How Cannabis Taxes Work, and Why They Backfire

Cannabis taxation was designed with two goals that pull against each other: raising revenue and discouraging use, while also displacing the illicit market. Set rates too low and you forgo revenue. Set them too high and you keep the unlicensed market in business.

Several jurisdictions have discovered the second problem the hard way.

The Three Ways Cannabis Gets Taxed

Ad valorem, by price. A percentage of the sale price, like most sales taxes. Simple to administer, and revenue falls when prices fall, which is exactly what has happened in maturing markets.

By weight. A fixed amount per ounce or gram, often at different rates for flower, trim and fresh plant. Revenue is stable regardless of price, and it becomes regressive as prices fall, since the tax becomes a larger share of a cheaper product.

By potency. A rate tied to THC content. The argument is that taxation should track the intoxicant, as with alcohol taxed by proof. In practice it is difficult, because potency testing is inconsistent and inflation-prone, so a tax based on reported THC creates an incentive to report lower numbers, reversing the existing incentive to overstate them.

Most jurisdictions use a combination, then stack general sales tax and local taxes on top.

Stacking Is the Real Issue

A single purchase can carry a state excise tax, a state sales tax, a local cannabis tax and a local sales tax. Combined burdens well above 30 percent have been common in some markets, and in high-tax jurisdictions the total can approach or exceed 40 percent.

Compare that with the untaxed alternative available from an unlicensed seller who also skips testing, tracking, packaging and licensing costs. The legal product is more expensive before anyone competes on quality.

Section 280E Sits on Top

Federal tax law compounds the problem. Section 280E prevents businesses trafficking in Schedule I or II substances from deducting ordinary business expenses, so licensed cannabis operators cannot deduct rent, payroll or marketing.

That is not a consumer tax, and it functions like one, because operators must price to survive an effective federal tax rate far above a normal business. Consumers pay for it in retail prices, and it is a major reason legal cannabis cannot easily undercut illicit supply.

What Happens When Taxes Are Too High

The pattern has repeated:

1. High taxes and licensing costs push legal retail prices above illicit prices. 2. Price-sensitive consumers stay with unlicensed sellers. 3. Legal market volumes come in below projections and tax revenue disappoints. 4. Legal operators struggle, some fail, and supply consolidates. 5. The jurisdiction cuts or restructures taxes to compete.

California's experience is the most cited, including eliminating a cultivation tax after it became clear the structure was undermining the legal market it was meant to fund. Other states have made similar adjustments.

The general lesson is that cannabis tax policy is competition policy. The relevant comparison is not what the state would like to collect, it is what the unlicensed seller charges.

Where the Money Goes

Allocations vary and commonly include:

Education, including school construction and programmes.

Public health, including substance use treatment and prevention.

Law enforcement and local government, often to jurisdictions permitting retail.

Social equity and community reinvestment in some jurisdictions.

General funds.

Colorado has collected well over a billion dollars cumulatively since retail sales began, and other large markets generate comparable or larger sums annually. That is real money, and it remains a fraction of a percent of total state budgets, so it funds specific programmes rather than transforming public finances.

Revenue has also declined in several markets as wholesale prices fell, which is a problem for jurisdictions that built spending commitments on ad valorem projections.

What Consumers Can Do

Check whether prices are pre-tax or post-tax. Menu prices frequently exclude tax, and the difference at the counter is substantial.

Compare on price per milligram of cannabinoid rather than per package.

Understand local variation. Neighbouring municipalities can differ significantly in local cannabis tax.

Recognise what you are paying for. Testing for pesticides, heavy metals, solvents and microbial contamination is part of the cost difference, and it is the part with a real safety benefit.

Bottom Line

Cannabis is taxed by price, weight or potency, then stacked with sales and local taxes, producing combined burdens that have commonly exceeded 30 percent. Section 280E adds an effective federal penalty that operators must price for. Where total costs push legal prices above illicit ones, the illicit market survives, which is why multiple jurisdictions have cut cannabis taxes to protect the legal market.

Disclaimer: This article is for educational purposes only and does not constitute tax, financial or legal advice.