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January 2012 › I Gaming Us What
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January 2012 › I Gaming Us What About Tax Policy
I-Gaming in the U.S.: What About Tax Policy?
Internet gaming, or i-gaming, is the hot topic in the gaming community. Nearly every week, i-gaming is the subject of a report in popular media outlets. In recent months, major U.S.-based casino operators have announced strategic alliances with European i-gaming operators. Gaming equipment manufacturers have dedicated significant resources to i-gaming, ranging from developing online games to the acquisition of Internet-based businesses. I-gaming has the attention of U.S. federal and state legislatures, as well as regulators.
From a policy and political standpoint, recent developments in i-gaming are occurring with increasing momentum. Examples include former stalwart opponents of i-gaming now advocating for the enactment of federal legislation authorizing i-gaming (Congressman Joe Barton is perhaps the most notable example). In late 2011, congressional committees conducted a series of hearings dedicated to i-gaming. The policy and political developments at the U.S. federal level are paralleled in state legislative chambers, regulatory agencies and Indian tribal governments.
At industry conferences throughout the world, the discussion often either is solely limited to i-gaming or quickly shifts to the prospects of i-gaming in the U.S. While the debate over i-gaming has shifted from “should it be authorized?” to “when will it be authorized?” now is the time to start looking more closely at various i-gaming regulatory models that have been proposed. Assuming that federal legislation paves the golden road to i-gaming, policy decisions must be made concerning the taxation of i-gaming. The tax structure will be influenced by several factors, including the role of Indian tribes and the states in i-gaming. This article will explore some of the tax policy issues that may be on the horizon when legalized i-gaming finally arrives in the U.S.
Ostensibly, most forms of i-gaming are likely illegal in the U.S. Attorneys will continue to debate the legal merits, with respect to whether various types of online games are legally permissible or impressible, and whether the analysis changes depending on the jurisdiction. The industry focus, on the other hand, has rapidly transcended to gaining express legal approval to conduct i-gaming through the legislative process. Absent the proverbial crystal ball, answering the question of when i-gaming will be authorized in the U.S. falls within the category of pure conjecture. While the timing question is difficult to answer, many signs point to the possibility of legislative action sooner rather than later. These signs include the increasing attention paid to the subject of i-gaming at the congressional level, changing societal attitudes, greater support among the land-based gaming community, and the need for new sources of public revenue.
The how and which form that i-gaming is likely to take in the U.S. is likely more easy to predict. A narrow consensus has developed among gaming industry observers that i-gaming will come to U.S. through federal legislation. This consensus view is that U.S. federal legislation will embrace a federal opt-in/opt-out model, likely have a potential for state regulatory oversight, and will be limited to online poker. The minority view is that i-gaming will arrive in the U.S. through state legislative chambers. Advocates of the minority view can state a compelling case. However, for a host of political reasons, it appears that federal legislative action will be more likely, even if a state legislature moves to approve i-gaming.1 Thus, with the view that federal i-gaming legislation will be enacted, a walk through the tax policy considerations is appropriate.
A starting point to develop a rational tax policy for the i-gaming industry lies with identifying the policy goal. Is the policy goal to raise revenue? Or is the policy goal a recognition of the prevalence of i-gaming and an effort to ensure the integrity of i-gaming for the public? Ultimately, there may be no single correct answer. In reality, a U.S. federally authorized i-gaming regime raises several complicated policy issues.
More Revenue? Maybe Not
A policy goal is not as simple as asserting the need for “more revenue.” Proponents of authorizing i-gaming in the U.S. often argue that permitting i-gaming to capture the revenue potential is sufficient reason alone to authorize i-gaming in the U.S. With a U.S. federal budget deficit exceeding $15 trillion as of December 2011, the carrot of new revenue quickly gains the attention of legislatures and policymakers. At the state level, advocates in California have focused extensively on the state’s massive budget deficit and the potential for immediate revenue that could be generated from licensing and regulating intrastate i-gaming.
