(MONEY Magazine) – IT'S 9 P.M. ON A WINTRY THURSDAY NIGHT AS THREE sweatshirt-clad New York State Lottery agents start working the crowd at a small tavern named Cavanaugh's in Blue Point, N.Y., a Long Island suburb of New York City. From their corner table at Cavanaugh's--one of 3,157 bars, restaurants and delis in which the state of New York has recently installed lottery machines--the officials schmooze with patrons, offering them baseball caps and key chains as well as free lottery tickets. They hope to persuade the crowd to play Quick Draw, a video keno--or bingo-type--game so addictive that players call it Lotto Crack.

The lottery agents don't have to do much selling. Quick Draw, displayed on three of the 10 television screens at Cavanaugh's, already has the zombie-like attention of a dozen or so customers. Players fill out cards, choosing as many as 10 numbers from 1 through 80, and then bet as much as $100 per card. When the game starts, 20 electronic balls float across the screens, landing on numbers. Players win prizes according to how many of their choices match. And win or lose, a new game begins every five minutes. As is typically the case with lottery games, tonight most players will lose far more than they win. Cavanaugh's Quick Draw winners collect $1,250 on an average night, about half of the $2,500 spent by all the players. "I know I'm probably going to lose," says Joe Doucett, a 29-year-old electrical engineer, "but I keep playing because I might just get lucky."

That, of course, is the idea. Tempted by the possibility of turning $1 into $1 million, Doucett and his fellow gamblers throw more than $88 million every day into lottery games--more than Americans spend on all spectator sports combined. As a result, lottery sales in the District of Columbia and the 36 states that have the games soared 12.2% in 1995 to $32.1 billion, up from just $2.9 billion 15 years ago, according to the North American Association of State and Provincial Lotteries in Cleveland. (This year, New Mexico became the 37th lottery state.) What the estimated 55 million Americans who play the lottery at least once a month probably don't realize, however, is how big a rip-off the state-run games are for them as taxpayers. A six-month investigation by MONEY reveals that the lotteries have neither lowered taxes for their residents nor boosted funding for education, as their champions have often promised. What's more, by helping turn people like Andy D. into compulsive gamblers (see the box on page 147), lotteries are adding an estimated $10.9 billion a year to the financial burdens of the states and their taxpayers. Among our findings:

--Lotteries are an inefficient way to raise public money. Of the $32.1 billion that states took in from lotteries last year, they kept just $11 billion--a mere third of sales--after shelling out about $21 billion on administrative costs and prizes (see the table at right).

--Cash-strapped states typically rely on lottery revenues to plug ever-widening budget holes rather than using the cash to lower taxes. Indeed, state spending by lottery locales (which make up 84% of the U.S. population) is projected to grow more than twice as fast in 1996 as it is in nonlottery states, according to data compiled by the National Conference of State Legislatures (NCSL) in Denver.

--Despite marketing slogans such as New York's "Supporting education since 1967," lottery states spend less of their budgets on education than do states that go without lotteries, on average. Some lottery lovers are enticed not only by the prospect of getting rich quick but also by the comforting notion that their money will go to pay for teachers and schoolbooks. But MONEY has learned that states that specifically target lottery dollars to pay for public schools often go on to decrease the share of general tax dollars budgeted to pay for education. The result: The proportion of state spending dedicated to education has remained relatively unchanged in the '90s--about 50% for lottery states and 60% for nonlottery states--despite the growth in lottery revenues.

When you add it all up, the marketing claims by most state lotteries are like losing numbers on instant tickets. They seem promising at first but are disappointing once you scratch beneath the surface. Let's examine some actual marketing pitches:

"Giving people the choice to raise money by purchasing lottery tickets will let your state hold the line on taxes." So said Gov. Thomas Meskill of Connecticut when he successfully proposed a lottery in 1971. But despite strong lottery sales ($670.8 million last year), Connecticut state legislators enacted the state's first income tax in 1991. That's because a lottery does not inoculate a state against higher taxes. To the contrary, most states create lotteries because they need all the income they can possibly generate. That explains why, although states with lotteries have raked in more than $128 billion in ticket purchases over the past five years, average per capita taxes in those states have increased 21.7% anyway, to $1,401 a year. That growth rate is three times as high as in nonlottery states, where annual per capita taxes are now $1,049, up just 7.2% since 1990.

Last year, when many state legislatures were in tax-slashing moods, your odds of seeing your taxes go up or down were pretty much the same whether or not your state had a lottery. Of the 36 states with lotteries in 1995 and Washington, D.C., 20 of them (56%) cut taxes and nine (25%) raised them, for a net tax reduction of $2.8 billion. Similarly, seven of the 14 states without lotteries (50%) reduced taxes, while only two (14%) passed increases, for an overall savings of $465 million.

According to gambling industry experts, lotteries don't offer much in the way of tax relief for two reasons. First, huge as they appear, lottery sales do little to alleviate state budget problems, because state governments don't get to keep most of the proceeds. Lotteries pay a majority of revenues back to players as prizes--about 54% in 1994 (the latest year for which data are available), according to data from International Gaming & Wagering Business. Operating costs--including advertising, salaries and commissions to agents and businesses that install ticket machines--gobble up another 12' of every sales dollar. That leaves states with only $34.30 in profits for every $100 of lottery tickets sold. By contrast, the typical charity retains $79.80 of every $100 it raises.

