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The MassachusettsScratch Ticket Lottery:Truth-In-Advertising Travesty
Vincent A. FulmerDavid G. Tuerck
Beacon Hill Institute
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f you are lucky enough to win a million dollars or more in a scratch ticket through any of the 7,500retail outlets of the Massachusetts Lottery, your prize is worth far less than you might imagine. Infact, 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 buyersthat million-dollar prizes will be paid in 20 installments of $50,000 each for 20 years. But that’swhere truthful advertising ends. The state gives no indication what the present value of the futurestream of annual after-tax payouts is worth in terms of today’s dollars. And, it does not tell thepurchaser, except by remote reference, that 30% will be withheld each year for federal and stateincome taxes.
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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 himuntil a year from today. If Josephine paid him now and he put the same $5,000 in the bank todayat 5% interest, the $5,000 would accumulate to $5,250 a year from now (ignoring income taxes). Bythe same token, $5,000 received a year from now is worth only $4,761.90 (= $5,000/1.05) today: At5% interest, Joe would have to deposit only $4,761.90 in the bank today in order to have $5,000 ayear from now. Joe should discount Josephine’s offer in this manner in order to decide whether totake on the job.Likewise, Joe has to consider the fact that he must pay taxes on his income. If the tax rate on $5,000of 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 present-value terms.While the average person will ordinarily take these details into account when making a businessdecision, he or she will be far less inclined to do so when tempted by a million-dollar lottery prize.Because gambling winnings seem like “free money,” there is a temptation to leave logic behind inplunking down money for a major prize. There is a temptation to ignore theprinciples of discounting and the inevitability of taxes in deciding whether togamble and how much to gamble.
BHI
On the Issue
February 2010
 
*Various scratch tickets offer different payment schedules and lump sum options.See http://www.masslottery.com/games/instantwin.html.
 
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Yet, the decision to gamble is —or should at least be treated as — a business decision. Given simi-lar odds, a gambler should skip a million-dollarlottery and risk his or her money, instead, ongambles that pay out immediately, for example,the slots or horse races. Yet, the marketing be-hind million-dollar prizes does everything possibleto discourage this kind of rational thinking.Table 1 shows how compound interest and taxesshrink the prize actually received by a million-dollar scratch-ticket winner. We apply a discountrate of 4.22%, based on assumptions about thewinner’s investment strategy, detailed below in theAppendix. We also reduce the annual payout by$15,142.51 to account for an estimated combinedfederal and state tax rate of 30.29% on the win-nings. The third column of Table 1 shows theNet Present Value (NPV) of the resulting annualafter-tax payout of $34,857.49 over the 20-yearpayout period.The present value of the combined20 payments is $484,310.01, less than half theadvertised million-dollar prize.
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There can be only one motive for spreadingthe winnings out over 20 years: The cost tothe state of paying out later is less than thecost of paying out now. If the state pays outnow, the cost (taking into account the taxes itcollects on the winnings) is $947,000. If it paysout over 20 years, the cost is$657,881 inpresent-value terms.
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In the corporate world, chief financial officersare never deceived by the high cost of factor-ing their accounts receivable. They under-stand the time value of money and the highcost of waiting for customers to pay. Con-sumers on the other hand are largely unawareof the compound interest factor and the dev-astating effect of the time value of money.Consider the rent-or-buy decision as it affectshousing. It seems unlikely that home buyersseriously consider the fact that they will endup paying two times the purchase price of ahouse by the time they finish paying princi-pal and interest. Rather, they commit them-selves to 30 years of mortgage payments inthe (perhaps illusory) hope that their housewill appreciate in value.Lottery prize winners display the same indif-ference to discounting scratch tickets; they donot seem to know, or even care, that million-dollar scratch tickets are subject to com-pound-interest shrinkage. The dominant at-traction of these scratch tickets is that theyoffer “instant winnings” to players. The tick-ets emphasize this feature. Players don’t haveto wait to find out whether or not they havewon. And the possibility of striking it rich fora “million dollar prize” is part of the packageand becomes a powerful psychological moti-vator.There is a further anomaly that characterizesthe decision to bet on a million-dollar prize.Prizes below a million dollars are paid out in-
Year Payment
($) After
Tax
($) NPV
($)
Present 50,000.00 34,857.49 34,857.491 50,000.00 34,857.49 33,446.702 50,000.00 34,857.49 32,093.003 50,000.00 34,857.49 30,794.104 50,000.00 34,857.49 29,547.765 50,000.00 34,857.49 28,351.876 50,000.00 34,857.49 27,204.387 50,000.00 34,857.49 26,103.338 50,000.00 34,857.49 25,046.859 50,000.00 34,857.49 24,033.1210 50,000.00 34,857.49 23,060.4211 50,000.00 34,857.49 22,127.0912 50,000.00 34,857.49 21,231.5413 50,000.00 34,857.49 20,372.2314 50,000.00 34,857.49 19,547.7015 50,000.00 34,857.49 18,756.5416 50,000.00 34,857.49 17,997.4117 50,000.00 34,857.49 17,268.9918 50,000.00 34,857.49 16,570.0619 50,000.00 34,857.49 15,899.42
SUM 1,000,000.00 697,149.80 484,310.01
Table 1
 
