Adams Analysis 

Vol 12, Issue 4

   4th Quarter 2016 

An Analysis of Gaming News and Trends by Ken Adams

Regulation and Taxation: A Cautionary Tale
Ken Adams
During a gaming and entertainment trade show in November in Macau, a panel discussed the challenges the former Portuguese colony faces. The panel's purpose was to help the city chart a path out of its doldrums. Among those on the panel was Eugene Christiansen, the chairman of Christiansen Capital Advisors, who has forty years experience observing and analyzing the gaming industry.
In his presentation, Christiansen offered Macau some advice; "Don't over-regulate and don't over-tax." He compared New Jersey to Nevada. Nevada has a 70-year history with casinos and New Jersey 40 years; that is more than enough time to see the impact of the enabling legislation, regulation, and taxation in each state. While the tax rates in the two states are comparable, the regulatory conditions and costs are much different.
Atlantic City and the Las Vegas Strip in 2016 are the products of governing regulations. The consequences of each regulatory scheme are much more obvious now than a decade or two ago. Christiansen is not the first to use a comparison between the two states as advice for other jurisdictions, but the comparison is not as common as it used to be, though it probably should be.
When gaming was expanding rapidly in the 1990s, states which were planning to authorize casino gaming could choose between New Jersey and Nevada for their regulatory model. Both Nevada and New Jersey stress the importance of gaming to the state and insist it be conducted in a way that maintains public confidence. Both seek to exclude dishonest characters and practices and seek to protect the good citizens of the state. But they differ in the details; it is those details that shaped the casino industry in each state.
Nevada's system uses "minimum standards" to achieve its goals. Under that system, each casino writes its own set of internal controls to meet regulatory standards. The regulations require licensees to have "adequate business probity, competence and experience, in gaming or generally" and adequate financing. Nevada sets broad standards and allows each casino to find its own path to success within those standards.
New Jersey uses a system of "detailed regulations" that are the same for each casino. New Jersey seeks to "extend strict State regulation to all persons, locations, practices and associations related to the operation of licensed casino enterprises and all related service industries." New Jersey and Nevada are both very diligent when licensing slot machines. But New Jersey extended its control further by dictating that no single slot manufacturer could have more than 50 percent of the installed base of games. Thus the market did not determine the game mix as it did in Nevada; instead, the Division of Gaming controlled the mix.
New Jersey used additional means to extend its control over every aspect of casino gaming. The state reserved the power of final approval for all architectural plans. The guiding principle was to be ease of enforcement; all plans had to meet law enforcement standards. Once again, for casino design, the market did not have the final say. It's unpleasant to imagine a Las Vegas designed by policemen. Instead, the Strip is the result of the genius of individual developers like Steve Wynn. New Jersey's system lacks the flexibility to adjust to changes in the market or the economy. Its regulations detail every aspect of a casino, even the ratio of supervisors to table games and dealers. (Some of that detail was revised under Governor Christie, first elected in November 2009.) And to ensure that owners, managers and all employees complied with the letter of the regulation, gaming agents were stationed in each casino 24 hours per day, with costs borne by the casino.
New Jersey's regulations were written with an exact and precise picture of what a casino should be, leaving no room for creativity or variation by the operators. The effect of this type of regulatory control is seen today in Atlantic City: only seven casinos survive, and those are not in a strong situation. For all practical purposes, the cookie-cutter regulatory concept froze Atlantic City in the 1978-1982 era - an unfortunate situation in the second decade of the 21st century.  
While Atlantic City casinos were frozen in regulatory ice, Las Vegas was constantly evolving and adapting to the changing conditions of the economy and customer preference. Three-thousand-room hotels, dolphins, white tigers, volcanoes, dancing fountains, Eiffel Towers and Venice-like canals are just a few of the examples of the creativity and risk-taking of casino developers on the Strip. With the exception of the worst years of the Great Recession, change and growth have been a constant on the Strip. Las Vegas has been a laboratory for the casino resort industry. There have been few restrictions on experimentation as long as each new casino meets the minimum standards and does nothing to harm the reputation of the state, keeps accurate records, and pays its taxes.
The amount of taxes Nevada casinos pay frequently bothers others. Lawmakers in other states are often quite certain that Nevada leaves too much money on the table, something they do not intend to replicate. For example, Pennsylvania, with only twelve casinos, collects more gaming tax per month than Nevada does from its more than two hundred casinos. That's because the effective tax rate on casino revenue in Pennsylvania is 55 percent, versus less than 8 percent in Nevada.
But taxes are a small part of the contribution that casinos in Nevada make to the state's economy. Casinos generate over $10 billion a year in revenue. Nearly 200,000 people work in the gaming industry in Nevada. Las Vegas alone gets over 40 million visitors every year, each spending, on average, hundreds of dollars per visit.
In addition to the direct employment, there are at least as many people indirectly employed in industries that support gaming. The investment in casinos and other developments in Las Vegas has been ongoing since the end of the Second World War; it has paused a few times but never stopped. New developments in Las Vegas draw more people and have for seventy years. It is an economic feedback loop: investment in new developments draws more visitors to the city and increased visitation simulates more investment.
No other jurisdiction has experienced anything comparable; most of the casino-related investment in other states comes in the first few years. After the initial stage, investment tapers off, except for what is necessary to maintain the properties and purchase new slot machines. The majority of what might have been free cash flow goes to taxes, not into updating and improving businesses. By the time new casinos open in New York, Massachusetts, and Maryland, in the next year or so, Pennsylvania casinos will be a decade behind current trends. It is very difficult for a ten-year-old casino to compete against a new one.Imagine a car or television manufacturer trying to survive selling 2006 models in 2017.
Christiansen was giving China and Macau good advice, although neither is likely to be listening. Like Atlantic City and many jurisdictions in the United States, the Chinese know what they want and they expect the casinos to simply conform to those wishes. Macau, however, is in a better position than Atlantic City; it has 1.6 billion potential customers just down the road and no competition for its casinos on the Chinese mainland.
Macau has been lucky up to this point as there has been no shortage of investments: five billion dollars in the last couple of years. But that investment is not likely to continue. The rapid growth has slowed and with the new limits on tables, restrictions on VIP gamblers, and the increased emphasis on mass-market tourists, it is doubtful anyone will be willing to invest two or three billion dollars in a new resort.
Christiansen put the issue into historical context: "Casino markets develop through some well-defined phases. The most important is the growth phase in which operating margins and return on investment capital are very high, allowing operators to build anything they want and that shapes the consumer market." Christiansen also pointed out that once the market matures that window of opportunity closes.
That cycle of investment is visible in many places: Atlantic City, Detroit, Pennsylvania, New Orleans, Illinois, and Indiana, for example. Like Eugene Christiansen, I would advise any jurisdiction considering casino gaming to closely examine the history of Las Vegas and Atlantic City. But I would also recommend a side trip down the road of taxation to Illinois (46.25% effective tax rate), New York (effective rate 37%), Maryland (51-56%) and Massachusetts (effective rate on slot parlors 49%). Of course it is too soon to see the implications of those tax rates in Massachusetts, New York, and Maryland. But Pennsylvania and Illinois can provide plenty of food for thought. As wonderful as MGM National Harbor in Maryland is today, maintaining its leading edge strategy will be very difficult while paying the state 56 percent of its slot revenues. Too heavy a tax burden and too much regulation is not the path to a long-term healthy industry, not in Macau, not in Atlantic City, not in any place.

But that is just my opinion, isn't it?
Ken Adams