Author Archives: aquinn2015

280E and Recreational Cannabis: It Keeps Coming Back to This

As California nears a ballot vote on legalizing recreational cannabis, the Ninth Circuit has ruled on the very important issue of whether cannabis businesses may deduct their business expenses. While the case, Olive v. Comm’r, dealt specifically with a medical cannabis business, it has far-reaching implications for future cannabis businesses (regardless of whether they’re medical or recreational). Deductions allowed for business expenses are the keystone tax benefits and incentives for taxpayers to run their own businesses. Without these deductions, running and owning a business becomes an even more cumbersome and costly endeavor. This, in turn, diminishes incentive for current black-market participants to enter the legal sphere. (See my previous post for a discussion on why these consequences should matter to all Californians, proponents and opponents of legalization alike).

On July 9, 2015, the Ninth Circuit affirmed a previous Tax Court decision denying a medical cannabis dispensary the typical tax deductions afforded for ordinary and necessary business expenses. Petitioner, herein referred to as Taxpayer, owned a medical marijuana dispensary and was denied deductions for his business expenses because his particular business fell under one very consequential exception of the Federal Tax Code: section 280E. Despite months of speculation as to whether Section 280E applies to cannabis businesses, it is now clear that it does apply to medical cannabis businesses, and, based on the rationale of the Court, will apply to recreational cannabis businesses as well.

For those unfamiliar with section 280E, it specifically prohibits deductions for business expenses incurred where the  “trade or business” consists of trafficking controlled substances prohibited by federal law. The Controlled Substances Act classifies cannabis as such a substance and federally prohibits its use or sale. Marijuana businesses are required, like all other businesses, legal or illegal, to adhere to both state and federal tax laws. 280E changes liability substantially: cannabis businesses have to capitalize the cost of the business expenses and have to wait until the product is off the shelves to report the “Cost of Goods Sold” (COGS). The items that constitute COGS are much more limited than the plethora of expense types typically allowed under the business expense deduction. COGS, for example, include the cost of purchasing inventory (or product such as cannabis flower), and storage. In contrast, the business expense deduction includes rent, employee wages, and insurance, among others.

In Olive v. Comm’r, Taxpayer argued that 280E should not apply and he should be allowed to deduct his business expenses. His argument relied on recent federal directives (e.g., the Cole Memorandum, 2015 Appropriations Act (128 Stat. 2217), etc.), which cumulatively give states the latitude to implement legalized cannabis systems without federal interference. The Court disagreed and pointedly explained that the applicability of section 280E to cannabis businesses is wholly separate from recent federal directives regarding the enforceability of federal preemption of statewide legalized cannabis systems. The Court’s opinion rested on the statutory interpretation and authority within section 280E, and the meaning of “trade or business” as used in the tax code.

First, the Court opined that recent federal directives regarding cannabis do not preempt or reverse the current statutory law governing tax deductions for business expenses. The determination of whether section 280E applies to cannabis businesses is a matter of statutory interpretation of section 280E and the Controlled Substances Act (CSA). To date, Congress has not amended or repealed the CSA. Thus, the sale and use of cannabis remains prohibited by the CSA, i.e., federally prohibited. And, as mentioned above, section 280E specifically precludes deductions for businesses whose “trade or business” consists of activities that are federally prohibited. The language of both federal provisions is simple and easy to interpret. The Court found that the first prong, as to whether the “trade or business” was federally prohibited, applied, and therefore prohibited the taxpayer from deducting his business expenses.

Next, the Olive Court defined “trade or business,” saying an activity constitutes a “trade or business” where the activity was entered into with the dominant hope and intent of realizing a profit. 792 F.3d 1146 at 1149 (citing 477 U.S. 105) (emphasis added). The Court was clear that Taxpayer’s sale of medical cannabis was the only activity that met the “trade or business” standard as it was the only one that generated income. The Taxpayer’s business offered patrons other services including, but not limited to, yoga, counseling, and food and drink. However, all of those activities were offered free of charge to patrons. Thus, the Court concluded that the free services were clearly not offered with the dominant hope and intent of realizing a profit. In the Court’s view, Taxpayer’s only “trade or business” was the sale of medical cannabis.

The Court recognized that the taxpayer’s business was legal on the state level. However, federal law still controls where the issue being litigated deals with federal tax law. Despite federal directives that have eased or eliminated enforcement of the CSA, the law is still the law in this court’s eyes. And unlike other tax codes, section 280E uses clear and plain language. There is no other way for the Court to interpret such a statute. Unfortunately, recreational cannabis also clearly falls under the CSA prohibition and therefore to section 280E. Thus, the analysis used here will remain the same. Section 280E will continue to pose a costly problem for cannabis businesses.

