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With Pot Taxes, It’s Bad to Get Too High

New York’s 13% levy on legal cannabis sales should help it avoid the mistakes of states like California, whose hefty taxes help underground dealers.
Optimizing tax rates on marijuana is a balancing act. Photo: KENA BETANCUR/AFP/Getty Images
By
Carol Ryan
Close Carol Ryan
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  • carol.ryan@wsj.com
April 16, 2021 5:30 am ET

This year will be the first that New Yorkers can legally light up a joint on April 20, the unofficial marijuana holiday known as 4/20. It will still take time to persuade them to buy supplies from a licensed seller rather than an illegal dealer, but a reasonable cannabis tax rate should help.

New York is one of several U.S. states that have recently gone legal. New Mexico, New Jersey and Virginia all signed or approved adult-use pot laws this year. Based on the latest tally from the Marijuana Policy Project, 18 states have now legalized recreational cannabis across the U.S. and 36 let citizens use the drug for medical reasons.

New York Gov. Andrew Cuomo says the marijuana industry could eventually generate $350 million in annual taxes for the state. That is a modest sum for New York, which raised $81 billion in levies overall in the 2020 fiscal year. But if the governor’s estimate is right, pot will become a bigger source of tax revenue than alcohol, which generated $260 million last year. This is already the case in Illinois, where monthly pot levies overtook alcohol for the first time in February.

It is tempting for newly legal states to jack up cannabis taxes, especially as some governments look for ways to shore up their long-term finances after the pandemic. Tax revenue projections must be generous to get conservative politicians and voters behind a legalization push in the first place. And the cash has to at least cover the cost of enforcing a legal marijuana market and remedies for social problems linked to the drug. New York will plow a fifth of whatever cannabis tax revenue is left after expenses into drug-treatment programs.

But very high taxes can cripple the legal market. Across the U.S., according to industry adviser MPG Consulting and others, two-thirds of marijuana purchases still happen with old-school drug dealers, who easily outcompete higher-cost licensed players. The New York cannabis market is already worth around $4.6 billion, MPG added. Luring all that business into the formal economy will be a challenge.

The tax rate New York has opted for is probably about right. The state will charge a 13% excise levy on the sales price and an additional fee based on a product’s strength—just as stronger alcohol like liquor is taxed more heavily than beer. All in, New York will have a 21% effective tax rate for the dried flower that is smoked in a joint and 25% on more potent edibles like cannabis-laced gummy bears, according to MPG. These are well below levels in Washington, which has the highest effective tax rate in the U.S. at 47%.

New York’s approach should help it to avoid the mistakes made by early pioneers. California went legal back in 2018, but around three-quarters of marijuana sales still take place in its vibrant underground market. California’s steep 36% effective tax rate and the legal industry’s higher operating costs mean that aboveboard cannabis is far more expensive than what can be bought illicitly. A report by BDS Analytics found the markup on legal cannabis is as high as 77%.

California may have a particular problem. Underground dealers in the state can be serious operators. Lax enforcement means they often have store fronts, offer home delivery and may have customer relationships that stretch back decades.

In most states, the good news for investors in listed U.S. cannabis growers such as Curaleaf and Green Thumb Industries is that legal sellers should eventually find it easier to compete. As a state’s cannabis market matures, increased supply tends to reduce prices and the markup on legal pot. Even if licensed sellers will never undercut drug dealers completely, consumers may decide that it is worth paying a small premium for products that have been through safety checks and are on the right side of the law.

Precedents offer reassurance here. When alcohol prohibition ended in the 1930s, it took around four years for the legal market to absorb syndicated bootleggers’ business, according to Ulrik Boesen, a senior policy analyst at the Tax Foundation. The Canadian cannabis market seems to be developing on a similar time scale. By the fourth quarter of 2020—two years after legalization—licensed operators sold 56% of all adult-use cannabis, official economic data shows.

The ultimate goal of New York’s tax authorities, in a rare alignment of interests with investors, is to put old-school cannabis dealers out of business. It will take time, but the state is on the right track.

Write to Carol Ryan at carol.ryan@wsj.com

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Appeared in the April 17, 2021, print edition as 'States Should Resist the Urge To Get Too High on Pot Taxes.'

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