The Economics of Legal Marijuana

Featuring Lutts’ Logic:

Al Capone and Barack Obama

The Economics of Legal Marijuana

A Famous Stock You Should Avoid


On Saturday, Sunday and Monday, one week ago, here’s what happened.

On Saturday, the New York Times ran a story on the drug wars in Mexico, describing how the power of the criminal gangs often outweighs the power of the law enforcers.

It’s a big problem, and the violence has increased since President Felipe Calderon launched an army-led assault on the cartels soon after taking office in late 2006.  More than 14,000 people have died in drug-related violence in Mexico since.

The Mexican gangs, of course, are just trying to make a living by serving the demands of a market … in this case the market for marijuana and other illegal drugs in the U.S.

Recognizing this, the U.S. attempts to help.  It’s currently giving $1.4 billion to Mexico to provide training and equipment to security forces.  And last week it conducted a massive sting operation that netted more than 300 arrests in 19 states.  But none of the arrested were upper-echelon figures, and U.S. Attorney General Eric Holder admits the gangs are too entrenched within the political and economic fabric of Mexico for the arrests to deal a deathblow to the gangs.

On Sunday, the Boston Globe noted that it was the 78th anniversary of Al Capone’s conviction on tax evasion charges, for which he received an 11-year federal prison sentence.

Alphonse Gabriel Capone, of course, became rich by satisfying the public’s thirst for alcohol during Prohibition, the 14-year period in which the sale of alcohol was illegal in the U.S.

While meeting the demands of this market, Capone, like the Mexican drug cartels, became very powerful, stymied law enforcement, and killed people.  Today, we generally recognize the folly of prohibiting the sale of alcohol during that period.  Even though one-third of Americans choose not to drink today, we know that instead of trying to outlaw it, it’s better to regulate it and tax it.  Today, the U.S. government collects more than $9 billion per year from alcohol taxes; individual states collect even more.

Then on Monday, President Barack Obama instructed federal attorneys that they should no longer prosecute marijuana users in the 14 states that allow it for medical reasons, but should defer to state laws instead.

Can you connect the dots?

The plain truth is that the War on Drugs (a term first used by President Richard Nixon in 1969) has been a failure.  In fact, the term is no longer used by the Obama administration, which prefers treatment to incarceration.

Yet the U.S. (federal and states) will spend about $47 billion this year on drug enforcement, clogging our court systems and overcrowding our prisons, in many cases dooming young men to a life in the underclass.

In fact, the United States has a higher proportion of its population incarcerated than any other country in the world … and roughly 25% of our inmates are in there for drug offenses, usually possession.

So who benefits from this War on Drugs?

Organized crime, certainly.  According to the United Nations, drug trafficking is a $400 billion per year industry, equaling 8% of the world's trade.

Also benefiting are arms manufacturers, the law enforcement industry, the prison industry and the legal industry.

And I don’t think we’re getting a good value for our $47 billion.  In fact, I think our efforts may be counterproductive, and that we should explore a more sensible route, the same one we use for alcohol and tobacco.

In short, legalize it, regulate it and tax it.

Legalization would quickly shrink that $47 billion annual cost of law enforcement to a small fraction of its present level.  In its place, we’d have federal quality control inspectors to keep tabs on the legal producers (thus reducing poisonings and overdoses).  Entrepreneurs would spring up out of the woodwork to become producers, and with the increased supply prices would fall to more reasonable levels.  Profits would drop.  And organized crime would soon be out of the business.

We’d have a more efficient legal system, and a more efficient prison system.  And we’d have a ready supply of legal marijuana for medicinal purposes (two-thirds of Americans are in favor of medical marijuana now).

And then we’d be able to tax it!  Every state in the country now taxes alcohol and cigarettes, and I think marijuana should be no different.  And how much would we collect from those taxes?

