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2 Executive Summary 1. A tax on gross profits has considerable advantages over a turnover tax from the standpoint of promoting efficiency, equity and the protection of tax revenues. 2. In particular, a tax on betting stakes, customer winnings or turnover is equivalent to a commodity (or unit or specific) tax, which is a tax based on the quantity of an item, whereas a tax that is levied as a proportion of the price charged to bettors (a gross profits tax ) is equivalent to an ad valorem tax. 3. A comparison of a turnover versus a gross profits tax or levy reduces, therefore, to a standard comparison of commodity and ad valorem taxes, which is well explored in the economics literature. 4. Under all reasonable assumptions, an ad valorem tax (GPT in this case) can be formally shown to be more efficient in terms of revenue generation than a commodity (turnover) tax. 5. The technical proof of the superior economic efficiency of a tax levied on gross profits compared to a tax levied on turnover is provided in the Appendix to this report. The analysis is reproduced and available in further detail in a number of top-ranked peer-reviewed economics journals, including the Economic Journal, which is the Journal of the Royal Economic Society, and the National Tax Journal. 6. A tax based on gross profits also provides more favourable incentives for firms to innovate and to improve their technical efficiency than does a system based on turnover. 2

3 7. More generally, a gross profits system is likely to protect tax revenue by removing some of the risk from industry and enabling it to compete more effectively, notably with overseas competition. 8. The decision in 2001 to change the basis of betting taxation from turnover to gross profits demonstrated an awareness of market conditions in which the betting industry operated and operates. For example, a GPT provides an automatic adjustment mechanism (a future-proofing ) to companies in the face of changes in the competitive environment 9. A GPT is also directly linked to the capacity to pay, whereas a turnover tax is not. 10. By maximizing turnover as well as enhancing gross profits, a gross profits system actually incentivizes behaviour which is to the benefit of both betting operators and those imposing the tax. 11. A tax based on some metric other than gross profits, notably turnover, is likely to have the perverse effect of reducing both revenue and gross profit, thereby reducing contributions paid by the operator, as well as increasing volatility in tax revenues. 12. Aside from the theoretical arguments, there is significant empirical evidence (outlined in Section 1 of this report) in support of a gross profits system of betting taxation relative to a turnover-based system. 13. The currently devised tax structure, based on the gross profits of betting operators with no pass-on to consumers, restricts or removes the incentive for bettors to engage in illegal untaxed betting, thus helping to protect tax revenue as well as helping to ensure that betting takes place within a properly regulated environment. 3

4 14. To conclude, the imposition of a turnover-based levy on betting cannot be justified in terms of economic theory or on the basis of established evidence. It would cause significant risk to operator revenues and profitability as well as to tax revenues. 15. A tax on winning bets or customer winnings tax is conceptually equivalent to a turnover tax, and so theory and analysis pertaining to each is equivalent. 16. A provisional estimate of the amount that would be raised (assuming other things equal, and no impact on turnover) by a 1 per cent customer winnings tax is between 40million and 50 million. The actual impact of a customer winnings tax, whether passed explicitly to the customer or not, would be to reduce turnover significantly, the extent of this depending on the incidence of taxation and the extent of customer passon. 17. Provisional estimates of the introduction of a customer winnings tax of 1 per cent on industry turnover (other things equal) would be to reduce it by a minimum of 20 per cent in the event of no pass-on and significantly upwards of this estimate in the event there would be any explicit pass-on to customers. There would be a complementary depressing impact on gross profits and so the effect of the introduction of such a tax could be quite considerable in terms of the revenue base on which the tax is levied. 18. For these reasons, the tax raised from a given rate of winnings tax would be likely to decline significantly in successive years. 19. A more comprehensive assessment of the positive effect of the imposition of a gross profits tax compared to a turnover tax on betting 4

5 would need to allow for direct, indirect and induced fiscal impacts. This would include the broader positive impact on company and personal earnings and employment both within the betting industry and across related industries, as well as tax revenues (including company, national insurance, income taxes) and reduced unemployment cost implications. 20. Making such allowance is likely to further strengthen the case for a gross profits system relative to a turnover-based system of taxation. 5

