INSIGHTS BLOG > Alternative Forms of Cannabis Taxes

Alternative Forms of Cannabis Taxes

Written on 23 October 2022

by Ruth Fisher, PhD

General Note on Cannabis Taxes
Cannabis Tax Systems by State
Comparisons of Alternative Forms of Cannabis Taxes

Germany’s proposed cannabis regulations have been in the news recently.^[1] They include a THC-based potency tax, that is, higher tax rates for products with higher THC content. These potency taxes differ in form from the excise taxes most commonly seen in the US, price-based excise taxes.

Taxes are an unfortunate part of life, and a much larger part of life in the cannabis industry than in most other industries. Besides being a burden, though, taxes also change consumers’ behavior. This fact leads me to wonder: What are the different tax systems currently being used across cannabis markets, and how will the different systems affect consumer behavior?

General Note on Cannabis Taxes

Governments use taxes either to dissuade consumers from purchasing taxed products and/or to generate revenues from their sales. The tax revenues may be used to offset social costs associated with the consumption of taxed products.^[2] Alternatively, tax revenues may be used to promote related social programs.

All the different forms of taxes – excise taxes, state and local sales taxes, social equity taxes, etc. – increase consumer prices in legal markets, making it difficult for legal businesses to survive,^[3]^{, ^[4]} driving many consumers to Black Markets.^[5]^{,^[6]} This is an unpleasant reality that legislators must understand when establishing cannabis tax structures and regulations.

Many regulators reason that taxes on cannabis will dissuade underage users from consuming cannabis. Yet, underage minors are already banned by law from consuming cannabis. ^[7] Presumably, many (most?) get their cannabis products from black market suppliers. In this case, increasing the price of legal market cannabis products will not dissuade minors from continuing to use cannabis.

Also, while cannabis products cannot flow across state lines, cannabis consumers can. So then neighboring states must keep their total (tax plus product) prices in line with those in other states. Otherwise, they risk riving consumers to purchase products across state lines.^[8]

Cannabis Tax Systems by State

Jackson Brainerd, Program Principal at National Conference of State Legislatures (NCSL), notes, “While robust revenue collections are typically associated with recreational marijuana sales, there are states that are generating a significant amount of revenue from medical marijuana programs as well.”^[9] Since:

1. The majority of tax revenues come from recreational (rec) use in states that have legalized both medical (med) and rec use;
2. Med and rec regimes have different tax structures, which complicates any discussion of joint med and rec markets; and
3. In all relevant respects, consumers in med only states respond to taxes in similar ways as consumers in joint med and rec states do,

I’m simplifying my analysis by focusing on rec states.

States with Uniform Price-Based Excise Taxes

All states that have legalized adult use (rec) cannabis have imposed both excise and/or sales taxes on cannabis activity. Most states – 15 of the 20 states that have legalized rec use – have imposed a uniform price-based excise tax. For example, both California and Colorado impose excises taxes on all dispensary sales to consumers of 15% of the product price, in addition to other state and local sales taxes.

Figure 1

Figure 1 provides aggregates cannabis excise and sales tax information across legal rec states. The information displayed in Figure 1 indicates the following:

The total price-based excise taxes in column [C] are the sum of excise taxes on sales by growers plus excise taxes on sales by dispensaries. These total excise taxes clearly differ somewhat by state.
In addition to the excise taxes, most states also impose state sales taxes (column [D]). (Some states impose local sales tax as well, not included in Figure 1.)
Most states do not impose excise taxes on sales of med cannabis (column [E]).
States with the highest excise taxes do not also appear to have the highest state sales taxes and med excise taxes.

I also wondered if perhaps states with higher excise taxes on cannabis also had higher excise taxes on alcohol. Figure 2 pulls in excise taxes on different forms of alcohol by state.

