Why legal marijuana is a good argument for tax reform

That was the headline for a story written by Rob Hotakainen of McClatchy Newspapers the other day. In less than a dozen words, it describes much of what’s wrong with the federal tax system.  And in an odd way it helps explain why tax reform is such a good idea.

State-legal marijuana producers and retailers are seeking to take advantage of deductions they are now denied under their ambiguous legal status. And, as I’ve written in the past, they probably should be allowed to do so. But some may want to get into the tax system just so they can harvest the many generous deductions it offers.

That pungent odor you smell isn’t Blue Skunk Special. It may be the sweet scent of a tax shelter wafting through the door.

First, let’s parse what’s going on. Several states have recently made marijuana legal. But weed remains illegal under federal law. Thus, while growers and sellers must pay federal income tax on their profits, they are explicitly barred under the Revenue Code from claiming deductions or credits.  Buyers don’t pay federal excise taxes as they might if they purchased, say, beer or cigarettes.

To be clear, the state-legal marijuana industry Rob wrote about doesn’t want to pay more taxes itself. Indeed, by gaining access to deductions, it would pay less. Buyers, on the other hand, would pay a new tax. Backers estimate a $50-per-once retail-level levy would generate about $20 billion a year.  

This is enough to give at least a few members of Congress the revenue munchies. And a couple of bills have been introduced to legalize, regulate, and tax sales of grass. One would create a national system. The other would allow states to tax marijuana—and grant deductions. Washington State wants to impose a 25 percent Value-Added-type tax on producers, processors, and retailers.

It would be interesting to figure out whether such a levy turns out to exceed an income tax without deductions. But either way, much of that tax would be passed on to buyers in the form of, um, higher prices. How much would depend on the willingness of buyers to pay more for legal taxable weed rather than lower-cost but riskier illegal dope. 

The new tax liability is all about the buyers, while growers and sellers have their eye on the deductions that come along with being in the tax system. They may be dope sellers, but they are still business people who want to maximize after-tax returns.

For instance, retailers could deduct costs such as rent, legal fees, and wages. And, like other small businesses, they might write off automobiles and office equipment. Growers could deduct the cost of farm equipment and the like.

This does get complicated. The current uncertain system discourages legal, regulated sales and encourages a black market, even in states where marijuana is legal. After all, paying federal tax without the benefit of deductions is a huge disincentive to reporting marijuana income. On the other hand, access to deductions may encourage the sort of gaming that infects today’s tax system.

While I’m sure this isn’t what the state-legal marijuana industry had in mind, the curious situation in which it finds itself may be yet another argument for trading off all those tax preferences for lower rates. After all, in a system without deductions and credits the marijuana industry would be treated no differently than any other business.

The legal dope industry is probably not the tax reform poster child House Ways & Means Committee Chairman Dave Camp (R-MI) is looking for. Still, its plight is an instructive story.