On Taxing Cannabis

[Music] I'm Brigitte Stomberg, and I'm Lisa DeSimone. And this is Taxes for the Masses. [Music] Today's episode is on the taxation of cannabis. As of late 2024, 24 states and the District of Columbia have legalized marijuana for recreational use. And another dozen or so have legalized it for medicinal use. Yet it remains a controlled substance at the federal level. In today's episode, we discuss the tax consequences of legalizing marijuana. [Music] Hello, Lisa. Hello, Ruby. Today we're talking about cannabis, pot, dope, marijuana, Mary Jane, the devil's lettuce. Really? You go to the devil's lettuce before you even go to weed? That's what the internet told me to do. Okay. We need to stop letting you go on the internet unsupervised. It's probably for the best. Did you ever heard that before? No. No. No. We learned something. Anyway. All right. We are not only talking about cannabis, dear listeners. We are talking about cannabis and taxes, of course. So I'm going to be blunt. Oh, nice one. Nice one. If this episode won't convince you that taxes affect everything, I'm not sure anything will. Excellent point. Excellent point. Thank you. Those listeners doing the devil's lettuce have already forgotten it by now. The plan for today is to first discuss why a state that has legalized marijuana might want to tax it. Then we're going to talk about the different ways a state could choose to tax marijuana and the pros and cons of each. Okay. But first terms are we sticking with cannabis? Are we sticking with marijuana? What's the word we're sticking with today? Yeah. So I actually googled it. Oh. So you can go on the internet. You can go on the internet. I'm not sure. I can. Yes. My understanding is that cannabis is the appropriate botanical term because it can refer to the plants themselves or the products that are derived from the plants. Okay. And includes everything from like industrial hemp to medicinal or recreational marijuana products. Okay. I will say though that one other reason I found for using cannabis instead of marijuana is that there's some thought out there that marijuana is anti-Mexican in origin? Yes. I saw that as well. Did you? Okay. Yeah. Washington State, for example, relabelled everything as cannabis and it's in its state laws in response to complaints that marijuana was basically using a phobic term. So we're going to try to stick with cannabis or devil's lettuce. Devil's lettuce. Devil's lettuce. We'll do what we can. Okay. First goal for the episode today is to address the question to you why would a state that has legalized cannabis weed went to tax it? Well, I know an answer to that question without doing an ounce of research. See what I did there? I do. I do. Okay. We've said it before and I'm sure we're going to say it again, but there are two main reasons governments impose taxes. We're going to talk about now one, raise revenue and two, shape behavior. So cannabis taxes are no different. They are not. We're going to draw a lot of our information from today's episode from a report out of the tax policy center on the pros and cons of cannabis taxes. And those authors list four distinct reasons that states tax cannabis and each of those reasons can pretty much all be tied back to those two objectives that you just talked about raising revenue and shaping behavior. And on a scale from one to 100, how likely do we think it is that the folks who wrote that report at the tax policy center use cannabis tax policy center? I don't know. I'm not going to comment on that. I mean, I'm basically asking if they're left of center right now. Yeah, I heard understood. Okay. Okay. Back to our reasons for taxing cannabis. Let's start with raising revenue arguing that cannabis taxes can fund broad government spending is often cited as a benefit of legalizing cannabis. So you bring it into the fold and you can tax it. You can raise revenues. Yep. The ability to generate a significant amount of revenue from a small portion of the population, which is money that can be spent to benefit a larger portion of the population is, let's face it, a pretty compelling reason. And it has worked pretty well to convince voters to legalize. Yeah, it is compelling and it is effective. By some estimates, cannabis taxes have generated over $20 billion of tax revenue in total since Colorado and Washington first legalized the drug in 2014. So just about 10 years ago, that's a nice pot of cash tax collections worth $3 billion in 2022 alone and legalizing cannabis nationwide could generate over $8 billion annually in state tax revenue by some estimates. It's so popular that in some states like Colorado and Washington again who are at the forefront, cannabis tax revenues have actually exceeded other sin tax revenues from cigarette and alcohol sales. Wow, that's pretty cool. Yeah. Okay. Next question. What do states spend the tax revenue on? And the answer? A wide variety of initiatives. In many cases, getting the drug legalized through ballot initiatives required earmarking revenue for causes that appeal to voters, especially those who would otherwise be unwilling to vote to legalize the drug. Yeah, I think that makes sense. So we see lots of spending earmarked for public education because we all love the kids. Arizona allocates about one third of its cannabis tax revenue for community colleges. No, cool. Colorado allocates all of its cannabis tax revenue to public schools and Michigan allocates about 35% to K through 12 education. I mean, it's just begging for signs around talent saying legalize weed for the kids. I mean, pretty much. Do it for the kids. Pretty much. Yeah, I love that. Yes, so legalizing drugs so kids can have books seems like, yeah, very, very popular. And really