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Hashing out rates: Taxing marijuana without extinguishing it

There is a profound and growing trend towards the acceptance of the use of marijuana for recreational purposes, and with that acceptance, a modern marijuana industry has boomed, resulting in revenue to the states in the form of taxes as typical sources of “sin” tax revenue are on the decline. Cigarette smoking is waning, resulting in decreasing revenue for the states. Gas prices are also relatively low, meaning that states are not able to tap into traditional areas of easy tax revenue. Taxpayers do not want higher income taxes or higher sales taxes, yet they also do not want to forfeit services provided by the state.

The marijuana industry, particularly the legalized marijuana industry, represents what many view as a solution to revenue shortfalls. Since many view marijuana as a vice, the industry accepts high tax rates as a cost of doing business. Yet this new industry presents its own set of new challenges – one of which is how best to tax this latest “sin tax” without hampering the revenue stream.

During 2018, Vermont became the first state to successfully legalize marijuana through the legislative process. Up until that point, legalization in the other eight states and the District of Columbia had occurred through ballot initiatives. The chart below shows the status of legalization and the respective tax rates adopted by those states that have implemented recreational marijuana taxing regimes:

State Recreational Marijuana Tax
Alaska* Wholesale tax -- $50 per oz on flower; $15 per oz for stems/leaves
Arizona N/A
Arkansas N/A
California Retail – 15% excise tax;
Wholesale -- $9.25 per ounce of flowers; $2.75 for leaves
Colorado Retail – 15% sales tax;
Wholesale –- 15% excise tax
Connecticut N/A
Delaware* N/A
District of Columbia Retail – no retail sales allowed
Hawaii N/A
Illinois Wholesale – 7% tax on cultivators/dispensaries
Maine Retail – 10% sales tax

Massachusetts

Retail – 10.75%;
State tax – 6.25%;
Local municipality tax – 2-3%

Michigan

N/A

Minnesota

N/A

Montana*

N/A

Nevada

Retail – 10% excise tax;

Wholesale – 15% excise tax

New Hampshire*

N/A

New Jersey

N/A

New Mexico

N/A

New York

N/A

North Dakota N/A
Ohio N/A
Oregon* Retail – 17% state tax + 3% optional local municipality tax
Pennsylvania N/A
Rhode Island N/A
Vermont N/A – legalized, but not yet regulated and taxed
Washington Retail – 8% sales tax + 37% excise tax

* State does not have a sales tax N/A State has not legalized/is not taxing marijuana

To determine what is the best tax structure for a new marijuana industry, a state must first determine the tax base and decide whether it wants to tax the dollar value or the volume sold. Historically, “sin” taxes tend to be excise taxes imposed on volume, i.e., at a specific amount regardless of the retail price – for instance, a gasoline tax per gallon or a cigarette tax per pack. Of the states that have legalized and are taxing recreational marijuana, Alaska (a state without a sales tax) is the only state that does not impose some form of sales tax on the end-user and taxes marijuana growers $50 per ounce when selling the product to marijuana dispensaries or retailers.

However, the nature of the recreational marijuana market makes a specific excise tax on volume problematic since marijuana comes in various forms – cigarette, edible, liquid, vapor – all with a wide variety of concentrations. States attempting to tax the end user may find volume difficult to measure. Therefore, states have tended to frame their respective marijuana taxes as a certain percentage of the retail or wholesale sales price. Both Washington and Oregon experienced difficulties in implementation when they deviated from the norm.n growers that was based upon a fixed dollar-per-flower amount. This was ultimately replaced by a 17 percent excise tax on the retail price because enforcement proved too complicated. Amid concerns over double-taxation, Washington also simplified its tax structure – moving from taxing marijuana at three points in the supply chain to a single price-based retail tax. Thus, in practice, a tax based upon retail or wholesale sales price has proved the most workable framework.

Once the tax base is determined, the state must then look to what tax rate it wants to implement. An important consideration in determining the tax rate is contemplation of the black market. Black markets are created when government policies force markets underground by outlawing them or imposing excessive regulation or taxation upon them. If marijuana tax rates are too high or too heavily regulated, buyers will be driven to the black market. Black market dealers can ignore the vast taxes and regulations that drive up the price of marijuana in the legal market, while concomitantly selling to underage buyers and ignoring safety protocols. Thus, if states set the tax rate too high, the black market thrives instead of the legal market. It is necessary to find the optimal tax rate that can minimize the black market, while maximizing a state’s revenue.