Although the Ninth Circuit’s ruling is legally sound, it is a disappointing outcome for cannabis businesses held in the states comprising the circuit. It also sets a strong precedent for other circuits to follow. For California, however, this ruling comes at an opportune time as it and a number of its sister states prepare for the so-called inevitable legalization of recreational cannabis. Armed with the knowledge that 280E will apply to cannabis businesses, California can take a more proactive approach and establish a state tax model that considers the effects section 280E will have on its local businesses.

States embarking on legalizing recreational cannabis should recognize the 280E problem and realize that it will continue to cost cannabis businesses more than those in other industries. Implementing a new recreational cannabis system with high State taxes will win votes and may draw in high revenues initially, but such a system will only make it more challenging for small businesses and new business owners to remain profitable and open for business. High taxes also do not help educate users on safety or help diminish the social harms associated with cannabis use. (See “Cigarettes and Booze” for the full discussion on this topic). Lower taxes or incentive programs that include state tax credits for compliance, on the other hand, are great options to relieve recreational cannabis businesses from the cumbersome consequences of 280E. Incentive programs and State tax credits can also be especially useful for encouraging “best practices,” or compliance with regulations that are specifically designed to lower specific social harms. (See my earlier post for examples from the tobacco and alcohol industries). From a business and economic perspective, they could also lead to a more stable industry by allowing businesses to flourish and thereby remain in the legal market. Above all, such options incentivize market participants to enter the legal sphere, and will help small businesses grow within California.

California Recreational Cannabis Tax: Model Options and Other Considerations

California does not need to re-invent the wheel when it comes to creating an effective taxation scheme for recreational cannabis. It has plenty of experience to draw from its vast history of taxing some of the nation’s largest industries. Bethany Brass and Keri Gross, students at Santa Clara University School of Law, wrote a paper that reviews the tax schemes utilized in other CA industries, and those of recreational cannabis markets in other states. It analyzes how some aspects of those models can complement a legal cannabis market in California. Overall, the paper is an effort to express taxation options that aim to drive public policy and can transition cannabis from the black market.

Here’s the link to the paper:

CA Cannabis Tax Options_Written By_B.Brass & K.Gross

Cigarettes and Booze: What They Can Teach Us About Regulating Cannabis

Proh_pic          MJ_Pic

As California voters prepare to cast votes at the 2016 ballot, it is time to draft an initiative that moves recreational cannabis into the legal sphere. Transitioning an illicit substance from the black market into the legal sphere is not a novel exercise for California (or the U.S. at large), just as prohibitionist posters (above) are not new. The Nation brought alcohol back into the legal market after over a decade of prohibition in the early 1930s. And, while tobacco never drew such dramatic attention, our recent history of anti-smoking sentiment has also taught us many things about which taxation and regulatory schemes are effective in minimizing harms correlated with harmful substances. Our past experiences regulating alcohol and tobacco provide us with useful insight into what regulatory schemes are effective and warrant future use. In many respects, the public feels the same way about cannabis as it does towards alcohol and tobacco products; we want to keep it out of the reach of children, prevent teen use, prevent over use or addiction, reduce criminal behavior associated with use, and encourage responsible marketing. While there are some important differences between cannabis and alcohol or tobacco, there are also some similarities between them, both of which offer lessons that cannabis regulators can apply throughout the recreational marijuana initiative drafting and subsequent rule-making process.

CIGARETTES

 Tobacco control in California over the past three decades is a good place to start the discussion. Throughout the late 1980s and 1990s California triumphed over the tobacco industry and minimized some of the harms of smoking through various taxation and regulatory schemes (ordinances such as smoke-free parks and smoke-free workplaces that reduced both secondhand smoke and rates of smokers, as well as advertising restrictions). The historic 1988 passage of Proposition 99 introduced a cigarette tax increase and a health education program against smoking and saw continued success in the decades that followed. Between 1988 and 1998 many anti-smoking regulations went into effect locally and statewide, and in 1998, California voters passed another cigarette tax increase via Proposition 10. While numerous tax increase initiatives failed to pass at the ballot throughout the early 2000s, anti-smoking regulations continued to succeed.  As a result of numerous anti-smoking regulations the California smoking rate reached a historic low by 2011.

