Are States Ready for Federal Cannabis Legalization?

Are States Ready for Federal Cannabis Legalization?
(AP Photo/Jessica Hill)
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Over the past month, conversations about federal reform of cannabis have accelerated. With 40 percent of the U.S. population living in states where adult-use cannabis is legally accessible, action from the federal government is inevitable. But it is not clear that state lawmakers are prepared for what’s to come.

Eighteen states to date have passed bills that regulate the sale, processing, and consumption of adult-use (21 and older) cannabis. The curious legal circumstances of these markets, legal at the state level and illegal at the federal level, have resulted in a variety of regulatory and taxation frameworks — most designed for a situation without interstate competition and trade.

Because of federal prohibition, cannabis products cannot cross state borders, meaning states control the entire value chain, from seed to sale. Cannabis consumed in New York must be grown and processed in New York; cannabis consumed in Illinois must be grown and processed in Illinois.

Fast-forward to a day when cannabis is no longer a Schedule I drug — having no currently accepted medical use and high potential for abuse — and is grown in Oregon or California but consumed in any state that allows adult use. This may seem elementary, but several states have designed their regulation and taxation with little consideration for federal reform.

This is where problems for states will begin to spiral. 

Take Alaska. Currently, cultivators there are liable to pay an excise tax when they sell or transfer the product to a retail store or processing facility. Once interstate trade becomes a reality, Alaskan consumers could purchase cannabis from anywhere in the country, but Alaskan cultivators would still be stuck paying the state’s excise tax, even if they’re selling out of state.

And it gets worse. Since most states tax cannabis when it’s sold to the consumer, products originating in Alaska would be taxed twice — once by Alaska and once by the destination state — while products that originate in another state but are sold in Alaska would not be taxed at all. As if Alaska cultivators needed more to worry about.

The 16 states that tax retail sales are also in for an unpleasant surprise.

Because cannabis businesses, which are legal at the state level, are still illegal in the eyes of the federal government, meaning they’re unable to benefit from federal tax deductions, resulting in very high effective income tax rates. For similar reasons, many banks decline to offer their services to the cannabis industry out of fear they may be charged with money laundering. Both issues are resolved through descheduling (removal) of cannabis as a drug.

Interstate sales, lower income tax rates, and access to banking services will make the market more competitive and almost certainly result in significant price reductions. Significant price reductions mean significantly less revenue for states that tax based on price.

Uncertainties must be resolved by the states before federal reform takes effect, but the examples cited only scratch the surface.

A slew of other questions remains for the federal government. What happens to medical cannabis if the Food and Drug Administration gets authority to regulate products? How does the federal government design an excise tax for this complex market without disrupting state markets? How can federal and state testing and product safety requirements be aligned, considering how much these differ state by state? How can states crack down on continued illicit sales following a reform intended to decriminalize?

Federal and state lawmakers still have some time to find solutions to these problems before federal legislation is passed — they would be wise to make the most of it. The success of federal cannabis reform depends on it.

Ulrik Boesen is a senior policy analyst with the Tax Foundation, a nonpartisan research organization in Washington, D.C.

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