Premise: A fragmented industry is harder to supervise and regulate.
Here’s what may be a counterproductive incentive of 280E. Say Mom and Pop operate a marijuana business:
Mom and Pop MJ | |
Gross receipts |
100 |
COGS |
-60 |
Other expenses |
-20 |
Actual pretax income |
20 |
Federal tax base |
40 |
Federal tax at 35% |
14 |
After tax profit |
6 |
They find an opportunity to expand their business that costs 30 and yields net pre-tax income of 40 by doubling CGS to 120 and doubling gross receipts to 200.
Mom and Pop MJ doubles | |
Gross receipts |
200 |
COGS |
-120 |
Other expenses |
-50 |
Actual pretax income |
30 |
Federal tax base |
80 |
Federal tax at 35% |
28 |
After tax profit |
2 |
After taxes, they are worse off. So they won’t expand. [Is this a real case or just a theoretical sport case? This example proves my point only if the second 40 of net pre-tax income costs more to earn than the first 40.]
The public policy problem is that section 280E tends to fragment the industry. Instead of one supplier, 280E creates an incentive for there to be two suppliers – each more profitable after tax than one expanded supplier.
By contrast, this disincentive does not happen if Mom and Pop operate a legal business:
Mom and Pop Legal business | |
Gross receipts |
100 |
COGS |
-60 |
Other expenses |
-20 |
Actual pretax income |
20 |
Federal tax base |
20 |
Federal tax at 35% |
7 |
After tax profit |
13 |
Let’s say they, too, find an opportunity to expand their business that costs 30 and yields net pre-tax income of 40 by doubling CGS to 120 and doubling gross receipts to 200. Absent taxes, the marginal revenue exceeds the marginal cost, so they would do the deal.[1] Taxes don’t change the result.
Mom and Pop Legal business doubles | |
Gross receipts |
200 |
COGS |
-120 |
Other expenses |
-50 |
Actual pretax income |
30 |
Federal tax base |
30 |
Federal tax at 35% |
10.5 |
After tax profit |
19.5 |
[1] It’s axiomatic that a business will take a deal where the marginal revenue exceeds the marginal cost.
http://www.cliffsnotes.com/study_guide/Profit-Maximization.topicArticleId-9789,articleId-9769.html