Figure 2

Excise taxes on beer and wine are too small to really matter (to the extent that taxes can be too small). However, excise taxes on liquor are more substantial, and there is a positive correlation across states between excise taxes on cannabis and excise taxes on liquor (0.69). This relationship is a bit clearer in the scatterplot in Figure 3. On the other hand, Figure 3 also shows that the relatively strong correlation between taxes on cannabis and liquor is largely driven by Washington state taxes. If we exclude data for Washington, then the correlation between excise taxes on cannabis and those on liquor (0.23) becomes much smaller.

Figure 3

(Washington state has no state income tax. Perhaps the state relies on excise taxes to fund state activities more than other states that do have income taxes. However, a fuller analysis to understand why taxes differ as they do across states is not the focus of this study.)

States with Form- & Potency-Based Excise Taxes

Five of the states that have legalized rec cannabis activity impose alternative (to price-based) forms of excise taxes.

Alaska and New Jersey both impose a uniform excise tax per ounce on cultivated flower, but no excise tax at the retail level. (Technically, New Jersey’s tax on growers is a “social equity excise fee.”^[10]) Maine also imposes a tax per poundon cultivated flower, in addition to a uniform price-based “special sales tax” on retail sales^[11] (see Figure 1).

The three remaining states, Connecticut, Illinois, and New York, have imposed different combinations of excise taxes by potency and form of use (see Figure 4).

Figure 4

Illinois’s potency-based excise taxes are still price-based taxes, so we can compare them to the price-based taxes for the other states in Figure 1. However, the structure of taxes in Connecticut (CT) and New York (NY) makes them difficult to compare. To get better sense of the impact of the CT and NY taxes, I created an example using average 2020 and 2021 prices reported by Headset for Flower, Edibles, and Vape Pens.^[12] The results are displayed in Figure 5.

Figure 5

There are a couple of points to note that are illustrated in Figure 5:

The price data in rows [1] and [2] of Figure 5 are described as, “… for combined market including California, Colorado, Nevada and Washington state.” It’s not clear whether the prices include CA, CO, NV and WA, along with data from other states, or if the data include only prices for those states.

Cannabis prices in Western states, which also tend to have older cannabis markets, tend to be lower than prices in Eastern states, which tend to have newer cannabis markets. If prices in CT and NY are, in fact, higher than the average prices reported here, then the tax rates (rows [9], [10], [13], and [14] in Figure 5) will be overstated. On the other hand, the state of CT portal for cannabis indicates, "In total, the tax rate is expected to be approximately 20 percent of the retail price of cannabis, in line with the tax rates in Massachusetts."^[13]This is consistent with the excise tax rates calculated in Figure 5.

The tax rate structures displayed in Figure 4 suggest that excise taxes on edibles are out of whack with taxes on flower and vape products. However, Figure 5 shows that edibles are much more expensive per mg of THC than either flower or vapes (rows [5] and [6]). As a result, the taxes on edibles are much more in line with those on flower and vapes than they initially appeared.
As prices decrease – which they will as markets mature, and especially if/when cannabis can flow across state lines – the effective excise tax rates will increase. This increase in tax rates is seen by comparing the rates for edibles and vape pens in row [9] to [10] and row [13] to [14].

Since prices for edibles and vaped only dropped by 5% between 2020 and 2021, the corresponding decreases in taxes rates were small. However, as new rec states, CT and NY should both experience more precipitous decreases in average prices over time. In this case if the tax rates remain constant at current levels, the effective tax rates will rise over time.

Take Colorado, for example, which legalized rec use in 2012. Inflation-adjusted average market prices of cannabis decreased from $2,376 in Jan 2014 to $999 in Jan 2022, an average annual decrease of 11.4% during that period (see Figure 6).

Figure 6

If 2022 and 2023 prices end up being 11.4% less than the respective prior year prices, then the excise tax rate on edibles will increase as follows:
- In CT taxes rates will increase from 18.6% in 2021 to 20.9% in 2022 and 23.6% in 2023 (Figure 6, rows [10], [16], [19])
- in NY tax rates will increase from 20.2% in 2021 to 22.8% in 2022 and 25.8% in 2023 (Figure 6, rows [14], [17], [20])

Comparison of Alternative Forms of Cannabis Taxes

Now that we have a bit of a flavor for price-based and form-based cannabis taxes, let’s take a more general view to see how all the different tax structures currently implemented compare. A closer look at Figure 1 shows that there are actually five different types of excise tax structures being implemented: medical vs. recreational, price-based, weight-based, THC-content, and form of cannabis use. More detail in terms of how each tax structure works, together with advantages and disadvantages for each relative to other forms of taxation, are presented below and summarized in Figure 9.

