How Should We Tax Legal Cannabis?

If we legalise weed, how should we tax it? A new working paper on the taxation of recreational marijuana in Washington State has a number of important insights. The study—released by researchers from the University of Oregon—focuses on the effects of Washington State’s unexpected 2015 switch from a 25% gross receipts tax (collected at every step in the supply chain) to a single 37% excise tax at retail. Three findings particularly stand out:

1) Gross receipts taxes on cannabis are inferior to excise taxes at retail.

The study finds that the tax change was roughly revenue-neutral, but the previous tax regime “discouraged otherwise efficient trades between cultivators and processors, thus creating deadweight loss.” The mechanism by which this occurred was the incentivization of inefficient vertically-integrated transactions: “an inventory lot of marijuana is considered ‘vertically integrated’ marijuana if it was cultivated and processed by the same firm.”

Put simply, if a transaction tax is levied at each stage of the cannabis production process, firms are encouraged to do everything in-house: even though this might not be the most efficient solution overall. This inefficiency is illustrated in the table below, which adjusts for the fact that “it takes roughly six weeks after processors purchase raw material from cultivators before the resulting products are sold to retailers” After the tax change, “the fraction of vertically integrated sales [fell] by 3.7 percent after the adjustment period (Column 1), which [was] driven by a 42 percent long run increase in non-vertically produced marijuana sold (Column 2)”:

Vertical integration can provide a number of useful advantages for cannabis firms, but there are also potential disadvantages. Although vertically integrated transactions continued to dominate the market after the tax change, the significant shift towards non-vertically integrated transactions provided efficiency gains. The study was careful to include new entrants to the market post-tax reform, since few incumbents would de-integrate: they would already have paid the fixed costs associated with vertical integration.

2) Mandatory vertical integration in the cannabis industry may reduce market inefficiency.

Since a move away from incentivizing vertical integration led to efficiency improvements, it follows that “requiring vertical integration, as Colorado does, will decrease market efficiency.” Those in favour of cannabis legalisation in the UK should make sure they does not repeat the mistakes of Colorado in this regard. Arguments in favour of mandating vertical integration center on the idea of easing the burden on regulators, who would only have to deal with one firm instead of several firms. But it seems implausible to suggest that the gains from making things easier for regulators would outweigh the efficiency losses from forced vertical integration.

3) Many U.S. states have set their cannabis taxation levels significantly below revenue-maximizing levels, although this is probably a good thing.

Another finding from the study was that Washington’s comparatively high levels of cannabis taxation were “close to the peak of the Laffer curve.” This is due to the fact that the authors’ estimates suggested the “medium-run response to a price increase [in cannabis] is elastic.”

In other words, there’s more state revenue on the table for places with lower levels of cannabis taxation. Does this mean that cannabis taxes should be set at Washington’s high levels? Not quite:

While our results suggest significant tax revenue may be left on the table in many jurisdictions, evaluating the impact of marijuana policy (and constructing optimal policy) in a broader social sense requires additional considerations. For one, the public health externalities of marijuana consumption are not well established. Nor is the relationship between legal marijuana consumption and the consumption of other ‘sin’ goods such as alcohol or tobacco. If it is indeed true, as many advocates claim, that marijuana consumption is ‘better’ in a public health sense than alcohol or tobacco consumption, the optimal regulation of marijuana should be designed to take into account responses in these other markets as well.

The authors of the study do not mention another problem with setting revenue-maximisation as the goal of cannabis taxation policy: potentially preserving the black market in cannabis. As the Adam Smith Institute and Volteface pointed out in our The Tide Effect report on cannabis legalisation last year:

Revenue from taxation of the legal market will benefit the Treasury, although this benefit must be secondary to ensuring the legal market is placed at a competitive advantage to the illicit alternative.

My colleague Sam Bowman has previously argued that “cannabis will be seen as the test case for further drug reform,” and a poorly designed taxation system will undermine the change in consumption patterns that provides the rationale for legalisation.

Finding the best cannabis taxation policy may not be the most exciting part of legalisation efforts, but getting it right is crucial if we are to ensure that the goals of harm-reduction and market efficiency are met.