the only way that we can get books to kids, apparently, in the country. So fair enough education spending and spending on public health and safety are pretty common. A few states are taking an innovative approach and allocating cannabis tax revenues to programs that address the negative effects of historical drug enforcement policies. And this is referring to the well documented fact that although the rate of cannabis use is similar among black and white Americans, black Americans are arrested for possession and distribution at a rate three to four times that of white America. Yes, it's not great. It's hugely problematic because arrests and imprisonment imposed into making costs on individuals and their families, including the loss in lifetime earnings and potential imprisonment and taking people away from their kids. There's all sorts of things here. It's not great to put it mildly. So a handful of states, you might guess democratic leaning states, including Massachusetts and New York, allocate a portion of their cannabis tax revenue to programs that support economic development and workforce training in communities that have been disproportionately harmed by these historical policing practices. Other states, earmark revenues for criminal justice reform. And I thought this was kind of cool. Montana and New Mexico actually use the tax revenue to fund programs that help residents that had prior cannabis related offenses expunged from their criminal records. Oh, wow. That is super cool. Pretty cool. So recap number one reason to tax cannabis or anything really is to raise revenue. Reason number two is to shape behavior. So you referred to this earlier. Cannabis taxes can be considered sin taxes, which means that in at least some instances, they're levied on legal but potentially harmful behavior. Here we're thinking about recreational use, I suppose, rather than medicinal use of cannabis. The idea behind sin taxes, as we've discussed on a prior episode, is to make individuals who engage in the behavior internalize the cost of that external harm that they cause. Yeah, so for me, the easiest way to think about it is thinking about cigarettes. We know that second hand smoke can cause lung cancer or other health issues, even for non smokers. And the cost of that is not embedded into the quote regular market cost of a pack of cigarettes. So cigarette excise taxes are partially meant to address that quote externality. But things are a little bit trickier with cannabis because although it can have negative side effects, particularly if it's inhaled in some way, it also has documented health benefits for users, in particular, a lot of mental health benefits. So to cleanly address the negative externalities, would require separating the tax systems that apply to any potentially harmful or recreational use versus approved medicinal uses. And that comes with a whole host of administrative challenges. So maybe it's not that surprising that some states instead, they just use a portion of the tax revenue to fund drug education and prevention programs as an alternative way of allocating, you know, the portion towards negative reducing negative externalities. Another way to target potentially harmful recreational use would be to tax the potency of the cannabis because the risks and negative health effects of cannabis use have been shown to increase in THC levels. So a target attacks on potency would potentially make more harmful products more expensive, which is kind of what you're trying to accomplish with a syntax. Yeah, but that strategy poses its own set of problems, which we'll discuss in a moment. So hold up, wait a minute, we started the episode by saying, if you're going to make it legal, you should tax it. Does cannabis actually have to be legal in order for a state to tax it? Great question. And the answer is a new. Okay. So many states do have attacks on controlled substances. If you live in a state that hasn't legalized cannabis like your state of Indiana, but nonetheless, you find yourself in possession of it. of the drug, you would head over to the Department of Revenue and purchase illegal drug tax stamps as proof of payment for your illegal drugs. Sure, sure I would. All of those things would happen. I would be in possession of the drug and then I would go all of these things very likely to happen. Okay, so I'm going to go out on a limb here and assume that compliance with that rule is not so high. No pun intended. That pun should definitely be happening. No pun intended. Yes, one, you should have intended that pun, two, you are correct. Nebraska as an example has sold only 225 stamps in total, over 30 years. Okay. So most of the revenue from illegal drug taxes come after the fact once somebody has been arrested for possession. And in fact, these taxes became popular during the war on drugs in the 80s and 90s that we grew up with. Some believed it was easier to impose civil penalties on drug dealers for nonpayment of the tax than to actually win a criminal conviction for actual drug dealing. Okay, taxes, this is like, this is ridiculous. Taxes are truly fascinating. They're lit. Well done. All right, we've explained why states tax cannabis. Now let's keep rolling and talk about how. So there are generally three different types of cannabis taxes at the state level and they all have their strengths and limitations. First, a percentage of price tax. Second, a weight-based tax. And third, a potency-based tax. And states can impose one or more of these taxes. So let's hit them on turn. First up is the percentage of price tax, which as the name implies, is a tax levied on the retail price of cannabis. It's paid by the seller at checkout, just like a sales tax, and is remitted to the