As more states usher in recreational marijuana, they face a thorny challenge: how to tax it effectively.
That’s especially true when it comes to prepping for eventual federal legalization, according to a new report from Tax Foundation.
The study shows that 23 states now have taxes on recreational marijuana, with methods ranging from weight-based levies to percentage taxes on retail sales. Some states have adopted more novel approaches, like Connecticut’s tax based on THC content.
However, striking the right balance is proving difficult. Set taxes too high, and states risk pushing consumers back to the illicit market. Too low, and they miss out on potential revenue.
“Recreational marijuana taxation is one of the hottest policy issues in the U.S.,” said Adam Hoffer, co-author of the report. “Many states have elected to regulate and tax legal marijuana sales, despite the ongoing federal prohibition.”
Connecticut, for instance, chooses to tax marijuana products based on their potency, charging $0.00625 per milligram of THC in plant material and $0.0275 per milligram in edibles. But the tech behind measuring THC is expensive to administer, which cuts into the revenue.
In contrast, Arizona opts for simplicity with a flat 16% tax on retail sales, but that approach fails to consider variable product potency or changing market prices.
“The wide variety of marijuana products and potencies renders taxation complicated,” the report noted.
Arizona also preemptively addressed the possibility of a federal excise tax by capping the combined federal and state tax rates.
“If a federal excise tax is imposed, AZ caps combined rates to 30% and automatically reduces the state rate to combine to 30%,” according to the report.
The ongoing federal prohibition adds another layer of complexity. With interstate commerce banned, each state operates in isolation, creating what the report calls “a siloed market within each legalized state.”
“Significant differences in tax designs may create negative effects and opportunities for tax avoidance,” it said.
The authors suggest that states should find a way to create tax systems that complement each other before detangling it becomes too onerous.
“States should prepare to harmonize their tax designs once interstate marijuana business is allowed – and would be better advised to coalesce around best practices now, before systems become more difficult to reform,” the report advises.
Some states are already trying to adapt to new dynamics. California recently switched from a wholesale tax to one based on retail receipts, while New York abandoned its THC-based tax for a simpler wholesale model.
The Tax Foundation recommends taxing marijuana based on potency where possible, arguing the approach “most effectively targets the actual harm-causing element.” It suggests taxing by weight only when “THC content is too difficult to measure.”
At the same time, the government-sponsored study recommended that the Centers for Disease Control and Prevention develop best practices for protecting public health in states with legal cannabis, including guidance on taxation measures.
Recent data from the U.S. Census Bureau shows how these various tax structures perform in practice. East Coast markets generally saw tax receipts increase in the second quarter of 2024, with New York topping the list with a 40% increase from the first quarter, collecting $28 million in tax revenue. Massachusetts saw a 21% rise, collecting $50 million, while Connecticut reported a 10.9% uptick, with $4.7 million in tax revenue.
However, some Midwest and West Coast states saw declines. Missouri’s tax collection dropped by 10%, though still delivering $18 million. California, while remaining the biggest contributor with over $155 million, saw a 1.1% downtick.
With public support for legalization eclipsing 70%, according to a 2023 Gallup poll cited in the report, more states are likely to enter the fray. Indeed, five states have legalization measures on their November ballots this year.
A separate report from the National Academies of Sciences, Engineering, and Medicine called for urgent federal action on U.S. cannabis policy, warning that state-level legalization efforts often prioritize commercial interests over public health.