Provinces and the federal government have no shortage of disputes about fiscal federalism, such as with equalization and appropriate federal transfers for healthcare. Once recreational cannabis is legalized in October and its associated revenues are available to be divided up, yet another such heated debate is likely to emerge. Agreeing in advance on a process to divide those revenues based on the degree to which each level of government bears the costs related to cannabis, however, could quell this particular fire.

Legalized cannabis will be accompanied by an excise tax regime to generate revenue for Canada’s federal and provincial governments. For the first two years of this excise tax regime, governments have agreed to split the revenues, with 25 percent going to Ottawa and the remaining 75 percent destined for the provinces.

In the first few years after legalization, the revenues from that excise tax are expected to be modest. Keeping prices for legal cannabis low will be a key tool for curbing demand for the black market product. Following that two-year period, the revenue-sharing arrangement will be subject to a review and, in all likelihood, a potentially heated federal-provincial negotiation over who should get what. The heat underneath that dispute will be generated by the expectation that significant revenues will materialize from the cannabis tax, as producers find efficiencies, creating profits that can be extracted from legal distribution.

Is the 75-25 split the best way to share revenue? Further, will this be the right split in two years, let alone 10 years?

The premise behind “sin” taxes is that the revenue they generate should help cover the societal costs created by the behaviour subject to the tax. It follows, then, that sin-tax revenues should be apportioned between governments according to the degree to which they bear those societal costs.

Cannabis before legalization has created substantial direct costs for governments. Most of these are open-ended costs in the health and criminal-justice sectors.

Cannabis-use disorders lead to acute-care hospitalizations and are an extremely common reason for admission into addiction-treatment programs. Research indicates that motor vehicle accidents attributable to cannabis-impaired driving are surprisingly prevalent. All of these represent a material draw on Canada’s publicly funded health-care system. (See Rebecca Jesseman and Matthew Young’s recent piece on mitigating the health costs of cannabis).

The criminal-justice costs created by the enforcement, prosecution and incarceration of cannabis-related offences under the Controlled Drugs and Substances Act are also a significant draw on public resources. In 2015-16, these health and criminal-justice costs combined to add up to an estimated $830 million.

These costs, however, were not borne equally across governments. Provincial, territorial and municipal governments are estimated to have shouldered just over 70 percent of those costs, with the federal government picking up the rest.

Shutterstock/By Teguh Jati Prasetyo

If the excise tax on cannabis is meant to help offset the costs it creates, arguably the revenues should be apportioned across governments according to who bears those costs. If the federal government has, up until now, borne 30 percent of the costs, this would mean it should receive 30 percent of the revenue.

But it does not necessarily follow that this is the appropriate revenue split either immediately after legalization or for the long term.

The estimate of the cannabis-related direct costs on government reflects a benchmark prior to legalization. Legalization will substantially alter that cost profile. Governments will need to incur several new costs to manage the regulation, distribution and municipal zoning elements of the legalization framework. All governments will face these new types of costs, but they are largely predictable in nature. How legalization will affect the open-ended health and justice costs, however, involves many unknowns.

The experience with other substances and the limited evidence from other jurisdictions that have legalized cannabis have shown that it takes years, if not decades, for such changes to fully take root. Predicting exactly how and when the health and criminal-justice costs will change as a result of legalization is certain to paint a less-than-accurate picture. It is possible, however, to outline what the high-level benefits and risks are, and which governments will reap them or bear them.

The largest potential for cost savings, is in the criminal justice sector. The sector is currently the largest contributor to direct cannabis-related costs, with municipalities carrying the largest share. Municipalities should also be the primary beneficiary of the potential cost savings. Possession offences have been responsible for more than 60 percent of cannabis-related criminal-justice costs before legalization. In the short-term, the relaxation of possession limits should lead to fewer offences and tangible fiscal savings. Municipalities should realize more than half of the fiscal benefit from a reduction in possession offences.

In the longer term, supply offences, which are less frequent but more expensive to enforce, should also decline. This will largely depend on the success of myriad policy approaches, including competitive pricing, in eliminating the market for illicit cannabis. These costs, particularly with respect to incarceration, are borne mostly by the federal government.

While federal transfers support provincial health spending, they are not reflective of actual health costs and will not be responsive to any risks that legalization might create. Provincial governments, therefore, will be exposed to the entire risk of potential health-cost increases.

Legalization will also create downside fiscal risks. For example, more access to cannabis could lead to increases in health costs. Provinces are responsible for administering the public health system. While federal transfers support provincial health spending, they are not reflective of actual health costs and will not be responsive to any risks that legalization might create. Provincial governments, therefore, will be exposed to the entire risk of potential health-cost increases.

The biggest downside risk comes from cannabis-impaired driving. Cannabis-impaired driving does not currently have a large impact on the criminal-justice system, and legalization will not necessarily increase the practice per se. But studies suggest that cannabis-impaired driving may already be approaching the same level as alcohol-impaired driving, which means that currently many cannabis-impaired drivers are just not getting caught. Improvements in roadside-testing tools and criminal prosecution practices, likely to emerge post-legalization, should change this.

Should cannabis-impaired driving prove to be anywhere near as common as alcohol-impaired driving, the increased criminal-justice costs could be staggering, and could become the largest cannabis-related expense post-legalization. The resulting increases in law enforcement and court costs would be borne disproportionately by municipal and provincial governments respectively. To increase public safety and help defray these potential costs, all governments could make considerable investments in education programs to prevent cannabis-impaired driving.

Shutterstock/By Mitch M

When the current intergovernmental revenue-sharing arrangement for cannabis taxes comes up for review in two years, the approach taken should have two main aspects:

First, the revenues should be allocated according to an updated assessment of the degree to which each level of government bears cannabis-related costs. This assessment, rather than being tied to actual costs, should be updated to reflect changing patterns in underlying cost drivers. This would remove any incentive for either order of government not to contain costs and thus increase their share of revenue going forward.

However, two years will not be enough time to establish a definitive picture of which governments will carry the cost burden over the long term, so a commitment to flexibility will be important.

Second, therefore, the revenue splits should be tied to ongoing reassessment cycles until the post-legalization system fully matures.

Agreeing on a process that will achieve these goals in advance of the next review of the revenue-sharing arrangement should substantially turn down the temperature on what could otherwise be another heated federal-provincial negotiation.

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

Photo: Shutterstock/By Wael Khalill alfuzai

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Erich Hartmann
Erich Hartmann is the Mowat Centre’s practice lead for intergovernmental affairs. Erich spent 13 years in the Ontario Public Service at the Ministry of Finance in a number of policy and management roles, most recently serving as manager of federal-provincial relations.

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