There are some core economic principles that will help determine how much cannabis is taxed, but getting the balance right is an ongoing process.

How should Canadian governments tax marijuana? Some possible guidance emerges from Canada’s recent experience in taxing cigarettes. As with cigarettes, the desire to tax sales to raise revenue and also to maintain public health must be balanced against the possibility that high taxes will encourage cross-border smuggling, either within the country (between provinces) or from abroad.

Economists approach the issue of taxation differently than do other social scientists. In particular, rather than focusing on how taxes can expand revenues, economists tend to focus on reducing the ways taxation distorts behaviour in the marketplace. As a starting point, the standard economic model says that an untaxed market maximizes social welfare by yielding the greatest amount of benefit to both the buyers and the sellers of a product. So economists tend to support the Ramsey Rule, which says it’s better to put taxes on the sorts of things that people will keep buying even after taxation has raised the price than it is to tax things that people will avoid buying because taxes have made them more expensive.

Taxation that follows this rule limits the reduction in social welfare that any level of tax tends to cause. In this framework, the appropriate level of taxation on marijuana depends on the extent to which the higher prices would deter people from buying it. The previously illegal nature of marijuana makes it difficult to estimate this sensitivity to its pricing, but demand for cigarettes is sensitive to price changes to only a small degree. The Ramsey Rule would therefore suggest that, as with cigarettes, any tax on marijuana should be relatively high.

Taxation can address social costs

While the Ramsey Rule is the first lens through which economists think about product taxation, a potentially more important issue is whether an item carries “external social costs.” Such costs are not borne only by the consumer of a particular product, but are imposed on nonconsumers as well. The existence of external costs has been used in Canada and most other nations to justify relatively high excise taxes on goods like cigarettes and alcohol.

The external costs of cigarettes include the harm imposed on nonsmokers exposed to second-hand smoke. With alcohol, such costs include the harm caused by drunk drivers: injuries, fatalities and property damage. Moreover, in a single-payer health care system like Canada’s, most economists would count any increased health care costs as part of a product’s external costs.

Most economists view these external costs as the appropriate basis for deciding tax rates on goods whose consumption harms nonusers. Since marijuana has the potential for external costs — it may lead to harm from second-hand smoke, impaired driving and higher health care costs that would be paid by all Canadians regardless of whether they consume marijuana — a solid understanding of these costs is crucial.

At this point the scale of these costs in future is far from clear. Indeed, today’s research still must rely mostly on data from periods before legalization. So as legalization expands the user base and possibly changes the amount or type of marijuana consumed, earlier estimates of social costs will become unreliable.

Another type of cost to be considered in the taxation of potentially addictive goods is “internal costs.” These are costs that users impose on themselves, often because they don’t have complete information. Most long-term smokers, for instance, start their life-long habit in adolescence, when they probably don’t understand the long-term health impacts or how difficult it will be to quit.

If marijuana consumption follows a similar life-course pattern, it may carry internal costs in addition to any external costs. For instance, it may reduce concentration, leading to poorer academic performance. The concept of internal costs remains controversial, but if a pattern of cause and effect becomes clearer, internal costs associated with marijuana would argue for an even higher tax on it.

How smuggling influences taxation

Both the Ramsey Rule and the social cost framework suggest a relatively high tax on marijuana. But Canada’s experience with cigarette taxation may offer a cautionary tale to consider.

In the late 1980s, several Canadian provinces sharply increased their excise taxes on cigarettes. Less than a decade later, they were forced to roll them back, in large part because of massive amounts of cigarette smuggling. The traffic was widespread, primarily bringing cigarettes in from lower-taxed jurisdictions in the United States.

The availability of smuggled cigarettes restrained the ability of Canadian governments to tax cigarettes at a level consistent with their perceived social costs, while resulting in the loss of cigarette tax revenue. The same scenario could play out with marijuana. That is, even if it is determined that the external and internal social costs of marijuana call for a relatively high tax, smuggling both within Canada — if different provinces establish substantially different tax rates or prices — and from abroad may result in a rollback.

Efforts to reduce smuggling would reduce the likelihood of repeating this episode, but they are usually very costly. And even after substantial interventions to counter it, the black market for cannabis and related products is currently huge. Care must be taken to balance the need to keep a lid on illegal activity against the broader goal of maximizing social welfare with respect to the sale of marijuana.

Much remains unknown about the social costs of the legalized recreational use of marijuana. As researchers and regulators learn more over time, the taxation regime we start out with is likely to require a great deal of revision, even if it is built on the best current understanding of economic principles.

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

Photo: Shutterstock/By PATARA


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