state or locality by the seller. The difference between this and a sales tax, a general sales tax, is that the rates are typically higher. Okay, so for example, in Washington state, the rate is over 35% of the sales price. Yeah, I thought a sales tax rate of over 8% was high. Yeah, well it is. And then 35% is like next level. The biggest strength of a percentage of price tax is that it's really simple to administer. Most states already have general sales tax. So there's already the infrastructure in place to add this cannabis tax that works, as you said, effectively the same way, just at a different rate. So these types of cannabis taxes are the most common. The biggest con is that the state's tax revenue is tied to the price of the weed, which can jeopardize funding for earmarked causes. Over time, the retail price of cannabis tends to fall after legalization. For example, in Colorado, the price went from about $117 per ounce in 2014 when it was first legalized to just $44 an ounce in 2022. Wow. So that volatility makes it difficult to forecast tax revenues, and the decline means that the kids might not get the books from the people who smoke the weed. That seems like that was always going to happen. All right, so next up in the rotation, weight-based taxes. With these taxes, the cultivator weighs the product and remits the tax to the state. There's wide variation both within and across states as to what gets taxed and at what rate. Examples. Alaska taxes flower at $50 per ounce and leaves at only $25 per ounce. In Maine, those rates are only $20 in $6 respectively. Colorado and some other states compute an artificial cannabis price based on market conditions and assess the tax based on that. Would you like an example? Yeah, because I don't understand any of that. Okay. So let's say the price per pound of flower and we're talking about F-L-O-W-E-R, not King Arthur, is $709. Colorado imposes a 15% tax on the estimated retail value of that pound. So a cultivator selling 100 pounds of flower would owe 15% on the estimated market value of $70,900 or about $11,000 in tax. Okay. So these weight-based taxes can be more predictable because they're not affected by market prices if they're designed using flat rates and not the Colorado method of taxing the hypothetical market value. Correct. The biggest con is that these taxes force governments and businesses to establish a process for an entirely new type of tax. And if that tax doesn't vary with market prices, which is what the government would want, then it essentially creates a fixed cost of entry for businesses, which can create barriers to entering the legal market. I see. Okay. Last up, the potency-based taxes. We said before the break that these types of taxes might most closely align with what one imagines when they think of a syntax because they're going to increase with the potential harm of the activity, right? More THC means more potential harm from smoking weed, which leads to more taxes based on a potency-based tax. So by design, the tax is intended to drive users to lower potency options. That's its biggest strength. But if you set the tax too high, states run the risk of driving users to the illegal market, set it too low and it becomes an ineffective deterrent. Yeah. And the biggest drawback of these potency-based taxes is that you have to develop a system to measure potency, which is neither easy nor cheap. No. A lot of the testing out there is pretty unreliable and subject to fraud. So perhaps not surprisingly, these taxes are the least common among states. But I will say that it does seem like a reasonable next step to require potency testing, whether it's for taxes or not, right? Yeah. Seems like some systematic way of testing and conveying potency of a product should be around. There are some pretty harrowing stories out there about people who, you know, over-consume cannabis, effectively because the products on the market, on legalized markets are becoming a lot more potent than they used to be when we were kids. With the books. Yes. You know, in high school, I think my brother hid his weed in a book. So that brings it all together. It's full circle. I love that. Cannabis is also on top of all of these taxes we've just talked about is also generally subject to the state's general sales tax. So from the buyer's perspective, considering the joint effects of cannabis taxes and general sales taxes, the total rate of tax can be quite high. We said Washington had about 35% state excise tax, but it also imposes state and local taxes so that the all-in rate of tax on cannabis is close to 50% of the retail price. Yeah, was there. And actually, those are only taxes on the buyer. Correct. Several states also impose a gross receipts tax on sellers. And these taxes can compound or basically create a pyramid scheme if they're assessed at multiple points along the supply chain. In California, New Jersey, gross receipts taxes are imposed on the cultivator, the distributor, and the retailer. Unless we forget federal taxes. Remember our good old friend Code Section 61? Always. All-income is taxable from whatever source derived, and that includes selling controlled substances. The real bastard in this situation is Code Section 280 Cap E, which says no deductions or credits are allowed to someone conducting an illegal business. Yeah, that's right. So into buzzkill fashion, the IRC is going to tax all-income from cannabis sales but allow very few deductions and no credits. You basically only get a deduction for the cost of goods sold. And deductions for things like advertising wages and the gross receipts taxes we've discussed, which are all, I think you and I would agree, ordinary and necessary business expenses, they're not