The Center on Budget and Policy Priorities estimates that the COVID-19 pandemic will lead to a $500 billion collective state budgetary shortfall through fiscal 2022.1 As it stands, rainy day funds and federal aid will only cover a fraction of this gap, leaving a $360 billion target for creative state revenue generation. Some politicians previously opposed to cannabis legalization are now warming to the possibility as a means of chipping away at this funding gap.2 As a Pennsylvania state senator put it, “Everything is on the table.”

It is perhaps unsurprising that states facing budgetary shortfalls are weighing the possibility of recreational cannabis taxation as a revenue source. Most, if not all, of the 11 states that legalized cannabis in the last decade cited revenue as a leading factor supporting legalization. Maybe more surprising, however, is the degree to which states vary in how they tax marijuana — from the type of tax levied, to the timing of the tax in the supply chain, to the ultimate rate borne by consumers. Eight years of state experimentation have yielded no uniform approach to cannabis taxation, nor a settled understanding of its optimal design. The same is true of how states choose to allocate the resulting revenues.

What can these eight years of lessons teach us about the viability of marijuana legalization and taxation as a means to addressing COVID-related budget shortfalls? Our analysis proceeds in three parts. Part I describes existing state cannabis taxation schemes, comparing the ways in which state legislators sold cannabis legalization to the voting public with the reality of how cannabis is now sold to the buying public. Part II attempts to define an optimal cannabis tax rate, considering two competing definitions between which states must choose: a revenue-maximizing rate, and a socially optimal rate that minimizes the externalities associated with cannabis use. Finally, Part III discusses both how a cannabis tax should be administered and how the proceeds should be spent. We conclude that, while cannabis is unlikely to be the revenue boon that legalization proponents once touted it to be, states can maximize its impact by implementing a price-based tax regime and allocating revenues between targeted funds and the localities in which sales are made.

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