TAXING IT

Richard M. Evans*


    As marijuana prohibition inexorably erodes toward collapse, the time has come to devote serious attention to how, exactly, the cannabis industry is to be taxed and regulated to best serve the underlying aims of repeal, namely, the protection of public health and safety, the reduction of crime and violence here and in Latin America associated with illicit trafficking, and the provision of revenue, as well as the achievement of law enforcement and corrections savings in a time of widespread fiscal crisis. This article attempts to lay out a menu of options and considerations, related to taxation,  that elected and unelected policymakers will face as they undertake the task of devising schemes to produce these results.

    Focusing on taxation leaves aside the myriad of other policy questions, like who may grow, distribute and sell cannabis, to whom it may be sold and where and in what form it may be used, and under what circumstances. Those discussions are for another page. The issue at hand is how the maximum amount of revenue can be extracted from this newly liberated industry, as it undertakes to satisfy a very large, and heretofore illegal, market. 

    The simultaneous legalization and taxation of a commodity is a rare occurrence in history. A precedent might be the repeal of the 18th Amendment in 1933, whereby the federal prohibition laws were repealed and states were granted authority to regulate and tax alcoholic beverages. But even then, people remembered a mere 13 years before when alcohol was legal, and its industries and  social protocols familiar. One might draw lessons from the taxation of other new-to-the-market commodities, such as tobacco when introduced to the old world in the late 19th Century. England hesitated hardly a fortnight before taxing it.

    Consider not a commodity, but an activity, and a recent and well-tested model springs to mind. Historically, nearly all forms of gambling have been prohibited in America. Starting with New Hampshire in 1964, however, over forty states have created their own lotteries. State employees run them and all earnings, after expenses and prizes, go to the public coffers. Competitiors remain illegal. Only certain functions, like providing the software, are contracted out to private companies.

    Applying the lottery model (a public monopoly) to cannabis, one can visualize farms and greenhouses owned by the state, sending their product to processors, thence to distributors, thence to retailers, all staffed by state employees. The retail price would nimbly rise and fall with the market. This neatly solves most of the usual--and vexing--issues surrounding taxation, discussed below.

    When alcohol was legalized in 1934, some states claimed a monopoly on the sale of alcohol at retail, and operate “state-owned” stores to this day, or commission private retailers to do so on their behalf. The public monopoly model is not unfamiliar.

    By the time that serious talk occurs in legislatures about taxing cannabis, the medical marijuana business may be so settled in some states (California and Colorado come to mind) that the legal medical cannabis industry may, in those states having good systems of regulation and oversight, provide a model for the legal non-medical cannabis industry.
   
    When we set aside the public monopoly model and medical marjuana, and look instead at a scheme similar to the alcohol control laws, we face questions that would apply to any commodity: who collects the tax and keeps the revenue; from whom is the tax collected, and at what point; what is the tax rate, and how is it adjusted; and how is bootlegging prevented and compliance proved?

1. Who collects the tax and gets the revenue?

    When alcohol prohibition was repealed in 1933, a patchwork of regulatory and taxation schemes emerged, state by state. In those states that allowed localities-- municipalities or counties--to make the rules for commerce in alcohol, sub-patchworks emerged, all governing production, distribution and sales of beverage alcohol. Many of the varied schemes, with all their virtues and all their faults, remain in place today, not much changed from 1934. 

    Although the federal government has the legal authority to tax cannabis as it used to tax fur, the prospect of a federal excise seems remote. If the federal government is to act at all on this subject, the likeliest approach would be to quietly recognize the states’ right to tax cannabis and give them a green light to enact and implement a plan, but Congress may well dither, forcing the federal government to surrender to state voter initiatives, and that will hardly be quiet.

    There are two broad options for states as to who collects the tax and keeps the revenue.

    The first option is that rules would apply statewide, and the state gets the revenue. Under this approach, the legislature would enact a uniform regulatory plan.  State employees would issue the licenses, collect the tax, and enforce compliance.  Localities may have the right to opt in or out of the scheme. Those who opt in would gain increased economic activity, whether or not they receive a cut of the revenue collected at home.

    The legalization proposals currently before the legislature in California and Massachusetts contemplate that the rules would be made at the state level and applied statewide to govern commerce among individual businesses.