deductible. And that can pose some pretty big problems, especially for start-up businesses. So let's say a medicinal cannabis dispensary in California has a million dollars of gross receipts during its first year of operations and it occurs $400,000 of cost of goods sold. Let's say they also owed $150,000 of gross receipts tax on those profits and they incurred $750,000 of first-year start-up expenditures. If they were a quote-unquote normal business or not selling a controlled substance, the taxpayer would report a loss of $300,000. But as a cannabis business because they're selling a controlled substance, they have to report taxable income of $600,000. So essentially we're in a situation where this start-up business has to pay federal taxes on a loss. And this won't change unless and until Congress removes all cannabis from the list of federally controlled substances. And I think that is straight trash. All right, time for the good, the bad and the ugly. And I will start it off by saying I learned how to spell cannabis. Good. I'm not sure that's a skill you're going to need in life, but sure. I'm not a great spell or so I'll take the wins where I can get them. Okay, fair enough. I learned a lot about how tax revenues on cannabis are a growing source of revenues for states. I don't think I knew they were a big deal, but I don't think I knew how big they are. I didn't either. And for some reason I thought that things were not going as well. In Colorado, now I understand that maybe it's because the price is declining. So maybe that's the culprit, but it's definitely not because people aren't consuming. Yeah. And based on walking in six street in Austin on a weekend night these days, I'm going to go ahead and say that cannabis and tourism are compliments. So legal. and taxing it could also have significant spill-over effects on hotel taxes and restaurant activity. I mean, just think of Amsterdam, right? That's a really good point. I have them occasionally. That's my one for 2025. There you go. I'm done. I'm out. Okay. You're raising some interesting research questions here. Bad, I think, is like these business owners aren't doing anything wrong. They're selling something that has been legalized in their state, but the federal tax laws are putting them in a tough situation because they're forcing them to potentially pay taxes on losses and they're making things really complex. Super complex. And the whole federal state interaction of not just tax laws but legalization laws is all, it makes my head hurt. It's weird and it seems like something that should be fixed by now. We're like 11 years into this experiment. It seems like we could have straightened this out. It's also sort of odd when you think about that federal state interaction that if Congress did make the change and they removed cannabis as a controlled substance, it might actually reduce federal income tax revenue because now these businesses could actually take the deductions and some credits and so there might be less taxable income and less tax. But they could probably offset that if they had a federal excise tax or something like that on cannabis. Excellent point. I just think this is a really interesting topic because we always talk about the unintended consequences and the spillover effects and how hard it is to design effective tax policy. And I feel like this episode was just a very glowing example of how hard it is to do something right. I agree. How about the ugly? It's mind-blowing to me. Banks don't want to do business with dispensaries or cultivars or anyone because they don't want to be seen as aiding and embedding a federal crime. So all these shops that you see dispensaries or whatever, they have a really hard time finding a bank to bank with and to manage their money. And that's true and we actually in researching this episode came across articles of people saying that they're basically making tax payments with brief cases of cash because they can't do a wire transfer. And this one guy was talking about how he doesn't go at the same time every week and he varies when he goes and he brings bodyguards with him because if someone knows that he has a dispensary and he's walking around with a duffel bag going to the department of revenue. And he knows that he has a ton of cash with him and he risks the likelihood of being robbed all because we've got this weird federal state mismatch. And seems like state should be doing more to help these businesses like if they're going to collect all these revenues by legalizing it, they should make it easier to run the business. You know, it's a really interesting point like think of all the investments that states have made to make electronic payments safe. Like they've done a lot to help. And you know, you know, you know, they're going to have to be able to curb cyber crime and you're not getting your money stolen when you make an online payment. Yeah, should they be thinking about doing something similar to make sure that you're not getting your money stolen when you're making a physical payment. I'm going to have one last thing that like really surprises me about this episode. Okay. I've never seen an edible named devil's lettuce. You're just coming up with all idea we're going to write several research papers about this and then we're going to come up with an edible called the devil's lettuce. Probably because nobody wants to eat an edible the taste like lettuce. But you don't know what the devil's lettuce tastes like. That is true. It's a good point. Okay. Take it back to the R&D team. But we're not going to get a deduction for it. [MUSIC] Well, that's all we have time for today. Be sure to join us for more tax and artery on future episodes of taxes for the masses. [MUSIC]