A comparison of some aspects of the tobacco industry and what we know about the cannabis market is also very useful. One way tobacco is similar to cannabis is that both are largely inelastic. Empirical evidence estimates “the elasticity of demand for cigarettes is -0.3 to -0.5, implying that cigarette consumption is fairly insensitive to price but certainly not completely insensitive.” The elasticity of demand for cannabis is estimated to be -0.54. Recall that price elasticity of demand measures how much consumption of a good changes (in percentage terms) in response to a one percent change in the price of that good holding all other factors constant. The price elasticity of demand is generally negative, indicating that when price goes up, consumption goes down. A value between 0 and 0.99 is generally considered to be “inelastic” or less responsive to price changes because consumption drops (in percentage terms) less than the price rises (in percentage terms).

The reasons for the inelasticity of both products, however, are not necessarily the same. The inelasticity of tobacco demand is largely the result of tobacco’s highly addictive nature and the fact that many consumers cannot willingly quit the vice. The reason for marijuana’s general inelasticity is not as clear. Most studies on cannabis elasticity categorize users by “prevalence of use” without accounting for “total amount consumed,” thus are not very reliable when used to try to calculate true elasticity. That is, someone might still get high as often when the price increases but might consume less on each occasion. Such categorization is unreliable because cannabis users fall into various categories, each having different degrees of elasticity based either on price alone or based on price and other factors. Regardless of the reasons for the inelasticity, the fact that it exists is important to account for when deciding how to tax and regulate cannabis in a legal market.

Lesson One: Cigarette Use Is Mostly Inelastic, And While High Tax Increases Create Some Elasticity, The Result Still Fails To Meet The Objective Of Significantly Reducing Harms Associated With Smoking.

The main argument against implementing a high tax for cannabis is the fact that it is likely to be regressive and have disparate impacts on users. This notion stems from the many experts who consider the high taxes on cigarettes regressive since high taxes do not significantly lower the rate of smokers and disproportionately affect low-income users. Another argument stemming from experience with the cigarette market is that if the desired product becomes too expensive, consumers will find other products to curb their need for tobacco, creating a substitution problem. A high tax alone will not do much to curtail consumption in the long run. Economists, however, do recognize that if consumers are faced with a high tax increase (say 50-100%), their consumption patterns do change in the short-term. The highly addictive nature of tobacco, however, leads to users seeking out potentially more harmful, albeit more affordable, products to feed their addiction. For cannabis, the preliminary issue of “substitution” may present as a market shift toward demand for more dangerous and typically more potent canna-products (e.g., butane hash oils) or by driving users to the black market. Both substitutes are undesirable for meeting our measures of successful recreational marijuana legalization schemes. Accounting for cannabis and tobacco’s shared degree of general inelasticity, we can tip our hat to the lesson tobacco taught us and respond accordingly in our implementation of the legal cannabis market. A reasonable response would be to set the price inclusive of tax to be near the black market price, and to avoid significant limits on types of consumption (e.g., smoking, edibles, oils, etc.).

Lesson Two: California’s Best Outcomes For Reduction In Tobacco Use And Its Associated Harms Have Resulted From A Combination of Taxation and Regulatory Schemes.

 Some experts suggest regulations and policies such as “smoke free workplaces,” “strong graphic warning labels,” and/or “anti-smoking media campaigns” are more effective at reducing cigarette use, while others argue that tax increases are more effective. However, studies have confirmed that the combined approach is the most effective, but warn that its effectiveness depends on “the magnitude of the taxes and the amount of media campaign expenditures.” Given our decades of experience taxing and regulating similar markets (alcohol and tobacco), it would be reasonable for us to apply our knowledge and take a comprehensive approach to taxing and regulating the cannabis market. Excise taxes and scheduled tax increases will help limit youth access, as they are the most price sensitive user group. The taxes however, should be set low enough to extinguish, or at least largely diminish, the existing black market. Policies implementing minimum age requirements for purchase would complement higher prices and raise barriers to youth access.

ALCOHOL

 Lesson One: Prohibition Does Not Work.

