Today, Senate Majority Leader Chuck Schumer (D), Senate Finance Committee Chairman Ron Wyden (D), and Sen. Cory Booker (D) released their discussion draft—the Cannabis Administration and Opportunity Act—for federal descheduling of marijuana. While federal descheduling impacts all states, it does not deschedule marijuana in states which choose to keep their own ban.

Nevertheless, descheduling would have a profound effect on the marijuana businesses operating in states which have already legalized use—either medically and/or recreationally—by normalizing income tax treatment, opening access to capital, and permitting interstate commerce in cannabis. The bill includes an excise tax with a rate of 10 percent in the first year, growing to 25 percent in the fifth year.

The House of Representatives already has a bill, the MORE Act, which would also deschedule and tax marijuana.

In the short term, existing businesses would benefit from descheduling by no longer being subject to Section 280E, enacted in 1982 to deny the deduction of business expenses to those selling drugs on Schedules I and II of the Controlled Substances Act. While intended to stop illicit sellers from deducting expenses like guns and yachts used in smuggling operations, the IRS applies it to state-authorized marijuana retailers, which hurts taxpayers trying to comply with the law and creates a competitive advantage for the illicit operators that Section 280E was enacted to penalize.

This particular section of the tax code limits the deductions businesses can take when calculating their income tax liability. Traditional businesses can deduct ordinary expenses such as rent, marketing, utility costs, and payroll, but marijuana businesses are limited to deducting cost of goods sold (COGS). Cultivators and wholesalers have had an easier time than retailers as more expenses are directly associated with COGS. The unfavorable treatment of state-legal businesses has resulted in retailers selling marijuana experiencing effective rates well above 70 percent.

Were a bill passed to deschedule marijuana at the federal level without a subsequent federal tax, compliant marijuana businesses would receive an effective tax cut. Repeal of 280E was estimated in 2017 to lower federal receipts as much as $5 billion over 10 years according to the Joint Committee on Taxation (JCT). In 2021, with significantly more businesses than in 2017, that number is likely to be higher. It should be included in any assessment of 280E that a repeal (and normal access to banking) is likely to increase taxpayer compliance by existing companies. A report from the Treasury Inspector General for Tax Administration found significant compliance issues and underreporting of income under the current system.

Tax cuts as a result of federal reform were always unlikely, and thus, the new bill includes an excise tax. The proposed tax rate will grow from 10 percent of removal price (cost at producer level or removal from bonded premises) in the first two years to 25 percent of removal price in the fifth year. The tax also applies to illegally imported or otherwise unlawfully removed products.

In the sixth year, products will be taxed differently based on whether THC content can be measured with sufficient certainty. Tetrahydrocannabinol (THC) is the main psychoactive compound and is generally used to define potency of the marijuana product, even though there are other compounds in the plant which may influence the effects on the user. THC-measurable products will be taxed based on grams of THC. For products where  measurements are not possible, products will be taxed per ounce. The rate will be 25 percent of the sales price in the previous federal fiscal year—for non-measurable products, it will be the sales price of cannabis flowers, and for measurable products, the sales price of THC. This could mean that the THC-measurable category will continue to expand as testing capabilities develop. Products considered drugs are exempt from taxation.

It is less than ideal to change the tax system after five years. Businesses will have built systems to comply with the first system and will then be forced to change when the system changes. There could be substantial pressure from the business community to extend the purely price-based tax design ahead of year six, even though potency-based taxes represent a superior design.

While the proposed federal rates start at the lower end, they quickly become substantial. Since all states with recreational sales already tax either cultivation, wholesale, or retail sales, the federal government should err on the side of lower tax rates. Overtaxing marijuana could result in a competitive advantage to illicit sales, which are still prevalent in most states—even in states that offer a licensed market.

Perhaps in acknowledgment of this, the bill offers a credit for qualified domestic manufacturers (a system also applied in alcohol taxation). This credit amounts to 50 percent of an applicable amount each year. This amount grows from $2 million in the first year to $5 million in the fifth year. The term “qualified domestic manufacturer” is not defined in the bill.

It is unfortunate that the bill relies on price as a tax base, as prices share no association with the negative externalities (harm) associated with consumption. Even though the tax eventually incorporates an element of potency and quantity, the rate will still be determined on sales prices. Such a design can lead to more volatile revenue generation, as prices fluctuate.

With the bill’s design, highly potent products would be more expensive and yield more revenue, reflecting higher societal cost associated with more potent products. In terms of internalizing externalities, this is a positive. By including the weight component, the levy would also respect the different harm profiles of smoking a little versus a lot of marijuana. Neither weight nor potency are perfect, but both are substantially better proxies than price for internalizing the externalities. However, a simpler way to achieve this without the need to reflect last year’s prices is shown here.

Using THC as a tax base assumes that THC content is the best proxy for potency and therefore the best measure of externalities related to marijuana consumption. This, however, is an area that should be studied further. There are hundreds of cannabinoids in marijuana and the understanding of the “formula for potency” is nowhere near complete. Even with a THC focus, there may be a need to levy one rate on edibles and another of concentrates to account for different and more potent absorption mechanisms. For instance, this year New York and Connecticut passed tax systems where edibles are taxed four times higher than concentrate.

Furthermore, one of the great challenges with tax design for marijuana is the sheer number and variation of product types available on the market, from pre-rolled joints to sparkling water, and the yet unknown products to come. Any tax system should either be nimble enough or be updated frequently enough to capture new products as they enter the market.

Finally, significant work remains to be done. The bill leaves certain questions to two federal agencies, the Food and Drug Administration (FDA) and the Alcohol and Tobacco Tax and Trade Bureau (TTB). The processes developed by FDA will be especially important for the future of medical marijuana. Furthermore, interstate commerce could radically change the operating environment for existing businesses.

The discussion draft is expected to undergo several changes before introduction of the final bill text.