6 Section 1 An assessment of the different implications of a turnover system of betting taxation relative to a gross profits based system A tax on gross profits has considerable advantages over a turnover tax from the standpoint of economic efficiency. In particular, a tax on gross profits is levied on price whereas turnover taxes are levied on quantity. Intuition suggests, therefore, that the former provides firms with an incentive to concentrate on a low-price, high-turnover strategy, whilst the latter encourages a high-price, low-turnover strategy. Indeed, under all reasonable assumptions, it can be demonstrated formally that equilibrium price will be lower and turnover higher under a gross profits system of taxation than under a turnover system of taxation. In economic terms, this is equivalent to suggesting that a gross profits tax is an allocatively more efficient and less distortionary means of taxing betting than a turnover tax. A tax levied on the gross profits of betting operators is more generally the optimal system from the point of view of promoting efficiency, equity and the protection of tax revenues. A properly constructed gross profits tax will also serve to maximize tax revenues. As such, a gross profits system of taxation benefits the best objectives of the operator and the tax authority, not only at any given point in time but in a manner which is proof against changes and developments over time. Theoretical considerations aside, a report issued by HM Customs and Excise in 2003 (HMCE, 2003), followed up by a report issued by the National Audit Office in 2005 (NAO, 2005), based on empirical evidence, both declared the GPT system a great success, in leading to a significant increase in both betting turnover and gross profit, as well as protecting tax revenue. In 2005, HM Revenue and Customs re-examined the theory and empirical evidence accumulated since the introduction in 2001 of the gross profits 6

7 tax on betting in the UK. Following this period of re-examination and reevaluation, HMRC declared itself satisfied with the existing tax system, i.e. a tax based on the gross profits of bookmakers. A Gross Profits system is also best suited to maximizing the potential of betting operators to compete in a rapidly changing technological and global environment. In particular, a betting tax based on gross profits might be expected to generate more tax revenue in the long run than any alternative system of taxation. This is because such a system reduces risk and uncertainty for the operator as well as promoting optimal industry incentives. Additionally, allowing betting operators to offset winnings paid out against stakes received means that the tax burden on each operator is broadly proportionate to the capacity to pay. This is also important in encouraging new tax-paying entrants to the market. The currently devised tax structure, based on the gross profits of betting operators, with no pass-on to consumers, also restricts or removes the incentive for bettors to engage in illegal untaxed betting, thus helping to protect tax revenue as well as helping to ensure that betting takes place within a properly regulated environment. It should also be borne in mind that the overwhelming weight of empirical evidence suggests that the demand for gambling is highly price-sensitive across a range of sectors and through time (see, for example, Paton, Siegel and Vaughan Williams, 2002, 2004; Suits, 1979, De Boer, 1986). As such, a tax based explicitly on turnover, stake or customer winnings is likely to have the perverse effect of actually reducing revenue and gross profit, thereby reducing contributions paid by the operator, as well as increasing volatility in tax revenues. For this reason, the optimal form of betting tax, according to economic theory, and based on several years of evidence, is one based as currently constituted on the gross profit of the operator. Indeed, the overwhelming weight of empirical evidence, which 7

8 is consistent with economic theory, suggests that this system of taxation (a tax on gross profits) has served to maximize tax revenue paid by each sector of the industry and by the industry as a whole. Moreover, it is directly linked to the capacity to pay. A tax levied on the gross profits of bookmakers is, therefore, not only optimal for the operator, but is also likely to be in the best interests of those imposing this tax. In conclusion, the overwhelming weight of economic theory and of empirical evidence available since the introduction of the gross profits tax on bookmakers is consistent with the analysis provided in the consultation document for HMCE (Paton, Siegel and Vaughan Williams, An Economic Analysis of the Options for Taxing Betting, 2000), and subsequently developed in a series of consultation reports for HM Customs and Excise/HM Revenue and Customs, and supported by the weight of empirical evidence. As such, an ad valorem tax (GPT in this case) is not only in the best interests of betting operators and their clients, but also in the best interest of those imposing the tax. More detailed argument is provided by Paton, Siegel and Vaughan Williams, who demonstrate more fully in the Australian Economic Review (2001) and the Journal of the Royal Economic Society, the Economic Journal (2002), that a switch to GPT from a turnover tax is allocatively more efficient. In particular, Paton, Siegel and Vaughan Williams (2001) show how a tax on betting stakes is equivalent to a commodity (or unit or specific) tax while a tax that is levied as a proportion of the price charged to bettors is equivalent to an ad valorem tax. This builds upon work by Smith (2000), which examines changes in the taxation of gambling in Australia. That paper provides support for a proposed shift from a system in which gambling is subject to a tax on stakes to the use of a goods and services tax (GST). Paton, Siegel and Vaughan Williams (2001) 8

