How tax competition can threaten marijuana revenue

The black market is not the only threat to tax revenue from marijuana. Competing jurisdictions, too, can reduce collections. Here’s what to know about cannabis tax competition.

1. The black market threatens cannabis taxes early on; competition may threaten later.

{mosads}Overall, cannabis taxes can go up over time — that’s because, after legalization, pre-tax cannabis prices will fall, for two reasons. First, the legal market will gain efficiency and cut costs; second, the black market will wither as law enforcement patiently roots it out. Early on, to beat the black market, some cannabis taxes should start low. As the legal market takes over, taxes can go up.

But that’s overall. Any particular jurisdiction can push taxes up if commerce can’t easily flee to a lower-tax jurisdiction. That’s a big if. 

2. States can readily tax cannabis retail sales; localities, not so much.

Low retail cannabis taxes will lure some consumers away from home, with some even spending more on gasoline than they save on taxes to buy across the border.

For states with high retail cannabis taxes, tax competition has been a tolerable threat. Washington state’s total retail taxes (at least 43.5 percent of price) exceed neighboring Oregon’s taxes (at most 20 percent), but Washington’s population centers aren’t near the Oregon border, so Washington consumers taking home small amounts of Oregon-taxed cannabis (violating a winked-at federal law) are not a major problem.

But localities are smaller, and closer to competing jurisdictions. A county in a state where cannabis is legal will benefit from high retail taxes only if nearby jurisdictions keep taxes high, too. If consumers can buy the same tested product legally and cheaper nearby, many will. (Oregon solves this problem by capping local retail taxes at 3 percent of price.)

3. States tax cannabis producers, who can’t flee; localities are different. 

Some background: At the production point, taxes on temptation goods, like alcohol and tobacco, are rare. This is for two reasons.

First, the rationale for these taxes is that consumption is problematic; production (distilleries and factories) is OK. Consumption can create harm that worries the public. So consumption is the tax target. (The United States doesn’t tax exported tobacco or alcohol, either; it’s up to each jurisdiction to protect its own consumers, by taxing consumption.)

Second, production, more than retailing or consumption, tends to end up in a low-tax environment. States want production, which means jobs. Take tobacco: Virginia, Kentucky and North Carolina don’t tax cigarettes manufactured there or tobacco grown there — only what’s sold at retail. The race to the tobacco-tax bottom has ended in a tie.

Cannabis taxes are different.

For now, federal illegality allows state protectionism, meaning all cannabis legally purchased at retail in a state is produced there (and vice versa). So Alaska, California, Colorado and Nevada are taxing cannabis producers — the equivalent of taxing consumption.

Meanwhile, many localities, especially in California, tax cannabis producers by percentage of price or square footage of canopy under cultivation. Those taxes will not last indefinitely. This is get-it-while-you-can time. The production tax base can disappear easily as competing jurisdictions cut taxes, content to get even untaxed economic activity. Think “tax havens” for cannabis production.

4. Federal legalization will change everything for states.

Cannabis markets and taxes are bound to evolve. State producer taxes will face intense competition if states can’t prevent imports — and protectionism end once federal legalization applies the Constitution’s Interstate Commerce Clause to cannabis. States can still tax by weight, as several do now. But they will tax importers, tobacco- and alcohol-style, not producers. If state taxes on consumers get too high, they may provoke massive commercial smuggling of tax-paid cannabis, such as when Virginia cigarettes are smuggled into New York, where the consumption taxes are much higher.

There is already a federal cannabis tax: Code section 280E’s denial of deductions for selling expenses. But an additional federal cannabis tax is likely to accompany legalization, to pull it along politically. With state tax competition looming, sharing the revenue from a solid federal tax may be the long-term best hope for state cannabis revenue.

Pat Oglesby is director and founder of the Center for New Revenue. He previously served as chief tax counsel at the U.S. Senate Finance Committee and as international tax counsel at the Joint Congressional Committee on Taxation. Find him on Twitter at @OglesbyPat