Voters in Four States to Vote on Recreational Marijuana

Taxes

Legalizing recreational marijuana is a hot topic in many states where the state budgets are in disarray because of the coronavirus pandemic and new revenue sources are being sought. Combined with a desire to decriminalize marijuana, the zeitgeist is ideal for legalization. This Election Day, voters in Arizona, Montana, New Jersey, and South Dakota will consider legalization and taxation of recreational marijuana.

Three out of the four measures (Arizona, Montana, and South Dakota) would impose an ad valorem excise tax (based on price) on marijuana at the retail level. Taxing based on price means there is a taxable event with a transaction, allowing for simple valuation. While that might be the simpler way to go, it does not necessarily offer an equitable solution. In addition to the excise tax, Arizona and South Dakota would tax recreational marijuana under the general sales tax. (Montana does not levy a general statewide sales tax.) Levying state sales taxes on recreational marijuana products should be encouraged. A well-designed sales tax is levied on all final consumer goods and services while exempting purchases made by businesses that will be used as inputs in the production process.

Estimating excise tax revenue from marijuana sales has been notoriously difficult due to a lack of data but is likely becoming easier as more states establish legal sales. Excise tax revenue estimates from the four ballot measures’ accompanying fiscal notes (see Table 1) are relatively conservative.

Arizona forecasts roughly $166 million, which is 16 percent below our estimate. Compare that to some of the measure’s supporters who suggest revenue would total $300 million the first year. Montana estimates $38.5 million, which is virtually identical to our estimate ($39 million). It is hard to compare South Dakota’s estimate as the state has bundled its projection to include revenue from excise tax, sales tax, and fees. We estimated excise tax revenue around $15 million in South Dakota.

While these figures represent meaningful revenue to many states, states will incur new expenses after legalization, relating to both regulating the new markets and administering the new taxes. In Montana, for instance, due to the appropriations stipulated by the initiative, the aggregate collections will not be sufficient to cover the general fund’s initial expenses of $6.3 million until FY 2025.

In New Jersey, Question 1 provides for the taxation of marijuana under the general sales tax but prohibits any further taxation of retail sales except for a local option sales tax of up to 2 percent. The measure does not prohibit taxation at wholesale or manufacturer levels, and as a result there is no revenue data available.

Table 1: State Ballot Measure’s Proposed Tax Rates
State Measure Structure Tax Rate Would the State Apply the General State Sales Tax? Excise Tax Revenue Estimates (Mature Market/FY2025)

Arizona

Proposition 207 Ad Valorem 16% (retail price) Yes $166.3 million

Montana

I-190 Ad Valorem 20% (retail price) N/A $38.5 million

New Jersey (a)

Question 1 Ad Valorem TBD Yes N/A

South Dakota (b)

Amendment A Ad Valorem 15% (retail price) Yes $29.3 million

Source: Ballotpedia; Ballot measure fiscal notes

(a) Ballot measure prohibits any sales taxes in addition to the general sales tax except for a local option of 2 percent. Taxes on growers or wholesalers would be allowed.
(b) Revenue estimate includes sales tax, fees, and excise tax revenue.

Local rates not included.

While ad valorem excise taxes may look like general sales taxes, there are important differences. Excise taxes target specific transactions due to some unique characteristic (often negative externalities), and general sales taxes fall on most consumer transactions. An excise tax should correspond to the harm it is addressing, or the cost it is internalizing, neither of which has much connection to the price at which the good is sold. Taxation should be neutral and aimed at the negative externality connected to marijuana consumption, which is best expressed by the level of THC (Tetrahydrocannabinol, the main psychoactive compound in marijuana) or weight. Thus, a marijuana product with similar qualities and in similar quantities should have equal tax liability regardless of design or price. While price could technically act as a proxy for the strength of the products, it is far from a perfect solution.

Beside not being equitable, revenue raised by ad valorem taxes risks being more volatile. Since they are price-based, and prices are likely to drop as the market matures, revenue raised per ounce of marijuana purchased may drop quickly. Preferably, lawmakers would design an excise tax based on quantity as such a tax would provide more stability in revenue collection. Quantity-based taxes would also limit a state’s exposure to changes to federal law, which could have big implications for the tax revenue from legalized marijuana. If businesses get access to banking, federal tax deductions, or interstate trading, prices will most likely fall—reducing revenue in states relying on prices as a tax base.