This lesson is barely applicable since the current voter sentiment towards cannabis legalization implies that we understand this and want to implement a more effective approach. Commentators on prohibition explain that during prohibition, alcohol was technically illegal but lack of enforcement, ease of manufacturing and distribution, and prevalence of public use prevented prohibition from having meaningful effect. One study found that an unintended consequence of prohibition was earlier onset of a drinking habit, with young adults reporting the “formation of a drinking habit” at an average age of 21.4 (males) and 27.9 (females) in 1914 and age 20.6 (males) and 25.8 (females) between 1920-23, compared to 23.9 (males) and 31.7 (females) in the years following the repeal of prohibition. Another unintended consequence of prohibition was the proliferation of organized criminal and gang activity due to the demand for bootlegged booze. Although prohibition did correlate with a decrease in alcohol related deaths, especially afflictions associated with the liver, the movement overall is considered a failure. The price of prohibition was too high; the government lost a significant source of revenue while simultaneously increasing its enforcement costs, and many drinkers had to rely on bootleggers or sought solace in other substances (e.g., opium, cocaine, patent medicines, etc.).

Similar issues are found in the illicit marijuana market. California’s medical cannabis system has created a quasi-legal cannabis market that has motivated many to enter the market regardless of the costs. This has created a similar phenomenon like that found with prohibitionist criminals; people are lured by the potential profits and the lack of meaningful regulation has led to large scale criminal trespass grows.” These “trespass grows” cause significant environmental harm, increase risk of criminal violence, and compromise the safety of cannabis use (e.g., increased risk of molds/fungi in products, potentially easier access to children).

Lesson Two: Legalization Will Only Significantly Diminish The Black Market If The Legal Regulatory System Is Flexible, I.E., Is Continually Monitored And Adjusted In Response To Market Demands.

During the early 1930s many believed that alcohol regulation was impossible. The illicit market was believed to be too financially strong and the participation in the black market was too ingrained in American life. To the disappointment of many prohibitionist sympathizers, repeal of federal prohibition and alcohol regulation worked. Of course, it was not an immediate success on all fronts, but based on the factors we delineated earlier as defining successful regulation, it met or exceeded expectations. A comprehensive regulatory system took effect, which allowed limited public drinking venues, licensed vendors to sell to individuals for private use, and local control was permitted to determine rules about time and manner of use.  The multi-faceted system is said to have been successful because it redirected the focus away from the moral woes associated with drinking towards a publicly conscious user market.  Regulators listened to their advisors’ warnings that the moral and social woes associated with alcohol could not be solved through regulation, but would need to be solved through other government and/or private agencies “as part of broader educational and health efforts.”

Unlike the history of taxing cigarettes, the alcohol market has not been the victim of such persistent tax increases. Efforts to reduce the harms associated with alcohol consumption have largely been pursued through policy and regulatory regimes, such as, for example, the federal Alcohol Traffic Safety Act of 1983, which encouraged and subsequently led states to increase the penalties for DUI, and the Federal Uniform Drinking Age Act of 1984, which set the minimum legal drinking age (MLDA) at 21 years of age. Our earlier exploration of the tobacco market revealed that regulatory schemes like local ordinances or system-wide limits tend to have greater impact on consumer use patterns than a tax could achieve on its own. Moreover, California voters are not always easily swayed into approving new or increased taxes. This is seen in the few tax increases passed compared to the large number of passed ordinances (city/county bar license limits, hours of operation requirements, local smoking bans in public parks, etc.).

There are a lot of rumors that the cannabis black market won’t play well with a legal market and will undercut it, but the post-prohibition alcohol market shows us that these rumors may just be sensationalized reactions from opponents to legalized recreational cannabis. Today’s California cannabis market is situated much like the alcohol market was during the last years of federal prohibition.  Like alcohol during prohibition, the illicit cannabis market is thriving. Rough estimates regarding use indicate consumption in California is holding relatively steady in the last decade. In order to capture black market participants, the legal market will need to offer a multi-faceted approach to regulation much like that of alcohol. Different licensing and venue structures and options for more private use should be accommodated. Rather than try to solve every problem related to cannabis use, California should focus on regulatory schemes aimed at quality control, ease of adult access, consumer choice/autonomy, setting and enforcing minimum age requirements and other license parameters. Revenues from tax and licensing fees should be earmarked for grants to agencies to complete scientific and social research to study the effects of legalization. Regulations should adjust and respond to the market as we learn more about how it functions.

Lesson Three: The Cannabis And Alcohol Markets Share The 80/20 Phenomenon Of Consumption.

That is, 80% of the total amount consumed is consumed by only 20% of market participants. This is important because it informs regulators that a “one size fits all” approach will not be effective if the goal of the regulations is to control externalities (social harms). Various groups of cannabis users will not respond to regulations the same way. This is also true with taxation. Levying taxes on cannabis products will not affect the whole market in one way.  This is really a culmination of the lessons we learned from both tobacco and alcohol; mainly that a combined approach of taxes and regulations is most effective to reduce harms associated with harmful substances.

