Taxation vs. Legalization: A Tipping Point

When cannabis legalization swept state by state, many saw it not just as a criminal justice reform, but also as a source of new tax revenue. States introduced excise taxes, sales taxes, potency taxes, wholesale taxes—all as part of bringing cannabis into a regulated environment. But as these taxes stack up, legal products become significantly more expensive than illicit ones. That price gap often pushes consumers toward unlicensed sellers who don’t collect taxes or comply with testing and labeling laws. And that creates a persistent illegal market.

How High Taxes Create a Competitive Disadvantage

1. Layered Taxes Inflate Prices
   In many states, cannabis carries both a cannabis-specific excise tax and more general sales or use taxes. Some also levy wholesale or cultivation taxes. In states where taxes are based on product potency (e.g. THC content), edibles or concentrates often carry much higher taxes. (Tax Policy Center)
2. Regulatory Costs and Compliance Add to Overhead
   Licensed producers and retailers often face expensive compliance: testing, labeling, security, licensing fees, and more. These costs are passed to consumers, unlike illicit sellers who usually ignore many (if any) of those requirements.
3. Tax Rates Too High Relative to Illicit Market Price
   If the after-tax legal price is much higher than what one can pay on the unregulated market, many customers will choose the lower cost, even if that means risking lower quality or no oversight. For instance, in California, tax increases (from 15% excise to 19%) have been criticized as making legal cannabis less competitive. (Marijuana and the Law)
4. Lost Revenue That “Could Have Been” Grown
   States often project large revenues from cannabis taxes. But where illegal markets are large, they undercut those projections. New York, for example, has estimated millions in lost tax income because many stores remain unlicensed and can undercut legal stores on price. (NY1)

Real-World Examples

• New York State: A big concern is that legal shops must compete with unlicensed ones that don’t pay state taxes. Many illegal storefronts offer cheaper cannabis products. The state has passed enforcement actions, including civil penalties and the power to shut down unlicensed sellers. However, even with stronger enforcement, many consumers continue to patronize illegal shops, largely due to price. (Governor Kathy Hochul)
• California: As of mid-2025, California raised its excise tax from 15% to 19%. Critics argue this increase (and prior high tax burdens) makes it harder for legal operators to compete and risks driving more sales back into the illicit market. (Marijuana and the Law)
• Illinois and Other States With Potency & Tiered Taxes: Illinois imposes excise taxes that scale with THC content. High potency products are taxed more. While this is intended to reward lower potency or regulate stronger products, it also increases the after-tax price in ways that illicit operators may ignore, thus making cheaper, unregulated high potency options more attractive. (MPP)

The State Tax-Design Dilemma: Finding a Balance

To reduce the size of the illicit market, states need regulatory tax systems that allow legal cannabis to be competitive. Some lessons and approaches:

• Set tax rates that approximate illicit prices or at least ensure legal prices are not prohibitively higher. From research, states that impose lower tax burdens at the point of sale tend to see more of the market shift into legal channels. (MPP)
• Simplify the tax structure so that consumers see transparent pricing (fewer layers). If taxes are compounded—wholesale + cultivation + potency + retail + local—it adds up fast, which can disincentivize consumer compliance. Simpler, flatter tax rates may reduce incentives for illegal purchasing. (Tax Policy Center)
• Enforcement and closing illegal operations are critical—but expensive and slow. States that strengthen inspections, levies, licensing enforcement help level the playing field. New York has done this by authorizing state agencies to impose civil penalties on unlicensed cannabis businesses, seize illicit products, padlock businesses, etc. (Governor Kathy Hochul)
• Using tax revenues to support the legal sector—for example, helping small or social equity businesses compete on cost and compliance—can reduce barriers. Also, using some cannabis tax revenue for public health, safety, and community reinvestment can improve the legitimacy of legal markets. (KOSU)

Conclusion

Legalizing cannabis opens up powerful possibilities: better quality control, reduced crime, social justice, and tax revenue. But if taxes are set too high, or regulatory burdens are too heavy, the illicit market remains resilient—sometimes thriving—even after legalization. States aiming to transition consumers from unregulated cannabis into legal channels must carefully calibrate tax rates, enforce unlicensed competition, and reduce overhead costs. Without that balance, the promise of legalization may be undercut by the persistence of illegal sales.