What's more, states typically treat lottery revenues as "found money" that they use to close budget gaps rather than to cut taxes or spending. This year, lottery states plan to spend a total of $315 billion, or $11 billion more than they did in 1995. That's a 3.7% spending increase and matches exactly the $11 billion in profits that lottery states kept in 1995. Spending in nonlottery states, by contrast, is slated to grow just 1.46% this year, to $40.2 billion, according to NCSL. "Voters want states to spend more, and politicians look at lotteries as a way to get tax money for free," says Elizabeth Davis, policy analyst at the Center for the Study of the States in Albany, N.Y.

"We are going to need new money if we want to have good schools. Either we have a huge tax bill or we approve a lottery." That's what then Gov. Ann Richards told her fellow Texans in a televised address the day before the state voted to establish a lottery in 1991. Money for education is the explicit or implicit promise that most lottery promoters make: 18 states specifically earmark lottery money for education, and most others claim that schools benefit from the games. Says Mary Fulton, a policy analyst at the Education Commission of the States in Denver: "There's a deep and widespread perception among the public that lottery revenues are being used to substantially fund education."

During this decade, however, states with lotteries actually dedicated a declining share of their total spending to schools. In 1994 (the latest year for which data are available), lottery states devoted 49% of their total spending to education, down slightly from 50.1% in 1990, according to the Center for the Study of the States. Meanwhile, over the same time period, the average budget share for education increased slightly for nonlottery states, from 58.2% to 58.9%.

Florida, which created its lottery in 1988 to "enhance education," is one of several states that claim to earmark lottery money for schools but in reality mix it with general funds, so it's next to impossible to know where the money goes. This year Florida plans to spend just $114 million, or 14%, of its projected $829 million in lottery profits on specific statewide education projects. The other $715 million will be sucked into the general budget. "We've been hurt by our lottery," says Gary Landry, spokesman for the Florida Education Association, the local school employees' union. "The state has simply replaced general revenues with lottery money--at a time when enrollments are increasing. It's a big shell game."

In New York State, lottery profits ($1.24 billion in 1995) are earmarked by law for education, and the phrase "Supporting education since 1967" appears on the back of every Quick Draw play card. The truth: Education funding is set by the state legislature and does not automatically rise with lottery sales. "If they want to use half the money to plug a hole in the budget, there's nothing to say they can't," says Bill Pape, spokesman for the New York State School Boards Association. "Once it's in the general fund, it can be used for anything."

"The benefits of the lottery far exceed the social costs." These are the words of Jeff Perlee, director of the New York Lottery. Wanna bet? The odds are that you will pick up some of the estimated $10.9 billion tab run up by the 1.5% to 7% of lottery gamblers who lose self-control from compulsive wagering. Robert Goodman, professor of public policy at Hampshire College in Amherst, Mass. and author of The Luck Business (Free Press, $23), conservatively pegs the annual cost to the U.S. economy of each additional problem gambler at $13,200. Reasons for the hefty price tag: Compulsive gamblers are more likely than healthy consumers to attempt suicide, destroy their families, write bad checks, embezzle money, go bankrupt and land in court or jail.

The proportion of callers to the Trenton, N.J.-based Council on Compulsive Gambling's national hotline who say they're addicted to lotteries has risen from 16% to 43% over the past decade. And the problem of compulsive lottery gambling seems destined to rise, as states offer more and more quick-action games. "If anyone thinks that putting lotteries and video terminals on every block won't lead to addictive and criminal behavior, they're in outer space," says Dr. Valerie Lorenz, director of the Compulsive Gambling Center in Baltimore. "We saw keno addicts within two weeks after it was introduced in Maryland." Even some state lottery officials agree. "Problem gambling was not apparent in Oregon before the state took video lotteries out of back rooms and turned them into a public experience," admits David Hooper, public affairs manager for that state's lottery.

Currently, state governments are spending more than $350 million a year to market a new wave of especially addictive instant-jackpot lottery games. Oregon, Rhode Island, South Dakota and West Virginia, for example, have legalized video lottery terminals, which blur the lines between lotteries and slot machines, generating $3.8 billion in sales last year alone. Keno games similar to New York's 12-games-an-hour Quick Draw are now available in 13 states and produced more than $1.6 billion in sales in 1995. "It's a consistent pattern," says public policy professor Robert Goodman. "Revenues are never able to meet the demands of the states over time, so they raise the stakes of the games. The states are the real addicts."

WHAT YOU SHOULD DO

Here are three tips for taxpayers:

--Find out how your state is using its lottery money. Call your state lottery commission or department of revenue, and ask how lottery revenues are allocated. Inquire whether lottery money is being used to replace general fund spending on schools, and find out if plans exist to expand your state's lottery games. If you don't like what you hear, write to your governor and state legislators and let them know.

--If you or someone you know is having trouble controlling spending on lotteries, get help. You can call the National Council on Problem Gambling (800-522-4700), a nonprofit agency whose staffers will refer you to local counselors and meetings.

--If you live in a state with an income tax and want to help its fiscal health while profiting at the same time, consider investing in your state's tax-free municipal bonds. Today, such bonds--yielding about 4.65% to 5.75%--often pay more after taxes than taxable alternatives such as bank CDs for people in the 28% tax bracket or higher (married couples with taxable incomes above $40,100 and singles with incomes above $24,000). Since the odds of winning a standard lotto jackpot are 1 in 13.8 million, according to James Walsh, author of True Odds (Merritt, $19.95), your chances of making money are substantially higher with muni bonds than they are with lottery tickets.

Reporter associates: Joan Caplin and Karyn McCormack