Further, consideration must be given not just for the tax rate imposed specifically on marijuana, but for the total effective tax rate. For instance, in California, cultivators pay a tax by weight (which increases the retail price), then marijuana is taxed at a 15 percent excise tax, plus an 8-10 percent states sales tax, plus a 2-20 percent city/county tax. At first glance, the 15 percent excise tax may not seem excessive, but a total effective tax rate of up to 45 percent can be crippling for a newly growing market, particularly one grappling with a well-entrenched black market. Based on data available in the states that have legalized and are taxing marijuana, it appears that even a 30 percent effective tax rate is too high to negate the effects of the black market. It has been suggested that a more realistic effective tax rate appears to be in the 10-25 percent range. However, this number likely varies by state, particularly in light of how entrenched the black market is in the community, levels of tourism, and overall perception and buying power of the public.

Finally, regardless of what tax base or rate is decided upon, in implementing a marijuana tax, states should be aware that statistics can be flawed in estimating the potential economic “boom” related to marijuana – both overestimating and underestimating demand. For instance, Pennsylvania’s Auditor General released a special report regarding the potential revenue and financial benefits that would inure from regulating and taxing marijuana. Therein, it estimates the potential market based on those individuals who – when surveyed – admitted to being regular marijuana users. The report used that number to estimate the percentage of the population that would use marijuana, if legalized. That number is likely skewed, since it represents a portion of the population that accepts the risk of using the drug, despite its current illicit classification. If that were to be removed, it follows that there would be an uptick in the amount of people using marijuana represented by those who were deterred by the potential criminality from the state perspective.

A marijuana-growing business in Colorado
Marijuana plants grow in a greenhouse at the Los Suenos Farms facility in Avondale, Colorado, U.S., on Thursday, Feb. 25, 2016. About 938 dispensaries, which outnumber Starbucks in Colorado, in 2015 yielded $135 million in state taxes and fees, 44 percent more than a year earlier. Yet as the market enters its third year after voters legalized retail sales in 2012, officials question whether the newfound income outweighs the escalating social costs. Photographer: Matthew Staver/Bloomberg

For states like Nevada that have a thriving tourist industry in Las Vegas, it may also prove difficult to predict the amount of revenue that will be generated from non-resident tourists. In fact, Nevada’s first year of recreational marijuana sales vastly exceeded expectations, bringing in nearly $70 million in tax revenue when combined with the tax imposed upon medical sales. That figure represented about 140 percent of what the state had anticipated receiving.

However, state projections can also underperform – as is the case in California, where its high effective tax rate, regulations and healthy black market are to blame for lackluster marijuana tax revenue. The governor’s January 2018 budget proposal predicted that $175 million would be generated from marijuana taxes in the first six months. Instead, California fell far short of the estimates, bringing in roughly $34 million in the first quarter of 2018.

Another issue affecting revenue estimates is the status of legalization in neighboring states. For instance, states like Pennsylvania, New Jersey and New York have been considering the idea of legalization. Whichever state enters the marketplace first would expect to see an initial increase in sales due to market exclusivity. Further, for states like Pennsylvania that closely regulate and define who can obtain medical marijuana, residents with medical ailments that find the state’s process too burdensome may instead migrate to purchasing the drug from neighboring states that have legalized marijuana, thereby not only causing an increase in revenue for the neighboring state, but also a decrease in revenue from medical marijuana sales. As neighboring states move towards legalization, that number should decrease as individuals would no longer need to cross borders to obtain the drug. However, as states move towards legalization, one factor that could continue to affect cross-border sales is the competitiveness of the pricing and taxing structure in the state. This again highlights the importance of a competitive tax rate in the market.

Lastly, since the most effective tax base is one based upon retail or wholesale sales price, states must understand that with price fluctuations come fluctuations in the amount of tax revenue. Prices are still stabilizing in most states as the market adjusts to supply and demand in the new industry, raising questions over where the price for marijuana will ultimately settle – which contributes to revenue projection uncertainties.