9 demonstrate how the literature on commodity and ad valorem taxation provides additional support for the desirability of this change in tax policy. In particular, it is clear that GST is levied on bookmakers net revenue and not total betting stakes. For example, the Australian Tax Office guide to the GST and gambling states that instead of taxing each and every bet or raffle, gambling operators will pay GST only on the margin. The margin is the amount wagered less the monetary amount paid out. (Australian Taxation Office, 2000). Thus the efficiency implications of the policy shift to the GST reduce to a standard comparison of commodity and ad valorem taxes. Such a topic has been the subject of a long-standing literature dating back at least to Wicksell (1896). Indeed, under all reasonable assumptions, it is shown that an ad valorem tax can always yield more revenue than an equivalent commodity tax. More generally, it is shown that a revenue equivalent ad valorem tax will result in lower prices and higher turnover in equilibrium, than will a commodity tax. The intuition behind this result, as noted earlier, is that an ad valorem tax provides an incentive for firms that have any market power to adopt a low-margin/high-turnover strategy. This is in contrast to a lowturnover/high-margin strategy, which they are likely to adopt in the aftermath of implementation of a commodity tax. In fact, Paton, Siegel and Vaughan Williams show how the fact that ad valorem taxes are welfare superior to commodity taxes generalises to a wide range of oligopoly markets (see, for example Skeath and Trandel, 1994). In particular, by taxing marginal revenue, ad valorem taxation increases the firm s perceived demand elasticity by the multiplier 1/(1-t), where t is the rate at which the ad valorem taxation is set. For this reason one would expect consumer prices to be lower under ad valorem than under specific taxation. In this sense, everyone gains from ad valorem taxation (Cnossen and Smart, 2005). Cnossen and Smart demonstrate further that in a standard industry oligopoly model a shift to ad valorem taxation will reduce prices and ultimately increase government revenues. 9

10 Supporting evidence for this perspective is offered in Delipalla and Keen (1992). Further, empirical support for this hypothesis is provided in several studies of excise taxes in the United States and Europe, markets which are also likely to be characterised by inelastic demand - see, for example, Delipalla and O Donnell (2001), using data from twelve European countries over sixteen years. In particular, Delipalla and O Donnell show that specific taxes in the EU are more likely to be overshifted (consumer prices rise by more than the tax) than ad valorem taxes - see also Stern, 1987; Baker and Brechling, In summary, as Paton, Siegel and Vaughan Williams (2002) point out, there is a consensus in the literature that an ad valorem tax under very general assumptions generates a welfare-superior outcome relative to a commodity tax. Moreover, they note that an ad valorem tax particularly welfare-dominates a unit tax that raises an equal amount of revenue when elasticity of demand in the market is relatively high, a condition which corresponds directly to the situation in UK betting markets. Even in the case in which the conditions for welfare dominance are not satisfied, Skeath and Trandel (1994) show that consumer surplus will still be higher under an equal yield ad valorem tax. In conclusion, the weight of academic literature supports the contention that a revenue- equivalent ad valorem tax will result in lower prices and higher turnover in equilibrium, than will a commodity tax. The intuition behind these theoretical results, as noted above, is that an ad valorem tax (such as GPT) provides an incentive for firms that have some pricesetting ability to follow a low-margin/high-turnover strategy rather than the low-turnover/high-margin strategy encouraged by a commodity tax. A related issue, pointed out by Paton, Siegel and Vaughan Williams (2002) is that the GPT provides more favourable incentives for firms to innovate and to improve their technical efficiency in that the resultant lower prices (due to lower costs) induce lower taxation. Moreover, they 10