Separate from the tax base, voters and lawmakers must also consider important trade-offs related to the rate: High taxes may limit adoption by minors and non-users but could hurt the competitiveness of the legal market. Low taxes may allow easy conversion from the illicit market but could increase consumption among non-users and minors.

Arizona, Montana, and South Dakota would spend revenue from recreational marijuana taxes on non-marijuana-related spending. In Arizona, revenue would be allocated to community colleges, police departments, fire departments, transportation funding, and a new Justice Reinvestment fund. In Montana, revenue would be divided among the general fund, conservation programs, veteran programs, drug addiction treatment programs, local authorities enforcing the initiative, and health-care workers. In South Dakota, revenue would be split between the general fund and state public schools. Since New Jersey’s measure leaves most of the legal framework to the legislature, it is not yet known how taxes would be levied or for what purpose.

Unfortunately, among these four measures, New Jersey’s Question 1 is the only one that allows lawmakers to design a stable and neutral excise tax—and such a development is far from a given.

While there are legitimate reasons for levying excise taxes on marijuana, legislatures and voters should proceed with caution. Due to their narrow base, excise taxes are not a sustainable source of revenue for general spending priorities. That is not to say that there is no new revenue available to states that choose to legalize. Beyond the general sales tax, legal marijuana businesses would also pay business taxes and employees would pay personal income taxes. Revenue from these broad-based taxes, combined with a potential saving as illicit operations decline, does represent general fund revenue. Expecting a large and sustained boost from marijuana-specific taxes, however, is shortsighted and represents poor tax policy.

Table 2: State Recreational Marijuana Excise Tax Rates and Structure
State Structure Tax Rate Does the State Apply the General State Sales Tax?

Alaska

Specific $50/oz. mature flower; $25/oz. immature flower; $15/oz. trim; $1 per clone N/A

California

Mixed 15% retail excise tax; $9.65/oz. flower; $2.87/oz. leaves cultivation tax; $1.35/oz cannabis plant Yes

Colorado

Ad valorem 15% excise tax (levied at wholesale by weight at average market rate); 15% excise tax (retail price) No

Illinois

Potency (ad valorem) 7% excise tax of value at wholesale level; 10% tax on cannabis flower or products with less than 35% THC; 20% tax on products infused with cannabis, such as edible products; 25% tax on any product with a THC concentration higher than 35% Yes

Maine (a)

Mixed 10% excise tax (retail price); $335/lb. flower; $94/lb. trim; $1.50 per immature plant or seedling; $0.30 per seed No

Massachusetts

Ad valorem 10.75% excise tax (retail price) Yes

Michigan

Ad valorem 10% excise tax (retail price) Yes

Nevada

Ad valorem 15% excise tax (levied at wholesale by weight at Fair Market Value); 10% excise tax (retail price) Yes

Oregon

Ad valorem 17% excise tax (retail price) N/A

Vermont (b)

Ad valorem 14% excise tax (retail price) Yes

Washington

Ad valorem 37% excise tax (retail price) Yes

Sources: State statutes; Bloomberg Tax.

(a) Maine legalized recreational marijuana in November 2016 by ballot initiative. The state is slated to implement a legal market later in 2020.

(b) Legislation is pending governor’s signature.

District of Columbia voters approved legalization and purchase of marijuana in 2014 but federal law prohibits any action to implement it. In 2018, the New Hampshire legislature voted to legalize the possession and growing of marijuana, but sales are not permitted. Alabama, Connecticut, Georgia, Idaho, Illinois, Iowa, Kansas, Kentucky, Louisiana, Massachusetts, Minnesota, Nebraska, North Carolina, Oklahoma, Rhode Island, South Carolina, and Tennessee impose a controlled substance tax on the purchase of illegal products (the tax is normally levied on a person in possession of controlled substances). Several states allow local taxes as well as general sales taxes on marijuana products. Those are not included here.

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