Refracting Green

I characterize the current push towards marijuana legalization in America as “refracting green”.  Refraction–or the change in direction of a wave due to a change in its transmission medium–is the phenomenon that leads us to misjudge an object’s position due to distortions caused within our environment.  Many policymakers, having realized that marijuana is a valuable commodity and not nearly as dangerous as our other legal drugs (nicotine, alcohol, caffeine, etc.), are hoping to cash in on this market by “formalizing” it–in other words, legalizing the drug, regulating its production and distribution, and taxing the resulting product.  Conversely, this formalization is also supposed to ensure control where the “war on drugs” could not.  Participants in the marijuana industry see it similarly; legalization ought to bring more profits by allowing access to customers who were out of reach before (due to the robust network characteristics of illegal marijuana distribution networks) and minimizing prosecutorial risk.  The pursuit of money–particularly in the realm of policy making–has distorted (and made impossible) the goal of control.  It has also made it impossible for the burgeoning, legal marijuana industry to operate legally.  How could this be?  It’s all about the taxes.

How should marijuana be taxed?  The answer depends on the goals of policy makers and on the structure of the existing local (informal market) for marijuana.  One of the least-considered issues is how the current, informal market will interact with newly created, formalized markets; researchers often view illegal and legal markets as separate entities, but they are really all part of a unified commodity production market.  I’ll provide an overview of the Washington approach, then offer my thoughts on how the Oregon market requires a unique approach (subsequent post).

Washington

Washington’s marijuana law is a sterling example of how to ensure actor non-compliance. Here’s why.  Washington adopted a three-tier distribution system similar to the much-maligned alcohol market (though producers can also hold processor licenses under newly adopted regulations) and has elected to impose a 25% tax at each stage of production/processing/retailing, as well as local sales tax to end consumers.  These rates were codified by I-502 and are, therefore, not alterable by the agencies tasked with implementing marijuana legalization.  Washington’s state budget agency (OFM) has projected that growers will receive $3 / gram, processors will receive $6 / gram, and the pre-tax retail price will be $12 / gram.  Retail sales taxes average 8.87% in the state.  Since the OFM doesn’t tell us if the “pre-tax retail price” includes the 25% excise tax, we end up with a wide range for the predicted average consumer price:  an ounce of legal marijuana should cost consumers between $370 and $465.  The company hired to provide analysis and policy recommendations–BOTEC–has produced a number of white papers analyzing the economics and consumer decision making processes at play in this newly formalized market.  As they note,

“Anecdotal evidence suggests that consumers will pay a higher price for legal, tested, and regulated marijuana than for black market product. What is not clear is how much more consumers would be willing to pay. If the price premium to purchase from a legal operator is set too high, consumers at some point will prefer to purchase from an illicit operator if doing so will save them significant money.”

Time will only tell if these retail prices are low enough to lure consumers in; more information on Washington’s informal market is needed to assess the viability of state-sanctioned marijuana sales.  My research on the Oregon marijuana market–which is only separated from Washington by the Columbia River–demonstrates that the average price per ounce in Oregon’s informal market is $177.  Will consumers willingly pay 200% more to legally purchase their marijuana from a store?

To make matters even more complicated, BOTEC has recently suggested that the original OFM analysis of retail prices is not accurate for compliant retailers due to federal income tax laws and because compliant producers will need to charge more per pound ($3125 vs. $2500) to earn modest profits from their trade.  After providing various income scenarios for growers, processors, and retailers, BOTEC argues that:

“Federal income taxes will have a much larger impact on pricing behavior, especially when we start to consider implications for IRC Section 280E. Retailers, unlike producers and processors, have many costs that might be disallowed for tax deduction purposes under this law provision. In theory, if Section 280E were to be strictly applied, the retail marijuana industry simply could not exist because the economics could not support income taxes calculated on gross margins. Under this theory, the excise tax the retailers pay to Washington would not be deductible. Using the average sized retailer as an example, the federal income tax would be $417,400, but the retailer would only net $392,200 before payment of any excise tax or federal income tax. Thus, even excluding the retailer excise tax, the retailer would not have enough cash to pay the federal income tax (assuming strict application of Section 280E).”