11 note that the GPT provides an automatic adjustment mechanism to companies in the face of changes to the competitive environment, and predict that if the GPT system of taxation is maintained then the UK betting industry will be better able to cope with further changes to the competitive and technological environments. HM Customs and Excise (2003) published a review of the introduction of Gross Profits Tax Report on the Evaluation of the Gross Profits Tax on Betting. In that report, they concluded that the reform had been successful, and that in particular industry turnover had increased significantly. One major impact of the reform, summarized by the National Audit Office (2005) has been increased turnover (since the introduction of Gross Profits Tax stakes on betting quadrupled, from 7.1 billion in to 32.2 billion in , and, according to complementary estimates, had almost doubled gross profits). These were in line with estimates provided in association with the 2000 consultation report for HM Customs & Excise (Paton, Siegel and Vaughan Williams, 2000). In summary, the switch in 2001 from a 6.75 per cent turnover tax to a 15 per cent gross profits tax had the effect within three years of hugely increasing turnover and significantly increasing gross profits, as a direct and indirect result of the switch from the tax on turnover to the tax on gross profits. 11

12 Section 2 Provisional estimates of the rates of tax required to raise given amounts and a provisional indicative assessment of the likely effect on customer demand. A tax on winning bets or customer winnings tax is conceptually equivalent to a turnover tax, and so theory and analysis pertaining to each is equivalent. I have prepared provisional, preliminary estimates of the level at which a tax on winning bets would need to be set in order to raise a given sum. According to these estimates, a winnings tax of 1 per cent would be revenue-equivalent to somewhere between 40 million and 50 million per year. This is a point estimate, however, and assumes that the imposition of such a tax has no detrimental impact on turnover, i.e. would not adversely affect liquidity. For all the reasons outlined above, the actual impact of a customer winnings tax, whether passed explicitly to the customer or not, would be to reduce turnover significantly, the extent of this depending on the incidence of taxation and the extent of customer pass-on. My very preliminary estimate is that the introduction of a customer winnings tax of 1 per cent would reduce (other things equal) industry turnover by a minimum of 20 per cent in the event of no pass-on and significantly upwards of this estimate in the event there would be any explicit pass-on to customers. There would be a complementary depressing impact on gross profits and so the effect of the introduction of such a tax could be quite considerable in terms of the revenue base on which the tax is levied. 12

13 In practice, there are strong reasons to believe that the introduction of such a tax would in fact hit turnover (or the liquidity of markets) and to this extent the tax raised from a given rate would be likely to decline significantly in successive years A more comprehensive assessment of the positive effect of the imposition of a gross profits tax compared to a turnover tax on betting would need to allow for direct, indirect and induced fiscal impacts. This would include the broader positive impact on company and personal earnings and employment both within the betting industry and across related industries, as well as tax revenues (including company, national insurance, income taxes) and reduced unemployment cost implications deriving from that. Making such allowance is likely to further strengthen the case for a gross profits system relative to a turnover-based system of taxation. 13

14 Appendix BETTING TAX: THEORETICAL ANALYSIS In order to explore the effects of turnover and gross profit taxes, a formal theoretical model of the betting industry is proposed here. First, consider an industry characterised by an unspecified degree of monopoly power. The industry demand curve is given by Q = f(p) where Q is quantity and P is price. P is given by the proportion of a 1 stake that is retained by the bookmakers (0 P 1) and Q is the number of 1 bets placed - in other words, the total turnover in the industry. The inverse demand curve is given by P = f -1 (Q). Marginal costs are given by MC = g(q). In the absence of any tax, the equilibrium output, Q*, will be at the point where the industry marginal revenue is equal to marginal cost. The equilibrium price, P*, is then given by the inverse demand curve. In this characterisation, a turnover tax is levied on Q, whilst a Gross Profit Tax (GPT) would be levied on P. The impact of each tax on the model is as follows: If a turnover tax is levied at a rate t, the industry demand curve is unchanged, but the marginal cost function is increased to: MC = g(q) + t. Tax revenue, T t, is given by: T t = t Q t * If a GPT is levied at a rate r, the demand curve now becomes Q = f[p/(1- r)] and the inverse function is: P = f -1 (Q) (1-r) where P is the price received by the industry. 14

