With most states experiencing reduced taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. revenues due to the coronavirus pandemic, several are contemplating whether recreational marijuana legalization and taxation may be one avenue to raise new revenue. While states that have already legalized do raise meaningful revenue, lawmakers should remember that establishment of legal markets takes time.
In Connecticut, Delaware, Maryland, Minnesota, New Mexico, New York, Pennsylvania, Rhode Island, Texas, Virginia, and Wisconsin, lawmakers are advocating legalization—generally arguing that new revenue is crucial due to budget shortfalls. This list is in addition to the four states where voters passed ballot measures to legalize marijuana on Election Day 2020. Furthermore, the federal government is likely to continue discussions over federal legislation.
A crucial element of legalizing recreational marijuana is tax design. Most states that currently allow and tax sales have opted for a price-based (ad valorem) excise taxAn excise tax is a tax imposed on a specific good or activity. Excise taxes are commonly levied on cigarettes, alcoholic beverages, soda, gasoline, insurance premiums, amusement activities, and betting, and typically make up a relatively small and volatile portion of state and local and, to a lesser extent, federal tax collections. . Taxing based on price means there is a taxable event with a transaction, allowing for simple valuation. While that might be the simpler way to go, it does not necessarily offer an equitable solution. Most states also levy the general sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. on recreational marijuana sales, which should be encouraged as a well-designed sales tax is levied on all final consumer purchases while exempting business inputs.
While ad valorem excise taxes may look like general sales taxes, there are important differences. Excise taxes target specific transactions due to some unique characteristic (often negative externalities), and general sales taxes fall on most consumer transactions. An excise tax should correspond to the harm it is addressing or the cost it is internalizing, neither of which has much connection to the price at which the good is sold. Taxation should be neutral and aimed at the negative externalityAn externality, in economics terms, is a side effect or consequence of an activity that is not reflected in the cost of that activity, and not primarily borne by those directly involved in said activity. Externalities can be caused by either production or consumption of a good or service and can be positive or negative. connected to marijuana consumption, which is best expressed by the level of THC (Tetrahydrocannabinol, the main psychoactive compound in marijuana) or weight. There are legitimate reasons for levying excise taxes on marijuana, but legislatures and voters in other states should proceed with caution. Due to their narrow base, excise taxes are not a sustainable source of revenue for general spending priorities.
Beyond not being equitable, revenue raised by ad valorem taxes risks being more volatile. Since they are price-based, and prices are likely to drop as the market matures, revenue raised per ounce of marijuana purchased may drop. Quantity-based taxes would also limit the state revenue from potential changes to federal law, which could have significant implications for the tax revenue from legalized marijuana. If businesses gain access to banking (if marijuana is descheduled at the federal level), federal tax deductionA tax deduction is a provision that reduces taxable income. A standard deduction is a single deduction at a fixed amount. Itemized deductions are popular among higher-income taxpayers who often have significant deductible expenses, such as state/local taxes paid, mortgage interest, and charitable contributions. s, or interstate trading, prices will most likely fall—reducing revenue in states relying on prices as a tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. .
In addition to the tax base, lawmakers should also be careful when setting rates. Licensed retailers are competing not only with each other but also with illicit operators who do not pay license fees or taxes. The ability of a legal market to generate meaningful revenue is determined by the ability of licensed operators to outcompete these illicit sellers.
Finally, there is revenue allocation and forecasting. As a rule of thumb, excise taxes should only be levied when appropriate to capture some negative externality or to create a “user pays” system, not as a general revenue measure. For marijuana, there are legitimate reasons to levy an excise tax as recreational consumption of marijuana may be associated with harm. Thus, the revenue generated by such a tax should be allocated to cover costs associated with consumption. In most of the states considering legalization, this principle is not well respected, as revenue is dedicated to either unrelated spending programs or the general fund. Only a handful of the 15 states have operated legal markets for long enough to generate useful data on revenue collection. The following table shows average potential revenue generation calculated based on the average dollars collected in fiscal year (FY) 2020 per estimated user of marijuana in states that have had a legal market for three years or longer. While it indicates that meaningful revenue can be generated by states within a few years, it also illustrates that this revenue is no solution to current budget woes.
|State||Potential Revenue||Actual Revenue (FY2020)|
|District of Columbia||$ 26,605,996||N/A|
|New Hampshire||$ 44,163,575||N/A|
|New Jersey||$ 158,974,353||N/A|
|New Mexico||$ 61,692,434||N/A|
|New York||$ 431,141,823||N/A|
|North Carolina||$ 182,947,622||N/A|
|North Dakota||$ 13,231,599||N/A|
|Rhode Island||$ 35,455,500||N/A|
|South Carolina||$ 96,680,914||N/A|
|South Dakota||$ 14,270,281||N/A|
|West Virginia||$ 38,327,540||N/A|
Note: Calculation is based on average recreational marijuana excise tax paid per marijuana-using resident in Alaska, Colorado, California, Nevada, Oregon, and Washington ($220 in FY 2020) and number of marijuana-using residents in every state. The $220 is likely an underestimation of the amount paid per legal user, as the total number of users include 18-21-year-olds who do not have access to the legal market in any state. Numbers may be slightly skewed the other way as an amount of excise revenue paid in legal states is paid by visitors. Numbers do not include general sales taxes, fees, or other business taxes.
Source: State departments of revenue, state comptrollers; SAMHSA; U.S. Census Bureau; author’s calculations.
Even though general fund revenue should not be the main priority when it comes to recreational marijuana legalization, there is revenue available to states that choose to legalize—just not in the short term. Beyond the general sales tax, legal marijuana businesses would also pay business taxes and employees would pay individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. es. Revenue from these broad-based taxes, combined with a potential saving as illicit operations decline, does represent general fund revenue. Expecting a large and sustained boost from marijuana-specific taxes, however, is shortsighted and represents poor tax policy.
For a detailed discussion of recreational marijuana excise tax design, click here.
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