THE BLOG
02/07/2014 03:18 pm ET Updated Apr 09, 2014

How Not to Tax Marijuana

With marijuana legalization gaining steam, we might ask not just whether to legalize, but how. Here are three tax mistakes that California and other states can still avoid.

Mistake 1. Collecting late

Alcohol and tobacco taxes get collected right up front, at the beginning of the supply chain, as product leaves the plant. The main federal and state taxes get collected then and there. Sure, at retail checkout, some states collect another tax, but that is just a sales tax -- no more than the tax you pay on shoe strings or key rings. The targeted vice tax was collected already.

Though Colorado and Washington tax recreational marijuana at the wholesale level, they are both counting on retail taxes for most of their marijuana revenue.

The reason all the main alcohol and tobacco taxes are collected ASAP, before a retail sale, is to prevent leakage during the supply chain. When tax is paid at the bottling or manufacturing plant, shoplifting at the retail store won't beat it. The store clerk who pilfers, gives a friend a break, or makes an honest mistake is way too late to beat that tax. And in the middle of the supply chain, when a truck driver alleges that his whole load was hijacked, his company may suffer, but the taxman has already been paid. "Collect early" is the first lesson in Excise Tax 101.

Colorado and Washington will collect some retail taxes, because not everyone will cheat - but that late tax net is porous. Some revenue will escape.

Mistake 2. Taxing manipulable price

We tax alcohol by gallons and tobacco by pounds. For liquor and wine, we factor in potency - percentage of alcohol. Volume and weight are easy to measure. So is alcohol content. Today, taxpayers don't go to court to fuss about the size of a shipment leaving the plant. The facts and the tax are obvious.

But so far, Colorado and Washington are trying to tax only by percentage of price. That's easy, and quick. Setting up weigh stations and testing facilities would take time. And they mean more government - which many in the marijuana community, driving legalization, feel justified in distrusting.

Price, though, unlike weight, can get slippery. For instance, what if the stated, manipulated price is . . . zero? What's the tax then? Hotel rooms featuring free marijuana are already popping up. Don't be surprised to see "expensive" e-marijuana vaporizers sold in a package with "free," highly potent cartridges. Tax-free? No way. How much is the tax? There'll be an argument.

The killer problem comes when a garden-to-customer business owes a wholesale price-based tax. Colorado is struggling with that today. There is no wholesale sale, so somebody has to make up a "transfer" price to tax. That's crazy. Accountants, economists, lawyers, and judges will have to sort out transfer prices again and again. Arguing about transfer prices is how fabled tax wizards make the big bucks.

Mistake 3. Tying lawmakers' hands

Federal taxes on alcohol and tobacco are regular laws, changeable whenever.

That's the kind of free hand that untried taxes need. Marijuana prices could collapse. Free to innovate, the industry will drive down pre-tax prices as economies of scale kick in. But an order of magnitude greater is the "prohibition premium" - the compensation for risk, which drove illegal prices so high. That will go to zero. Ultra-low prices could bring a backlash or federal intervention as product leaks out of state or to kids.

Amending Washington's initiative, during the first two years, requires a 2/3 supermajority - not a major obstacle if consensus for a fix develops. But Colorado's Taxpayer Bill of Rights famously requires November votes on legislative tax increases.

At the beginning of a voyage into unexplored territory, putting the ship on autopilot with the throttle and the wheel locked in place for years might lead to . . . shipwreck.

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What about this year's crop of marijuana revenue proposals? Some ace the test, avoiding late retail collections, price manipulation, and rigidity. Bills in Maine, Maryland, New York, and Rhode Island - and an initiative in Alaska - tax at the wholesale level by weight, and don't tie lawmakers' hands. That's 3 for 3 right. But the most prominent California initiative, The Control, Regulate and Tax Marijuana Act, would tax only at retail by percentage of price, and would freeze taxes through 2022. That gets everything wrong: 0 for 3.

We are just figuring out how to legalize marijuana. Some legalization plans will work, but some won't. We can follow, adapt, or learn from models for tobacco and alcohol - which we've been forming and reforming since Colonial times. That way, we can at least avoid making the same old mistakes over and over. We'll be making plenty of new ones.