In 2010, the Congressional Budget Office (CBO) prepared a cost estimate for federal i-gaming. The cost estimate is based on the legislation sponsored by Congressmen Barney Frank and John Campbell. The CBO estimated that a federal i-gaming system would only generate modest revenue.2 The CBO estimate concluded that federal i-gaming will generate $435 million in new revenues for the federal government over the 10-year period of 2011 to 2020. After factoring in regulatory costs, the CBO estimate concluded that the revenue from i-gaming would only reduce the federal budget deficit by $283 million over the same 10-year period.
There has been a long-perceived misconception that gaming is the golden goose that solves governmental revenue shortfalls. Economic studies, however, have challenged the notion that gaming can solve budget woes.3 The findings of economic studies are consistent with recognized academic principles of tax policy. While the studies have focused on land-based gaming, the underlying theoretical principles may have wider application to other facets of the gaming industry. Specifically, the rate structure of a tax model can reach a breaking point that serves as an economic disincentive to engage in commercial activity.
There invariably will be debate in Congress whether a federal i-gaming system should be revenue neutral or revenue raising. Rumors have circulated that certain influential members of Congress have insisted that any federal legislation authorizing i-gaming be revenue neutral. As a result, there is speculation that for any i-gaming legislation to receive congressional approval, the states would have the right to receive any tax revenue.
Indian Gaming and State Lotteries
Developing a tax policy for i-gaming becomes more complicated when Indian gaming is factored into the equation. Without a doubt, Indian tribes have become an important stakeholder in federal gaming policy. Indian tribes are not only major economic hubs within the gaming industry, but they are also politically powerful.
A difficult policy question centers on whether Indian tribes should be allowed to be both i-gaming operators and regulators. Without trying to put the cart before the horse, to the extent that Indian tribes enter the U.S. i-gaming market as operators, important tax policy considerations are implicated. The National Indian Gaming Association has already staked out the tribes’ position: “Consistent with long-held federal law and policy, tribal Internet gaming revenues must not be subject to tax.”
The tribes’ position raises tax equality and fairness concerns. Particularly, whether certain industry participants should be favored by the tax laws. Tax equality and fairness tenets would dictate that all market participants should bear the same tax burden. Whether such policy goals are politically feasible, however, is an entirely different question.
The participation of state lotteries in the i-gaming market presents a similar tax policy concern as that raised by Indian tribes. The income of state and local governments generally is not subject to federal income tax.4 Consequently, state lotteries have a preferred tax status. State lotteries are also exempted from the federal wagering excise tax.
The policy debate point is the same for state lotteries and Indian tribes. From a policy perspective, state lotteries presumably would have a competitive economic advantage over other i-gaming market participants if federal tax policy dictates that state lottery operated i-gaming is exempt from income tax. Again, notions of tax equality and fairness would direct that market participants bear the same tax incidence. Politically, the situation for state lotteries may differ from Indian county. Lotteries generally operate in a different role in terms of the type of gaming activities they conduct as compared to Indian tribes. From a tax policy perspective, however, consideration must given whether state lotteries should be in such a tax-favored position.
Congressman Jim McDermott (D–Wash.) introduced the Internet Gambling Regulation and Tax Enforcement Act, H.R. 2230, which would establish a three-tier i-gaming tax system. First, a tax would be imposed at the rate of 2 percent on the amount of all funds deposited by customers. The tax would be imposed monthly. While the base of the first-tier tax is determined through customer deposits, the tax would not be collected directly from customer deposits. Rather, H.R. 2230 would prohibit operators from directly deducting the tax from amounts deposited to place wagers.
The second-tier tax of H.R. 2230 is the extension of the federal wagering excise tax to i-gaming operators.
Third, electing “qualified states” and “qualified Indian tribal governments” would be eligible to receive an online gambling tax. The tax would be equal to 6 percent of monthly customer deposits.
