Growing Momentum in Legalized, Taxable Marijuana

The Bloomberg BNA Tax Management Weekly State Tax Report filters through current state developments and analyzes those critical to multistate tax planning.

Tax Policy

On election day, voters in four more states voted to legalize and tax purchases of marijuana, making the number of Americans in a state with legal marijuana now 1 in 5. In this article, the tax Foundation's Joseph Henchman discusses the hard work of setting up a tax and regulatory structure in those states.

Joseph Henchman

By Joseph Henchman

Joseph Henchman is the Tax Foundation's vice president of legal and state affairs.

Voters in California, Maine, Massachusetts, and Nevada approved ballot measures to legalize and tax purchases of marijuana, joining Alaska, Colorado, Oregon, Washington and the District of Columbia. Before election day, about 1 in 20 Americans lived in a state with legalized marijuana. Post-election, now 1 in 5 Americans live in such a state.

Although a similar ballot initiative in Arizona was defeated, there is undeniable momentum in the states, and many more will likely consider legalization. Now comes the hard work of setting up a tax and regulatory structure. With the entire west coast and neighboring Nevada choosing to legalize this industry, policymakers in those states also need to be cognizant of how taxes impact the competition for this new industry.

Tax Competition Among States

As we noted in our marijuana tax ballot measure preview, states that have previously legalized marijuana provide a few key lessons on taxation and regulation. First, tax rates that are too high do not reduce the black market. Secondly, the most efficient and simple way to tax marijuana is by taxing the final retail sale. Other forms of taxation have proved to be cumbersome and result in double taxation for some businesses. Lastly, large tax and regulatory differentials between the medical and recreational marijuana market can become a problem for states.

In California, Proposition 64 establishes a tax structure that could create issues for tax administrators and marijuana retailers. The new law imposes a 15 percent tax on retail marijuana sales, as well as processor-level cultivation taxes of $9.25 per ounce on flowers and $2.75 per ounce, plus state and local sales taxes that average about 8.48 percent. By deviating from simply applying a flat rate based on the sales price, California runs the risk of leaving substantial activity in the black market or losing business to Oregon and Nevada.

Previously, Oregon levied a “harvest” tax on marijuana growers, as well as different taxes depending on the type of product sold. Because of the complexity this created for enforcement officials, Oregon lawmakers replaced it with a 17 percent tax on the retail price. Meanwhile, Nevada's newly enacted law will impose a 15 percent tax on wholesale marijuana sales, plus applicable licensing fees, and retail-level state and local sales taxes. If marijuana businesses in California face substantially higher tax compliance costs, Oregon and Nevada sellers will have an advantage in attracting this new industry.

A Tax Foundation study from May 2016 highlights the potential economic and revenue benefits in play. In California, a 15 percent retail tax on its own could generate approximately $646 million per year, while a rate of 25 percent could raise more than $1 billion. However, the potential revenue and economic activity may not pan out if the state's tax structure pushes businesses and consumers to neighboring states or unregulated black market activity.

As California and Nevada join their neighboring West Coast states in legalization, we may begin to see increased competition between the states for both marijuana sellers and tax revenue from purchasers. Even if state competition doesn't impact California in the short term, it could become a larger concern if and when more states legalize marijuana. As we've seen with tobacco taxes, high rates have fueled a large amount of smuggling from states with low tobacco tax rates into high-tax states.

High Regulatory Costs May Limit Benefits

Along with the economic competition consequences, high regulatory compliance costs could also limit the marijuana tax funds available for the stated policy goals included in many of these ballot initiatives. Under California's new law, the first $25 million in revenue will go toward health and law enforcement expenses related to legalization. Of what's left, 60 percent is dedicated for youth drug education and treatment, 20 percent to environmental programs, and 20 percent to programs to reduce driving under the influence. If the costs to administer the new law exceed $25 million, it will have implications for the rest of the state's budget. Oregon's experience with attempting to implement varying tax rates suggest that this could be an issue.

Nevada's marijuana tax policy seems more straightforward than California's, but administrative costs could still exceed what proponents of the new law anticipated. According to our analysis, legal marijuana in the state could raise $48 million per year or more. The revenue will be used for costs of administration and regulation, with the remainder used for education funding. The law calls upon the Department of Taxation to regulate the new marijuana industry. It's unlikely that a revenue department has the expertise on hand to manage consumer, agriculture, and other regulatory issues. The law also requires the department to “establish regulations to determine the fair market wholesale value for marijuana in the state.” The more funds the state has to use to help tax officials get a handle on regulating this industry, the less funds it will have from marijuana taxation to use for education spending. Some other states, like Washington and Alaska, delegate regulation to separate offices, typically the same entity that controls alcohol sales and regulation.

Policy Changes Ahead

As with Colorado and Washington—the two states with the most experience regulating and taxing retail marijuana—it's likely that California, Nevada, and other states that pursue legalization will need to adapt their tax rates and structure moving forward. Massachusetts officials have already indicated that they intend to increase the tax rate established by Question 4, which applies a 3.75 percent retail tax—far lower than other states—on marijuana sales along with existing state sales taxes. Colorado and Washington do provide some lessons learned, but policymakers will need to anticipate making changes to the regulatory landscape of marijuana. As more and more states join the fray, the bourgeoning marijuana retail market will continue to change as well.

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