Rocky Reefer Roll-out: The Right Tax Lesson

Partygoers smoke marijuana during a Prohibition-era themed New Year's Eve party celebrating the start of retail pot sales, at
Partygoers smoke marijuana during a Prohibition-era themed New Year's Eve party celebrating the start of retail pot sales, at a bar in Denver, late Tuesday Dec. 31, 2013. Colorado is to begin marijuana retail sales on Jan. 1, a day some are calling ?Green Wednesday.' (AP Photo/Brennan Linsley)

Marijuana prices may soar in the first hours of legalization in Colorado as pent-up demand meets gearing-up supply. Those high prices include new state taxes at both wholesale and retail levels. Are those inflexible taxes so high that they will undermine a sustainable market -- and threaten legalization itself? Well, it's complicated.

To paraphrase an old story, two men, disagreeing about marijuana taxes, agreed to go to the rabbi for help in figuring out the situation. The first man arrived and said to the rabbi, "Please read my paper, 'Marijuana taxes will be too high.'" The rabbi read the paper and said, "My friend, you are right."

Later in the day, the other man arrived, saying to the rabbi, "Please read my paper, 'Marijuana taxes will be too low.'" The rabbi read the second paper and said, "You are right."

Later, the rabbi's wife, who had overheard all this, said to him, "Rabbi, you told both men that they were right. This cannot be." To which the rabbi replied, "You are right, too. And they will both be wrong -- as the market develops and as events play out."

"At first," the rabbi continued, "marijuana taxes will overly burden the legal industry as it competes with bootleggers. In the early days, legitimate start-ups will struggle with unfamiliar problems, pay one-time expenses to get licenses and acquire capital, and make expensive mistakes that they won't make again. As legalization begins, even pre-tax prices will be high, and adding inflexible taxes will just make things worse. Tax-evading bootleggers will undercut legal prices.

"Later, in a mature marijuana market, today's tax rates will be too low. In time, innovation, the profit motive, and economies of scale will kick in. Pre-tax prices will then collapse. Absent a big tax rate increase, the resulting super-low total price will provoke worried parents and even the federal government, concerned about interstate leakage as well as youth use."

Figuring out how to handle and tax a newly legal intoxicant is not easy. (Avoiding tax conundrums, Uruguay is instead legalizing with a nimble state monopoly.) Around 1600, when tobacco first came to England, King James I didn't know what to do. His tax rate per pound zigzagged from 2 pence up to 78 pence -- and then back down to 12 pence. A newly legal marijuana market will probably be just as puzzling.

King James could impose taxation without representation. Legislatures do not act so nimbly, even at best. Colorado's Legislature can't increase taxes without voter approval, thanks to the state's Taxpayer Bill of Rights. And Californians may follow Colorado's lead in tying the hands of Legislators. In California, "The Control, Regulate, and Tax Marijuana Act" initiative would limit, until 2022, the tax burden on marijuana. And that burden would be lower than the total (state and federal) taxes cigarettes bear. Under California law, only another voter referendum could undo the freeze to provide needed flexibility.

Maybe the proposed California ballot initiative, which could be well-funded, will allow victory at the polls. But in Oregon in 2012, despite the tide that legalized marijuana in Colorado and Washington, an overly pro-marijuana-industry initiative failed at the ballot box. If California voters think a tax freeze through 2022 overreaches, that freeze may prove counterproductive for legalization advocates. Or maybe the threat of that inflexibility will force the hand of the slow-moving California Assembly and produce a sustainable legislative solution to the marijuana problem at last.