Marijuana's momentum has been undeniable in recent years. Last year, we saw Canada become the first industrialized country in the world to legalize recreational cannabis in the modern era. Now, Mexico looks to be just months away from becoming the third country worldwide to OK the sale and consumption of adult-use weed.

We've also seen 33 states since 1996 wave the green flag on medical marijuana in the United States. A third of these medical weed states have also passed legislation allowing the consumption and/or sale of recreational pot.

A judge's gavel next to a handful of dried cannabis buds.

Image source: Getty Images.

Marijuana's scheduling in the U.S. puts pot businesses at a serious disadvantage

And yet, despite two-thirds of the American public favoring some sort of national legalization program, the U.S. federal government continues to classify cannabis as a Schedule I substance. That means it's entirely illegal, is deemed to be prone to abuse by users, and is considered to have no recognized medical benefits. In fact, cocaine has a less stringent scheduling than marijuana, according to the Controlled Substance Act. But the illegality of marijuana is just the start.

Even though the federal government has taken a hands-off approach to state-level regulation, this isn't exactly making life easy for companies in the cannabis space. For one, U.S. pot businesses have limited or no access to basic banking services. Since banks are insured by the Federal Deposit Insurance Corporation (FDIC), and the FDIC is a federally created agency, they fear potential financial and/or criminal repercussions if caught aiding cannabis companies. This means limited or no access to everything from loans and lines of credit, to something as simple as a checking account.

In addition, marijuana businesses in the U.S. can be subjected to Section 280E of the tax code. Implemented in the early 1980s to curb cocaine smugglers from writing off their business expenses on their federal income taxes, 280E disallows businesses from taking normal corporate income tax deductions if selling Schedule I and II drugs, save for cost of goods sold. For pot companies and retailers, cost of goods sold tends to be a relatively small percentage of sales, which can lead to exceptionally high effective tax rates for profitable cannabis companies.

However, the House of Representatives wants to change this. All of it.

The facade of the Capitol building in Washington. D.C.

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The House aims to legalize cannabis in the U.S.

Four months ago, on July 23, Rep. Jerry Nadler (D-N.Y.) and Sen. Kamala Harris (D-Calif.) introduced the Marijuana Opportunity, Reinvestment and Expungement Act, or MORE Act, in Congress. The MORE Act is on track to be the first comprehensive marijuana reform legislation set to be voted on in Congress after the House Judiciary Committee voted 24-10 in favor of the bill on Wednesday, Nov. 20. The MORE Act now moves to the next stage of the process, which would be a vote in the Democratic-dominated House. (Note that Democrats have a considerably more positive view on legalizing cannabis than Republicans do.) 

If the bill were approved in its current form, here's a brief summary of its key points: 

  • Decriminalizes cannabis at the federal level by removing it from the Controlled Substances Act.
  • Requires federal courts to expunge prior convictions for cannabis offenses, or at least allows prior offenders to request expungement or a review of their case.
  • Establishes a 5% federal tax on cannabis and cannabis products that'd be used to create an Opportunity Trust Fund. This Fund would assist individuals disproportionately impacted by the War on Drugs, provide loans to small businesses in the pot industry, and help those adversely impacted by the War on Drugs minimize barriers to marijuana licensing and employment.

Essentially, the MORE Act ensures that states would have the right to regulate their own industries, but it would allow the federal government to collect their piece of the pie with a 5% tax on legal product. It would also help to right the perceived wrongs of the War on Drugs by helping those most impacted by the federal government's efforts to stamp out drugs use, including cannabis.

The MORE Act already has more than 50 co-sponsors, and it looks to have a very good chance of passage in the House.

A suspicious-looking young man in a blue hooded sweatshirt who's holding a potted cannabis plant.

Image source: Getty Images.

The MORE Act has a fatal flaw that may not be apparent at first glance

If the MORE Act were to pass the House, it would then move on to the Senate, where things get considerably cloudier. Senate Majority Leader Mitch McConnell (R-Ky.) is certainly no fan of cannabis and has blocked riders specifically targeting marijuana reform in the past. With McConnell at the helm, cannabis reform continues to look unlikely.

What's more, Republicans have a more adverse view of cannabis than Democrats or Independents. The latest Gallup poll shows that 76% of self-identified Democrats and 68% of self-identified independents support legalizing pot in the U.S., with only 51% of self-identified Republicans on board with legalizing weed. There would need to be strong bipartisan support in the Senate for the MORE Act to pass, and that doesn't seem likely to happen, at least in the way the bill is currently written. 

But, interestingly, neither Mitch McConnell nor the more adverse beliefs of the GOP toward cannabis are the biggest concern of the MORE Act. The bill's fatal flaw is actually the establishment of a 5% federal tax on cannabis.

Arguably the biggest hurdle in recreationally legalized states right now is black market marijuana. Illicit producers don't have to wait for cultivation, processing, distribution, or sales licenses to be approved, they don't pay state or federal income tax, and they avoid state, local, excise, and wholesale taxation (depending on the state). If the federal government adds yet another layer of taxation atop legal marijuana, it's only going to make the price disparity between legal and illicit pot even wider.

A green highway sign that reads, Welcome to California, with a white cannabis leaf in the upper-right corner.

Image source: Getty Images.

For example, California, the biggest marijuana market in the world by annual sales, applies a state and local tax, a 15% excise tax, and a wholesale tax on leaves or dried cannabis flower, to every pot sale. Mind you, this doesn't include other expenses, such as laboratory testing, that you can count on being added into the final cost of a product by retailers. Now imagine tacking on an additional 5% tax from the federal government. Based on a variety of estimates I've seen, we could be talking about an aggregate tax on legal Californian cannabis of between 50% and 80%, which would make it virtually impossible for legal producers to complete against the black market.

And if you think this worry is all for naught, think again. On Jan. 1, 2018, California opened its doors to recreational weed sales, but only managed $2.5 billion in total cannabis sales last year (that's recreational plus medical). This represents a decline of $500 million from the previous year, when only medical marijuana was legal. Consumers are clearly showing their displeasure with high tax rates, and its players like MedMen Enterprises (OTC:MMNFF) that have suffered the consequences.

Multistate operator and dispensary operator MedMen has been expanding in California rapidly, with the company now sporting more than a dozen locations in the Golden State. The passage of Prop 64 and the opening of retail doors in Jan. 2018 should have allowed MedMen to recognize rapid sales growth and potentially push toward profitability. Instead, MedMen's losses have been astronomical, and the company's sequential quarterly sales growth at its California locations has chimed in at a meager 5% and 10% in the fiscal third and fourth quarters, respectively.

California has shown us what happens when you overtax marijuana, and the MORE Act appears to have ignored that lesson entirely.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.