15 Equilibrium output, Q r *, is at MC = MR and the price paid by consumers, P r *, is determined according to the original inverse demand function. Tax revenue, T r, is given by: T r = P r * Q r * r The equilibrium of the model depends on the form of the industry demand curve and the extent of monopoly power in the industry. For purposes of illustration assume a linear inverse demand function as follows: P = a - b Q where a 1 Marginal costs are assumed to be constant (at least over the relevant region) and equal to c. The marginal revenue schedule will depend on the extent of monopoly power within the industry. Specifically, defining x as a coefficient of monopoly power, a general expression for marginal revenue is: MR = a - x b Q where 1 x 2 A value for x of two implies a pure monopoly, whilst x = 1 implies perfect competition. Setting MR equal to MC, gives Q* = (a - c)/(x b) and P* = [a (x - 1)+ c]/x With a turnover tax at rate t we get Q t * = (a - c - t)/(x b) and P t * = [a (x - 1) + c + t]/x 15

16 With a GPT at rate r, marginal revenue is: MR = (1 - r)/(a - b x Q) Equilibrium price and quantity are now: Q r * = [(1-r) a - c]/[(1-r) b x] and P r * = [a (1 - r).(x - 1) + c]/[x (1 - r) It follows that price and quantity are unchanged only for the case in which we assume there to be no monopoly power at all (that is, x = 1). For any other value of x, equilibrium price and quantity changes when we move between revenue equivalent tax regimes. The result is quite general from the model. In the presence of at least some monopoly power, a revenue-equivalent GPT will lead to a lower price and higher output. In economic terms, allocative efficiency is increased and welfare (or deadweight) losses are reduced. The greater the level of monopoly power, the greater will be the efficiency benefits of a gross profits tax, but in any case, a revenue-equivalent GPT is always at least as efficient as a turnover tax. The intuition behind this is that a GPT is levied on price whereas the current tax is levied on turnover. Consequently such a tax provides an incentive for firms to follow a lowmargin/high-turnover strategy rather than the low-turnover/high-margin strategy encouraged by a turnover tax. Thus, the efficiency implications of the policy shift to a GPT reduce to a standard comparison of commodity and ad valorem taxes. In these terms, the logic derived above indicates that a revenue equivalent ad valorem tax will result in lower prices and higher turnover in equilibrium than will a commodity tax. 16

17 The intuition behind this result is that an ad valorem tax (such as the GST) provides an incentive for firms that have some market power to adopt a low-margin/high-turnover strategy. This is in contrast to a lowturnover/high-margin strategy, which they are likely to adopt in the aftermath of implementation of a commodity tax (e.g. a standard tax on betting stakes or customer winnings). In fact, the result that ad valorem taxes are welfare superior to commodity taxes generalises to a wide range of oligopoly markets in which this restriction does not apply (see, for example Skeath and Trandel, 1994; Delipalla and Keen, 1992). Further, empirical support for this hypothesis is provided in several studies of cigarette taxes in the U.S. and Europe, markets which are also likely to be characterised by inelastic demand. For example, Barzel (1976) and Johnson (1978) report that commodity taxes have a greater impact on cigarette prices in the U.S. than ad valorem taxes. This result was confirmed by Delipalla and O Donnell (2001), using data from twelve European countries over sixteen years. In summary, the available theoretical and empirical evidence suggests that a shift towards taxing net revenue, rather than gross stakes or customer winnings, will have a neutral impact, at worst, on allocative efficiency and economic welfare. The greater the level of monopoly power in the industry, the greater will be the relative efficiency benefits of the GPT. To conclude, a GPT has considerable advantages over a turnover tax from the standpoint of economic efficiency. By construction a GPT is levied on price whereas turnover taxes are levied on quantity. Intuition suggests that the former provides firms with an incentive to concentrate on a lowprice, high-turnover strategy, whilst the latter encourages a high-price, low-turnover strategy. The formal model introduced earlier confirms that, 17