CONCLUSION

Today we’ve discussed some of the successes of alcohol and tobacco regulation and we’ve seen that while regulating illicit or harmful substances in the legal market is challenging, it is not impossible. If we keep our eyes toward reducing social harms and setting balanced regulation, introducing a legal cannabis market is feasible. Similar to the alcohol prohibition of the early 1900s, cannabis prohibition is not working. All of our fears about cannabis are being realized under prohibition. The only likely solution to our cannabis problem is to responsibly regulate adult/recreational use. Some of the lessons learned from alcohol and tobacco became repetitive. As a researcher, I cannot do much about that. But, as Californians, we have the opportunity to learn from our past. Let’s take what we’ve learned from regulating the alcohol and tobacco industries and apply our knowledge to the regulation of cannabis. Like everything else in life, the best result will come from taking an “everything in moderation” approach. The regulatory framework for cannabis should feature low to moderate taxes, time, place, manner restrictions, a range of licensing options, and public health education programs to instill responsible use among Californians.

Alexa Quinn for Drug Law and Policy

 Follow Drug Law and Policy on Twitter @DrugLawPolicy or Alexa @aquinn_dlp.

You can also contact Alexa Quinn by email: aquinn.dlp@gmail.com.

Excise Tax: What is it good for?

A recent Huffington Post headline read “Legal Marijuana Has Already Generated $15 Million For Schools”. The funds are appropriations from Colorado’s marijuana tax revenue. The appropriations weren’t the result of magic, but were instead the result of specific terms in Colorado’s Amendment 64 that levied an excise tax on recreational marijuana and specifically dedicated that revenue to schools. An excise tax is a tax on the sale or use of a particular good or service. It is more commonly known as a sin tax and is typically attached to goods or services deemed to be harmful or otherwise discouraged (e.g., alcohol, tobacco, and gambling).

An article from the Canna Law Blog outlines four government purposes for levying excise taxes: “1) generating revenue; 2) tailoring the tax burden to those that benefit from the services the excise tax funds; 3) controlling externalities; and 4) discouraging consumption of potentially harmful substances individuals might over-consume absent taxation.” The third and fourth purposes are the most relevant to an excise tax on marijuana, with the primary focus on controlling externalities such as youth use, prevalence of illicit markets, and marijuana abuse.

At first glance, levying an excise tax seems to be an obvious choice. But, as I argued in my last post, there are a lot of “unknowns” about how the marijuana market will respond to legalization. There is also an issue with whether the marijuana market is well-suited to an excise tax. While market research is limited, current research shows marijuana to be largely inelastic in demand. That means that market demand doesn’t change dramatically with price changes, so raising the price via taxation won’t decrease demand. Teens aged 12-17 are the only group showing any relative price sensitivity. If these numbers are true, an excise tax on marijuana won’t help control many externalities and won’t discourage consumption because people will be happy to pay more, not consume less. Even if consumption didn’t decrease, however, revenue generated from an excise tax would benefit California and could be earmarked for programs that aim to improve social welfare such as, education, youth substance use prevention, and more. This article explores some of the ways a marijuana excise tax revenues can improve social welfare and also explores some of the important drawbacks that an excise tax would have on California’s overall marijuana market.

California has experience levying excise taxes on alcohol, gasoline and tobacco products. An excise tax on marijuana is likely next in line given our familiarity and the precedents among states with recently legalized marijuana. Colorado, Oregon and Washington all implemented excise taxes on marijuana. As mentioned earlier, Colorado implemented a marijuana excise tax that specifically reserved the first $40 million raised each year for school infrastructure. Oregon and Washington, on the other hand, dedicated their excise tax revenue to a variety of different programs including, but not limited to, school funding, research on marijuana’s health impacts, youth education, enforcement of new regulations, and similar programs focused on reducing externalities. California should prioritize funding research with tax revenue given the lack of reliable data currently available. There is great need for scientific research that analyzes the health and intoxication effects of the 80 plus compounds in marijuana, the development of reliable testing modules for quality control, and also DUID. Sociological research is also important because marijuana’s current illegality severely limits our ability to gather reliable data on consumer usage patterns, the true size of the market, user quality of life, and long-term social outcomes (e.g., user productivity, mental health, and increases in overall usage).

An excise tax on recreational marijuana has both positive and negative implications for society. On the positive end, the funds collected from excise taxes can be dedicated to a particularized cause. For Colorado it is school infrastructure; for Oregon and Washington it is a host of various social programs. Either way, the excise tax revenues guarantee funds to specified causes that aim to improve social welfare.