Medical vs. Recreational

In all states except CA, med users benefit from lower cannabis excises taxes than do rec users. In fact, in 16 of the 20 states, med users pay no excise tax on cannabis purchases, though they generally pay state and/or local sales taxes. One could argue that giving medical users a tax break recognizes the more dire circumstances of med users relative to rec users. On the other hand, to qualify for the lower tax rates, med users must:

1. Pay to see a doctor to become qualified for a state medical cannabis card,
2. Pay the requisite fee to receive a state-issued medical card, and
3. Purchase cannabis products from dispensaries licensed to sell to med users.

In this sense, one could argue that giving medical users a tax break simply helps offset the additional cost burdens associated with participating in medical use channels. Otherwise, medical users would have a greater incentive to simply switch to rec and avoid all the extra costs.

More generally, governments often segment industries so as to be able to tax or subsidize segments at different rates. For example, diesel fuel, which is used much more heavily by drivers of commercial trucks than by drivers of passenger cars, is generally taxed at a higher rate than gasoline. The excess fuel taxes paid by commercial drivers can then be used to pay for road repairs, which makes sense, since heavier commercial vehicles cause more wear and tear on the roads.^[14]

Price-Based

As already discussed, the most common form of cannabis excise tax is a price-based tax. In this case, consumers pay higher excise taxes on higher-priced products. Since higher prices decrease demand, price-based excise taxes incentivize suppliers to minimize costs (i.e., increase efficiency) so they can lower prices and thus associated taxes.

On the other hand, price-based taxes encourage people to buy less expensive products, which tend to be products that are lower-quality and/or mass-produced. To the extent that mass-production is generally achieved by scaling production, then price-based taxes encourage larger suppliers over smaller ones.

Of note is the fact that Illinois and Nevada levy price-based excise taxes on growers, in addition to price-based excise taxes at the retail level. Generally speaking, taxing suppliers at multiple points on the value chain is not a good idea, because tax rates compound. This leads to lower levels of supply and higher prices at the retail level than those that could be achieved using a single retail tax. Everyone loses.

Weight-Based

Alaska ($50/oz) and Maine ($335/lb = $20.94/oz) levy weight-based taxes on growers.

Cannabis weight-based taxes impose taxes based on the weight – in ounces or pounds – of cannabis products, so that consumers pay higher taxes for heavier products. Weight-based taxes are independent of product price. This reduces the uncertainty surrounding tax burdens when prices are volatile, but it creates heavier tax burdens when prices drop. At the same time, however, it ensures legislators that product sales will achieve minimum level of tax revenues, even as prices drop.^[15]

With weight-based taxes, growers have an incentive to minimize any excess weight of the biomass they sell to customers. The highest-value part of the cannabis plant is the trichomes or resin sacs, which are most densely concentrated on cannabis buds. Cannabis growers will thus maximize profits under a weight-based tax system by growing trichome-rich plants and selling the buds with as little of the other plant biomass as possible.

At the same time, however, in markets where THC is more highly valued than other substances in cannabis resin (e.g., other cannabinoids and terpenes), then weight-based taxes would incentivize growers to focus on high THC cannabis cultivars.

Finally, regulators can encourage or discourage larger or smaller grow operations by using tiered, weight-based taxes structures. Specifically, larger operations can be encouraged by using tiered tax rates that decrease with weight, while smaller operations can be encouraged by using tiered tax rates that increase with weight.

THC-Content

None of the rec states use a pure THC-content-based excise tax (also called a potency tax). Connecticut and New York combine a THC-content-based tax with a form of use tax. Illinois combines a THC-content-based tax with a price-based tax and form of use tax.

