Cannabis Taxes: Start Low, Go Slow

With several states having legalized cannabis now, and taxing it, what lessons have we learned thus far?  It would seem that the biggest one of all is, "start low, go slow" when it comes to taxes.

As Rear Admiral Luther E. Gregory found out after the repeal of alcohol Prohibition, the black market does not vanish right away, and setting the tax rate too high at first will keep the black market in place, while setting it low to start with will undercut it.  And once the black market is gone, it will not return easily, so then one can raise the tax rate quite high without worrying about the black market making a comeback.  Of course, there is still such a thing as "too high" in that regard, but the threshold for significant black market formation and persistence is much higher afterwards than it is in the very first year or two post-prohibition.

Fast-forward to cannabis legalization in 2014, Colorado and Washington found out the hard way what happens when cannabis excise taxes are too high.  Though otherwise successful, their legalization success was hampered by a fairly persistent black market, albeit smaller than the pre-legalization one.  So they both ended up having to cut their tax rates as a result.  

So why did they start out with such high taxes?  Well, the promise of much-needed revenue certainly helped sweeten the deal for the fence-sitters.   But also, there was a widespread belief that before-tax prices would plummet by at least half, and perhaps even 80% or more, upon legalization or very shortly after.  And yet, that did not happen.  If anything, prices went up at first due to higher demand in the short term, and with or without the taxes the prices three years later still have not dropped very much compared with the status quo ante.  And while the price elasticity of demand for cannabis remains controversial to this day, it is generally thought to be relatively inelastic overall, though estimates vary dramatically.

Still, the long-term trend in cannabis prices does seem to be downward, both in legalization states and nationwide.  And contrary to what the fearmongers claim, that is not necessarily a bad thing, given how cannabis is overall safer than alcohol and generally tends to substitute for it.  Many studies strongly suggest that when one advances, the other retreats, albeit with some nuance.  Cannabis may even take a bite out our nation's deadly and devastating opioid epidemic as well, according to some studies.  Thus, cheaper weed, especially if it is legal, may very well be a net public health and safety benefit on balance.   And there is also no hard evidence that teen cannabis use has increased as a result of legalization--on the contrary, the latest NSDUH data find that cannabis use among 12-17 year olds nationally has dropped to a 22-year low, even as it has risen among both 18-25 year olds and those 26 and over since 2008.

As for specifics as to what the the tax on cannabis should be, it seems that an initial rate of 30% or more on final retail sales like Colorado and Washington originally had is too high to eliminate the black/gray market, and 10-25% is now what most legalization states are aiming for.  Alaska chose a flat $50/oz., which based on the average price of $250/oz. would be about 20%.  There are pros and cons to either method, ad valorem or by weight, and California is apparently combining both types of taxes.  And once the black market is gone after a year or two, then jack the rate up to a level just shy of what would cause a significant black market to return.   But to start with, Twenty-One Debunked recommends a rate of 10% and/or $10-20/oz. for the first year or two before raising it any higher, and perhaps even a "tax holiday" for the first three months of legalization like Oregon did.

Also, once the kinks are worked out, we think it would be a good idea to have the tax rate be at least somewhat proportional to THC levels and perhaps even inversely proportional to CBD levels as well.  For now, though, a simple single rate (whether ad valorem or by weight) will likely be the most workable starting point for any states that are new to legalization.  And if they wish to incentivize THC not being too high or CBD too low, the regulators are free to cap THC levels and/or set a floor for CBD levels.

As for California's idea of having a combination of different taxes (a $9.25/oz. cultivation for flowers, $2.75/oz. for leaves, and a 15% ad valorem tax on retail sales, plus any additional taxes levied by municipalities if they so choose), that's fine.  But both the state and municipalities really might want to consider reducing their rates for the time being, as the combined rates  may be as high as 45% in some parts of California by the time it reaches the consumer.  Ouch.  And unlike in Colorado and Washington, medical cannabis will soon be taxable in California as well, so that's a double ouch.   Best advice?  Municipal taxes shouldn't be too much of an issue, since one can just go to the next town.  But the state should aim for a retail excise tax of 10% and $10/oz. for flowers at the cultivation level.  Ten and ten.  The lower rate for leaves makes sense too, given their generally far lower THC content.  "Start low, go slow."