05/08/2017 10:55 EDT | Updated 05/08/2017 11:15 EDT

Taxing Legal Marijuana Could Keep The Black Market In Business

The balancing act of cannabis taxation

The legalization of adult-use cannabis in Canada may create a revenue-generating marketplace as early as mid-2018. This massive shift in legislation and industry promises a variety of economic benefits, from reduced policing costs to substantial job creation. Jurisdictions where cannabis has been legalized already demonstrate increased government revenues from taxation.

marijuana growing

(Photo: Drew Angerer via Getty Images)

At the time of this writing, the State of Washington has seen tax inflows of over US$400 million since legal sales of recreational cannabis began in 2014. Similarly, the State of Colorado boasted almost US$200 million of inflows from recreational sales in 2016 alone.

There are many who ascribe the value of a sin tax to non-medical cannabis use. The argument for high taxation levels is to increase government revenues and discourage the use of an inebriating substance. Proponents of this argument might go as far as to say the more tax the better.

This creates a problematic externality. There are costs associated with producing cannabis legally, including fair wages for workers, lab testing every batch, and security costs mandated by federal regulation. These are costs that the black market does not bear, already putting legal producers at a pricing disadvantage. If legal producers are to erode the market share currently owned by black market incumbents, any tax borne by the end user creates a financial disincentive to purchase cannabis from a legal supply chain.

Public-sector benefits

Two core financial incentives for governments to adopt cannabis legislation and enact public oversight are:

  • A reduced burden on the judicial system associated with minor and non-violent cannabis offences, and
  • Tax revenue to be generated from the sale and distribution of recreational and even medical cannabis.

Legalization may be an imminent reality, but balancing the stated priorities of the federal government with provincial incentives will create inevitable challenges. Restricting child access and reducing flow of untaxed revenue to the black market are the stated goals of the Trudeau Administration's plan to legalize. However, the priority of reducing untaxed revenue to the black market likely reduces the incentive to maximize tax revenue in the first days of legalization.

medical marijuana

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To tax or not to tax: a delicate equilibrium

Without oversight and competitive pricing from the regulated market, black market sales could continue to thrive. This diverts potential tax revenue and inhibits a transition to legal purchasing habits. Although there may be a significant reduction in policing minor cannabis crimes, enforcement of trafficking and more serious crimes could very well increase as the market adjusts to a legal supply chain.

There may be months or years of settling out when it comes to stifling the black market, as the industry of legal and regulated cannabis becomes the norm. This equilibrium of taxation and enforcement costs will be unique from province to province. In terms of taxation, Colorado provides an example of the benefits that state or provincial governments can capitalize upon.

Taxation policy must be thoughtful to be sufficiently profitable without hindering the legal industry's ability to disrupt the black market.

According to Colorado's Department of Revenue, in the fiscal year of 2016, Colorado earned over US$200 million from gross cannabis tax revenue, and generated from more than US$2 billion in legal cannabis sales. Of course, there are costs attributed to the oversight of this regulation, but the state distributed around 60 per cent of all cannabis-related taxes in 2016 after the costs of regulation and enforcement were taken into account. By year end 2015, Colorado had collected more taxes from cannabis consumption than alcohol sales.

This money has been widely dispersed throughout the state's programs, including US$12 million towards education, US$22 million towards health care, US$1 million for the attorney general's office, US$900,000 for transportation, and US$500,000 for veterans' benefits, among a plethora of other projects.

Taxation policy must be thoughtful to be sufficiently profitable without hindering the legal industry's ability to disrupt the black market. Some policy advocates suggest taxation could be conducted on the content of the psychoactive cannabinoid tetrahydrocannabinol (THC) rather than weight or volume of the cannabis product, since this chemical component elicits the greatest feeling of inebriation. This is also important in the wake of increasingly potent forms of the product such as highly powerful oils, waxes, and other edibles with increasingly high amounts of THC.

marijuana dispensary canada

(Photo: Steve Russel/Toronto Star via Getty Images)

Complications of tiered taxation for medical and recreational use cases

Another externality of blending medical and recreational cannabis sales with different taxation rates is that the tax-exempt or low-tax status of medical use can result in missing potentially taxable consumption. Washington State is one example of this phenomenon. Reduction in tax revenue is weighed against the social value of easier access to cannabis medicines for lower-income users.

If the more expensive commercial sector is forced to compete with an untaxed and poorly regulated medical sector, as seen in Washington State, the incentive to participate in a medical system and ergo reduce costs associated with higher recreational tax levels could lead to reduced tax revenues.

This lead Washington State to merge its medical and recreational systems on July 1, 2016 -- a lesson in failed policy that should be duly noted by provincial legislators in Canada.

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