Regulatory capture in the marijuana market

Among the threats facing marijuana legalization in Washington State is regulatory capture, a likely consequence of “market consolidation in which a few firms dominate the whole industry.”  The dangers of regulatory capture appear in America’s alcohol and tobacco industries — politically powerful enough to weaken regulation and taxes and economically powerful enough to manipulate demand.

One response is to push for a “market with smaller, fragmented firms.”  One way to favor small firms is with tax rules.  The Federal Tax Code has so many kinds of rules favoring small firms that my former boss (in private law practice) and former top Treasury official Ed Cohen used to jokingly urge a uniform definition of small businessmen:  one who stands under 5’6” in height – a criterion he met.

Federal alcohol taxes could provide an outline of a solution in Washington State, though such a solution would require legislative change. For instance, small wine businesses, producing no more than 150,000 gallons a year, pay just 17 cents a gallon – instead of the standard Federal rate of $1.07 — on the first 100,000 gallons.  Small and medium sized brewers, on the first 60,000 barrels, pay $7 a barrel instead of the standard $18.  Big companies don’t get any benefit those from low rates, which the Federal Tax Code phases out.

The existing Federal alcohol excise tax breaks may have the rationale of leveling the playing field for small firms by counteracting the advantage that large firms gain from economies of scale.  But the tax breaks may just reflect political clout.  And the use of a tool for one purpose – field-leveling – does not prevent its use for another – preventing consolidation.

Crafting rules to favor small marijuana firms might well involve several tiers of rates.  And there’s another wrinkle:  You need rules to prevent affiliated businesses from calling themselves “small” – rules of the kind now in place that effectively prevent abuse of the Federal wine and beer benefits for small businesses.

Anti-tax hysteria might result in easier ways to prevent regulatory capture.  One way is state monopoly.  Monopoly would probably prevent regulatory capture better than fragmenting the industry would, but people don’t trust government these days (the Founders would understand).

If monopoly won’t happen, a fragmented industry  is the answer, I reckon.  A fragmented industry — one with lots of growers — is more difficult to regulate and tax than an industry consisting of just a few firms, but if a fragmented industry with many growers  is what the legalizing community wants, taxes can help along the path to that destination.

Now taxes are not the only, or even necessarily the best, way to fragment the industry.  Quotas are another way to fragment.  Quotas, unlike taxes, might happen in Washington without legislation.  Quotas let policymakers set a precise target for total supply, while taxes require policymakers who have such a target in mind to engage in a huge amount of guesswork about what many independent potential suppliers would do.  That is, in evaluating tax rate options, policymakers would have to figure how the entire supply side of the market might respond to various sets of tiered tax rates.  Taxes will push every licensee in the same direction (less production), and taxes can push production from large growers to small ones, but taxes can’t provide the calibration the State needs to hit a target for total amount produced.

But quotas offer no easy solution.  Someone has to assign the quotas – by perceived merit, by lottery, or by auction.  Taxes operate on their terms without respect of persons:  Taxes treat everyone the same, and operate by categories and formulas, unlike perceived merit, which can lead to cronyism and does lead to binary distinctions if some applicants get no quota at all.   That’s leaving aside the rifle shot tax relief — or favors — that you see from time to time, and that can degenerate into regulatory capture.  A license system says who;  taxation says instead how much.

In any event, taxes and quotas can co-exist.  The law could be changed to say that a producer who gets a larger-than-average quota could pay a higher tax on production in excess of the average quota — just as Budweiser bears more tax than craft beer in a non-quota regimen.  Or that producer with a higher quota could pay a higher than proportional license fee.   For instance, a 2x quota might require a  4x or 8x license fee:  if grower A gets a quota of twice the pounds, or plants, or square feet of canopy that grower B gets, grower A’s license fee could be four or eight times grower B’s license fee.  (Graduated tax rates could follow a similar pattern, with all the line-drawing and thresholds and fine-tuning anyone wants.)

In any event, penalties for exceeding quotas can look a lot like taxes.

The best argument for quotas is that they don’t need legislative action.  But to think that the Washington law needs no tinkering is wishful.  Regulating marijuana is no easy task.  The Wright Brothers knew the theory of flight, but it took years and hundreds of iterations before they could make a plane stay up in the air.

[Update: Another vital issue for regulatory capture is whether vertical integration strengthens the industry to the point that capture is easier.]