THC Tax? The Unintended Consequences of a Novel Tax Structure
An Analysis of the THC-Based Tax in New York.
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The Castetter Cannabis Group has researched the effects that a novel THC-based tax proposed by Governor Cuomo would have on a nascent New York Cannabis industry. This report was done in partnership with CCG tax expert Jason Klimek.
Summary
New York is on a track to legalize the adult-use of cannabis, opening a marketplace that is estimated to be worth $3.7 billion in the first year. Not only would the Empire State be the 2nd highest populated state to legalize, but the state attracts millions of tourists each year for its culture, food, and natural environments. New York City is also the financial capital of the world while housing one of the most sophisticated illicit cannabis markets.
Suffice to say, legalization is monumental not just for residents but as an opportunity to export a model globally that promotes equity, small business growth, innovation, and public health. In developing a regulatory structure that will shape the entire industry, how the product is taxed could be one of the most consequential policy decisions to be made. Taxation affects consumer behavior, pricing, supply chain architecture, and could decide who will benefit most.
As of now, there are 14 other states that have legalized cannabis sales to adults, yet none have implemented the type of tax system proposed by Governor Andrew Cuomo.
What was initally included as part of the Governor’s proposal implements a complex system of both percentage and THC percent-based taxation. Levied at the wholesale level, this new way of taxing based on the percentage of THC present in the final product will result in high retail prices that will be uncompetitive with neighboring states and the illicit market. A static excise tax will have a disproportionate impact on small businesses by highly incentivizing large-scale production. We found that this system could also result in hundreds of millions in tax calculation errors based on industry accepted measuring uncertainty.
Overall, the THC based tax proposal could spell disaster for a nascent industry in a state reeling from historic economic losses by adding a layer of unnecessary complexity and costs. In this analysis we will touch on ways the that novel approach could affect all levels of the supply chain and obfuscate the vision for a world leading cannabis industry.
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Key Takeaways:
Tax Structure
Because the final MRTA levies taxes at two levels, the tax compounds - meaning it is a tax-on-a-tax. This departs from the U.S. approach to taxing goods - we generally only apply taxes at the point of sale. The old MRTA applies a tax only at the wholesale level, avoiding the issue of compounding but differing slightly from the standard taxing at retail.
As was seen initially in the Governor's Proposal, the THC-based taxation included in the MRTA is completely tied to the product’s THC percent and the rates differ based on product category. This approach has never been tried before on cannabis nor any other consumer goods that we’ve been able to find. The only other similar structure is in Illinois, as shown below:
Complexity of Tax Calculation
This novel approach also presents unique challenges for both entrepreneurs and the State when it comes to the calculation and collection of taxes.
Measure of Uncertainty
When calculating the tax due, analytical labs will need to report a THC percentage result. However, each lab reports a different Measure of Uncertainty (MU) that could result in varying calculations of tax owed. We estimate that this could conservatively result in potentially $39 million in over or underpayment of taxes each year.
Sampling
Because cannabis plants mature from the top-down, many of the flowers or buds will reach different levels of maturity depending on when they were harvested. In practice, this will result in a batch of cannabis to contain a varying range of THC levels. In our example, using a modest variation of 3% across the total yield on a 17.40% THC crop, extrapolated to 1 million pounds of demand could result in a $258 million margin of error. That is – the state could stand to under or over collect $258 million based on conservative assumptions of the variations on THC level in cannabis plants and testing.
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"Promoting Temperance"
Previously, the Governor’s office explained the THC based structure is “for the purposes of fostering and promoting temperance in consumption…”. This theory most likely draws parallels to alcohol taxes, however, it is likely that the structure would make some products much more expensive than others while driving more sales to the unregulated marketplace. Unlike alcohol, where lower-proof products require substantially more volumetric consumption, cannabis does not have the same type of relationship.
We use an example of different product types in the alcohol and cannabis markets to show that the structure doesn't really "promote temperance".
The equivalency of a shot to a beer is 1:8, whereas the equivalency of a vaporizer
cartridge to flower is 1:2.5.
A Race to the Bottom
As neighbors such as New Jersey and Massachusetts inevitably grow their cannabis
markets and the in-state illicit trade continues to flourish, there will be enormous pressure
on retailers to offer competitive pricing. As a result, cultivators will be expected to offer
lower wholesale, yet their tax burden per pound stays the same. Large producers will
be able to meet the lower prices while balancing the lower profit margins with volume.
This will create an outsized advantage over craft cultivators who will be stuck at a set
cost per pound, inflated by a static wholesale tax, and unable to be reduced without
scaling.
If the taxes were calculated based on a percent of the sale value, as proposed in the
old MRTA, the craft cultivator would have more flexibility to offer competitive pricing.
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High Prices for the Consumer
Applying the same assumptions and using data from other legal states, we find that the old MRTA comes in to be much more competitive and closer to our eastern neighbors in Massachusetts. Importantly, our estimates have New Jersey with a much higher retail price than in New York – which could have the effect of driving business to the Empire State.
Additionally, the increased tax rate on concentrates and edibles creates unsustainably high prices. For example, the median price of a 1-gram cartridge in Colorado is $46.9 The CRTA would create a price at retail for a 1-gram cartridge that is nearly 33% the amount ($58.76). The high price of some products further threatens public health as illicit vaporizer cartridges can be sold as low as $30 per gram. While there is a substantial risk to consumers who obtain illicit vaporizer cartridges, the 200% increase in price on the regulated market could be a high enough disincentive to keep many consumers purchasing from regulated retailers.
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