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laws were repealed and states were granted authority to regulate and tax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
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
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
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
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
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
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
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
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.
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
*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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