Cannabis Taxation in the United States

In the United States, cannabis legalization at the state level has vastly increased over the last 10 years. Currently, 23 states have legalized recreational cannabis, and 38 have legalized some form of medical cannabis. The shift to legalization has brought new challenges and difficulties for states implementing regulations and effective tax systems for recreational and medical cannabis use. Like alcohol prohibition in the early 1900s, during which states awaited federal regulations and oversight, cannabis legalization has created similar issues.

Growing and consuming cannabis was legal in the United States until the 1910s, when states started to enact laws criminalizing it. At that time, cannabis was included in the United States Pharmacopeia, the list of permissible and federally approved medicines, but in 1937, the federal government followed the states’ lead by passing the Marijuana Tax Act. As of 1970, the cannabis sativa plant (spelled marihuana in the law) is listed in Schedule I of the Controlled Substances Act because of its high potential for abuse attributable to tetrahydrocannabinol effects and the absence of accepted medical use. Although the federal government has chosen not to interfere with states that have legalized it, cannabis is still classified as an illegal, Schedule I controlled substance.

New Initiatives, New Challenges

In the 1990s, a shift among some states back toward legality began to take hold, starting with the legalization of medical cannabis, and later recreational use, in states like California, Colorado, and Washington. In 1996 California was the first state to enact medical cannabis use (Proposition 215). More recently, some states allow for narrowly defined medical use; for example, in Alabama, medical cannabis use is only legal in the form of non-psychoactive CBD oil for children with epilepsy.

Colorado began taxing recreational cannabis sales on January 1, 2014. Colorado’s cannabis sales tax increased from 10 percent to 15 percent on July 1, 2017. The cannabis excise tax is 15 percent, but the average market rates fluctuate quarterly. Before fiscal 2016, the Washington cannabis excise tax was based on a three-tier model levied at 25 percent at the production level, 25 percent at the processor level, and 25 percent at the retail level. Beginning in fiscal 2016, Washington has levied only the excise tax on retail sales at 37 percent.

Legalization at the state level created banking and federal tax filing challenges for cannabis-related businesses. Because of marijuana’s federal classification, cannabis businesses cannot use FDIC-insured banks and do not have access to many federal deductions that are available to most other businesses. Internal Revenue Code section 280E prohibits a taxpayer from deducting or claiming credits for the business expenses of any trade or business that “consists of trafficking in controlled substances (within the meaning of Schedule I and II of the Controlled Substance Act).” Thus, even when the sale of cannabis is legal under state law, section 280E denies deducting ordinary and necessary business expenses, such as “rent, utilities, compensation, costs of administration, and charitable gifts to promote goodwill.”

Courts have repeatedly rejected constitutional concerns about section 280E and have sided with the IRS in determining that even businesses in states where cannabis sales are legal are not entitled to deduct business expenses.

Taxation Methods

The discrepancy between state legality and federal restrictions presents a unique legal framework under which cannabis use and sales operate, effectively complicating the domestic market. Cannabis products cannot be transported legally across state borders, so the entire seed-to-consumer process must occur within state borders. This unusual situation has resulted in a wide variety of tax designs and ongoing discourse. Different states levy different taxes, with some even levying multiple taxes, including excise taxes and general sales tax, on cannabis purchases. The three main ways states tax recreational cannabis may be categorized as price-based, weight-based, and potency-based.

Price-based taxes on cannabis are the most popular among states. Like general sales tax, the tax is calculated as a percentage of the retail price, paid by the consumer, and remitted to the government by the retailer.

Weight-based taxes are akin to other “sin taxes,” like taxes on alcohol and tobacco. Weight-based taxes are based on weight or quantity, not the price. The measurement can vary based on the part of the plant being sold, and the calculation method for these taxes varies among states. A cultivator is responsible for paying the tax following the sale of its product to a distributor or retailer. The tax is then incorporated into the purchase price paid by a consumer.

Potency-based taxes are like taxes on liquor and are based on the product’s content. Potency-based taxes on cannabis are based on the product’s THC content because THC is the primary psychoactive compound in cannabis. Some states, like Colorado, Illinois, and Nevada, use price-based and weight-based tax methods, while other states, like New York, use price-based and potency-based tax schemes.

Factors That Can Affect Revenue

Although cannabis tax collections are performing well overall, they are not an immediate or infallible revenue solution. Revenue growth may slow as more states legalize recreational use and there is more product in the market, lowering prices overall and affecting tax revenue. According to the Pew Charitable Trust, it has been difficult to accurately forecast cannabis tax revenues. Some states have underestimated revenue (e.g., Nevada exceeded projections by 45 percent), others overestimated revenue (e.g., California missed projections by 45 percent), and some, like Colorado, were close to projections.

With this still unpredictable revenue potential, states should consider setting up trust funds or another mechanism during high-revenue periods to balance low-revenue periods. Cannabis legalization and taxation should not be seen as an immediate fix or magic bullet for budget shortfalls. It can take years to fully develop effective regulations, licenses, and a legal framework, and for revenues to match expectations.

The variety of approaches to state cannabis taxation and each state’s unique features, such as the size of its population, also make it challenging to compare rates between them. Most state cannabis tax systems have existed for only a year or two, and many have operated exclusively without competition from neighboring states. The possibility of major federal cannabis law reform could radically change how it is sold and taxed in states across the United States.

As legalization increases, significant tax differences will be reflected in product pricing — leading consumers to travel across state borders to purchase cheaper cannabis in neighboring states. Cannabis products vary, requiring state tax systems to be flexible enough to adjust as products enter the market. Medical cannabis sales tax rates are often lower than those for recreational use, which can create a downward pressure on recreational cannabis tax rates. In 2019 a study of California suggested that illegal cannabis sellers outnumbered legal ones by almost 3 to 1.

The challenges and opportunities states face in creating their cannabis taxation systems may be as unique as the states themselves. As states legalize and implement their cannabis tax programs, they face a variety of hurdles.

California, Washington, and Alaska provide examples of how states are moving forward. Through June 30, 2022, California’s cultivation tax was imposed on cannabis cultivators for all harvested cannabis based on the weight and category of the cannabis that entered the commercial market, with the final distributors being responsible for reporting and paying the tax to the California Department of Tax and Fee Administration. Washington conducted an extensive analysis of gross receipts and cash logs in addition to bank statements, including alternative cashless transactions that transfer funds from a consumer’s account to the business’s account. Alaska Gov. Mike Dunleavy (R) established a task force to review and recommend reforms to the state’s taxation of its legal marijuana industry, which the task force issued on January 13.

Three Principles for States to Follow

The underlying aim of cannabis legalization is to reduce illegal sales and provide regulation of poor quality or high-potency products. Taxing cannabis sales should help fund government services and address negative consequences of cannabis consumption. The challenge of taxing cannabis is achieving these goals without creating an overly complex tax system.

In developing and implementing cannabis tax programs, states may use the following principles as a basis for their excise tax rates on recreational cannabis:

• keep tax rates low enough to undercut or, at the very least, stabilize the illicit market;

• design a tax regime that would bring in consistent revenue, even while cannabis product prices fluctuate; and

• generate sufficient revenue to fund cannabis-related programs and infrastructure, including mitigating societal costs associated with cannabis product consumption.

Should cannabis become legalized on the federal level, large tobacco and pharmaceutical companies will be important industry stakeholders. With the ever-evolving cannabis markets and possible state and federal law reforms, states should stay informed and flexible.