Marijuana Tax Lessons Learned

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

Tax Policy

Recreational marijuana use is currently legal in four states and the District of Columbia, and on Nov. 8, voters in five others could expand that list even further. In this article, the Tax Foundation's Joe Henchman discusses tax policy issues inherent in marijuana legalization.

Joseph Henchman

By Joseph Henchman

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

Recreational marijuana use is currently legal in four states and the District of Columbia, and on Nov. 8, voters in Arizona, California, Maine, Massachusetts, and Nevada could expand that list even further. Tax policy has been a partial driver of the support, with states seeking to expand their tax base and raise additional revenue.

Alaska and Oregon legalized marijuana fairly recently, but Colorado and Washington have been taxing marijuana sales since 2014. A Tax Foundation report from May 2016 highlights their experience in taxing this newly legal product and offers important lessons to consider to ensure that marijuana is taxed fairly and effectively. Otherwise, marijuana tax collections may come in lower than expected and regulatory issues may catch policymakers off guard.

Be Patient on Revenue Projections

Revenue from marijuana sales in both Washington and Colorado are now growing at levels beyond what was initially predicted. Based on those figures, states could raise billions of dollars in revenue combined under a nationwide legalization-and-taxation regime. But, as Washington discovered, tax collections may grow very slowly at first.

Initially, Washington estimated marijuana taxes could raise nearly $200 million per year for the first five years. But retail sales in Washington in October 2014 were only $7 million, though sales for October 2015 did reach $35 million. However, as of April 2016, marijuana sales in Washington now average over $2 million a day. Sales at that rate would raise an estimated $270 million per year in excise taxes, far greater than the $134 million predicted for fiscal 2016. Colorado had a similar experience, with tax collections jumping from $56 million in the 2014 calendar year to potentially more than $140 million in 2016.

The potential for significant revenue is there, but it won't happen overnight. Consumers and businesses will need time to familiarize themselves with the new legal landscape and regulatory framework.

Keep the Black Market in Mind with Tax Rates, Administrative Costs

Besides sales taxes, marijuana sales are also typically subject to excise taxes. Marijuana can be sold in a variety of different forms with vastly different concentrations, so imposing one tax rate on the final retail sales price has proven to be the most workable solution.

Initially Oregon imposed a “harvest” tax on marijuana growers, while marijuana flowers were taxed at $35 per ounce, leaves at $10 per ounce, and immature plants at $5 per ounce. Recognizing the concerns with enforcing this complex system, legislators replaced it with a 17 percent tax on the retail price.

Washington previously imposed a 25 percent tax on three stages of distribution: sales to processors, sales to retailers, retailer sales to customers. This created the possibility of double taxation and retailers having excise taxes included in their federal gross adjustable income. The state has since moved to only imposing an excise tax of 37 percent on the final sales price.

States should not only keep in mind the structure of the tax, but also the effective rate. Excessive taxes could prevent sellers and consumers from moving from the black and gray market to the regulated economy. Including all state and local taxes, Colorado's effective tax rate on marijuana is currently 29 percent. By comparison, the tax on medical marijuana in Colorado is 2.9 percent. A state-sponsored study found that the retail right kept the black market viable and also discouraged shifting from medical to retail sales. In response, lawmakers have approved a rate reduction to go into effect for 2017. Similarly, Washington and Oregon have taken steps to reduce their marijuana tax rates, with Alaska considering the same. Evidence suggests that initial rates of 30 percent or more did not reduce the black market sufficiently, and more recent ballot initiatives propose tax rates of between 10 and 25 percent.

Regulatory Hurdles

As the trend to legalizing recreational use continues, it's worth remembering that 21 states have already authorized the use of marijuana for medical purposes. In general, medical marijuana is usually more loosely regulated and taxed at a lower level. States where medical marijuana is already legal need to consider a regulatory structure that doesn't favor one type over another. Washington, where medical use has been legal since 1998, encountered this problem. The medical marijuana industry dealt with few, if any, licensing requirements or production standards and only had to impose the state's general sales tax. By contrast, recreational sellers faced a number of regulatory barriers that deterred moving non-medical sales to the retail market. Washington has since implemented a harmonized regulatory framework covering all marijuana businesses to address these discrepancies.

Ballot initiatives are driving the legalization push, so policymakers also need to think about other regulatory issues that may arise after the fact, including rules on health, agricultural, and zoning. Ballot measures generally don't address such details, leaving states to resolve issues during the implementation process.

It's hard to ignore the growing number of states seeking to legalize and tax marijuana, but lawmakers and regulators should plan accordingly to avoid some of the unintended consequences encountered in Colorado and Washington.

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