18 assuming the existence of some monopoly power, the equilibrium price will be lower and turnover higher under a revenue equivalent GPT. In economic terms, this suggests that a GPT is an allocatively more efficient and less distortionary means of taxing betting than a turnover tax. 18

19 References Australian Taxation Office (2000), GST and Gambling, NAT3018, ATO, Canberra. Baker, P. and Brechling, V. (1992), The Impact of Excise Duty Changes on Retail Prices in the U.K., Fiscal Studies, 13 (2), Barzel, Y. (1976), An Alternative Approach to the Analysis of Taxation, Journal of Political Economy, 84, 6 (December), Cnossen, S. and Smart, M. (2005), Theory and Practice of Excise Taxation, Chapter 2, p.39, Oxford: Oxford University Press. De Boer, L. (1986), Lottery Taxes May be Too High, Journal of Policy Analysis and Management, 5, Delipalla, S. and Keen, M (1992), The Comparison between Ad-Valorem and Specific Taxation Under Imperfect Competition, Journal of Public Economics, 49, 3 (December), Delipalla, S. and O Donnell, O. (2001), Estimating Tax Incidence, Market Power and Market Conduct: the European Cigarette Industry, International Journal of Industrial Organization, 19, 6 (May), Delipalla, S. And Keen, D. (1992), The Comparison Between Ad-Valorem and Specific taxation Under Imperfect Competition, Journal of Public Economics, 49, HM Customs and Excise (2003), The Modernisation of Gambling Taxes: A Report on the Evaluation of the Gross Profits Tax on Betting, May. 19

20 Johnson, T.R (1978), Additional Evidence on the Effects of Alternative Taxes on Cigarette Prices, Journal of Political Economy, 86, 2 (April), National Audit Office (2005), Gambling Duties, HC 188 Session , 14 January. Paton, D., Siegel, D. and Vaughan Williams, L. (2000), An Economic Analysis of the Options for Taxing Betting, Report for HM Customs and Excise. Paton, D., Siegel, D. and Vaughan Williams, L. (2001), Gambling Taxation: A Comment, Australian Economic Review, 34, 4 (December), Paton, D, Siegel, D. and Vaughan Williams, L. (2002), A Policy Response to the E-Commerce Revolution: The Case of Betting Taxation in the UK, Economic Journal, 112, June, 2002, pp Paton, D., Siegel, D. and Vaughan Williams, L. (2003), The Demand for Gambling: A Review, in Vaughan Williams, L. (ed.), The Economics of Gambling, London: Routledge, p Paton, D. Siegel, D. and Vaughan Williams, L. (2004), Taxation and the Demand for Gambling: New Evidence from the United Kingdom", National Tax Journal, vol.57 (4), pp Skeath, S.E. and Trandel, G.A. (1994), A Pareto Comparison of Ad Valorem and Unit Taxes in Noncompetitive Environments, Journal of Public Economics, 53, 1 (January),

21 Stern, N.H. (1987), The Effects of Taxation, Price Controls and Government Contracts in Oligopoly and Monopolistic Competition, Journal of Public Economics, 32, Suits, D.B. (1979), The Elasticity of Demand for Gambling, Quarterly Journal of Economics, 93, Wicksell, K. (1896), Taxation in the Monopoly Case, reprinted as chapter 16 in: Musgrave, R.A. and Shoup. C.S. (eds.) (1959), Readings in the Economics of Taxation, London: Allen and Unwin, Disclaimer: Although all reasonable efforts have been made to ensure the accuracy of the material and the integrity of the analysis presented here, no liability is accepted for any actions taken on the basis of its contents. 21

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