Several states may legalize recreational marijuana in the coming years as the coronavirus pandemic has left many state budgets in disarray and policymakers looking for new revenue sources. Combined with a desire to decriminalize, the zeitgeist is ideal for marijuana legalization.

Montana is one state that could legalize sooner rather than later as campaigners for a ballot initiative (I-190) have collected the required signatures for the initiative likely to be on the ballot in November.

The impetus for the Montana initiative seems related more to decriminalization than revenue generation. This is evident by the proposed excise tax rate at 20 percent on the value of marijuana sales. While 20 percent is comparatively low nationwide, taxing by price (ad valorem) can prove problematic.

Most states have implemented price-based taxes on recreational marijuana levied at the retail level. This is likely due to the simplicity associated with establishing an ad valorem system. Taxing based on retail prices means there is a taxable event with a transaction, allowing for simple valuation. However, ad valorem taxes are not capable of capturing the negative externality (secondhand smoke, driving under the influence, health impacts) related to marijuana consumption.

Conversely, taxing based on the price harms consumer choice and product quality as it incentivizes manufacturers and retailers to reduce prices to limit tax liability. It also incentivizes downtrading, which is when consumers move from premium products to cheaper alternatives. Downtrading effects have no relation to any externality the tax is seeking to capture.

Furthermore, while it may be simpler to levy the tax based on price, it does not necessarily offer an equitable solution. A marijuana product with similar qualities and in similar quantities should have equal tax liability regardless of design or price, but this principle is ignored by an ad valorem tax design. Moreover, an ad valorem tax in an immature market runs the risk of being too high in the beginning, where supply is low, and too high after a few years, if prices drop significantly. Price drops have been registered in most states that have legalized and as economies of scale kicked in.

An excise tax should be based on the following principles:

  • Tax rates should be low enough to allow legal markets to undercut, or at least gain price parity with, the illicit market.
  • Taxes should be designed to offer stable revenue in the short term regardless of potential price declines.
  • Taxes should raise enough revenue to fund marijuana-related spending priorities and cover societal cost related to consumption.

An excise tax design that delivers on these principles and best captures the externality would be based on a combination of potency and weight. 

Excise tax revenue should be appropriated to relevant spending programs. For marijuana these could be programs like addiction treatment, youth prevention programs, substance research, or illicit trade enforcement.

Initiative I-190 allocates the revenue to a large variety of unrelated spending programs: 4.125 percent to nongame wildlife, 4.125 percent to state parks, 4.125 percent to trails and recreational facilities, 37.125 percent to wildlife habitat, 10.5 percent to the general fund, 10 percent to drug addiction treatment and substance abuse treatment, 10 percent to local governments, 10 percent to veterans’ affairs, and 10 percent to Medicaid.

As a general rule of thumb, excise taxes should, as a guiding principle, only be levied when appropriate to capture some negative externality or to create a “user pays” system—not as a general revenue measure.

The fiscal note for I-190 estimates excise tax revenue of $38.5 million in 2025. In our estimation, we calculated excise tax revenue of $39 million in the fifth year after legalization in Montana. While this is not insignificant revenue for Montana, it is an important consideration that establishing and maintaining the system required to manage a legal market is not without costs.

According to the initiative’s fiscal note, general fund expenditures will total $6.3 million in fiscal year (FY) 2021. With sales estimated to begin in the middle of fiscal year 2022, the state would not be collecting any revenue in FY 2021.

After sales operations begin, revenue allocated to the general fund is estimated to be $369,201 in FY 2022, $1.9 million in FY 2023, $3 million in FY 2024, and $4 million in FY 2025. As a result, the aggregate collections will not be sufficient to cover the initial cost of $6.3 million to the general fund until FY 2025.

This is not an argument against legalization, but a reminder that recreational marijuana is no solution to short-term budget shortfalls. The legal market for recreational marijuana is still young and there is much to learn about recreational marijuana taxation. Whatever the outcome in Montana, lawmakers should remain flexible and up to date when it comes to recreational marijuana policy.

For a complete guide to taxation of recreational marijuana, click here.

Original Article Posted at : https://taxfoundation.org/montana-recreational-marijuana-legalization/