Edition 35: Higher Taxes and Competition
Do states risk killing competition in the cradle?
This week, we’re taking a look at how high taxes will function in the more macro competitive landscape across the country.
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Let’s dive in.
Warning: this week’s edition will be a bit wonkier than usual. We’re going to dive into why higher taxes in new states have the potential to benefit larger operators in the earlier stages of customer acquisition in any given new state. Even if total profits are a bit lower, larger operators will have a strong chance to prevent the successful emergence of new competitors in a high tax environment.
Setting the Scene
Generally, gaming tax rates had all been in a relatively similar order of magnitude (more or less, we know there are some anomalies) during the first wave of states to legalize. Legalizing sports betting is popular and takes off quickly in state legislatures. It’s the kind of easy, visible to the public, win that state legislators can tout to show what they have accomplished in a form of government the average person barely know exists. It’s not really something that is divided on party lines either. Additionally, legalizing gambling provides some extra revenue for the state, generally split among problem gaming resources and either the state’s general fund or some uncontroversial area like education spending. But, gaming revenue isn’t projected to make up large shares of most states’ budgets. To give some context here, in FY 2021, the state of New Jersey spent over $40 billion dollars in its budget (and ran a small surplus!). New Jersey saw about $10 billion in total wagering handle in 2021. Assuming a hold percentage of 5% (give or take), that only leaves $500 million in revenue to be taxed. Even a tax rate at 25% of revenue only yields $125 million, well under 1% of the total state budget. These numbers obviously aren’t exactly what New Jersey does and are just for illustrative purposes. But the bottom line doesn’t change: the mathematics simply don’t work for sports gambling tax revenues to be a game changer in state budgets.
But that doesn’t mean state governments aren’t going to try to milk gaming taxes for all they are worth. Money is fungible and more money from sports betting means more money into some politician’s district. So some states have decided to get more aggressive with their taxes, namely New York recently set the tone for large states entering the market at 51% tax rate on operator revenue. This leaves only 49% of revenue for operators with both the cost of operations and profit remaining. Yet, numerous operators still entered New York. Operators still offered incredibly generous promotions to sign bettors on. And by and large, the numbers coming out of New York have been fantastic from a customer conversion standpoint. New Yorkers have signed up en masse and are active gamblers.
Now, states don’t necessarily follow each other's decisions. And because the revenue is such a small portion of any state’s given budget, legislators may not want to get too bogged down in setting the highest possible tax they think they can get away with. But they still will go higher than they otherwise might have without New York’s launch being such a success. In short, New York’s successful launch with such a high tax may not make every state rise to that level, but it shifts the curve of potential taxes that legislatures would consider upward. Meaning, across the board state legislators can reference the New York tax and its success to justify higher taxes than they would have otherwise considered, even if those taxes only move from the high teen percentages to the high twenties.
So why doesn’t this hurt operators equally?
Generally, these are flat taxes for operators, regardless if their market share is 80% or 2%. However, sports gambling is generally associated with higher fixed costs and lower marginal costs, especially at recreational books. Let’s explore this concept further. Getting lines up for as many markets as possible is necessary to succeed as a sports book. Whether you have one thousand customers or 10 million, bettors will want to see the variety of markets they are accustomed to from operators. Paying a third party service is the strategy for most smaller operators, and setting an original line for a new market is inherently a fixed cost. Then, soft books that cater to recreational bettors don’t really need to trade based on the bets they take. More or less, they just need to ensure the lines that are available at their operation match those that are prevailing in the market. This is a fixed cost. It takes a certain amount of people to ensure that all lines stay close to the market regardless of how many bets the operator takes. Sure, there’s some vague interest in having a balanced book, but at soft operators the goal isn’t to be trading off Average Joe’s $50 wager and balancing the book, it’s keeping a line consistent with other operators. That is a fixed cost proposition. Tech development including running a competent app and website are also primarily fixed costs. Yes, it’s more expensive to run a website with more users than fewer, but the big expense will be creating the website and app and ensuring it meets market standards. Advertising is a bit more of a variable cost, but also isn’t necessarily based on the total number of customers an operator has, but rather how much cash they have and how many customers they hope to sustainably acquire. Advertising spend is not directly related to total customers on the book.
In short, a relatively fixed amount of money is required to actually run the operations of a recreational book. A higher sum of revenues taken by taxes mean that revenues need to be higher to justify the cost of being an operator. If the taxes are too high, it simply will make it impossible for operators to cover their costs at smaller market shares. As a result, larger operators will gobble up even more market share for themselves, cementing a market without much space for innovators. New entrants will require serious capital to ensure that they can manage their fixed costs as they fight to gain market share. In short, a high tax rate means there is less leeway for scrappy operators to enter a market and cover their costs.
The surprising conclusion to this is that the 51% tax rate that New York passed may not be as much of a tailwind for the larger operators as thought. We’ve already begun to see the exodus of smaller operators from the sports betting scene. Parx shut down, Wynn is looking to sell their brand, Resorts left New Jersey, among others. If tax rates in new states coming online increase, it could make life easier for players like DraftKings and FanDuel by lowering the number of operators in the original mad dash for customers.
We like competition. We generally recognize that there needs to be a tax on gaming, but think it should stay in the lower range to encourage competition and a variety of operators. Higher taxes give more power to larger firms. In the absolute worst cases, we could even see larger firms try to exert pricing power by changing the juice to -115 if there are fewer operators. Yes, gaming should raise revenue. But it should also promote competition. Now, it’s important to remember that we are not saying that every state is going to 51%. We are saying that the window of taxes the states will consider has moved in the upward direction as a result of the success that New York is having, which will lead to higher taxes across the board.
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