Flawed Federal Taxation of Recreational Marijuana

September 3, 2020

A House vote is expected this month on the Marijuana Opportunity Reinvestment and Expungement (MORE) Act, which would de-schedule marijuana, expunge prior convictions, impose a federal excise tax on marijuana sales, provide access to capital for small marijuana businesses, and allocate revenue to people impacted by prior drug enforcement policies. While it is unlikely to become law in the short term, it would be the most significant federal legislative development on marijuana policy in 50 years.

Federal legalization would have a massive impact on the marijuana markets in the states that currently allow sales and consumption—particularly on prices. Because legalization opens the way for interstate trade, it could revolutionize the business as brands become available nationwide and companies apply economies of scale. Currently, products must be grown, processed, sold, and consumed within state borders due to federal prohibition.

In addition, de-scheduling would grant marijuana companies access to regular banking services and end the unfair tax treatment under IRC § 280E. 280E was enacted in 1982 to deny the deduction of business expenses for illicit operators selling drugs on Schedules I and II of the Controlled Substances Act. Combined, these factors could drive down prices—according to one estimate, federal legalization could drive prices down to between $5 and $18 per ounce from approximately $250 per ounce today. Existing businesses, designed to operate under the current legal framework in states, could find it hard to compete in the event of federal legalization.

The MORE Act would impose a federal excise tax on marijuana at a rate of 5 percent. The tax would be levied ad valorem as a percentage of the value. Taxing based on prices means there is a taxable event with a transaction, allowing for simple valuation. Yet, while it may be simpler to levy the tax based on price, it does not necessarily offer an equitable solution.

 

Excise taxes, which target specific transactions due to some unique characteristic (often negative externalities), are different than general sales taxes, which 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. A marijuana product with similar qualities and in similar quantities should have equal tax liability regardless of design or price, but this principle is ignored by an ad valorem tax design. Taxation should be neutral and aimed at the externality, which is best expressed by the level of THC (Tetrahydrocannabinol, the main psychoactive compound in marijuana) or weight. While price could technically act as a proxy for the strength of the products, it is far from a perfect solution.

Beside not being equitable, revenue raised by ad valorem taxes risks being more volatile. Since they are price-based, and prices are likely to drop significantly, revenue raised per ounce purchased may drop quickly. Preferably, lawmakers would design an excise tax based on quantity as such a tax would provide more stability in revenue collection.

On a positive note, the MORE Act does not suggest allocating marijuana tax revenue to general fund spending. Rather, the bill appropriates funds to designated and related spending programs. As excise taxes are often volatile, they should not be relied upon for recurring spending. To that end, excise taxes should only be levied when appropriate to capture some externality or to create a “user pays” system.

The MORE Act would also have implications for state revenue. Recreational marijuana is legal in 11 states, each with its own regulatory framework. While some states can report relative success in developing in-state marijuana markets, others are still struggling. (See our state by state analysis here.) It is hard to imagine that any of the states are ready for federal legalization—especially the states still working to establish a competitive legal alternative to the illegal market. One major issue is that most states (10 out of the 11) levy their taxes on retail selling prices. If significant price declines follow federal legalization, these states would see immediate impacts on revenue. At the same time, however, federal legalization paired with the development of a federal tax framework would likely entice other states to tax marijuana.

Several states could be uniquely exposed to the effects of federal legalization. For instance, California and Alaska levy taxes on cultivators, and under a federal framework that allows interstate sales, those taxes could hurt the states’ competitiveness by increasing costs for in-state cultivators. For states that apply ad valorem taxes, a federal ad valorem tax could partially be a tax on a tax, resulting in tax pyramiding depending on when it is levied.

Though 5 percent may not seem like an excessive tax, combined with high state taxes in some states, there is a risk of hurting businesses’ competitiveness with the illegal market.

State Recreational Marijuana Excise Tax Structures and Rates
State (a) Structure Tax Rate

Alaska

Specific

$50/oz. mature flower; $25/oz. immature flower; $15/oz. trim; $1 per clone

California

Mixed

15% retail excise tax; $9.65/oz. flower; $2.87/oz. leaves cultivation tax; $1.35/oz cannabis plant

Colorado

Ad valorem

15% excise tax (levied at wholesale by weight at average market rate); 15% excise tax (retail price)

Illinois

Potency (ad valorem)

7% excise tax of value at wholesale level; 10% tax on cannabis flower or products with less than 35% THC; 20% tax on products infused with cannabis, such as edible products; 25% tax on any product with a THC concentration higher than 35%

Maine (b)

Mixed

10% excise tax (retail price); $335/lb. flower; $94/lb. trim; $1.50 per immature plant or seedling; $0.30 per seed

Massachusetts

Ad valorem

10.75% excise tax (retail price)

Michigan

Ad valorem

10% excise tax (retail price)

Nevada

Ad valorem

15% excise tax (levied at wholesale by weight at Fair Market Value); 10% excise tax (retail price)

Oregon

Ad valorem

17% excise tax (retail price)

Vermont (c)

Washington

Ad valorem

37% excise tax (retail price)

Sources: State statutes; Bloomberg Tax.

(a) District of Columbia voters approved legalization and purchase of marijuana in 2014 but federal law prohibits any action to implement it. In 2018, the New Hampshire legislature voted to legalize the possession and growing of marijuana, but sales are not permitted. Alabama, Connecticut, Georgia, Idaho, Illinois, Iowa, Kansas, Kentucky, Louisiana, Massachusetts, Minnesota, Nebraska, North Carolina, Oklahoma, Rhode Island, South Carolina, and Tennessee impose a controlled substance tax on the purchase of illegal products (the tax is normally levied on a person in possession of controlled substances). Several states allow local taxes as well as general sales taxes on marijuana products. Those are not included here.

(b) Maine legalized recreational marijuana in November 2016 by ballot initiative. The state is slated to implement a legal market later in 2020.

(c) Vermont legislators passed legalization of recreational marijuana in January 2018. The process to establish regulated sales are ongoing.

Due to a lack of regulatory framework in the MORE Act, it is unknown how the end of prohibition would impact recreational and medical marijuana markets (and tax revenue) in the 33 states and District of Columbia which allow one or the other. That depends on the actions of relevant federal agencies. While the Food and Drug Administration (FDA) has not intervened in the current state medical marijuana programs, that could change post-prohibition. If recreational marijuana were to be regulated in a similar way to tobacco, the pathway to market (FDA authorization) may be too expensive for small businesses—almost certainly an unintended consequence. Another result may be that recreational marijuana ends up regulated in a similar way to alcohol by the Alcohol and Tobacco Tax and Trade Bureau (TTB).

Depending on the result, existing regulation and federal law could impact labeling, marketing, and ingredients. Furthermore, marijuana businesses have good cause to pay attention to ongoing federal deliberations on vaping liquid and federal import requirements for vaping equipment, which is often used to consume THC.

Designing excise taxes (and regulations) should play a key role in allowing the legal market to undercut and outcompete the illicit market, which should be one of the first priorities. Thus, legalization of recreational marijuana at the federal level should be done with respect to the massive implications it may have for existing state systems as well as a growing industry.

Errata: This post has been updated to reflect that the tax would be imposed at the manufacturing level.

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The 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.

Tax pyramiding occurs when the same final good or service is taxed multiple times along the production process. This yields vastly different effective tax rates depending on the length of the supply chain and disproportionately harms low-margin firms. Gross receipts taxes are a prime example of tax pyramiding in action.

A 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.

An 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 make up a relatively small and volatile portion of state and local tax collections.