The downside to sin taxes is that, by its nature, the tax is typically associated with the sale and/or use of a particular good or service, which presents a very costly issue for marijuana businesses. Ordinarily, businesses can deduct the costs of doing business—such as materials, rent, advertising, etc.—from revenues, meaning that they pay tax only on profit. Under federal law 280E, however, marijuana businesses cannot claim these deductions. Instead, they have to capitalize those costs and report them as cost of goods sold (COGS) once the product is actually off the shelves. However, COGS only includes direct costs of production and labor: it does not include all costs.

Given the state of federal law, recreational marijuana businesses subjected to a state excise tax will most likely not be able to deduct those taxes from their federal bill—meaning that they will have to pay for it twice. Let’s say the wholesale cost of an ounce is $50 and a retailer has to pay $50 in excise tax when she buys it from the grower. The retailer then passes the cost on to the consumer and adds $50 in profit, making the total cost of the ounce $150 ($50 to he grower, $50 excise tax, $50 markup). But even though the profit is only $50 in this scenario, the retailer cannot deduct the cost of the excise tax and instead has to pay tax on $100 ($150 revenue minus only the cost of the goods from the grower, $50). The retailer pays the excise tax and then, when that cost is passed on to the consumer, the reimbursement for the excise tax has to be reported as income. This is not a problem with excise taxes, but more a problem of excise taxes combined with 280E.

One negative aspect of these federal costs is that they force businesses to impose much higher pre-tax prices. High prices post-legalization could prove to be costly for society by way of preserving the dominance of the black market. Marijuana businesses also suffer huge profit losses due to the combination of the federal tax costs and state imposed tax burdens, such as excise taxes. These combined costs may make it difficult for such businesses to survive tax season, never mind make any profit. There have been suggestions that a potential cure may be as simple as imposing the excise tax on marijuana production so it could be included in COGS, but it is unknown whether the federal government will accept such clever maneuvering. For now, federal deduction exclusions remain a very real detriment to marijuana businesses profit margins and their ability to thrive in this burgeoning market.

Why should we care about whether marijuana businesses profit? For starters, the livelihoods of Californians depend on the state’s economic success. In 2013, California was ranked the 8th largest economy in the world. That makes for a very large pool of employees and individuals dependent on California’s economic health. Moreover, according to the ArcView Group, California’s legal marijuana market is the largest in the U.S., worth an estimated $1.3 billion. Colorado has a smaller market but legalization still created upwards of 10,000 new jobs for Coloradans. Even if California market estimates are optimistically high, the numbers and experience in Colorado reveal that marijuana business failures post-legalization could have crushing results for Californians. Thousands of individuals who invested their lives and money to this burgeoning industry would be thrust into unemployment or, worse, driven to the black market. All things considered, it would be prudent for us to examine the consequences federal deduction exclusions have for California’s economy post-legalization.

The takeaway from today’s discussion is that there are social but also economic harms that a marijuana excise tax can offset or exacerbate if not thoroughly considered in tandem. Additionally, an excise tax is just one mechanism by which the positive outcomes discussed today can come to fruition. The state could also achieve these through other forms of taxation or by funneling a portion of the funds from licensing fees into research or other worthy causes. As my title suggests, the discussion of levying an excise tax on marijuana really boils down to the question, “What is it good for?” Recall the metaphor of the marijuana tax seesaw from my first post. The consideration of a marijuana excise tax has a similar seesaw; this seesaw has competing social interests on either end. On one end we can generate funds for projects that increase social welfare (sociological research, reducing/preventing youth access, elimination of marijuana criminality), and on the other, we can increase socio-economic health (encourage new businesses, move black market participants into legal market) by generating less tax revenue to allow new (local) marijuana businesses to thrive. To remix a Motown hit song, “sing it with me, Excise tax- huh- what is it good for?…” Unlike Edwin Starr, we cannot unequivocally claim “absolutely nothing,” but it is still a worthy question to ask.

Alexa Quinn for Drug Law and Policy

Follow Drug Law and Policy on Twitter @DrugLawPolicy or Alexa @aquinn_dlp.

You can also contact Alexa Quinn by email: aquinn.dlp@gmail.com.