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stantly. Because there is no waiting to collect thoseprizes, there is no compound interest shrinkage.Further, prizes below $5,000 are subject to lesswithholding or no withholding.
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There is a fundamental mistruth in a ticket thatpromises instant winnings but pays off instantlyonly for less-than-one million dollar prizes. Themillion dollar prizes are illusionary. They merelyheighten the get-rich-quick aura of the scratchtickets without delivering on the psychologically-induced perception of an immediate million-dol-lar prize.Where are all the consumer advocates to protestthese subtle features that betray truth-in-adver-tising? Why aren’t they accusing the state of falseadvertising? To begin with, gaming is alreadyon shaky moral grounds, despite its acceptancein — of all places — church basements where bingo and $1,000 clubs provide an often meagerrevenue stream. The social costs of gambling ad-diction are large and poorly documented. Whatis known is that gambling losses impose a larger burden on low income recipients than on moreaffluent players. Little wonder that casino gam- bling stirs passions on both sides of the issue.There are three defenses of the lottery and otherforms of legalized gambling. First, criminal en-terprise is removed by granting the state powerto control and regulate gaming. Second, lotteryrevenues in Massachusetts go to support schools,and gambling revenues in general lessen the burden of government on taxpayers. Third, thereis a principled, libertarian argument that peopleshould be permitted to gamble or not, as theychoose.People have the right to gamble with their ownmoney and are, by the same token, responsiblefor informing themselves about the true worthof the advertised prizes. It is a long-settled prin-ciple of government, however, that private sec-tor businesses must adhere to certain standardsfor truth in advertising. It is particularly trou- bling, therefore, for the very government that ischarged with administering the truth-in-adver-tising laws to engage in its own brand of de-ceptive advertising. Indeed, we view the prac-tice as a travesty.A reported 42 states now have state lotteries.Most, if not all, also sell scratch tickets at retailestablishments. It is a strange policy to rely onmisinformed and gullible gamblers for revenuethat smart gamblers avoid in the first place.This kind of asymmetrical information wouldnot be allowed in most commercial transac-tions.Despite the need for revenue, government issupposed to represent the people’s interests notexploit the gullibility of a few. This exposes agrand irony. Elected officials often demonizethe denizens of Wall Street who by sleight ofhand mislead and defraud investors. In Mas-sachusetts, it makes for great theater to go af-ter Wall Street. But when it comes to the lot-tery, many politicians are no different from un-savory investment bankers. The theft takesplace off stage. Massachusetts scratch ticket pa-trons deserve better.To make its advertising more truthful, the Mas-sachusetts Lottery Commission should speedup the payouts on its million-dollar prizes. Oneeasy reform would be, for example, to pay outwinnings over five to seven years, rather than20. That would send out the signal to scratch-ticket patrons that the value of their winningswould be worth more. And, in a state plaguedwith one widely-perceived political scandal af-ter another, our elected officials could upgradetheir moral standing with the voters.
Appendix: Methodology
Because of time preference – the preference fora dollar now over a dollar later – and inflation,the calculation of the discount rate is necessary.
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Consider the example of Josephine, the home-owner, and Joe, the painter, in the ex-ample above. When Josephine offered Joe $5,000 a year from now to paint herhouse, Joe had to discount her offer by
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