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Why the Illicit Cannabis Market is Alive and Well in California - Part 2.5 - Taxes
Without a major course correction on the tax side, the illicit market will remain alive and well.
Robert Hunt access_time 10 min read

One thing we all need to remember is: To lawmakers, tax revenue is heroin. If regulators believe they can extract more tax revenue from an industry, they will. This is especially true of the cannabis industry. The belief is that the industry will not push back all that much. After all, what leverage do they have. What they are producing, distributing, and selling is still Federally illegal. The belief of lawmakers is that any concessions they make to allow cannabis businesses to operate should be welcomed with open arms by the industry. The alternative is operating in the illicit market, where doing so can come with serious risks to ones liberty. So the Faustian choice they force the industry to make is; break the law, or pay excessive taxes for the privilege of State legality. To date, their belief is misguided as it appears that roughly 75% of the California industry are happy to remain outlaws, rather than become upstanding cannabis business owners. The primary reason for this are profit and taxes. And while objectively I can’t condone illicit behavior, while others are doing their best to walk the line, to paraphrase the famous words of Chris Rock; “I’m not saying you should break the law…but I understand”.

Why do I understand? Because despite the fact that the IRS, the State House, and the Municipalities love the tax revenue that these businesses produce, they don’t love the industry. They only love the money. For the outlaws, why support those who will not support them. Better to be a profitable outlaw than a business owner trying to do the right thing when everyone else has their hand in your pocket. The goal of any business is to turn a profit, but if the deck is so stacked against you and the regulations are designed to make it more likely than not that you will fail, then why transition from the shadows to the light? The way the system is currently designed, there is no incentive to do so in California when the tax burdens are so heavy.

Every day we see news stories discussing how much revenue cannabis excise taxes produce for the state. In the first two quarters of 2019 the state of California realized $137.3 million in excise tax on roughly $900 million dollars in retail sales. This based on a 15% excise tax rate at the retail level. But that is just the state. And that is just the excise tax. And that is exclusive of the state’s 8.5% sales tax or the 10% cannabis business tax. And that is only on one portion of the supply chain. The municipal tax rates can be equally egregious. Oftentimes these taxes are another 5 – 15% on top of the state tax at the retail level. These taxes are all on top of the cultivation taxes imposed by the state and the municipality. They are also in addition to taxes on manufactured products and distribution. Simply stated, the state of California has been taxing the cannabis industry out of existence.

This means that at every level of the supply chain there is a tax. A tax on the cultivator. A tax on the manufacturer. A tax on the distributor. A tax on the retailer. And finally, a massive tax on the consumer. Ultimately, if the price of a good across the counter is significantly more expensive than the same product that can be accessed just as easily in the still existing illicit market, the consumer will choose not to access the legal market. From a financial standpoint, they are making the prudent decision. In the illicit market, there is no tax on the cultivator, manufacturer, distributor, retailer, or consumer. Almost every dollar of gross margin becomes net margin and the consumer wins. It is not even a close call, the illicit market product is often half the price of its legal counterpart, which makes it all but impossible for one market to compete with the other.

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But even with the excessive taxes levied at the municipal and state level, they all pale by comparison to the most onerous tax of them all: Section 280(e) of the Internal Revenue Code. This section of the tax law in and of itself all but guarantees that the illicit market will remain strong and active. This point was discussed in detail in part 1 of this series, but more emphasis should be made with respect to how much pressure this section of the tax code places on cannabis retailers. If 280(e) were to be eliminated, the mark up in price between wholesale and retail cannabis could be significantly smaller and retailers could still be profitable, even with all the other taxes listed above. But the IRS has refused to budge and Congress has refused modify the law to remove this section of the code. Why? Because money. This section of the tax code provides an enormous windfall to the Federal Government every year. It is the proverbial example of having their cake and eating it too. The Federal Government is more than happy to keep cannabis illegal, but that does not mean it does not want to take as much money out of the industry that it can. The Feds do not care if a cannabis business survives or fails. In fact, based on all that we have seen over the past six years of adult use cannabis at the state level, they would prefer that cannabis businesses fail. But, so long as they are alive, they will take every dime from the business that they can.

