How to regulate a legal cannabis market

In what had before seemed a distant future for pro-cannabis legalisation advocates, cannabis will soon be legally traded in recreational pot shops as a market good.

The passing of Amendment 64 to the Colorado Constitution last November allows U.S. states to create their own laws regulating marijuana production and consumption within sanction of the federal law.

And back in March, the Colorado Marijuana Task Force released a series of 58 recommendations for the regulation and taxation of non-medical marijuana.

Before Amendment 64, regulatory options on cannabis use and possession worldwide ranged from total prohibition with criminal penalties, prohibition with civil penalties, partial prohibition prohibiting commercial cultivation and supply, a regulated cannabis market like alcohol or tobacco, and the free availability of cannabis with a minimum of regulations [1].

Cannabis laws differ from state to state in both the U.S. and Australia, swinging between outright prohibition with criminal consequences and ‘soft’ prohibition attached to fines and treatment referral. Only recently have brave Colorado and Washington State started to venture down the way of market regulation.

Why should this happen? It’s important to note that when it comes to demerit goods like illicit drugs, alcohol and smoking, economists will almost always come down the side of regulation. Allowing underground markets for these goods to operate (and operate they do, ostentatiously) amounts to no less than total market failure. You see, consumers will always be paying a premium on illegal goods, which are by nature not freely available and limited in supply. Under the correct legislation, the government can capture that excess, divert resources to needy programs and save on judicial costs in the process. Taxes collected would serve as a funding mechanism to support the new regulatory and enforcement scheme.

This is just what the Colorado Marijuana Task Force is hopeful for.

The proposed regulatory structure is two pronged: first comes production regulation, then taxation measures.  What is being trialed out in Colorado will be a ‘vertical integration’ model – uniting the cultivation, processing, manufacturing and retail sales in ‘a common enterprise under common ownership’ [2]. This makes state licensing restrictions easier to impose and precludes most of the messy parts of enforcement.

As for taxation, the marijuana regulation industry can borrow and improve on the examples given by alcohol and cigarette industries. Too high a figure, and the law risks being sidelined by a persisting underground market. Furthermore, a combination of both sales and excise taxes could be used to maximise tax revenue.

A sales tax included in the price of the good would likely place the tax burden on consumers, and the precise percentage amount could be decided by popular vote. An excise tax, similar to the alcohol tax in place, can be further imposed on the transaction from cultivation to product manufacturers or retailers.

Colorado State has earmarked the first $40 million collected from tax revenue to go towards public school capital construction. A worthy end that is likely to appease detractors of cannabis legalisation, but overall is this a good model of taxation to use?

To answer this question we’d have to examine the ways marijuana can and will be taxed. It would be folly to tax marijuana the same way as alcohol. That is, a tax rate based on volume or weight. Inflationary fluctuations cause tax rates to decline over time due to the ‘collection lag’: the difference in time between a transaction and the actual payment of tax. As prices increase, a fixed tax rate will yield lower revenues over time.

On the other hand, if excise tax rates were based on the value of transaction – the price of good added other licensing and packaging costs, vertically integrated businesses which own production through to retailing processes would be tempted to understate the price.

It seems that the only viable option is to tax marijuana production based on an average market price as determined by state taxation departments – no more, no less.

Of course, economists must also consider the positive and negative externalities accompanying legislation of this kind. Where possible, state regulation should mandate public education about effects of marijuana use and safety. This sort of healthy instruction is otherwise impossible under criminalisation. Society could begin to treat drug addiction as a public health issue, rather than a crime that unequivocally merits punitive measures.

There are a lot of missing blanks remaining, mostly due to the obfuscation of data concerning activities deemed to be criminal. “It’s difficult to size up a market even if it’s legal, certainly if it’s illegal,” said Jeffrey Miron, a Harvard University economist cautions [3].

While Australia is missing the public support necessary for this level of legislation as yet, Australian lawmakers, legalisation advocates and detractors will be closely watching the implementation of Amendment 64 over coming months.



1. Hall, W.D. (2008), What does the history of Australian cannabis policy suggest about its likely future shape? The University of Queensland Centre for Clinical Research

2. Brohl, B. and Finlaw, J. (2013), Task Force Report on the Implementation of Amendment 64: Regulation of Marijuana in Colorado, State of Colorado

3. Wyatt, K. and Cooper, J. (2012), Legal Marijuana Could be Tax Windfall, But Skeptics Abound, Huffington Post