H.R. 2230 may face more political than policy challenges. Specifically, as noted previously, a rumor traveling in the political circuit is that certain influential members of Congress have conditioned support of, or dropping objections to, federal i-gaming legislation on a federal system that is revenue-neutral. While the third-tier tax of H.R. 2230 is potentially viable, a revenue-neutral model could spell problems for the first and second-tier taxes. Policy wise, the federal tax system embraced by the H.R. 2230 would be preferable to a host of states implementing a variety of tax models with differing rate structures.
While i-gaming is the topic du jour in the U.S., there remains several important policy questions to be resolved. If there is a desire to have a robust i-gaming market in the U.S., tax policy must be taken into account. As our neighbors in Europe can readily explain, non-uniform tax policy with respect to i-gaming can gravely impact the health and viability of an i-gaming market. Thus, in designing an efficient and fair tax model, there are several principles that should be considered:
(1) Any i-gaming tax should have low tax rates. The lessons from Professor Thompson’s economic studies are equally applicable to the i-gaming market. If the tax rates are too high, the i-gaming market may never develop. Europe is already facing the problems associated with high rates. High tax rates can operate as a disincentive.5
(2) Tax policy should embrace uniformity in rates and uniformity in applicability to market participants. Otherwise, the issues arising from multiple tax policies that differ among jurisdictions could destroy an i-gaming market before it ever fully develops. Europe is already contending with these challenges. The uniformity considerations are, therefore, two-fold: First, a uniform federal tax system would be more efficient than state-level tax regimes; second, tax fairness and equality principles militate against a tax system that accords more favorable treatment based on the identity of the market participant. The political issues, however, are complex. If i-gaming legislation ever has a realistic chance of being enacted by Congress, all stakeholders must be willing to have the difficult conversation and be willing to compromise.
(3) The use of deposit accounts as the tax base is a practical policy approach. The base is easy to measure and would likely be efficient to implement. H.R. 2230 adopts a modified deposit account approach by using deposits as the base but prohibiting i-gaming operators to pay the tax from deposit accounts. It may be more efficient policy to impose the tax as an excise tax directly on deposits.
(4) An i-gaming tax system could include reporting and withholding obligations. The benefits include addressing money laundering/suspicious activity concerns to increasing tax compliance, both at a federal and state level.
(5) The decision to impose an entity-level income tax on i-gaming can and should be left to the states.
As the U.S. moves closer to permitting i-gaming, the time is now ripe to focus some attention on developing a rational tax policy for i-gaming.
1 Recent history with Indian gaming can serve as anecdotal evidence. One year after the Supreme Court‘s decision in California v. Cabazon Band of Missions Indians, 480 U.S. 202 (1987), upholding the right of Indian tribes to conduct gaming, Congress responded by enacting the Indian Gaming Regulatory Act to establish a federal-tribal gaming regulatory regime.
2 See Congressional Budget Office Cost Estimate of H.R. 2267 Internet Gambling Regulation, Consumer Protection and Enforcement Act (Sept. 22, 2010).
3 In particular, Professor William N. Thompson has demonstrated the potential negative impact high tax rates can have on economic success of the gaming industry. For example, see William N. Thompson and Christopher Stream, Casino Taxation and Revenue Sharing: a Budget Game, or a Game for Economic Development, 22 T.M. COOLEY L. REV. 515 (2005)
4 Income that a state receives from the exercise of an essential governmental function is exempt from tax under federal tax law.
5 Certainly to the extent that policymakers desire to dissuade i-gaming, tax policy could be used as the means by establishing extraordinary rates. Theoretically, for example, if tax rates are set at 95 percent, it would be difficult for profit-motivated participants to economically justify entering such a market.
Peter J. Kulick is a tax and gaming attorney with Dickinson Wright PLLC, which has an international gaming law practice with offices in Michigan, Nashville, Washington, D.C., Toronto and Phoenix. He received his LL.M in tax law from New York University. Kulick may be reached at pkulick[at]dickinsonwright.com.
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