Marijuana Taxes are Unlikely to be a Long-Term Fiscal Solution for U.S. States

Carol H Spain 

More and more U.S. states are considering legalizing marijuana, whether it be for medical or recreational purposes. Currently, 11 states have fully legalized marijuana use, while 34 have legalized it in some capacity. Support for marijuana legalization crosses party lines at both the state and federal levels. S&P Global Ratings expects slow-but-substantial growth of legal marijuana over the next decade. This reflects not only a change in public sentiment, but also a practical component for states—net taxpayer savings and a bump in revenues. However, we are cautious about viewing the use of marijuana taxes as a long-term fiscal solution.

Although states frequently cite social equity considerations as a reason to legalize marijuana use, fiscal implications are a key incentive. Legalization can lead to fewer arrests and incarcerations for nonviolent offenses, for example, thereby saving taxpayer money. While some critics argue that higher public health and safety costs, such as related motor vehicle accidents, could offset these savings, we believe there is insufficient research to draw this conclusion. Second, states can collect license fees for dispensaries and levy a sales tax, whether it be for recreational or medical use.

Currently, taxation on legalized marijuana ranges from 10% to 37% of the sale. Based on our research of nine states who collected marijuana tax revenues in fiscal 2018, receipts ranged from 0.2%-2.2% of general fund revenues, with Colorado leading the pack. (see "Is Marijuana Legalization The Answer To States’ Budget Pressures?" published Feb. 21, 2019, on RatingsDirect).

States typically earmark these revenues for health, criminal offense, youth, public safety, and education programs, supplementing or offsetting resources that would have otherwise come from general operating fund dollars.

Notably, many of the states moving toward marijuana legalization and taxation have done so during economic expansion, when budgets should be easier to balance and support for increases in general state taxes, like sales and income taxes, would be greater. Following the recession, however, many states have been more tax-averse, as the general taxpayer might not be enjoying the full benefits of the economic recovery. Also, states have been facing more constrained budgets, as pension and Medicaid costs continue to consume an increasing share of the budget, unmatched by slower revenue growth. As neighboring states legalize marijuana and reap revenues, "fear of missing out" might also come into play.

Why, then, our caution about this approach? The first few years of receipts for early adopters are unlikely to be indicative of future receipts not only for these states, but also more broadly.

Particularly in the first few years of adoption, it is difficult to correctly forecast revenues. There a lack of track record specific to a state's unique demographics and access to other neighboring state markets, and implementation could also take longer than expected. States need licensed stores to open, which can be a lengthy process. Limited access to financing for illegal substances and the cost of regulation can prove a barrier to entry for store owners. Also, the risk remains that federal intervention could hamper revenue collections.

Additionally, marijuana taxes are typically based on the price of the good, not quantity sold, and hence depend on the market price of marijuana. Unlike many other tax sources, marijuana has a deeply entrenched black market, and the legalized product faces steep competition from illegal sources that do not carry the same tax or regulatory burden. Many states also allow marijuana retail sales to be taxed by local governments, increasing the tax burden per sale. To the extent that the taxes imposed on legalized marijuana create a competitive disadvantage for what is available through unlicensed sources, the total revenue available to states remains susceptible to black market leakage and unrealized revenue. In addition, legalization could lead to an increase in product supply, thereby driving down the market price.

At this time, additional revenue from marijuana taxation has not changed our overall view of states' fiscal conditions or credit quality for the better or worse. Although we consider the revenue source unpredictable and adding to budget volatility, when compared to the size of state budgets, the impact is small.