Chris Lindsey, the senior legislative council for the Marijuana Policy Project, who helped draft the IL cannabis legislation, indicated that the idea behind IL’s THC-content-based taxes was to “do something similar to alcohol and tax it at higher rates for those who want to purchase higher amounts.”^[16]

As for NY, according to Sean Teehan from New York Upstate, while NY legislators knew their tax structure “was a departure from” that in other states, but they were “in line with” CT’s tax structure.^[17] And as previously noted, CT was seeking to keep their tax levels, if not tax structures, “in line with the tax rates in Massachusetts."^[18] In other words, legislators are trying to make sure their policies are in line with those in neighboring states.

Advantages of Potency Taxes

THC-content-based taxes levy higher taxes on products with greater THC content. This form of tax would be similar to a weight-based tax in that it is independent of price. In this regard, this form of tax reduces the uncertainty surrounding tax burdens when prices are volatile, it creates heavier tax burdens when prices drop, yet it also ensures legislatures of minimum tax revenues when prices drop.

Taxes (or package limits) on THC content discourage products with high THC content. On the one hand, this encourages the supply of products with more non-THC cannabis substances, namely CBD and other minor cannabinoids, terpenes, etc. At the same time, trying to sell products with less THC and more other cannabinoids and terpenes might induce sellers to provide more education to consumers about the benefits of all the other non-THC substances in cannabis.^[19] This would definitely be a good thing for the industry as a whole.

Disadvantages of Potency Taxes

Potency taxes are highly disputed by the cannabis community. Many disadvantages of such taxes have been noted, including the following.

Taxing THC content will encourage suppliers to provide other non-delta 9 THC substances that have similar effects but that aren’t taxed, such as delta 8.^[20]These alternative substances are less safe than THC to the extent that they are unregulated, untested, and/or unreported.
To the extent that medical patients need higher doses of THC, then any potency-based taxes on medical users creates an undue burden for them.^[21]
Some legislators use the structure of excise taxes on alcohol as a model for cannabis. However, alcohol and cannabis differ in an important respect: You have to drink a lot more beer than liquor to get drunk than you have to smoke weaker than stronger cannabis to get high.^[22]^{,^[23]}An example will help clarify this sentence monstrosity.

Suppose:

You have a ½ gram joint
You have 2 samples of flower, one that’s 10% THC and the other that’s 30%

How much more of the 10% THC sample do you have to smoke to consume, say, 25 mg of THC? The answer is that you have to smoke ½ of the joint instead of 1/6 of the joint. (see Figure 7). In other words, if you want to consume some fixed dose of THC, it’s not that difficult to get there using weak cannabis rather than strong cannabis. A potency tax on cannabis will thus not have a great deterrence effect on people who want to consume moderately high amounts of THC.

Figure 7

“Prohibitionists routinely argue that today’s weed is ‘not your grandpa’s reefer’ because most flower now tests at or above 20% THC. But what those critics fail to remember, is that concentrated hashish has been the most commonly used form of cannabis across the globe for hundreds and hundreds of years.”^[24]
State legislators’ attempts to discourage growth of high-THC cannabis will simply cause “a brain drain,” that is, knowledgeable growers will move to states without potency-based regulations.^[25]
Finally, many consumers will continue to consume higher doses of THC. To the extent that taxes on THC content lead producers to reduce the amount of THC in individual products or packages, consumers seeking to consume a given dose of THC must consume more products and/or packages. This has two big disadvantages. First by consuming multiple products, consumers are forced to consume more “fillers” (e.g., sugar in edibles, carrier oil in tinctures and vapes, or carcinogens in smoked flower) to achieve their desired dose, which is generally less healthy. And second, being forced to buy multiple packages with lower or limited amounts of THC, rather than single packages with more THC, generates more packaging, which is less environmentally friendly.

Form of Use

As indicated in the previous section, CT and NY both use form of use tax structures, in combination with other tax structures. Form of use taxes involve different tax rates for different forms of use.