A 2008 study by Harvard economist Jeffrey A. Miron estimated that legalizing drugs would inject $76.8 billion a year into the U.S. economy--$44.1 billion from law enforcement savings, and at least $32.7 billion in tax revenue ($6.7 billion from marijuana, $22.5 billion from cocaine and heroin, the remainder from other drugs).  I’m not ready to argue for legalizing those harder drugs, but I do think a country as deep in debt as ours should stop giving money away on unproductive projects and start looking for positive cash flows.

Leading the way already is our country’s lifestyle pioneer, California.  This past July, 80% of Oakland, California voters chose to impose a tax of 1.8% on medical marijuana sales, which could bring the cash-strapped city nearly $300,000 next year.

And California Assemblyman Tom Ammiano, a Democrat from San Francisco, introduced legislation that if approved by the California Legislature, would put pot on the same legal footing as alcohol--legalizing its sale and having the state tax it.  Ammiano called it "simply nonsensical" to keep marijuana, the state's top cash crop, unregulated and untaxed in light of the state's massive financial problems.

The value of California's marijuana crop is estimated at $14 billion annually. That’s almost twice the combined value of vegetables and grapes, the state's second and third most-valuable crops.  Ammiano estimated passage of his pot legalization proposal could generate more than $1.3 billion for state coffers.

Finally, turning to our neighbor Canada, I found this:

“In a recent study for the Fraser Institute, Economist Stephen T. Easton attempted to calculate how much tax revenue the Canadian government could gain by legalizing marijuana.

The study estimates that the average price of 0.5 grams (a unit) of marijuana was $8.60 on the street, while its cost of production was only $1.70. In a free market, a $6.90 profit for a unit of marijuana would not last for long. Entrepreneurs noticing the great profits to be made in the marijuana market would start their own growing operations, increasing the supply of marijuana on the street, which would cause the street price of the drug to fall to a level much closer to the cost of production. Of course, this doesn't happen because the product is illegal; the prospect of jail time deters many entrepreneurs and the occasional drug bust ensures that the supply stays relatively low. We can consider much of this $6.90 per unit of marijuana profit a risk premium for participating in the underground economy. Unfortunately, this risk premium is making a lot of criminals, many of them with ties to organized crime, very wealthy.

Stephen T. Easton argues that if marijuana were legalized, we could transfer these excess profits caused by the risk premium from these growing operations to the government:

“If we substitute a tax on marijuana cigarettes equal to the difference between the local production cost and the street price people currently pay--that is, transfer the revenue from the current producers and marketers (many of whom work with organized crime) to the government, leaving all other marketing and transportation issues aside we would have revenue of (say) $7 per [unit]. If you could collect on every cigarette and ignore the transportation, marketing, and advertising costs, this comes to over $2 billion on Canadian sales and substantially more from an export tax, and you forego the costs of enforcement and deploy your policing assets elsewhere.”

One interesting thing to note from such a scheme is that the street price of marijuana stays exactly the same, so the quantity demanded should remain the same, as the price is unchanged. However, it's quite likely that the demand for marijuana would change from legalization. We saw that there was a risk in selling marijuana, but since drug laws often target both the buyer and the seller, there is also a risk (albeit smaller) to the consumer interested in buying marijuana. Legalization would eliminate this risk, causing the demand to rise. This is a mixed bag from a public policy standpoint: Increased marijuana use can have ill effects on the health of the population but the increased sales bring in more revenue for the government. However, if legalized, governments can control how much marijuana is consumed by increasing or decreasing the taxes on the product. There is a limit to this, however, as setting taxes too high will cause marijuana growers to sell on the black market to avoid excessive taxation.

When considering legalizing marijuana, there are many economic, health, and social issues we must analyze. One economic study will not be the basis of Canada's public policy decisions, but Easton's research does conclusively show that there are economic benefits in the legalization of marijuana. With governments scrambling to find new sources of revenue to pay for important social objectives such as health care and education expect to see the idea raised in Parliament sooner rather than later.”