Marijuana and Tax: It’s Complicated

The other day I was walking my dog through a park and I saw two children gleefully playing on a seesaw. As I returned home and got back to work the image of the seesaw stuck with me. The seesaw is a great metaphor for the legalized marijuana tax conundrum because it demonstrates the challenge of balancing interests. If we imagine California’s marijuana tax scheme as the seesaw, we can see the Golden State’s two primary objectives sitting at each end: generating state revenue on one end and reducing externalities (social harms attributed to marijuana use) on the other. Although both objectives can play nice, if the interests are not balanced and cognizant of the other, one end of the seesaw will crash into the dirt while the other soars sky high. And the dirt in this case isn’t the playground kind that can be dusted off; it is muddied public policy that would incentivize the black market.

The good news is that balancing these objectives is attainable and reasonable. First, generating state revenue is attainable once a system to tax marijuana is in place. Colorado is a great example of this: it gained a new source of revenue by implementing a multi-faceted tax approach that generated $52,570,081 in 2014. The recreational marijuana market generated $40,968,203 alone. Second, tax can serve as a mechanism to offset some of the most salient social harms attributed to marijuana use such as youth access and use, drug crime, and the health risks of ingesting unregulated products.

The difficulty of deciding how to tax marijuana is not only in trying to balance interests. The idiosyncrasies of the marijuana market add to the difficulty of creating a balanced tax structure. We have very limited data on the marijuana market due to its status as an illegal drug. As such, it is difficult to gather reliable information about marijuana users and how they respond to market changes. This creates a lot of guesswork and “best estimations” which may be wrong and could create problems once in play within a burgeoning market. In addition, the marijuana plant itself is unlike anything else we have taxed before. Alcohol and tobacco are the nearest in kind to marijuana but both substances are easier to tax by nature. We are able to tax distilled spirits by alcohol content because alcohol is a homogeneous material that lends itself easily to testing. Marijuana, on the other hand, is not homogenous and technology still needs to be developed for reliable potency testing processes. The heterogeneity of marijuana plants also distinguishes it from tobacco because taxing marijuana by unit or weight is not as effective as it is to tax cigarettes (details of this are discussed below).

In order to meet our objectives we need to establish the type of tax, basis for the tax, the rate, the collection point, and the market structure that will best achieve our objective(s). None of these variables is mutually exclusive and there are various ways to stack them. For example, marijuana can be taxed by weight, potency, price, or even by product type (e.g., raw material, edibles, concentrates). The tax can be imposed on growers, processors, retailers, consumers, or some combination of these. Each of these combined, however, has different degrees of efficacy. If we really want to meet both objectives (revenue and reducing negative externalities), we’ll need to consider the different benefits and drawbacks to each approach. Each approach will require different tradeoffs and will have real-life effects on consumer usage, safety, and even business sustainability. The discussion on how to tax marijuana is lengthy and complicated. Today, the goal is to start the conversation by looking at the various tax bases and how each can help California meet its tax objectives.

Let’s move now to discussing how the various tax bases fare on the seesaw of generating revenue and offsetting externalities. First, a tax based on price is easy to administer but does not necessarily help control prices. This will not bring in much revenue if post-legalization prices plummet as predicted by many in the industry. Revenue aside, there are numerous other reasons price control is desirable. The most salient is thwarting youth access. It is well established that youth substance use rates are particularly price sensitive. Youth access and use decrease as prices increase. One important caveat to a price-based tax is that it only remains easily administrable if it functions in a horizontally integrated system. Rather than have “jacks of all trades,” horizontally integrated systems feature distinct entities with limited roles within the market (e.g., growers, processors, and retailers). The RAND study “Considering Marijuana Legalization” explains that a horizontally integrated system is preferable when imposing price-based taxes because they depend on the existence of a real price—normally, on an arm’s-length sale between unrelated parties. On the other hand, if prices do start and remain high, a price-based tax can be too high and push consumers into illegal black markets. Going back to the seesaw image, it is apparent that a price-based tax alone cannot achieve both objectives of legalizing marijuana. The seesaw of marijuana tax objectives can only come close to being balanced if we compromise the amount of revenue generated for more positive impacts on social harms. Further, the outcome of a balanced seesaw depends on multiple variables aside from price alone.

Marijuana can also be taxed by weight. Similar to a price-based tax, a weight-based tax is also easy to administer. It also has the distinct feature of bringing in a steady amount of revenue since it isn’t determined by market price. The difficulty of a weight-based tax is in the details. For instance, the weight of each marijuana plant changes over time due to drying and trimming and weight changes aren’t exact among each plant. We have to establish timelines for when marijuana plants should be weighed and our timelines may not coincide with the initial objectives of taxing the product. The main concern, however, is the risk that it will incentivize production of higher potency products. This is a disadvantage for three reasons. One, consumers may unwittingly ingest more potent products, which may lead to health and safety issues. Two, the tax base wouldn’t encourage consumers to purchase less potent products. Third, potential revenue for higher potency products would never be captured within the market.