CT defines edibles as products “containing cannabis or cannabis concentrate, combined with other ingredients, that are intended to be ingested”.^[26]

NY defines an edible as, “a product containing either Cannabis or concentrated cannabis and other ingredients, intended for use or consumption through ingestion, including sublingual or oral absorption.^[27]

NY defines concentrates as “the separated resin, whether crude or purified, obtained from cannabis; or a material, preparation, mixture, compound or other substance which contains more than three percent by weight or by volume of total THC.^[28]

In NY concentrates include dabs and vapes, whereas tinctures are considered a form of edible.

CT imposes excise taxes separately on “plant material,” “edibles,” and “other than plant material or edibles.” Presumably, sublinguals are classified as edibles, but it’s not clear which category topicals fall into. NY imposes taxes separately on “cannabis flower,” “cannabis edible products,” and “concentrated cannabis.”

Regulators can use form of use taxes to encourage or discourage certain forms of use over other forms. For example, regulators might tax edibles at a higher rate if they think children are find this form of use appealing. Alternatively, regulators might tax concentrates at a higher rate in lieu of using a more explicit potency-based tax.

At the same time, preferences for specific forms of cannabis use differ by customers’ age/generation (see Figure 8). Form of use taxes will thus discriminate for or against certain generations.

Figure 8

Figure 9

Conclusion

Taking as given that all taxes distort activity, what can be said about the best form of tax for cannabis? Aspects of the cannabis market environment I think are important to consider are:

We want to minimize the burden of collecting enough tax revenues to satisfy legislators/regulators.
As suppliers become more skilled and experienced over time, and as markets mature, product prices will continue to decrease. We don’t want tax burdens to increase as prices drop.
In states that tax flower by weight, trim is taxed at a much lower rate than flower, which recognizes the differential value of the two types of biomass.^[1]^{,^[2]}We want to encourage this distinction.
We want to encourage the supply of wide varieties of resin-rich cannabis products, that is, products that vary in cannabinoid and terpene content, and not just high THC products.
We want to encourage small businesses, so many of which are operated by legacy cannabis market participants.

Generally speaking, it’s more efficient to tax final goods than raw materials because you can achieve the same tax revenues with greater supply at lower prices. Basically, it’s the idea that you can use lower tax rates by spreading the tax burden over a larger tax base. In the discussion at hand, this means it’s generally better to tax retailers than growers.

However, what we’re seeing in cannabis is increasing consolidation of grow operations, where legacy growers are being squeezed out of the market. Consolidation of operations generally leads to more mass-product flower and less variety. I, for one, don’t want cannabis to end up like the US beer market, where two suppliers, Molson Coors and AB InBev, supply 60% of the market.^[3] In this case, a tax on growers might better encourage less consolidation of growers, at the expense of slightly higher tax burdens. Obviously, others may disagree.

Tiered, price-based and weight-based grow taxes, with higher tax rates at higher weight tiers, and with separate tax rates for flower and trim seem to achieve most of the goals. Figure 10 provides an example of what this type of excise tax might look like.

Figure 10

In other words, like income taxes, all growers pay the same rate on the first, say, 500 pounds of flower or trim they grow, they pay a higher rate on the next 500 pounds they grow, and they pay the highest rate on anything they grow above 1,000 pounds each year. This form of tax would achieve the following:

It favors smaller growers over larger ones.
It encourages efficient supply of biomass (resin-rich parts of the plant).
It does not either penalize or favor high THC-content flower over flower that’s rich in other cannabinoids and terpenes.
A single excise tax (i.e., at the wholesale but not retail level) minimizes the tax burden on retailers and consumers.

This tax structure does not discourage consolidation of retailers, which might be considered a problem. On the other hand, by encouraging variety in the supply of flower, perhaps encouraged by direct-to-consumer sales by growers, competition among retailers may still force dispensaries to offer decent amounts of product variety to consumers at reasonable prices.

^[1] https://www.salestaxhandbook.com/alaska/marijuana

^[2] https://www.salestaxhandbook.com/maine/marijuana

^[3] https://www.statista.com/statistics/972647/leading-beer-suppliers-market-share-us/