Marijuana Legalization and Taxes: Federal Revenue Impact

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Key Findings

• Marijuana 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. collections in Colorado and Washington have exceeded initial estimates.
• A mature marijuana industry could generate up to $28 billion in tax revenues for federal, state, and local governments, including $7 billion in federal revenue: $5.5 billion from business taxes and $1.5 billion from income and payroll taxes.
• A federal tax of $23 per pound of product, similar to the federal tax on tobacco, could generate $500 million per year. Alternatively, a 10 percent sales surtaxA surtax is an additional tax levied on top of an already existing business or individual tax and can have a flat or progressive rate structure. Surtaxes are typically enacted to fund a specific program or initiative, whereas revenue from broader-based taxes, like the individual income tax, typically cover a multitude of programs and services. could generate $5.3 billion per year, with higher tax rates collecting proportionately more.
• The reduction of societal risk in being engaged in the marijuana trade, as well as the inclusion of taxes, will combine to reduce profits (and tax collections) somewhat from an initial level after national legalization.
• Society pays all the costs regardless of legality but tax revenues help offset those costs.

Revenue Impact of State Legal Marijuana Enactments to Date

Four states and the District of Columbia have legalized the sale of retail marijuana by popular vote, with an additional 25 states permitting medical marijuana or decriminalizing marijuana possession.[1] Beginning in 2011, polls consistently show a majority of Americans supportive of legalizing marijuana,[2] and a number of states are likely to consider legalization ballot initiatives or legislative measures in the next few years.

In those states that have fully legalized marijuana, revenue collections have exceeded initial estimates. Colorado anticipated $70 million in marijuana tax collections per year, and after a slow initial start, state collections will likely exceed $140 million in calendar year 2016.[3] In Washington, after a slow start to bring the licensing system online, sales are now averaging over $2 million a day with revenue possibly reaching $270 million per year.[4] If all states legalized and taxed marijuana, states could collectively expect to raise between $5 billion and $18 billion per year. While these amounts are not stratospheric, they are considerable and exceed additional enforcement and regulatory costs incurred by the states.

Estimated Revenue Impact of Legal Marijuana

It is estimated that the current size of the marijuana market nationally is $45 billion per year, approximately 0.28 percent of gross domestic product and comprising some 26 million pounds of marijuana consumed per year.[5]

Federal and state governments have several options for taxes on a legal marijuana industry. A federal 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. on marijuana similar to that of cigarettes, approximately $23 per pound of product, would raise approximately $500 million in additional revenue. A 10 percent sales surtax, similar in nature to those adopted recently by Colorado and other states and proposed in recent legislation by Rep. Earl Blumenauer, would raise approximately $5.3 billion in additional revenue; higher excise tax rates would raise proportionately more.

Business income from marijuana production would initially raise almost $5.5 billion in federal revenues and an additional $1.5 billion in state and local revenues. These revenues are expected to fall as more businesses enter into the market and drive down profit margins. 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. and payroll taxA payroll tax is a tax paid on the wages and salaries of employees to finance social insurance programs like Social Security, Medicare, and unemployment insurance. Payroll taxes are social insurance taxes that comprise 24.8 percent of combined federal, state, and local government revenue, the second largest source of that combined tax revenue. es from labor in the marijuana industry, which would be reported after legalization, contributes $1.5 billion in federal revenue and an additional $1 billion in state and local revenues. These revenues are expected to increase as production expands.

At the state level, assuming no black market, state taxes on marijuana similar to Washington and Colorado could increase state’s tax revenues by $13 billion nationally, with an additional $5 billion from normal 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. es. If high tax rates or other factors perpetuate the black market, tax collections would be less.

Effect of Legalization on the Marijuana Market

Two economic forces will act on the marijuana market when recreational use is legalized. First, those currently involved in the marijuana trade require a higher return than the rest of the economy due to the high risk of imprisonment, confiscation of capital, and unenforceable contracts. Anecdotal estimates suggests that profit margins need to be 100 percent and can be as high as 1000 percent.[6] This is considerably higher than profit margins of similar industries, such as the tobacco industry.[7] Legalizing marijuana will drastically reduce the risk involved in producing marijuana, which reduces the required return to engage in the activity. The lower risk should increase the entrance of new entrepreneurs into the market, which increases supply and forces down prices.

The second force is the inclusion of taxes in the price. Taxes, which are not levied directly in the black market, should have an upward pressure on prices. Many taxes are passed directly to the consumer through higher prices. Marijuana, similar to alcohol and tobacco products, is less sensitive to changes in price than other products. Thus, a tax increase is likely to be passed directly to the consumer. At the same time, when businesses operate in the black market, there is a considerable loss of tax revenue to federal, state, and local governments. These losses are not solely from sales and excise taxes. Business, wage income, and payroll taxes as well as business and licensing fees are also lost.

Using estimates of demand, from domestic and international studies, and the long-run after-tax profit margins from the alcohol and tobacco industries, we estimate that overall taxes should fall from over $28 billion to just over $22 billion, assuming that all states implement a 25 percent sales surtax and the federal government has an excise tax similar to that of cigarette.[8] The change in tax revenues is largely from a reduction in business profits as production increases and profit margins fall. In addition, as the price of marijuana falls due to increased production, sales tax revenues should also decrease somewhat.

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