New Jersey Is Trying to Figure Out How to Tax Weed

(Bloomberg) -- It’s a question straight out of economics 101: What’s the optimal tax rate on legal marijuana if the goal is to eliminate the black market?

That’s being debated on the West Coast as legal marijuana moves into the mainstream. There are signs that California, with its longstanding pot culture and thriving black market, is taxing weed too much, while Washington state has already moved to lower its rate.

Now, New Jersey could be entering the fray, prompting a conversation about just how elastic the demand is for cannabis on the East Coast. Put another way, how much more are consumers willing to pay to buy pot legally in a retail store?

The argument for marijuana legislation, generally speaking, is that a lot of people are already consuming cannabis, so it’s better public policy to legalize and tax it, especially when there are roads and schools to repair. Lawmakers debating the issue are typically trying to balance two goals: generating revenue to boost state coffers while also creating a legal market that will put street dealers out of business.

‘Price Matters’

“You have to give people an incentive to come in from the cold,” said Scott Hammon, a California accountant and chief operating officer of the MGO-ELLO Alliance, which offers tax and accounting services to the cannabis industry. “For anybody who uses cannabis, at some point price matters.”

New Jersey Is Trying to Figure Out How to Tax Weed

The tax issue could be the final hurdle for New Jersey, which is poised to become the second East Coast state to legalize the sale of recreational marijuana. The legislature has advanced a bill that would set the tax rate at 12 percent, while giving local towns the right to tack on an additional 2 percent. Governor Phil Murphy, a Democrat, has said he prefers a 25 percent rate.

He campaigned on a promise to legalize pot and estimated the industry could generate $300 million in tax revenue. Murphy hasn’t weighed in on the legislature’s bill, which could be approved this month. The first retail pot stores on the East Coast opened recently in Massachusetts, where voters passed a marijuana law with a 12 percent tax rate, which the state government subsequently increased to a total of 20 percent. Washington taxes marijuana at 37 percent, while Colorado’s combined levies total 30 percent. California taxes can run as high as 40 percent when local fees are included.

The economics of elastic demand hold that consumers will buy less of a product as it gets more expensive, and the theory is being tested in the various legal markets around the U.S.

East Coast Economics

The tax issue will get more attention once a critical mass of East Coast states have legalized marijuana, industry observers said. And while New Jersey would be among the lowest-tax states if the legislature gets it way, it could be looking ahead to a time when legal marijuana is widely available in New York, Pennsylvania and Connecticut, putting pressure on prices.

The economics of marijuana are different on the East Coast, which is farther removed from places like Oregon and California where cultivation has thrived historically. Those states, where weed prices have always been lower on the street, have struggled to eliminate the black market, in part because high tax rates and regulatory red tape have made it attractive for some producers, sellers and customers to stay underground.

New Jersey would do well to study Colorado if it wants to combat the black market, while California is a prime example of what not to do, said Tom Adams, managing director of industry intelligence at BDS Analytics.

Light taxation and liberal licensing under Colorado’s adult-use law slashed the black market to 33 percent of cannabis sales last year, Adams said. In contrast, illicit sales were 78 percent of California cannabis sales and were even higher this year under adult-use laws that imposed extraordinary taxes and regulatory hurdles, he said.

Black Market Prices

Taxes and regulations add about 77 percent to California cannabis prices, Adams said. A California dispensary that charges about $11.08 a gram could be undercut by drug dealers who could charge close to the wholesale price of $6.25, and as a result, the state’s legal sales will shrink this year, he said.

“California has increased the appeal of the black market because of its tax and regulatory load,” Adams said. New Jersey has nearly $100 million of legal cannabis sales under its medical program, with another $1.3 billion sold illegally, he said.

“We have a model in Colorado suggesting that most of New Jersey’s illicit market could go legal quickly,” Adams said.

Think tank New Jersey Policy Perspective calculates the black market for weed differently, estimating it’s more than $850 million in the state, using an average price of $350 an ounce. As the legal market develops, the tax rate is important, but so is access to the product, said Adam Orens, co-founder of the Denver-based Marijuana Policy Group. He said if a consumer can’t conveniently access legal pot, for instance if there are too few stores or not enough product, the black market won’t go away.

“The availability and the price work together,” he said. “They could probably get away with charging 25 percent, but if truly want to get rid of the criminal element you have to think about access.”

Jonathan Caulkins, a drug policy researcher and professor at Carnegie Mellon University, considers the debate over marijuana taxes silly. In his eyes, it doesn’t make sense for states to set the tax rate low in a bid to quickly eradicate the black market. He argues that cannabis consumers will gravitate to retail stores, even if the prices are high, with societal norms eliminating illegal sales.

Cannabis Commodity

He sees marijuana becoming a commodity, like wheat or cotton, and that eventually the price per gram will plummet, leaving states without their promised pot of gold from tax revenue if their tax rates are low.

“It’s fine if the market is small five years after legalization, you don’t have to lose the benefit of a sensible tax rate,” Caulkins said.

So far, there’s little consensus about the right way to tax marijuana. One idea -- starting the tax rate low to make prices competitive and then hiking it in subsequent years -- had been on the table in New Jersey before the Legislature settled on its combined 14 percent rate. There’s also an argument that many existing cannabis consumers, and some who are curious but waiting on the sidelines, would prefer not to break the law, and will be willing to pay up to obtain marijuana legally.

Another part of the appeal of shopping legally: Cannabis dispensaries on the West Coast have massive menus of buds, edibles, vape pens and other products, far beyond the offerings of the typical street dealer.

“In the early days of a program, 25 percent is too high when the infrastructure isn’t there to meet demand,” said Kris Krane, president of the cannabis company 4Front Ventures, and a former executive director of Students for Sensible Drug Policy. “But in the end, it might not matter that much -- once the market develops, people get used to it.”

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