Last month, US Senate Majority Leader Charles Schumer and senators Cory Booker and Ron Wyden introduced draft legislation to legalize cannabis federally.
Some commentators say that by expunging federal, nonviolent marijuana offenses from criminal records, the proposed legislation could repair some of the harm caused to mostly young people of color during the “war on drugs.” The proposal has also been lauded for reflecting public sentiment in removing cannabis’s classification as a Schedule I drug.
"The legal cannabis industry is hamstrung by its federal illegitimate status."
Support for legalizing cannabis has been growing steadily over the years. According to the Pew Research Center, as of April 2021, 91 percent of adults in the United States supported legalization; 60 percent supported legalization for both medical and recreational use. Medical marijuana is now legal in 37 states. Recreational marijuana is legal in 18 states.
Scant attention has been paid, however, to the profound impact that federal legalization would have on the cannabis market. Essentially, it would squeeze out the illicit cannabis market, along with all its concomitant ills.
Legal cannabis businesses face severe penalties
The legal cannabis industry is hamstrung by its federal illegitimate status. Barred from interstate commerce, the US cannabis industry has become an agglomeration of 37 fragmented, isolated markets. Each state that has legalized cannabis must have cannabis grown, distributed, sold, and consumed within its boundaries, regardless of supply, demand, or efficiency considerations. Cannabis cultivated in California, which has five to six outdoor growing seasons, can’t be sold in Massachusetts, which has only two outdoor growing seasons.
Interstate commerce prohibition causes cannabis in states like Massachusetts to be unduly expensive and prevents growers in states like California from achieving economies of scale because of limited market size. Small, fragmented markets also limit cannabis suppliers from incurring investments, such as efficient distribution networks, that would lower total cost.
Further, cannabis businesses pay a much higher share of net income as taxes, compared to other businesses of similar scale. That’s because, according to the Internal Revenue Code, businesses that “traffic” in Schedule I controlled substances aren’t eligible for federal tax deductions or credits.
"Banks are extremely chary about extending capital to them. Even if they do, banks charge cannabis firms hefty fees."
These inefficiencies are compounded by a dearth of capital. Banks face a severe penalty—nullification of depositary insurance provided by the Federal Deposit Insurance Corporation—if they participate in a federal offense. Because cannabis businesses operate in a penumbra of selective state legitimacy, but face federal illegitimacy, banks are extremely chary about extending capital to them. Even if they do, banks charge cannabis firms hefty fees for their services.
Institutional investors, such as endowments and pension funds, often have “vice clauses” prohibiting investments in Schedule I industries. Even private investors are dissuaded by the industry’s lack of access to bankruptcy protections. Bankruptcy law is a product of federal jurisdiction and is therefore unavailable to cannabis firms as long as the substance remains federally prohibited.
The cannabis industry is also disadvantaged by a lack of intellectual property protection. Intellectual property and trademark enforcement lie within the purview of federal jurisdiction. Cannabis firms, unable to adequately protect their brands, recipes, and manufacturing processes from infringements, underinvest in research and development, innovation, product differentiation, and quality control.
Thus, federal prohibition imposes tremendous penalty on the legal cannabis industry, fractionating it into inefficient local markets that face capital scarcity, absence of downside protection, and lack of differentiation.
The illegal industry grows
The devastating consequence is that the unregulated cannabis market continues to thrive as a substitute. Legal cannabis is expensive, relatively undifferentiated, and available only where demand justifies its significant set-up costs. Illicit cannabis is particularly attractive to price-sensitive consumers in locations where access to legal cannabis is limited. These consumers tend to be young, have less disposable income, and reside in under-resourced neighborhoods.
Communities with flourishing illicit cannabis markets suffer a host of associated problems, including high incarceration rates (often exacerbated by prosecutorial bias), violence as the primary means of dispute resolution in illicit commerce, and health emergencies as buyers consume risky products without the safeguards of consumer protection laws.
Legalizing cannabis nationally would significantly reduce the space available to the illicit cannabis industry. By allowing interstate commerce, it would also remove a market failure that is exploited by operators with the means and connections to acquire licenses in multiple states.
Unfounded fears of a marijuana frenzy
Despite these potential benefits, the legislation proposed by Schumer and his colleagues has faced lukewarm support and pushback. People worry that federal legalization will lead to a flood of demand, rise in drug-related crimes, loss of state autonomy, and negative health consequences for vulnerable sections of the population. These concerns are misplaced.
Experiences of US states and countries such as Uruguay, Australia, and Canada suggest that crime doesn’t rise perceptibly, and demand doesn’t increase significantly, following cannabis legalization. And federal legalization doesn’t supersede states’ rights. The proposed legislation, for instance, removes federal penalties but defers to states to determine whether and how to allow, limit, or prohibit cannabis production, distribution, or possession. It allows states to enact suitable legislation to support local cannabis businesses.
Evidence on health effects of cannabis use is mixed. Some studies offer evidence of negative health effects of cannabis use, particularly among adolescents, pregnant women, and individuals suffering from or at risk of mental illness involving psychosis. Other studies suggest the cannabis compounds can treat a variety of health conditions, including seizures, inflammation, and chronic pain.
However, because cannabis is federally deemed an illegal Schedule I drug, research into the potentially harmful or beneficial effects of its various constituents has been stymied. Federal legalization would give a fillip to research, leading to evidence-based policies on whether and how to regulate the industry to foster effective medical use and safe recreational use.
The need for action
Maintaining the current patchwork of federal illegality and selective states’ approval will continue to hobble the legal market, which has been cornered by those with access to political influence and private capital. Meanwhile, the illicit cannabis market will continue to thrive in vulnerable sections of society.
Legalizing cannabis federally would shrink the illicit market and help the legal market grow, within the ambit of regulations and informed by research, thereby also generating tax revenue.
What is popular is not always what is socially right. But, at this moment, the proposed federal legalization of cannabis addresses both overwhelming public support and a pressing social need.
This article originally appeared on LinkedIn. Follow Ashish Nanda and Tabatha Robinson on LinkedIn to read more of their posts.
About the Authors
Ashish Nanda is a senior lecturer and the C. Roland Christensen Distinguished Management Educator at Harvard Business School. Tabatha Robinson (MBA 2020) is a New York-based lawyer who studies the cannabis industry.
[Unsplash/Roberto Valdivia]
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