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How To Tax Legal Cannabis

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Dave Silberman 20 Nov 2018

Note: This is a re-print of a commentary Dave Silberman wrote for VTDigger January 17, 2017. Dave is an attorney and pro bono legalization advocate in Middlebury. In light of the Governor’s Tax&Regulate Subcommittee’s preliminary recommendations, we thought it an appropriate moment for another look at Dave’s wisdom.

Dave also said to us, “In an ideal world, I’d update that thing for 2019, but I am too busy right now.” 

We totally understand…

Shortly after his election, Gov. Phil Scott listed three specific things that legislators must address when considering cannabis legalization, if they want to avoid his veto pen. “I hope they hear me loud and clear,” he warned, that road safety, THC-infused “edibles,” and taxes are the three critical questions around legalization.

I agree – these are excellent questions. Fortunately, they’ve also been studied for years, and the path forward on each is clear. I’ve previously laid out effective, evidenced-based solutions for addressing the risks of impaired driving and edible products ; let’s now turn to cannabis tax policy.

But, first, let’s recognize one undeniable truth: It would be awfully hard to do a worse job of taxing cannabis than we do today. While Vermonters spend nearly $200 million on cannabis each year, the state collects nothing in taxes; no sales tax is applied, and no income tax is received on the unreported profits from this large, underground economy. While we should strive for the best possible policy, making a hash of it would still be an improvement over the status quo of zero taxes and zero regulation.

Optimizing cannabis taxation requires balancing two somewhat competing goals. On the one hand, it is imperative that retail prices in the regulated market be low enough to attract consumers away from the illicit market. On the other hand, sufficient revenues must be raised to fund both the new regulatory system, and the other priorities identified by the Legislature and administration (such as public outreach campaigns to address youth education and drugged driving, or, perhaps, tax relief). The former goal calls for keeping taxes low; the latter, for higher rates.

Vermont’s legislators should focus not only on tax rates, but on ensuring that the regulated market has sufficient supply, by not artificially restricting the number of cultivation licenses.

When Washington state began permitting cannabis sales in July 2014, it appeared as though they had botched the first goal. When stores opened, prices inside were higher than out on the street. Analysts seized on Washington’s high excise tax as the leading cause for this upside-down market – a separate 25 percent tax was paid by the grower, processor and retailer, meaning that the tax would be paid three times over by the time the consumer took the product home. By the end of 2014, the state had collected only $16 million in tax revenues on a paltry $49 million in sales.

It’s likely, however, that Washington’s high prices were predominantly due to a supply shortage, rather than to high taxes. Washington’s Liquor Control Board was reported to be “overwhelmed” by applications for cultivation licenses, and by July 1, 2014, had granted only 80 licenses, out of more than 2,600 applications. As stores began running out of product to sell, prices shot up, responding to the forces of supply and demand.

Vermont’s legislators should focus not only on tax rates, but on ensuring tat the regulated market has sufficient supply, by not artificially restricting the number of cultivation licenses.

The wholesale tax should be flexible, and responsive to market conditions, while the sales tax should be fixed (I’ve proposed 10 percent, like our alcoholic beverages tax), but subject to a “floor.”

Washington’s lawmakers quickly addressed both problems. Within a year, the triple-layer tax was replaced with a single 37.5 percent sales tax, and the license backlog subsided. Supply was able to catch up with demand, and prices fell; today, an ounce of cannabis retails for about $200 in Washington, compared to $300-$350 in most prohibition states. Consumers responded by ditching their dealers for regulated stores, buying over $320 million of regulated cannabis in 2015, paying over $120 million in taxes, and roughly double that in 2016.

To avoid these early missteps, Vermont’s legislators should focus not only on tax rates, but on ensuring that the regulated market has sufficient supply, by not artificially restricting the number of cultivation licenses. Because plants take time to grow, those licenses should be granted at least six months prior to the launch of retail sales. By avoiding regulatory supply crunches, the Legislature will give itself added flexibility in determining what taxes to levy: there will be more “room” for taxes without worry of high prices driving consumers to the illicit market.

In testimony to the Joint Legislative Justice Oversight Committee this past October, I proposed that the state should implement both a sales tax and a wholesale tax, providing an optimal balance of flexibility and revenue stability, and allowing regulators to ensure that licensed cannabis retailers consistently undercut the illicit market. The wholesale tax should be flexible, and responsive to market conditions, while the sales tax should be fixed (I’ve proposed 10 percent, like our alcoholic beverages tax), but subject to a “floor.”

While I’m skeptical of the League of Cities and Towns’ belief that legalization will increase local law enforcement costs, I agree with their call for sharing cannabis tax revenues with municipalities.

As Washington’s experience proved, if initial prices in the regulated market are not competitive with the parallel illicit market, consumers will stay with their dealers. Unlike sales taxes, wholesale taxes paid by the retailer get incorporated into the “menu” price the consumer sees, and thus have a larger influence on purchase decisions. Thus, the wholesale tax can be a powerful tool for policymakers to influence retail prices up or down as needed. I’ve proposed that the wholesale tax initially be set at 10 percent, but that the appropriate regulator be empowered, subject to legislative oversight, to adjust the rate every three to six months as the power of the illicit market diminishes, up to a maximum of 25 percent.

We expect that regulated market prices will decline substantially over time, as the “risk premium” associated with illegality disappears – as has happened in other jurisdictions. As prices fall, however, revenues from a percentage-based tax will decline as well. In order to ensure a base level of revenues despite falling prices, I’ve advocated for a minimum sales tax by weight (e.g., $30/ounce, $10/quarter-ounce, and $6/eighth-ounce).

By replacing the “risk premium” with sensible regulations and taxes, the Legislature will ensure not only that licensed retailers drive out criminal traffickers, but that sufficient revenues are collected so that – in addition to the many other benefits associated with regulation – legal cannabis is a self-sustaining, net contributor to the state’s budget.

Finally, I believe that tax policy should be used to reward cities and towns for hosting cannabis retailers. While I’m skeptical of the League of Cities and Towns’ belief that legalization will increase local law enforcement costs, I agree with their call for sharing cannabis tax revenues with municipalities. Encouraging more municipalities to host stores, by giving them a portion of the taxes collected, would help ensure wider geographic distribution of those stores, giving more Vermonters convenient legal access without having to drive hours from home. I’ve proposed that we follow Colorado’s model, where 15 percent of sales tax proceeds are distributed to municipalities, based on their respective sales. Alternatively, the state could add a “municipal” sales tax of up to 2.5 percent, which would then be similarly distributed to participating cities and towns.

These proposals are based on the lessons learned from the successes – and mistakes – of other jurisdictions. The combined tax rates fall somewhere between Colorado and Washington – two states in which after-tax cannabis prices are significantly lower than what Vermonters currently pay, both in the illicit market and at our four medical dispensaries.

While these proposals represent best practices, the Legislature could succeed with different choices, especially given our starting point, where high prices reflect the cost of legal risk to sellers, but we collect no taxes at all. By replacing the “risk premium” with sensible regulations and taxes, the Legislature will ensure not only that licensed retailers drive out criminal traffickers, but that sufficient revenues are collected so that – in addition to the many other benefits associated with regulation – legal cannabis is a self-sustaining, net contributor to the state’s budget.

 

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