Blue smoke and seers: measuring latent demand for cannabis products in a partially criminalized market

Abstract

Cannabis, otherwise known as hemp or marijuana, is one of the nation’s fastest growing cash crops. In the late 1990s, proponents of legalization began a successful effort to decriminalize cannabis at the state level. By 2020, over half of the U.S. population will have the ability to purchase legal cannabis in their state of residence. Even in open markets, widely varying state laws and a patchwork of reporting make direct observation of consumer purchases impossible. Governments seeking tax revenue, businesses seeking reliable market indicators, and consumers wanting reliable suppliers all have an interest in filling this knowledge gap. We approach this question from a perspective of fundamental economics and describe a methodology to estimate demand for legal cannabis products across all 50 states. From these estimates, we construct a monthly index of demand for medical and adult-use products and find that the data illustrate (1) continual increases in demand since 2016; (2) significant product substitution, especially for alcoholic beverages; (3) emerging brand differentiation; and (4) the existence of far-reaching regulatory and tax obstacles in many states. We note that these obstacles often cause tax revenue to be substantially smaller (and the black market much larger) than anticipated.

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Fig. 1

Notes

  1. 1.

    One lyrical passage reads:

    And now, with time, space expanded also… The whole atmosphere seemed ductile, and spun endlessly out into great spaces surrounding me on every side.

  2. 2.

    The film begins with a scrolling narrative: “The film you are about to view may startle you. It would not have been possible, otherwise, to sufficiently emphasize the frightful toll of the new drug menace which is destroying the youth of America in alarmingly increasing numbers. Marihuana is that drug—a violent narcotic—an unspeakable scourge.”.

  3. 3.

    As noted below, the actual tax imposed was $1 per ounce.

  4. 4.

    Milton Friedman wrote the foreword to this volume, and the CATO Institute maintains an extensive online library on this topic at cato.org/research/drug-war.

  5. 5.

    The U.S. Tax Court case (U.S. Tax Court 2007) is an example, if not a precedent. The tax court prevented a legal medical marijuana dispensary from deducting ordinary and normal business expenses of providing marijuana (but not its cost of goods sold). In practice, it appears the tax is often calculated on the gross margin of the business (revenue less Cost of Goods Sold or COGS). A 2015 cannabis industry association guide to Sect. 280E asserts that deducting the cost of goods sold is allowed for state-legal businesses. It helpfully identifies various categories of expenses (such as storage and administrative costs) that may or may not be accepted as part of COGS. The same document declares that it is “not…legal or tax advice.”.

  6. 6.

    It is difficult to compare income taxes with excise taxes, but nothing in the recent history of corporate income taxes in the United States evidences an “income” tax rate of 25% on gross margin, which would imply a tax on actual income of over 100% for the majority of firms in many industries. The Michigan Single Business Tax was the nation’s only value-added tax until it was repealed by a citizens’ initiative in 2006, and had a rate of 2.35% for most of its existence. It provided for a calculation of value-added that was quite similar to gross margin.

    Other history is also instructive. In one of the most famous tax evasion cases, gangster Al Capone was convicted in October 1931 of evading $215,000 in income taxes on millions of dollars in earnings from illegal alcohol trade and other criminal dealings (Federal Bureau of Investigation n.d.). According to historical records kept by the Tax Foundation, the corporate income tax rate during the 1928–1931 period varied between 11 and 12%, after a $3000 exemption. Marginal corporate income tax rates during the rest of the twentieth century ranged as high as 53% in high income brackets (often involving a temporary surtax). Marginal corporate tax rates from 2000 through 2012 were typically 25 to 35%.

  7. 7.

    The Act was repealed in 1969 when a new federal statute was enacted criminalizing narcotics.

  8. 8.

    According to the Washington State Liquor Control Board, “recreational marijuana sales to the public began July 8, 2014,” and “I-502 creates three separate tiers: marijuana producer, marijuana processor, and marijuana retailer.”.

  9. 9.

    A number of organizations track state laws in this regard. The categorization used here incorporates the classification “medical and decriminalized,” and is associated with the Marijuana Policy Project. Other sources include the National Council of State Legislatures and Governing magazine.

  10. 10.

    Two implications from these data, one of which we can only now begin to explore, involve the success or failure of the criminalization of the substance during the last few decades, and the degree to which underground market prices reflect a premium for risk and criminal activities.

