Less Should be MORE with Federal Cannabis Taxation

May 28, 2021

Today, Rep. Jerry Nadler (D-NY) reintroduced the Marijuana Opportunity Reinvestment and Expungement Act (MORE Act) to reform federal treatment of marijuana by descheduling it, meaning it no longer would be a prohibited substance. Not surprisingly, the bill includes an excise tax on all sales of marijuana products, which would take effect six months after the bill becomes law. The issue with the tax design is twofold: first, by relying on price, it does a poor job of internalizing the externalities associated with marijuana use, and second, it adds a significant tax burden to an already highly taxed market.

Currently, products must be grown, processed, sold, and consumed within state borders due to federal prohibition, but this would all change if the MORE Act becomes law. As such, the MORE Act would have a massive impact on the marijuana markets in the states that currently allow sales and consumption—particularly on consumer prices. Because descheduling would allow companies to conduct interstate trade, give access to banking services, and lower federal income taxes on marijuana businesses, it could revolutionize the industry as businesses obtain access to more capital, as brands become available nationwide, and as companies apply economies of scale.

These developments could, however, be impeded by the excise tax in the bill. The tax has a novel design, as rates increase from 5 percent of manufacturer value to 8 percent of manufacturer value over five years. After five years, the tax becomes a quasi-weight-based system, where products are taxed per ounce based on the prevailing sales price rather than manufacturer value. This price will be determined for each calendar year based on sales during the last federal fiscal year, meaning that the price in 2027 would be based on transactions for the 12 months ending September 30, 2026.

The bill defines two categories for taxation: marijuana product and THC-measurable marijuana product. Tetrahydrocannabinol (THC) is the main psychoactive compound and is generally used to define potency of the marijuana product. In addition to the excise tax, an occupational tax of $1,000 is levied on each premise on which marijuana business is conducted.

The MORE Act’s Proposed Excise Tax Design
Product Years 1 and 2 Year 3 Year 4 Year 5 Year 6
Marijuana product 5% 6% 7% 8% 8% of prevailing sales price
THC-measurable marijuana product 5% 6% 7% 8% 8% of prevailing sales price

Note: THC-measurable marijuana product means products about which the Secretary of Health and Human Services has determined that the amount of THC in such product can be measured with a high degree of accuracy, or which is not marijuana flower and the concentration of THC in which is significantly higher than the average such concentration in marijuana flower.
Source: Marijuana Opportunity Reinvestment and Expungement Act (MORE Act).

Rather than relying on price, a tax on marijuana should be levied at a rate that corresponds to the externalities associated with the product. Granted, this is difficult as the actual externalities are hard to estimate for any product, and not many studies on the subject exist for marijuana. Not only is it hard to estimate cost related to marijuana use, but external cost is also impacted by substitution. For instance, the external cost of marijuana use is smaller if consumption of marijuana is substituted for alcohol, painkillers, or tobacco consumption.

For this and perhaps other reasons, most states with legal recreational marijuana have implemented price-based (ad valorem) taxes on recreational marijuana levied at the retail level. This solution seems impractical for the federal government (no other federal excise tax is levied at retail) due to the huge number of taxpayers. Levying the tax on retail sales allows for simplicity because there is a taxable event with a transaction, allowing for simple valuation. However, with an ad valorem tax levied early in the value chain (as under the MORE Act), it becomes difficult for vertically integrated businesses to calculate the taxable value, as there is no actual transaction—an issue known as transfer pricing. Transfer pricing can become a big issue, as it has for large cigars, the only tobacco product with an ad valorem federal excise tax.

To avoid all these issues, the tax should be based on either potency or weight. A weight-based tax would respect the different harm profiles of smoking a little versus a lot of marijuana, as opposed to simply measuring the cost of the product. A specific, separate category could be created for edibles and concentrates as they are easier to test (a principle reflected in the MORE Act). Under a potency tax, highly potent products would be more expensive and yield more revenue, reflecting higher societal cost associated with more potent products. Neither weight nor potency are perfect, but both are substantially better proxies than price for internalizing the externalities.

While the MORE Act does seek to account for potency by taxing based on THC content in certain products, its reliance on price to set the rate partially negates the intent, as fluctuations in the value of THC share no relationship with the externalities associated with consuming THC. A better approach is to impose specific taxes on marijuana, with smokable plant material subject to a specific tax per ounce, while edibles and concentrates have a specific tax by milligrams of THC content. (Testing for THC in plant material may still need time. Thus, a tax could be established purely on weight for now.) Using THC as a tax base assumes that THC content is the best proxy for potency and therefore the best measure of externalities related to marijuana consumption.

This, however, is an area that should be studied further. There are hundreds of cannabinoids in marijuana and the understanding of the “formula for potency” and “serving size” is nowhere near complete. For instance, does different ratios of cannabinoids in a product affect the potency, or does 10 mg of THC in a gummy bear affect the consumer differently than 10 mg of THC in a sparkling water?

Even with a THC focus, there may be a need to levy one rate on edibles and another of concentrates to account for different and more potent absorption mechanisms. For instance, New York State has recently proposed a tax system where edibles are taxed four times higher than concentrate.

The MORE Act would also have implications for state revenue. Ballot measures or bills to legalize sale and use have passed in 18 states, each with its own regulatory and tax 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 states are ready for federal legalization—especially the ones still working to establish a competitive legal alternative to the illegal market. One major issue is that 16 of the 18 states levy their taxes on retail prices. If significant price declines follow federal descheduling, these states would see immediate impacts on revenue. At the same time, moreover, federal descheduling paired with the development of a federal tax framework would likely entice other states to tax marijuana, cutting into markets in states where sales are already legal.

Several states could be uniquely exposed to the effects of federal reform. For instance, Alaska levies 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 the majority of states that apply ad valorem taxes at retail level, a federal ad valorem tax would partially result in tax pyramiding, since the federal tax would be embedded in the sales price taxed by the state. In addition, several of these states already levy high taxes (above 30 percent effective rates) on marijuana products and adding a federal levy on top could be a boon to illicit sellers.

Appropriately, the MORE Act does not suggest allocating 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. Excise taxes should only be levied when appropriate to capture some externality or to create a “user pays” system.

Finally, while the MORE Act technically exempts medical products from taxation, under the bill’s definition, no medical products exist in today’s market, because they would need Food and Drug Administration (FDA) approval. Moreover, the FDA has not intervened in the current state medical marijuana programs, but that could change post-prohibition. If marijuana were to be regulated similar to tobacco, the pathway to market (FDA authorization) may be too expensive for small businesses—almost certainly an unintended consequence. 

Many other questions remain to be answered. How can federal and state testing and product safety requirements be aligned, considering how much these differ state by state? How can states crack down on continued illicit sales following a reform intended to decriminalize marijuana? Federal and state lawmakers should come together and answer these questions before federal legislation is passed.

 

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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.

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.