Yale Budget Lab – Paper: Federal tax implications of legalizing marijuana

Marijuana has been classified as a Schedule I controlled substance under the Controlled Substances Act (CSA) since Congress enacted the statute in 1970, a designation that formally assigns the drug the most restrictive category of federal control.  This classification means that the federal government treats marijuana as having “no currently accepted medical use” and “a high potential for abuse.” However, this designation is in flux: a December 2025 executive order directed the Administration to loosen the regulation of medical marijuana.1 Though the recent administrative actions are not sufficient to render marijuana use legal without a prescription under federal law—which would likely require congressional action—they constitute a small relaxation in marijuana regulation.

That regulatory environment is a complicated one and has become more so as an increasing number of states legalized marijuana for medical and/or recreational use. As of 2026, this has produced a patchwork regulatory environment. California was the first state to legalize medical marijuana in 1996; since then, medical use of cannabis has been legalized in some form in 47 states and the District of Columbia, while adult recreational use has been approved in 24 states and the District of Columbia. This dual regulatory environment comes with several structural complications: cannabis businesses generally cannot use federally regulated banks, cannot deduct business expenses on federal income taxes, and cannot use water from federally managed resources. In states where marijuana remains illegal, either for medicinal or recreational us or both, cannabis is sold and consumed entirely outside the formal sector.

The formal (i.e., state-legal but federally illegal) cannabis market has grown into a substantial economic sector, though market size estimates vary depending on data sources and methodologies. We use state tax revenue data to estimate the legal recreational market size, finding that the U.S. recreational cannabis market was roughly $25 billion in 2024. We project that, if the market continues to grow without federal legalization or any new states legalizing, the market will reach nearly $40 billion in 2035.  The medical segment, while more established, represents the smaller share of total activity at only about 20 percent. As such, the medical marijuana segment accounts for between $5 and $8 billion in sales each year from 2024-2035.

It is more difficult to project market size under different assumptions about federal and/or state policy. Projections about market size over the 10-year budget window are subject to significant uncertainty, driven primarily by assumptions about the pace of conversion from illicit activity to the formal sector and any proposed excise tax rate’s effect on consumer prices and behavior. It is also unclear to what extent businesses are complying with current federal law and how this would change in the wake of federal legalization.

We consider two hypothetical policy scenarios in this report. The first includes federal legalization of marijuana for both medical and adult recreational use with no states changing the legal status of marijuana. In other words, states that currently allow medical and/or recreational use continue to do so, but states that currently prohibit marijuana continue to do so. The second policy scenario includes federal legalization along with all states legalizing as well.

Both policies include a simple unit-based excise tax on cannabis products, collected from producers by the federal government when the product moves to the retail location—as is the case with other federal excise taxes. The federal government currently levies excise taxes on alcohol and tobacco, structured around the quantity and potency of the key underlying substance (alcohol or nicotine) rather than the retail price.2 This is also the logic of our modeled potency-based cannabis excise tax: it more directly addresses the externality from the psychoactive substance, remains stable as market prices fluctuate, and produces revenue that scales with actual consumption of the substance rather than with nominal expenditure.

The excise tax we impose is $0.00625 per milligram of THC. This rate of tax implies that a gram of marijuana would face a tax of $1.31. At an average price of $8.59 per gram of marijuana, this tax would amount to about a 15% increase in the tax-inclusive price.

In policy scenario #1, the federal government legalizes marijuana and states hold their own policies constant. We assume in this case that the market (absent the tax) is unchanged relative to current policy. In policy scenario #2, all states legalize marijuana for medical and recreational use. We assume in this case that sales activity rises in the states that change their laws, partly in the form of redistributed activity from states where marijuana had previously been legal, and partly in the form of new sales.

Table 1 shows ten-year budget window revenue projections under each scenario, assuming the tax is implemented in calendar year 2027.

Tax revenue estimates in Table 1 are subject to several kinds of uncertainty. One source of uncertainty is typical: the response of market activity to the proposed tax may be larger or smaller than envisioned in our calculations.

Another source is unusual in a tax context: the business activity subject to the tax proposal is currently illegal under federal law and the laws of some states. It is therefore not clear how large the tax base would be after federal and/or state legalization. This type of uncertainty takes a few forms.

First, cannabis businesses themselves sometimes operate on a cash basis, outside the formal sector and out of compliance with federal and/or state tax law. Federal legalization would likely cause some fraction of those businesses to become compliant with tax law. Second, some workers may not be paying income and/or payroll taxes, as required by current law. Federal legalization would likely cause some fraction of those workers to do so. Third, under current law many cannabis business expenses that would typically be deductible are not. To the extent that these businesses currently follow the law and do not claim those deductions, federal legalization would allow them to do so.

