Weed And Taxes: Why This Is One Of The Biggest Dilemmas Of Legalization

Legalizing marijuana is often cited as a way to mitigate fiscal deficits for states and countries.

But after looking at data from the Canadian market, two bold economists dare to challenge this notion. 

While there are both social and health-related benefits of cannabis legalization, economists Ian Irvine and Miles Light warn that legalizing adult-use cannabis might not be the golden goose that many expect.

In a research paper published in Canadian Public Policy, the co-authors state that legalization comes with an inherent paradox: in order to beat black market prices, jurisdictions are forced to bring down taxes. In some cases, this can turn legalization into an unfruitful endeavor from a tax revenue perspective.

As legal cannabis eats away at the market share of other commodities like tobacco and alcohol, jurisdictions that place high taxes on these products can actually experience a drop in overall tax revenue, after legalization occurs.

“You can’t have a huge legal market and have huge legal tax revenues, because that would require a high rate of taxation on each unit of cannabis,” Irvine said. 

Irvine, who is a professor of economics at Concordia University, co-wrote the paper with Light, who is a research economist at the University of Colorado.

They believe legal cannabis can bring a valuable source of revenue for jurisdictions, not in the form of a sales tax, but from personal and corporate income taxes paid by industry workers and firms, as they become integrated into the legal space.

Unintended Consequences

Irvine and Light studied the legal adult-use cannabis market in Canada hoping to find valuable insights for jurisdictions contemplating legalization.

Tax revenue arising from legal adult-use cannabis is subject to two variables, they said. First is the ability of the legal market to defeat the illicit market.

In a reductive interpretation, this event alone would be translated into an automatic rise in tax revenue. Every gram of cannabis that is legally sold accounts for a new penny in tax revenue that would otherwise be diluted in the unregulated black market.

The second variable proposed by the authors considers the implications that cannabis legalization can have on the consumption of tobacco and alcohol. When these industries are highly taxed, losing market share to cannabis results in a huge loss in fiscal revenue.

Recreational cannabis is highly substitutable with tobacco and alcohol, according to a 2018 study.

After looking at data from the legal Washington State market, the authors estimate that the availability of adult-use cannabis decreases alcohol demand by 12% and tobacco by 20%.

Legal cannabis will only thrive if its prices are competitive and legal products offer some kind of added value against black market products. So if low-taxed cannabis replaces some high-taxed tobacco and alcohol products, overall tax revenue can actually decrease.

High-sin-tax vs. Low-sin-tax Economies

Adult-use legalization in the state of Colorado showed the world that bringing a large segment of the underground economy into the legal sphere can come accompanied by a huge increase in state income from cannabis sales and excise taxes.

But Colorado is a “low-sin-tax economy," the authors wrote. That means that taxes on alcohol and tobacco products stay on the low side, when compared to other economies.

Canada, meanwhile, is a “high-sin-tax economy.” The so-called “sin” industries like tobacco and alcohol represent a large portion of fiscal revenue.

In high-sin-tax economies, the inclusion of legal cannabis into the “sin” economy can disrupt fiscal revenue generated by tobacco and alcohol to a level where overall revenue can turn out to be lower than pre-legalization.

“Most of Scandinavia, Britain, Ireland, and some other European economies have excise and sales taxes that are sufficiently high to result in outcomes similar to what we obtain,” they wrote.

Australia also falls into this category.

As for the U.S., the situation varies from state to state. Taxes for tobacco in New York, the District of Columbia and Rhode Island can be up to 10 times higher than in low-sin-tax states like Virginia, Tennessee and The Carolinas.

Bringing An Entire Workforce Online

One silver lining to cannabis legalization in terms of tax revenue, is that it brings an entire workforce online, which would otherwise remain excluded from taxation.

“In some new economic production activities, little additional net direct tax revenues may be generated, because resources arrive from other legal sectors of the economy where income and profits taxes are already being paid. In the case of cannabis, however, resources are ultimately arriving from the illegal sector where taxes are mostly avoided,” the report states.

As a result, both personal and corporate income taxes in the cannabis sector represent genuine new revenue.

Personal and corporate income taxes can even offset the losses that come from the replacement of tobacco and alcohol with cannabis, but the authors warn that “the overall net tax revenue from legalization will be limited,” and advise advocates of models based on cannabis tax revenue to revise their arguments.

“If legalization generates social value, then it should be based primarily on the case that a legal market for marijuana represents an improvement over a pervasive illegal market and that legalization generates a substantial surplus to consumers,” they add.

Cannabis legalization in Canada results in an individual surplus of CA$500 (US$380) per year for every cannabis consumer, when compared to how much they would spend in an illicit market.

Legalization Still Makes Sense

The idea of legalizing cannabis to cash in on sales taxes might not be universally applicable, but that does not make it an argument against legalization.

From a broader social and economic point of view, there are clear benefits of legalization, Light told Benzinga. It brings a reduction in crime and policing costs, along with safer products and transparent business operations. There's also health and social benefits related to reduced tobacco and alcohol use.

Possible drawbacks can be associated with increased incidence of drug use among younger populations and increased use of high-potency marijuana products among adults.

“Despite the risks of revenue loss from alcohol, lottery, or tobacco taxes, legalization may still make sense – especially when neighboring jurisdictions become legal,” says Light.

Eliminating black market competition can be a good strategy for jurisdictions, who’d be able to raise taxes in the long-term, even though overall fiscal revenue may decrease in the beginning.

“The worst-case scenario is keeping sales illegal in the home-jurisdiction, and having households spend their discretionary income next door," Light says. "Such ill-considered policies are common in the USA, where a county bans cannabis sales (and fails to collect revenues), but cannot ban cannabis use."

Lead image by Ilona Szentivanyi. Copyright: Benzinga.

Original publication: October 24, 2020