Economically, I think legalization and taxation is a no-brainer.  The less easily defeated arguments come from people who argue that all drug use is bad (the old Puritan argument that drove Prohibition) or that marijuana is a stepping-stone drug.  In any event, Obama’s directive to stop prosecuting marijuana users in states that approve medical marijuana use is one small step on the road that should ultimately lead to legalization and taxation.  I have no doubt that it’s a very long road.  But the journey has begun.
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Moving on to the market, I have two main thoughts.

The first is that the bull market is healthy as a horse, and it will remain healthy until enough people stop arguing with it, questioning it and simply denying it.

The second is that market leadership is probably beginning to narrow, as the identity of the greatest growth stories becomes clearer.

Last Friday, for example, brought an awesome 23% jump in (AMZN), the result of a crackerjack earnings report.  In short, is selling an enormous (but secret) umber of Kindle e-book readers, and they’re very profitable.

What gets my attention is this number, $11 billion.  That’s the amount of value that’s stock gained in the market on Friday, thanks to the buying of major investors.  At the market close on Thursday, AMZN was judged to be worth $40 billion.  Twenty-four hours later, the market said it was worth $51 billion!

This big number tells me that some very serious investors, are projecting some terrific earnings power for, through both its main retail operation and its proprietary Kindle unit.  Both are revolutionary.  The Web site has already changed the world and is still increasing in its influence.  And the era of the Kindle is just beginning.  With newspapers and magazines shrinking and dying, has an enormous opportunity to become a preferred information/entertainment medium.

Other new leading stocks, all of which have been written about in Cabot Wealth Advisory before, include Apple (AAPL), Baidu (BIDU), Maxwell Technologies (MXWL), Netflix (NFLX) and Rackspace (RAX) … and I could write about any of them again, but I don’t want to bore you.  If any of them are unfamiliar, go to our Web page and in the left column, under “NEWSLETTERS,” click on “Featured Stocks.”

Today, I can’t resist noting that an event I’ve been waiting for finally occurred last week; Coca-Cola (KO) broke down.  It happened on Tuesday, after the company released an earnings report that revealed the fourth consecutive quarter of no growth from the previous year.  Trading volume on the breakdown was only slightly elevated, so this was not a major technical signal … but it’s a start.  

And I think there will be more breakdowns in the future, as the realization slowly dawns that in the new world, where the fight against obesity is taken increasingly seriously, Coca-Cola’s products, full of empty calories, are the enemy.

And here’s the thing.  Coca-Cola is an icon.  It’s a universally known, well-respected institution.  To most people, that means it’s something to be respected.  To me, that means it’s something to be questioned, because I know that when every last buyer of a stock has bought, and public perception reaches a peak, there remains only one direction for a stock to go, and that’s down. In the future as I see it, doubt slowly creeps into investors’ perceptions about Coca-Cola, and they begin to sell some of their stock and move into other, more attractive alternatives.

It starts as a trickle, but it ends as a deluge.

So consider this.  Less than a year ago, KO was owned by 648 mutual funds.  At the end of June, the number was down to 622, and I expect it to keep on shrinking in the quarters ahead.  Meanwhile,, which is changing the world in a good way, has yet to see its mutual fund ownership cross the 600 level; it was at 512 at the end of June (its highest level ever).  And little Netflix, also a great growth story today, had just 213 mutual fund owners at the end of June.  

If you want to make money, I suggest you be aware of these trends.  Get out of KO and get into growth stocks like AMZN and NFLX.

Yours in pursuit of wisdom and wealth,

Timothy Lutts
Cabot Wealth Advisory

Editor's Note: Both Amazon and Netflix have been recommended in Cabot Top Ten Report, the #1 source of new stock ideas with the greatest momentum in the market each week. Editor Michael Cintolo employs technical and fundamental analysis to each stock so you know exactly why and when you should be buying. Click this link to get started today.

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