    The second option is that localities would make the rules and get the revenue. As many states, in 1934, deferred to localities to decide who could legally produce, sell and have alcohol within their boundaries, so too can localities make those rules for cannabis if given such authority. Section 11302 of the Lee Initiative in California (on the 2010 ballot) permits local governments to impose “appropriate general, special or excise, transfer or transaction taxes, benefit assessments, or fees, on any activity [newly] authorized,” leaving it up to local government to fill in the details. No doubt the plans will vary widely, locality by locality, which is not necessarily a bad thing, as it allows for experimentation on a small scale with low stakes.  Localities can adjust more quickly than states. Choosing among competing models and theories, policymakers are likely to try different approaches, and to tinker with initial efforts.  Then cities—and the public—will learn from early mistakes and successes. In this day when local governments are granted scant discretion in how they operate, constantly constricted by federal and state rules, allowing local governments to make their own rules would allow rare and welcome latitude.

2. From whom is the tax collected, and at what point?

    When we say we are “taxing cannabis,” what we mean, more precisely, is that we are taxing certain people, not cannabis itself. Only people pay taxes, not things. And the people we are taxing are those who are engaged in commerce, i.e., people who cultivate cannabis, process it, distribute it and sell it to consumers, all for profit, in accordance with the new law.  For such compliance, they gain the benefits generally conferred upon law abiding businesspeople, such as access to civil contract, the courts, insurance policies, accountants and most especially their freedom.

    An axiom of excise tax collection is to work at a choke point, where the smallest number of people and locations are engaged in commerce.

    In the case of tobacco, farmers sell bundles of leaves at auction to tobacco companies who process it and affix a tax stamp to every pack of cigarettes or cigars that leave their plants, signifying that the state tax has been paid. Processors thus “front” the revenue to the state and pay themselves back from proceeds of sales to distributors.  The Massachusetts bill is so modeled, providing, further that the farmer may sell his crop only to a licensed processor, who is required to affix the tax stamp to every package that goes out the door. The processor, as the choke point, becomes the taxpayer.  The Massachusetts bill also provides for a “farmer/processor/retailer license,” envisioning small operations where growers would themselves process and sell directly to consumers.
 
    In addition to revenue from licensed sales, states or localities will also collect licensing fees from everyone engaged in the chain of commerce, from farmers to retailers, a not insignificant source of revenue if the vast illegal industry is to be transformed into a new legal one.
   
    Necessarily, pre-choke point activity will need to be closely monitored to prevent leakage in commercial quantities. 

3. What is the tax rate, and how is it adjusted?


    This is tough. Set it too high, and bootlegging runs rampant. Set it too low, and insufficient revenue is realized. The trick is to find the sweet spot in the middle.

    The California(Ammiano) bill, AB 390, would tax marijuana at the rate of $50 per ounce, aiming only to fund drug-education and rehabilitation programs. In the Massachusetts bill, on the other hand, the rate would depend on potency, measured by percentage of THC. The rate is ten dollars per 1% THC per ounce, hence a package of cannabis having a potency level of 5% THC would be taxed $50. These rates appear reasonable when you bear in mind that people are routinely paying $400 for an ounce of high-potency weed today, the production costs of which are likely in the low double digits.  The huge gulf between production costs and retail sale price represents the “prohibition tariff,” the premium paid to the dealer for incurring extraordinary expenses and imperiling his liberty. Eliminate those expenses and that risk, and prices to dealers inevitably fall.

    Tying the tax rate to THC level will require processors to test and establish the THC levels, adding a business expense and complicating enforcement, as testing for potency has to be monitored.

    As the labels on alcoholic beverage bottles state the alcohol content by percentage, cannabis packages will carry the THC content, so that consumers will know exactly what they’re getting. Depending on the rate, low-potency pot may prevail in the market, as low-potency alcoholic beverages dominate the commercial market.

    No one knows where the price of “legal” marijuana will eventually stabilize, hence the necessity to adjust the tax rate in response to market conditions. Typically the legislature adjusts tax rates, but the legislative process may not be sufficiently nimble to respond to ever-changing conditions. The Massachusetts and California bills provide for rate adjustments by a board, although a board, whoever selects its members, could be slow and unaccountable as well.  Other options for rate setter include the Governor or a Commissioner of Cannabis.

4. How is bootlegging prevented and compliance proved?

    Smuggling and bootlegging are naturally problematic when taxing goods whose profit potential is substantial, and which are easily produced and concealed. Bootlegging is best prevented by eliminating the incentive to bootleg in the first place, i.e., when conditions are created where the rewards of illicit commerce are simply not worth the hassle and risk.

    One of the first questions policymakers will face is whether licenses to engage in cannabis commerce ought to be generally available to qualified applicants, or restricted to a few, perhaps based on a quota system as is widely used for alcoholic beverage licenses. How they decide will bear strongly on the incidence of bootlegging. Under the Massachusetts bill, licenses would be fairly easy to get from the state office in charge.