To make a profit under the new legal regime, producers, processors, and, especially, retailers will be forced to either sell marijuana for exorbitant prices (compared to the black market) or become creative in their marijuana acquisition programs.  Washington’s tax structure is essentially nudging would-be legitimate marijuana operators into the black market to remain profitable.

It gets worse.  Washington has set a limit on the total amount of licensable growing space for the state, which will be divided amongst licensed producers; it amounts to 2 million square feet or, roughly, 46 acres.  There is no distinction made between outdoor and indoor production–if it’s used to grow marijuana, it counts toward the 46 acres.  Is this enough to meet Washington’s marijuana demand?  To find out, we need to consider the use patterns among specific demographic groups.  First, no one under 21 years of age will be allowed to use.  Second, the use rates differ between age groups (21-25 are most likely to use).  Third, use amounts differ dramatically between user types (light and heavy).  Since no study has assessed the amount consumed by individual Washington users, we’ll also have to substitute data I’ve collected on Oregon users (grams / month).  This can be formalized as:

Yearly Demand = Light User Demand Model + Heavy User Demand Model

where:

Light User Demand = ((21-25 POP * % Users) * Light Use Amount) + ((26+ POP * % Users) * Light Use Amount)

Heavy User Demand = ((21-25 POP * % Users) * Heavy Use Amount) + ((26+ POP * % Users) * Heavy Use Amount)

or

218,437.905 lbs. = 17,727.33 lbs. + 200,710.575 lbs.

The Washington marijuana market demands approximately 218,000 pounds of product each year.  With the capped growing space policy (46 acres), each acre licensed for marijuana production will have to yield a minimum of 4,748 pounds of finished product to meet the state’s yearly demand.  And those are perfect conditions (which do not exist in Washington!).  Throw in a conservative 15% loss rate for pests, molds, and bacteria and each acre will need to produce close to 5,500 pounds.  Many outdoor marijuana farmers in Southern Oregon have suggested that each plant should have a footprint of 20 feet x 20 feet (400 square feet).  This reduces the spread of disease, maximizes air flow, and allows farm workers enough space to operate without damaging plants.  Using this calculation, each outdoor acre can safely support 109 marijuana plants; the entire state would have 5,014 legal marijuana plants.  Each of these plants would have to yield over 50 pounds of finished marijuana to meet consumer demand.  Have you ever seen a 50 pound marijuana plant?  No one has.  How about a 25  pound plant (218 plants per acre)?  No one has.  A more likely scenario–involving large-scale green houses and costly supplementary lighting–is a 10 pound average per plant @ 109 plants per acre:  this would result in about 50,000 lbs. of finished marijuana and a 168,000 pound shortfall.  Where will it come from?  Well, who’s located nearby and grows a lot of pot?

It’s no wonder that BOTEC’s president–Mark Kleiman–responded to questions about marijuana “leakage” out of Washington as “a non-problem”.  The Washington system was designed to underproduce expensive marijuana; it will not be economically feasible for individuals to ship legally produced marijuana out of the state (a win for advocates of marijuana control in the state).  On the other hand, it forces the legitimate marijuana industry to rely on illegally produced marijuana, both from within and outside of the state–which limits the likelihood of collecting excise taxes and a full reporting of marijuana-related incomes (BOTEC calculates two compliance rates for their tax estimates:  100% and 97%–neither seem likely).

This approach strikes me as a 20th century solution for a 21st century problem.  We have much more effective tools available to us to enable compliance and protect new participants in the formal market.  Things are taking off at the Oregon legislature and I’ll post my thoughts on appropriate ways forward soon.