The Agenda

Marijuana Taxation is Really Confusing

Marijuana dispensaries are mushrooming as a growing number of states permit the medical use of marijuana, and one expects that they will continue to do so as states like Washington and Colorado experiment with new strategies for controlling its recreational use. Yet the tax treatment of marijuana dispensaries is somewhat awkward, and a new bill, the soothingly-titled Small Business Tax Equity Act, aims to fix that. As Alex Rogers of Time notes, it is all but impossible that the bill will become law. It does, however, raise a number of interesting questions about we regulate marijuana, and how we ought to regulate it in the future.

Right now, marijuana dispensaries are unable to claim business expense deductions. Americans for Tax Reform, which backs the Small Business Tax Equity Act, explains the basics. Under U.S. tax law, all income derived from whatever source is taxable, and so the IRS has often gone after criminals operating in the underground economy for failing to pay taxes. One enterprising criminal, facing a tax assessment for income he earned in the course of operating an illegal business, insisted that he had the right to claim “ordinary and necessary” expenses against his taxable income, and a tax court agreed with him in 1981. The next year, Congress created Section 280E of the tax code, which forbids the use of deductions or credits for expenses incurred in the business of selling controlled substances prohibited by federal or state law. Marijuana dispensaries earn income by selling a controlled substance prohibited by federal law, and so they pay what is in effect a gross receipts tax instead of an income tax.

Americans for Tax Reform argues that allowing marijuana dispensaries operating in compliance with state law is a simple matter of tax fairness. “By definition, these businesses are operating in states where their product is no longer illegal,” and so amending Section 280E “has nothing to do with any narcotics that remain illegal under federal and state law.” The problem, however, is that Section 280E targets business enterprises that traffic in controlled substances prohibited by federal or state law, not federal and state law. That is, there is a space between federal and state law that has opened up for a number of reasons, including the following: (1) the regulation of medical practice is a state rather than a federal concern, and international drug control treaties generally exempt medical use; and (2) the federal government recognizes that it can’t enforce marijuana laws without the help of state and local authorities.

So as far as I can tell, and I’m certainly open to other interpretations, Americans for Tax Reform is not quite right to say that marijuana dispensaries “are operating in states where their product is no longer illegal,” as their product continues to be illegal under federal law. The tensions between federal and state law will likely grow as some states, led by Washington and Colorado, move towards permitting the recreational use of marijuana.

Recently, Mark Kleiman of UCLA published a new paper that aims to contain federal-state legal conflicts, and he submitted a letter describing his approach in broad outline to the Senate Judiciary Committee earlier this week. Kleiman argues that the federal government has a strong incentive to cooperate with state governments seeking to reform their marijuana laws. States could simply repeal their marijuana laws entirely, but doing so would greatly exacerbate the tensions between federal and state law and it might lead to a surge in consumption. A tax-and-regulate strategy, in contrast, has the potential to both reduce the size of the illicit market while also controlling use. Rather than close off this option, Kleiman proposes that the federal government create cooperative enforcement agreements with state governments or pass new legislation that would allow for policy waivers. The goal would be for the federal government to work with state governments to create marijuana regulation regimes that advance the legitimate core goals of federal drug policy, e.g., containing violent crime, protecting minor children, and limiting the downsides associated with heavy use of narcotics.

Kleiman is skeptical about the wisdom of creating “alcohol-like” cannabis industries, in which state governments regulate competing for-profit firms. I’ve come to share his skepticism, in large part because I have great confidence in the power of the profit motive. In Drugs and Drug Policy: What Everyone Needs to Know, Kleiman, Jonathan Caulkins, and Angela Hawken observe that “the volume of drug consumption doesn’t depend very strongly on the total number of users.” What really matters is the number of heavy users. The top tenth of drinkers, for example, account for roughly half of alcohol consumption. The implication, according to Kleiman et al., is that “when we create a licit industry selling an abusable drug, the resulting businesses will have a strong profit motive to create and sustain abusive consumption patterns, because people with substance-abuse disorders consume most of the product.”

One alternative approach, which Kleiman describes in his letter to the Senate Judiciary Committee, is to either create a state monopoly on retail sales of marijuana and (perhaps) other controlled substances or to limit production and sale to consumer-owned growing cooperatives. This approach would largely concerns about the tax treatment of marijuana dispensaries, as dispensaries would be supplanted. But I’m guessing this approach won’t please proponents of tax equity for marijuana dispensaries.


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