Policy-makers should consider that some Canadians might replace alcohol or tobacco consumption with cannabis. Taxes should be set accordingly.

The looming legalization of cannabis pushes policy-makers to focus on cannabis taxation as a means to either raise revenues, curb the illicit market or reduce potential harms associated with consumption. Not to be overlooked is how taxes and the price of cannabis can alter the demand for potentially substitutable goods, such as alcohol and tobacco. To achieve the desirable economic and public health benefits associated with legalizing cannabis, policy-makers should set cannabis taxes with an eye to how it affects cannabis, alcohol and tobacco use. Further, governments should revise these taxes over time if cannabis prices encourage individuals to consume potentially more harmful products.

Do consumers switch between cannabis, alcohol and tobacco?

The research is somewhat mixed, but the best-quality evidence suggests these products act most often as substitutes for one another rather than being used together. One novel US study looked at alcohol and cannabis consumption just before and after age 21 — the legal age for accessing alcohol. Despite no obvious changes in consumer preferences around age 21, the authors found a drop in cannabis use the month after individuals passed the legal drinking age, suggesting substitutability.

Additional research highlights the complicated, and sometimes conflicting, nature of substitution, based in part on the type of alcohol product (beer, wine, liquors or spirits), as well as the type of cannabis product (cannabis cigarettes, oils or edibles). However, nearly all earlier research has serious limitations: studies on substitution that use data collected before legalization provide only partial results, because legalization affects the broader societal acceptance of cannabis use and can change the perceived safety differences between legal and illegal products.

Most relevant to the Canadian context is recent evidence from Washington State that shows replacement of alcohol and tobacco products with cannabis after legalization. The authors find that a 10 percent price increase of marijuana leads to a 2 percent increase in the quantity of alcohol purchased and a 1 percent increase for tobacco.

Despite some uncertainty in the magnitude of substitution in Canada between cannabis, alcohol and tobacco products, the likelihood of substitution is high and Canadian policy-makers should factor this into their policy plans.

Cannabis legalization and tax revenues from alcohol and tobacco

The federal government currently imposes excise taxes on alcohol and tobacco products and splits revenues with provincial and territorial governments. For alcohol, the excise tax rate is set per litre, with variations depending on the type of alcohol (spirits, wine or beer) and the alcohol content: stronger products with more concentrated alcohol face a relatively higher tax. In provinces where alcohol is sold or distributed to retailers almost entirely through provincial and territorial Crown corporations, the price of alcohol is further controlled through markups rather than taxation.

For tobacco, the excise tax rate and the provincial-territorial tax rates are per carton for cigarettes, per 1,000 units for cigars, per stick for tobacco stick and per gram for other tobacco products.

Cannabis will be taxed similarly to alcohol and tobacco: excise duties at either $1 per gram or 10 percent of a product price, whichever is higher, will be administered federally and then shared among the provinces (in addition to GST/HST). The potential for greater substitution of goods upon legalization has important impacts on the quantities of each good consumed and on tax revenues.

How might total government revenue from the taxation of alcohol, tobacco and cannabis look a couple of years after the legalization of cannabis? We use available alcohol and tobacco data in 2016-17 (from Statistics Canada and Physicians for a Smoke-Free Canada) for our simulation, and we estimate the size of the cannabis tax base using the data in a report on cannabis by the Office of the Parliamentary Budget Officer. The study assumes that if the legal price of cannabis were around one dollar higher per gram than the illicit price, about 65 percent of consumers would purchase legal cannabis. From this, we estimate that tax revenue from cannabis will be slightly above $700 million.

In modelling potential substitution of products, we cautiously approach how well consumer preferences in Washington State would reflect those in Canada. On one hand, taxes on alcohol and tobacco are relatively higher in Canada than in the US, meaning that higher prices on these goods could result in greater substitution of them with cannabis. On the other, cannabis in Canada is already a much more accessible and societally acceptable substance than in the US. Substitution could already be common among some recreational consumers. We conservatively estimate that substitution in Canada would resemble substitution in Washington State. We assume that competitively priced legal cannabis would lower the quantity of alcohol and tobacco consumed by about 2.5 and 2.0 percent, respectively.

Although the introduction of cannabis will lead to greater government revenues, net revenues, in all likelihood, will not go up by a lot, due to lower alcohol and tobacco revenues. Cannabis legalization should cannibalize some tax revenue from what otherwise would be generated by alcohol and tobacco sales (figure 1). In fact, the amount of total cannabis revenue collected after substituting between products could exceed half of all cannabis taxes.

Setting cannabis policies and taxes

The effect of substitution on government revenues has other important policy implications that relate to public health and the broader economic costs to society. Improper drug use from alcohol, tobacco and cannabis can lead to direct health care costs or lost worker productivity, among other things. Hence, substitutability also brings into question other policy levers like age of legal access, packaging and place-of-use issues. Policies that aim at restricting the use of one substance —through higher prices, age limits, or limited places of use — will, in many circumstances, only increase the use of another.

The overarching lesson for tax and pricing is that approaches to each substance should not be made independent of one another.

To best address the impacts of substitution on taxation policies, Canadian governments should

  • improve their knowledge of cannabis, alcohol and tobacco substitution by careful monitoring of consumer data;
  • set the tax rate for cannabis relative to other substances, with an eye to discouraging the most harmful uses of each product; and
  • consider taxing cannabis based on potency, in the same way that alcohol is taxed based on alcohol content.

As policy-makers learn more about substitution over time, relative tax rates can be altered accordingly. However, governments should not think of cannabis as a massive new source of additional tax revenue.

This article is part of The Economics of Canadian Cannabis special feature.

Photo: Shutterstock/By Lisa Top

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