It should be noted at this point, that since the valuations of cannabis businesses began to decline significantly in 2019, there has been a great deal of criticism directed at cannabis executives by those outside of the industry including those who claim that California based cannabis businesses are failing due to the lack of business acumen in the C suite. The common refrain is that these executives spent too much capital on trying to seize market share through marketing and promotions. While it is true many of them exhausted critical investment capital while the market was flush with money, many executives realized that due to these tax burdens, scale was the only way to ultimately make their businesses profitable. The fixed costs on many of these businesses remained static and until the business scaled, they would be operating at a loss due to high tax rates. This forced many of these companies to try and go through an aggressive ramp, even though in any other industry they would likely have not made these decisions, because they would not have been contending with the same regulatory headwinds. If the same businesses attempted to grow holistically and organically, they likely would have been suffocated by the margin compression that came largely at the hands of high tax burdens and not robust competition from other legal operators. Essentially, this is a polite way of saying that while many cannabis executives made mistakes with their capital allocations in 2018 and 2019, those mistakes are not the primary driver of why these businesses were struggling; taxes were.

Make no mistake, no matter how many times the industry is told by most lawmakers that they support the cannabis industry, what they are really telling you is that they support the production of tax revenue that feeds the insatiable appetite of their respective budgets. There is no altruism. The tragedy of this position, at the local, state, and Federal level, is that all they are accomplishing is wiping out shareholder value, destroying otherwise good businesses, and handing the cannabis industry right back to the outlaws who have controlled it for the last 40 years. Until lawmakers accept this reality, the illicit market never goes away. If lawmakers were to realize that the most important thing they can do over the next several years is to eradicate the illicit market, they would eventually get the tax revenue they so desperately want today. They just need to learn that there is a difference between being short-term and long-term greedy. The former destroys the legal industry. The latter eradicates the outlaws.

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So what can the California cannabis industry do about these issues? The answer in the short term is not very much. The industry can and will continue to lobby the state to amend its regulations, but in a state the size of California, change happens slowly. For the first time since adult use launched in California we are finally seeing some hope on the horizon. Lawmakers, such as Assemblyman Rob BontaAssemblyman Tom Lackey, and state Treasurer Fiona Ma, have come together to propose new legislation that would help prevent a mass wave of cannabis business failures. After several years of being told by entrepreneurs, industry groups, and now lawmakers, Governor Gavin Newsom is now beginning to realize the gravity of the situation. If the state does not act rapidly and decisively, there may not be a legal cannabis industry left in California, and billions of dollars of investment capital would be wiped out due to overburdensome taxes that have all but crippled an otherwise great industry.

While these changes would not alleviate the issues associated with 280(e), they would go a long way in bringing the cost of legal cannabis in California down to a price that is closer to the illicit market. Should 280(e) go away, which the IRS independently has no motivation to budge on, then California would easily have the largest and most profitable stand alone cannabis industry in the world. The migration from illicit to legal at that point would happen very quickly and all the promise that the industry had from an investment standpoint would be realized. After all, at that point the consumer would have no reason to access cannabis from anyplace but a legally licensed shop. No illicit market exists for any good, in any industry, unless the price on the illicit market is less expensive than the legal market.

With COVID-19 acting as an accelerant that will drive cannabis business insolvencies, the time for the state to act is now. Without a major course correction on the tax side, the illicit market will remain alive and well. When the legal industry collapses and reverts back to the illicit market, lawmakers will have no one to blame but themselves. The problem is, they likely won’t care. Remember, lawmakers love the money the industry produces for them, but they don’t love the industry. If they did, these issues would have already been addressed. The fact that they have not tells you that short term greed is still winning over common sense.

Parts 1 and 2 of this series may be found here and here.