Marijuana taxes: Vertical integration and transfer pricing

Any commercial legalization of marijuana will face the issue of vertical integration.  The law can require it (as Colorado does in most cases), ban it (as Washington state does for producers and retailers), or tilt toward it or against it.

The statesmen who brought us out of alcohol Prohibition banned vertical integration:  They set up a three-tier system that prevented the return of the brewer-owned Saloon.  Maybe that has some relevance for marijuana legalization.

Tilting against vertical integration turns out to solve a tax problem that might crop up.  While a weight or potency base for marijuana taxation is preferable to an ad valorem or percentage base for reasons discussed over and over at www.newrevenue.org, many primitive marijuana excise taxes use that unfortunate ad valorem base.  A wholesale level tax is better than a retail level tax, because a wholesale tax avoids leakage (ranging from pilferage to hijacked trucks).  But for a vertically integrated business, a wholesale level ad valorem tax requires guessing at an artificial price – the same transfer pricing problem that has made a laughingstock of the world’s international tax rules.  What did the left hand (the farmer) charge the right hand (the retailer)?  There’s no right answer.

If an ad valorem tax and vertical integration co-exist, applying the tax at the first sale to an unrelated party solves the transfer pricing problem.  Everyone will know the price, because it’s an actual arm’s-length price.

Maybe that solution to the tax problem tilts against vertical integration, because the total tax paid would be higher later in the supply chain, when more value has been added.  Maybe the alcohol rules  have served their purpose.  But maybe, as the repealers of Alcohol Prohibition thought, preventing the accumulation of market power in the marijuana industry would be a good way to start.

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Author: patoglesby

From 1982 to 1990, I worked in tax policy for Committees of the United States Congress. In recent years, I was Adjunct Lecturer at UNC-Chapel Hill's Business School and then Adjunct Professor at its Law School.

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