Prior to the 2012 election in which Washington voters passed a marijuana legalization initiative, state officials estimated that legalization would generate up to $560 million in new tax revenue in its first year, with the expected state income projected to increase in later years. Subsequent work by Jon Caulkins and the BOTEC analysis group that the state retained for policy advice estimated annual state marijuana consumption at 165 million grams. Will the State of Washington really reap $3.39 in tax revenue for every gram of marijuana consumed?

It’s not likely, for at least four reasons:

1. Ad valorem tax revenue is dependent on the price of marijuana, which will fall under legalization

The initiative created a marijuana industry modeled on the alcohol industry, with a tri-part structure of growers, processors and retailers. A 25% tax was assessed at each transfer point and sales tax (statewide average 8.87%) is also applied at retail. Note that you can’t just add those numbers to get the effective rate at retail because marijuana increases in value as it moves through the production chain. When that is taken into account, tax at retail works out roughly to 45% of purchase price.

That’s a set up for enormous revenue if marijuana prices stay constant, but they will not. Illegality, by design, imposes many costs on the drug business. For example, you have to compensate employees for risk of arrest and enforce contracts privately. That’s why legalization will lower marijuana prices, perhaps by as much as 80% or even more. Unless the price drop leads to a spectacular increases in consumption, ad valorem taxes will bring in substantially less revenue than expected.

Some organizations and individuals advocating marijuana legalization propose excise taxes (e..g, $50/ounce irrespective of market price). This should generate more predictable revenue and also have the public health benefit of putting a floor under effective price.

2. The medical marijuana system is very loosely regulated and tax-free for consumers

California’s legendarily loose medical marijuana system is fascistic compared to that of Washington. With minimal effort, virtually anyone can get marijuana for recreational use through the current system. Critically, there is no tax, meaning that it will likely underprice the legal recreational market. If you are trying to maximize state tax revenue, that hits you right in the pocketbook.

The state has an available solution, which is to close the medical system. Recreational users currently in the medical system would thus have to start paying tax to use their drug (entirely consistent with the initiative’s concept of regulating pot like alcohol). The small proportion of medical marijuana users with AIDS, cancer, terminal illnesses etc. could be issued a license that allowed them to purchase marijuana tax free within the legal recreational market.

3. The black market in Washington is large and resilient

Despite the easy access and lack of tax in the medical marijuana system, most marijuana in Washington is sold in the black market. Even though risk of arrest for marijuana possession is very low (About one arrest for every 10,000-15,000 joints smoked), one would think that that eliminating that risk entirely through a medical market would have tempted more people out of the black market. This challenges the assumption that black markets necessarily fade away when a legal market is available.

The size of Washington’s black market means that even if the medical system were eliminated, the state would miss out on a very large amount of potential tax revenue. This problem could be addressed with a burst of high-profile enforcement against the black market as soon as the legal recreational market is up and running. A few big time illicit suppliers should be brought to trial, with the police and prosecutor generating as much press as possible throughout the case to send the proper signal about how the new marijuana regime works. Any marijuana users caught in the dragnet would be given a warning and a list of legal outlets where they can purchase in the future, thereby enhancing future state tax revenue.

4. The State will allow vertical integration of growers and processors

Even though the initiative envisioned an industry with a tri-part structure, a curious decision was made to allow the same individual to hold both a license to grow and a license to process. To compound this problem, such licensees are exempted from the 25% tax otherwise levied in the grower to processor transfer.

Vertical integration in itself will lower tax revenue by increasing efficiency and thereby lowering price. And in this case the drop in revenue is even greater due to the decision to waive taxes when the grower and processor are the same licensee.

It would be wise for the state legislature to reverse this decision in the future. There are enough barriers to obtaining marijuana tax revenue without compounded the challenges with self-inflicted wounds.

[Cross-posted at The Reality-Based Community]

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Keith Humphreys

Keith Humphreys is a Professor of Psychiatry at Stanford University and served as Senior Policy Advisor in the White House Office of National Drug Control Policy in the Obama Administration. @KeithNHumphreys