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The marijuana industry continues to be in a trial-and-error period. Banks, financial institutions, insurers, transport companies, and other businesses are cautiously attempting to find their footing in a booming and lucrative—but risky—market. So are state governments, which have been grappling with questions about the appropriate levels of regulation and taxation. Recent data from California suggests that over-taxation threatens to keep marijuana consumers in the black market. This hurts both the state government and marijuana-related businesses that operate in California. Regulators and entrepreneurs in other states contemplating legalization of recreational marijuana (like Illinois) should heed that lesson as they craft their tax and regulatory plans.

Tax Revenue Versus Industry Growth

With hopes of alleviating budget concerns, state governments are anxious to tap into the new revenue stream available via licensing and taxing legal marijuana sales. This is understandable; when state governments began legalizing marijuana, they often focused on the potential for increased state revenues as justification. Similar to state lottery systems, state governments argued that the taxation and licensing of marijuana products and businesses would provide net benefits to communities by increasing funding for various initiatives. For example, 40% percent of Oregon’s marijuana tax gains go towards a “Common School Fund.” In order to effectuate their funding goals, state governments have implemented expensive licensing regimes and enacted sometimes steep taxes on marijuana.

Marijuana is taxed at a significantly higher rate than most consumer goods: Washington taxes marijuana at 37%, Oregon taxes it at 17%, and Alaska taxes it at $50 per ounce. In California, combined taxes result in an effective 45% tax rate on marijuana. By contrast, most ordinary state sales taxes fall between 5% and 8%. These marijuana-specific taxes are often added to the ordinary sales tax and costs are often increased due to local and municipal taxes.

The question then is whether these taxes are maximizing revenue. An understanding of economics and consumer behavior teaches us that if the taxes are too onerous, marijuana consumers will be incentivized to continue to purchase marijuana on the black market. After all, for most of its history, marijuana was only available on the black market. As a result, marijuana purchasers are likely more sensitive to marijuana taxation and also better equipped to navigate the black market for marijuana than, say, tobacco users have been when tobacco taxes were raised.

Recent data from California suggests that marijuana tax rates of up to 45% are too onerous, to the detriment of both the state government and legal marijuana businesses. For the first six months of 2018, California generated $84 million in tax revenue from marijuana. While that is a substantial number, it is $101 million lower than projected. That certainly suggests that a significant number of marijuana consumers are continuing to purchase marijuana on the black market to avoid the 45% tax rate.

Admittedly, state governments will always be at a certain disadvantage when taxing legal marijuana operations because their competition—illegal marijuana suppliers—will always have an effective tax rate of 0%. And state governments also do not want to set the tax rate too low lest they leave available revenue on the table. But the California data suggests that over-taxation can significantly reduce the population of consumers willing to purchase marijuana in the legal market. And it is not only the state government that is harmed—less marijuana tax revenue necessarily means that there were less marijuana sales for marijuana-related businesses.

Keeping the New Legal Marijuana Industry Viable Via Reasonable Taxes and Regulations

In the coming years, it will be critical for states to develop a viable tax and regulatory scheme for marijuana. Although the legal marijuana industry only accounts for approximately $13 billion right now, the estimated total demand for marijuana (legal or otherwise) is at least $50 billion annually. While most marijuana users would prefer that their purchases be legal, it is clear that price remains the driving force for many. Legalization can provide an economic boon and significant funding to unrelated initiatives, but the utility will be limited if marijuana consumers are taxed out of the legal market.

California appears to have learned its over-taxation lesson the hard way—lawmakers recently introduced a bill that would, through 2022, reduce the marijuana excise tax from 15% to 11% and suspend the cultivation tax. Other states considering legalization, including Illinois, should consider that experience as they enact new tax and regulatory schemes.