ITEP Report – Taxing Cannabis

Executive Summary

State policy toward cannabis is evolving rapidly. While much of the debate around legalization has rightly focused on potential health and criminal justice impacts, legalization also has revenue implications for state and local governments that choose to regulate and tax cannabis sales.

For decades, analysts interested in the tax revenue potential of legalizing cannabis had to use unreliable survey data and speculation regarding how a legal market might operate. But this is changing. This month marks the five-year anniversary of the first legal, taxable sale of recreational cannabis in modern U.S. history. In January 2014, recreational cannabis establishments in Colorado opened their doors to the public, followed soon thereafter by businesses in Washington State, Oregon, Alaska, Nevada, California, and most recently Massachusetts. These states’ experiences with a tax that did not exist just a few years ago are providing invaluable information to lawmakers across the country as they consider legalizing and taxing recreational cannabis sales.

This report describes the various options for structuring state and local taxes on cannabis and identifies approaches currently in use. It also undertakes an in-depth exploration of state cannabis tax revenue performance and offers a glimpse into what may lie ahead for these taxes.

Key Findings:

  • State and local excise tax collections on retail cannabis sales surpassed $1 billion for the first time in 2018. This marks a 57 percent increase over 2017 levels, driven partly by the start of legal retail sales in California and partly by rapid growth in cannabis tax revenues in five other states reporting revenue data: Alaska, Colorado, Nevada, Oregon, and Washington State.
  • In states allowing taxable sales of recreational cannabis, annual cannabis excise tax revenues ($1.04 billion) already rival total excise tax revenues collected from all forms of alcohol ($1.16 billion) including beer, wine, and liquor. In Colorado and Nevada, cannabis excise taxes raise more revenue than alcohol excise taxes, and the same is projected to occur in California by 2020. Notably, all six states reporting cannabis revenue data raised more from excise taxes on cannabis than from sales of beer and wine, and the total amount of cannabis excise tax revenue reported across these states ($1.04 billion) more than tripled the amount of revenue raised from excise taxes on beer and wine ($304 million) in 2018.
  • General sales taxes on cannabis are also raising substantial revenues. In 2018, general sales taxes on cannabis generated a combined total of more than $300 million in California, Colorado, Nevada, and Washington. Alaska and Oregon do not levy statewide general sales taxes and Massachusetts is not yet reporting data.
  • While cannabis tax revenues are meaningful, and growing rapidly, they still represent less than 1 percent of total state and local tax collections in each of the six states reporting data. Cannabis taxes are a potentially important source of revenue for states and localities, but they will not be a transformative one.
  • Cannabis tax revenue is growing rapidly and has tended to grow fastest in the first few years following legalization as legal businesses expand their operations to meet consumer demand. Across states reporting multiple years of revenue collection data, annual revenue growth has averaged 158 percent between years one and two before slowing to 55 percent growth, 29 percent growth, and 17 percent growth in each subsequent year.
  • The price of cannabis is falling, and this will pose a major challenge to cannabis tax revenue collections in many states. In Colorado, for instance, average wholesale cannabis prices are down 61 percent from their 2015 peak. Most states with legal sales underway base their tax systems on the price of cannabis, meaning that price cuts leave these states vulnerable to reductions in revenue. So far, the amount of cannabis being sold on the legal market has grown quickly enough to prevent a price-induced revenue decline. But when consumption begins to stabilize, states that have linked their tax systems to the falling price of cannabis will likely be disappointed by the revenue yield of those taxes.
  • Nationwide legalization and taxation of recreational cannabis could generate approximately $11.9 billion in state and local excise and sales tax revenue each year. This assumes taxation levels similar to those that currently exist in Washington State. Revenue estimates for all 50 states are provided in Appendix B of this report.

Policy Recommendations:

  • States should apply their cannabis excise taxes based wholly, or partly, on the weight of the cannabis being sold. Taxing the product based exclusively on its price poses a major challenge to the long-run sustainability of state and local cannabis tax revenues because prices have been shown to fall dramatically following legalization. In the long-run, states are likely to see faster revenue growth, and less volatility, from a tax based on weight rather than price.
  • Weight-based tax rates applied to cannabis should be indexed to grow alongside the rate of inflation each year. This will prevent erosion in the real value of these taxes over time.
  • States should phase-in their cannabis taxes over time, rather than locking in a permanently low rate of tax. Low tax rates can help legal businesses price cannabis at levels more competitive with the illicit market during the early stages of legalization when legal prices tend to be highest. But as prices fall and consumers become accustomed to shopping in the legal market, low tax rates will no longer be needed to discourage shopping in the illicit market.
  • Earmarking cannabis revenues to specific public services should be done sparingly and should be limited to causes with a direct relation to cannabis such as the regulation of the market and the implementation or expansion of substance abuse treatment programs. Arbitrary constraints on how certain revenues must be spent can make it difficult for lawmakers to craft budgets that direct public revenues to the areas where they are needed most.




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