winners in that pool. Players, therefore, never know how much they will win until after the drawing is over. Players may win $80,000 one day for matching five out of six numbers and only $30,000 for the same winning number combination on another day.

There is a maxim in the lottery industry that a fixed prize payout invariably results in more gaming activity because players like to know how much they can win. [12] The lottery's experience suggests that this maxim is true. When the Lottery offered Keno as a banked game it earned $8 million per week. Immediately after the Supreme Court's ruling, the lottery suspended Keno and replaced it with Hot Spot, a keno game with pari-mutuel prizes instead of fixed prizes. Sales fell from $8 million per week to about $3.3 million per week. This illustrates how much more popular and profitable the same game can be when offered as a banked game. [13]

The Lottery Act contains some of the most stringent restrictions on game themes in the nation, specifically banning the use of roulette, dice, baccarat, blackjack, Lucky 7's, draw poker, slot machines and dog racing. These so-called "casino themes" are very popular in more successful U.S. lotteries. The California lottery, however, cannot employ the themes that are most successful in the gaming marketplace or the games that work most productively in tandem. [14]

In 2002, Senate Bill (SB) 1932 (Chapter 888, Statutes of 2002) was passed that lifted the restriction against the use of bingo-themed lottery games. The Lottery introduced a Bingo Scratchers® game in 2003 and it has become the top-selling Scratchers® game grossing over $3 million per week. For the entire Scratchers® product category, sales through the first five months of this fiscal year are about $20 million higher than for the same period last year due primarily to the new bingo game. [15]

There have been two unsuccessful attempts to change the law to allow the lottery to pay out more in prizes. There have not been any attempts, however, to change the law to allow the lottery to offer banked games. Prior legislation initially intended to eliminate all game theme restrictions was amended to just eliminate the restriction against the use of the bingo-theme, as noted above.

SB 930 was introduced in the 2001 legislative session and SB 329 was introduced in the 2003 legislative session. Both of these bills would have increased the percentage of gross lottery revenues allocated to prizes by reducing the percentage allocated to education and administration. SB 329 also had a sunset clause and it guaranteed that education would continue to receive at least $1 billion dollars per year from the lottery. The California Teacher's Association (CTA) opposed both of these bills and neither one made it out of the Legislature.

Assembly Bill 2938 is under consideration in the current legislative session. This bill would allow increasing allocations to payouts to 62 percent, reducing allocations to education to 25 percent and reducing allocations to administration to 13 percent. Like SB 329, it has a sunset clause and a $1 billion dollar guarantee to education. CTA has already expressed its opposition to this bill. [16]

California lottery players, retailers and, most importantly, its public schools, all stand to gain from changing state laws that restrict the lottery's ability to increase sales. These changes are not only consistent with the mandated purpose of The Lottery Act as approved by the voters, they represent the only risk-free way to ensure that lottery dollars to education will not actually decrease. These changes are also less controversial than other revenue generating opportunities, such as allowing the lottery to operate Video Lottery Terminals (electronic slot machines).

Reducing allocations to education and Lottery administration, resulting in increased allocations to prize payouts by at least 62 percent of gross revenue, will generate more than $250 million per year in additional funds for public education by the third fiscal year after implementation. [17] This increase will come from higher price point Scratchers® games that sell for $5, $10 and $20 each. The Lottery has been unable to offer these very successful products because payout restrictions limit it to offering $1, $2 and $3 games.

California was the only state in the country that did not offer a $5 game last year. This year, 26 states are offering $10 instant games and six states are offering $20 instant games. The average payout for these games is about 70 percent. [18]

Reinstituting banked games will generate about $78 million per year in additional funds for public education by the third full fiscal year after implementation. This increase will come from replacing the pari-mutuel Hot Spot game with the original fixed-prize Keno game and from introducing a new draw game with fixed prizes in FY 2007-2008. Hot Spot grosses about $170 million per year; Keno grossed about $400 million per year. The lottery believes that it can recapture about 75 percent of this lost revenue and boost gross sales from $170 million to around $300 million per year. The Lottery also believes that it can introduce a new fixed prize draw game that should gross at least $100 million per year. [19]

Eliminating game theme restrictions will generate about $15.6 million per year in additional funds for public education by the second fiscal year after implementation. Given that bingo is the most popular instant game theme in the nation, revenue estimates assume that a new theme game will only generate 40 percent of the annual gross revenue (or about $62 million) that the Bingo Scratchers® generate today. This figure also assumes that the Lottery has the ability to increase prize payouts and that education will receive 25 percent of the $62 million. Lottery officials believe that without higher payouts, they will be unable to take full advantage of the more popular casino themed games like blackjack and poker. [20]

The following table shows the anticipated additional funds that public education will receive if the Legislature changes state law to increase prize payouts, allow banked games and eliminate game theme restrictions prior to FY 2005-2006. These funds are in addition to the $1 billion per year that the lottery currently raises for education each year. First and second year additional funds from increased prize payouts and the elimination of game theme restrictions are lower to allow time for new product development and distribution and player and retailer acceptance. Additional funds from banked games increase significantly in the third year with the introduction of a new fixed-prize draw game in FY 2007-2008. Because the lottery is not a General Fund agency, all costs associated with implementing these changes will be absorbed by the lottery.

Note: The dollars and PYs for each year in the above chart reflect the total change for that year from 2003-2004 expenditures, revenues and PYs.