    Bootlegging may be defined as engaging in cannabis commerce without the requisite licenses under  the new law. The important word there is “commerce.” Whether cannabis is in commerce determines whether it is taxable.

    Both the California and Massachusetts bills make that distinction. The California bill taxes marijuana only when “sold at retail.”  The Massachusetts bill draws the line between “gratuitous” and “non-gratuitous” distribution.  Etymologically (though not in some restaurants) a gratuity is a gift. Growing prize tomatoes and sharing the bounty with friends and neighbors does not require one to pay any tax, beyond the ordinary sales tax on seed and fertilizer. If, however, one accepts something of value in exchange (“consideration,” in legal terms), the transfer is nongratuitous and thus subject to taxation, whether money or anything else of value accepted in trade.  Federal tax laws treat income from barter just like income from cash, and substantial jurisprudence exists on that issue. 

    As the market price and tax rate stabilize at a level that encourages legal entrepreneurship, and the bulk of cannabis consumed is derived from a legal market—as with tomatoes—there will inevitably be gardeners  who go beyond gratuitously helping out their friends and start supplementing their income. The question for policymakers is how is legal (taxed) cannabis to be distinguished from illegal (untaxed) cannabis, so that compliance may be established and bootlegging detected?

    In the case of alcohol, licensed distilleries are required to affix a stamp or other mark onto every bottle sold, signifying that the tax has been paid, and thus protecting anyone else in the chain of commerce from a charge of possessing untaxed alcohol. The stamp is proof of compliance. 

    In the case of cigarettes, processors affix a similar stamp to every package of 20 rolled cigarettes. When smokers buy a pack at the convenience store, they are reimbursing the retailer for having reimbursed the distributor who reimbursed the producer who paid the tax.

    The Massachusetts bill, anticipating that hand-rolled joints are likely to remain popular, provides that cannabis would be sold in one-ounce packages of loose cannabis, like pipe tobacco (like this website's logo).. As possession of a few joints will not be a criminal offense, it does not matter if they came from a stamped package or not. 

    But what of those who operate outside the law? During Prohibition, bootleggers risked arrest for clandestinely providing clandestinely-produced or imported product to meet consumer demand. Following repeal, bootleggers sold cheap booze, often in Mason jars to consumers indifferent as to what chemicals, exactly, were in the beverage, how potent it was, and where it came from.  Today, moonshining has become so rare that it does not represent a significant loss to the public treasury in tax revenue. When prosecutions occur, they are for evasion of the tax laws.  Commerce in alcoholic beverages has been brought under control. The public health has been protected against poisonings, people know the potency of what they’re drinking, and beer distributors no longer resolve their disputes with machine guns.

    After a breaking-in period, the legal cannabis market will stabilize and take its place among other regulated commodities. Until that happens, many consumers will grow their own or obtain their supply from friends who do.  In recognition thereof, the Massachusetts bill exempts from the regulation laws and the prohibition laws, growing or possessing cannabis for personal use, or giving it away. As it is legal today to brew a personal quantity of beer, or wine, so too will it be legal for home gardeners to cultivate their own supply, and share it with their friends. In not too many years, however, “home grown” cannabis will regain its original reputation as being of poor quality, as most consumers will turn to the better, commercially grown product available in licensed outlets.

Conclusion

    The anomalous circumstance of simultaneously legalizing and taxing a commodity provides a rare opportunity to policymakers to start from scratch in designing a system that works, whether a public monopoly or one involving private enterprise. It also provides them with an opportunity to shape the role that cannabis will play in the public lives of people and in our culture, as it steps from behind the shadows of illegality.  The perfect scheme, for sure, will protect the public health and safety, eliminate the crime and violence associated with illicit trafficking, raise copious new revenue and produce significant savings in law enforcement and corrections, but it will also promote a sense of responsibility by people who choose to use cannabis. When prohibition is repealed, the notions of use and abuse will no longer be officially conflated, and an ethos will emerge to define appropriate settings for cannabis use.  A good tax scheme will do its part in fostering that emergence. 6.10.10
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*Richard M. Evans practices law in Northampton, Massachusetts, and maintains the website,www.cantaxreg.com.  He is grateful to Patrick Oglesby, former Chief Tax Counsel of the Committee on Finance of the United States Senate, who blogs at  www.newtaxes.org, for inspiring this article and providing many of the ideas in it.

 

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