  11. 11.

    An additional assumption we intend to revisit involves state-level tax and regulatory burdens borne by cannabis product sellers in newly-legalized states. As discussed below, these vary greatly across states. In some states, they are sufficiently costly to cause reductions in legal sales.

  12. 12.

    AndCan is a registered trademark of Anderson Economic Group.

  13. 13.

    One widely-cited estimate stated:

    We’re estimating $520 million in taxes from 2020-24,” said Andrew Livingston, a policy analyst with VS Strategies. “By 2023, Michigan will reach maturity with sales of just under $1.5 billion (for both medical and recreational marijuana).

    A Senate Fiscal Agency analysis, prepared by government economists, estimated similar figures, concluding that new revenue of over $660 million would be generated from 2019 to 2024.

  14. 14.

    This story cites both high taxes and the “black market” as reasons for the shortfall.

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Appendices

Appendix 1: Equations

Equation 1: Latent Demand Equation

$$D_{s,t} = f\left( {\hat{Y}_{s,t} ,p_{t} ,\varOmega_{t} ,\lambda_{s} } \right),$$
(1)

where Ds,t is the demand for the product among residents of state s, at time increment t; \(\hat{Y}_{s,t}\) the income among residents of state s, at time increment t; pt the relative prices of the product; Ωt the costs, tax burdens, and risks involved in buying and selling the product; λs the consumer tastes for the product, among residents of state s.

Equation 2: estimated demand equation

$$\hat{D}_{s,t} = f\left( {\overline{Y}_{s,t} ,\overline{p} ,\overline{\varOmega } ,I(\hat{X}_{s,t} ,\hat{m}_{s,t} ,\hat{\hat{D}}_{s,t} )} \right);$$
(2)

where \(\hat{D}_{s,t}\) is the estimated demand for the product among residents of state s, at time increment t; \(\overline{Y}_{s,t}\) the trended income among residents of state s, at time increment t; \(\overline{p}\) relative prices of the product, presumed to be constant during a limited time period; \(\overline{\varOmega }\) costs, tax burdens, and risks involved in buying and selling the product, presumed to be constant during a limited time period; \(I( \cdot )\) indicator function for estimation methods; \(\hat{X}_{s,t} = \hat{X}(\lambda_{s,t} )\) the demand estimated from observed sales of substitute product X, (alcoholic beverages) among residents of state s, based on consumer tastes λ, λs consumer tastes for the product, among residents of state s; \(\hat{m}_{s,t} = \hat{m}(\lambda_{s,t} )\) demand estimated from observed sales of substitute product m, (medical marijuana) based on consumer tastes λ; \(\hat{\hat{D}}_{s,t}\) demand estimated from reported sales in state s, at time increment t.

Note: carets indicate observed or calculated variables; bars indicate variables presumed to be constant during a short time period, which may also be unobserved.

Equation 3: index construction

$${\text{AndCanIndex}}_{t} = \frac{{\sum\limits_{s} {\hat{D}_{s,t} } }}{{{\text{AndCanIndexBase}}_{{{\text{November}}2016}} }} \times 100;$$
(3)

where \(\hat{D}_{s,t}\) estimated demand for residents of state s, at time increment t; AndCanIndexBaseNovember2016 the Level at November 2016.

Appendix 2: Figs. 1, 2, 3, 4

Fig. 2
figure2

Market adjustment after legalization: state experiences. Per Capita Recreational Cannabis Sales (Population 18+). Source: State reports and estimates by Anderson Economic Group

Fig. 3
figure3

AndCan Index Data—state demand for legal medical cannabis. Estimates reflect both latent and observed demand. Source: Analysis by Anderson Economic Group using methodology and data described in text

Fig. 4
figure4

AndCan Index—December 2019 release. Consumer Demand for Legal Cannabis Products in the United States. Source: Analysis by Anderson Economic Group using methodology and data described in text

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Anderson, P.L. Blue smoke and seers: measuring latent demand for cannabis products in a partially criminalized market. Bus Econ 55, 26–40 (2020). https://doi.org/10.1057/s11369-019-00159-y

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Keywords

  • Marijuana
  • Cannabis
  • Legalization
  • Taxes
  • Demand
  • Regulation