Another option is a tax based on potency or product type which has the benefit of addressing more externalities but would be difficult to administer given our current lack of knowledge regarding marijuana compounds. It’s important to clarify that for purposes of brevity in this post, I am conflating potency and product type (some edibles might be less potent, others might be more). A tax based on potency and/or product type can be used to shape usage patterns and implicitly impose limits or restrictions on how marijuana can be consumed. Therefore, it is advantageous in the sense that it addresses more social harms related to marijuana use. For example, California could impose a higher tax on products that typically yield higher potency and are more difficult to dose appropriately (e.g., edibles and concentrates). This could encourage users to purchase products, such as raw marijuana, which is typically smoked. This could be a desirable outcome because our familiarity with this form of marijuana enables us to better predict behavioral outcomes and leads to shorter durations of intoxication. In contrast, California could promote lung health and discourage smoking marijuana by taxing the raw material higher than other ingestible forms. Potency could be measured by the amount of THC, CBD, or THC:CBD ratio. However, the difficulties and inaccuracies in current technology for testing potency pose an immediate obstacle to the feasibility of such a tax. Plus, even a single marijuana plant can have inconsistent potency throughout. Finally, our experiences with the tobacco and alcohol industries have taught us that higher taxes do not always have positive impacts on public health.

At its inception, any potency-based tax should have at least three features. First, a potency-based tax would have to be set in ranges. These potency ranges would need to be set high enough to discourage divergence to black markets. Second, any potency tax would need to include a provision for revision based on timely reviews of any developments in new information regarding potency ranges and/or limits. Third, the previous feature necessarily requires at least some of the revenue be dedicated to research that can advance the system. Research could explore various topics such as testing modules, scientific improvements in measuring potency, and studies on the effects different products and potency had on users’ intoxication levels.

This discussion of the various ways to tax is only the tip of the iceberg and will be covered in more detail in future posts. Of particular interest is the history of alcohol and tobacco taxes. Both can serve as a great resource for what works and what doesn’t in terms of taxing to affect use and offset social harms. After we cover the lessons learned from above, you can join me in the related discussion of which market structure (vertical or horizontal integration) better facilitates particular tax methods. Join me next time for a discussion on sin taxes and the impact they can have on the burgeoning marijuana market.

Alexa Quinn for Drug Law and Policy

Follow Drug Law and Policy on Twitter @DrugLawPolicy or Alexa @aquinn_dlp. You can also contact Alexa Quinn by email: aquinn.dlp@gmail.com.

Marijuana Taxation: Can Taxes Help Shape a “Healthy” Marijuana Market?


Alexa Quinn
J.D. Candidate 2016

Can marijuana legalization raise revenue and eliminate the black market? And can marijuana taxes help offset other social harms attributed to marijuana use? My research will try to answer these questions through comparing the different approaches taken by Colorado and Washington in structuring their recreational marijuana markets. I’ll also look at the lessons we learned from taxing and regulating the alcohol and tobacco industries. Legalization forces us to consider a number of issues. My focus is on the benefits and drawbacks of taxation schemes and market structures as they relate to eliminating the black market, normalizing use, and sustaining the recreational market (e.g., price control, revenue, etc.). My goal is to weigh the social tradeoffs inherent to the various ways to tax marijuana and establish what the best options are for California. In the end, I think we’ll find that California can better serve its goals by establishing recreational marijuana taxes and regulatory schemes that simply pay the costs to oversee the legalized system and do not function as a “get rich quick” plan for the state.

About the Author:

Alexa Quinn is a lifelong resident of the Golden State. Ms. Quinn grew up in sunny southern California and completed her undergraduate degree in the very diverse city of San Francisco. She is a second year law student at Santa Clara University School of Law. She recognizes the immense change marijuana legalization can bring to her home state. California has an opportunity to give its voters a marijuana initiative that is, among other things, sound, fiscally responsible, feasible, and represents the entrepreneurial and innovative style of its residents. It is important to Ms. Quinn that the 2016 California ballot initiative seizes the opportunity to create balanced and informed policy. To see future posts by this author please follow this blog. You can also follow Alexa Quinn on twitter @aquinn_dlp.