Federal legalization could result in a large-scale transfer of economic activity from the untaxed underground economy into the tax-compliant legal market. This shift holds implications for income and payroll tax revenue that is analytically distinct from, and additive to, the excise tax revenues. The marijuana market is vast, encompassing approximately $100 billion in economic activity between legal and illicit activity. However, despite legalization across the US, 75% of this economic activity remains illicit. California has seized over $2.8 billion of illegal cannabis, amounting to 800 tons, since 2019. In 2024 alone, California officials seized $534 million. Despite legalization, these illicit sectors persist because distributors are unburdened by compliance costs, licensing fees, and state excise taxes compared to their legal competitors.

All else equal, the addition of federal excise taxes could reinforce illicit marijuana markets. But federal legalization of illegal operators would offset this effect. By eliminating barriers to banking services and interstate commerce, many individuals in the currently illicit sector would be drawn into the formal sector and subjected to taxation. It is of course uncertain to what extent this would occur.

Our model includes a portion of the illicit market moving to the formal sector. Another source of uncertainty is the amount of “cannabis tourism” in the current market numbers. In the scenario in which all states legalize, we move a portion of that tourism to the new legal states to account for less tourism.

Federal legalization would likely generate income and payroll tax revenue beyond that collected through the excise tax. Illegal activity is not taxed, as there is no legal basis on which to do so. Were federal legalization to occur, two different groups of laborers in the sector would be affected in different ways. The first consists of cultivators, distributors, and retail sellers. As employees, they would receive W-2 wages and pay income and FICA taxes. Given the size of the illegal cannabis market, this shift could be large. A 2024 estimate (the Cannabis Jobs Report by Vangst) indicates that more than 440,000 workers are employed just at the firms that currently comply with state law (in jurisdictions where their activity is legal).

The second category consists of self-employed individuals, including dispensary sole proprietors and some cultivators. These individuals would file a Schedule C or Schedule K-1 attached to Forms 1065 or 1120-S (if they operate as pass-through entities). As self-employed individuals, they would pay self-employment taxes under IRC §1401 and federal income tax on net profit.

The Tax Foundation has estimated that individual income taxes and payroll taxes from labor in a legalized marijuana industry would contribute approximately $1.5 billion in annual federal revenue, though that estimate was constructed under a narrower set of market assumptions than those modeled here, and likely understates the revenue gain from illicit market conversion given the size of the underground sector documented above. Projecting this revenue stream requires assumptions about the rate at which illicit workers transition to formal employment status, the distribution of wages and profits across the newly legal workforce, and the share of newly reporting sole proprietors who will have historically underreported—or entirely omitted—self-employment income on prior-year returns. All of this constitutes a noncompliance situation that the IRS’s existing informal-economy enforcement infrastructure is poorly equipped to observe in the pre-legalization period. All of this constitutes a noncompliance situation that the IRS’s existing informal-economy enforcement infrastructure is poorly equipped to observe in the pre-legalization period. Consequently, we do not include effects through this margin, but acknowledge that they are likely to raise the revenue associated federal legalization.

As a general matter, taxpayers cannot deduct business expenses associated with activities that are illegal under federal law, even when those expenses (like rent or payroll) would otherwise be permissible deductions. This is specifically the case for those trafficking Schedule I or Schedule II controlled substances, as specified in Section 280E of the Internal Revenue Code, whether or not state-licensed cannabis operators are operating in full compliance with state law. The practical effect is that a cannabis retailer cannot deduct rent, payroll, utilities, marketing, insurance, or any other ordinary business expense, leaving firms taxed on gross income rather than net income. The only relief available under §280E is the cost of goods sold deduction, which allows cannabis businesses to reduce their taxable gross receipts by the direct costs of producing or acquiring the inventory they sell.

This legal situation yields effective federal income tax rates for cannabis businesses that could significantly exceed the 21 percent statutory corporate rate. The interaction with state law is fundamentally asymmetric: states that have legalized adult-use cannabis have generally conformed their own tax codes to allow ordinary business deductions, meaning that a cannabis operator in Colorado or California pays state income tax on something approximating net income while simultaneously paying federal income tax on an inflated taxable base. This creates a burden with no analogue in any other legal industry and has been widely cited as the largest impediment to transitioning the cannabis industry away from cash-intensive operation (and tax noncompliance) toward the formal sector that state legalization was intended to create.

Under either of the policy counterfactuals considered in this article, the burden of Section 280E would be lifted. This would likely cause some businesses to fully transition into the formal sector. However, in the absence of data with which to model shifts on this margin, we do not include any such effects in our calculations.

The Budget Lab is grateful to Adam Hoffer for insightful feedback on an earlier draft.

Some non-substantive edits were made to a small portion of the text on August 18, 2026. None of the calculations were altered.