Why the Illicit Cannabis Market is Alive and Well in California – Part 2 – Taxes

Licensed stores can be hard to find, because many local areas have refused to allow retailers to open.

One of the driving forces behind the support for Proposition 64 was the tax revenue the program would create for the state. Initial estimates from the office of former Governor Jerry Brown was that in 2018 the state expected to produce $643 million in tax revenue. In reality, it only produced $345 million. In 2019, the guidance was actually revised to be projected lower with an expected $288 million in excise tax for the calendar year with an additional $90 million or so produced in cultivation tax. This was not as a result of less people using cannabis in the state, but rather a combination of high excise tax rates that encouraged consumers to continue accessing the illicit market coupled with a very few municipalities that had retail cannabis stores. NPR news accurately reported the issue as follows in August of 2019:  

 As for what’s holding California back…licensed stores can be hard to find, because many local areas have refused to allow retailers to open. And then there are the tax and regulatory costs: In addition to requiring wholesale distribution, California imposes a number of levies on the cannabis industry…Confronted with high taxes in the legal market and new requirements for getting an annual medical marijuana card, many cannabis users in California have turned to the illegal market. (quote source

Additionally, the city or county may impose onerous application fees, annual license fees, and excise taxes above and beyond what the state requires, meaning cannabis businesses are frequently venue shopping between towns to determine where to set up shop. For example, Oakland has a 10% local tax rate on all sales throughout the supply chain, whereas San Fancisco has none. This can make it prohibitively expensive for operators when coupled with all other expenses that they need to shoulder already. In this case, the operator needs to balance the high cost of rent in San Francisco against the high cost of taxes in Oakland. Either way, the bottom line of the operator is negatively affected. 

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By way of example, if a business is a cultivator in the city of Santa Cruz, CA in 2020 it would need to pay $9.65/oz or $154.40/lb to the state as a cultivation tax. This would be in addition to 6% of its gross revenues to the city. This means that an indoor cultivator who is producing cannabis at roughly $900/lb and selling it at $1600/lb is paying $234/lb in just cultivation and municipal tax on that pound, or 14.625% of the sales price. This is just the tax to the business. Contrast that with the illicit market where the state derives no tax revenue at all. This of course does not imagine the costs that still exist for packaging, labeling, testing, or transporting the product, much less the costs associated with distribution, or the lag of being paid by the retailer or processor for the harvest. Ultimately, there is very little margin left for the producer. The illicit market has none of these associated costs.

This scenario becomes more problematic when considering it from the perspective of the consumer. Here there is the existing 7.25% sales tax rate for the state that exists on all retail products, coupled with what is often an additional 1% sales tax that is remitted to the municipality, coupled with an additional 15% state excise tax on all retail cannabis sales. What this means is that a consumer in a cannabis dispensary may see an item on the store shelf selling for $100, but by the time the tax has been added, that same product will cost $123.25 out the door. CBS News in San Francisco described it as follows in September of 2019: 

Of course it’s not just just business owners and would-be entrepreneurs staring at high taxes — it’s any single adult in California who is thinking about buying marijuana. Those purchases come with a state excise tax, a sales tax and local cannabis taxes…“There’s not a lot of incentive for longtime users to come into the (legal) market.”

Additionally, there remains an even larger looming tax burden in the way of Internal Revenue Code 280(e) which reads:

No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by Federal law or the law of any State in which such trade or business is conducted.

While this section would seem to suggest that cannabis businesses are unable to make any standard business deductions, the U.S. Tax Court in 2007 provided specific exceptions for the cost of goods sold, and further qualified their intent again in 2018 when it ruled

The fact that Harborside can’t deduct any of its business expenses doesn’t mean it owes tax on its gross receipts. All taxpayers–even drug traffickers–pay tax only on gross income, which is gross receipts minus the cost of goods sold (COGS)…Congress understood that when it enacted section 280E…We’ve understood it ourselves.

These allowances for COGS deductions are very helpful for cultivators and even manufacturers, but this section of the tax code is especially onerous to cannabis retailers who are only able to deduct the cost of the products they purchase for sale. Everything else, from facilities costs to payroll are not tax deductible. What this means is that for cannabis retail stores to be profitable, they must maintain very large gross margins on their sales and have high volumes. In California, many retailers tell manufacturers that in order to carry their brand, they must be able to realize a 60% gross margin on the sale.    

What is clear is that in its desire to generate tax revenue, the state neglected to consider that the illicit market remained alive and well and unless the consumer could purchase cannabis from a retailer at a price commensurate with that of an illicit supplier, then the market would never transition completely from the dark to light. Aggressive taxing on producers and manufacturers has already caused retail products to be expensive, but when coupled with excise taxes that the consumer absorbs, suddenly the price for legal cannabis is no longer attractive to the consumer. The only rationales for consumers to access the legal market are convenience in towns where it is available, the robust selection of products within the store, and the comfort of knowing the product has been tested for safety and efficacy.

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Over time the state has become very aware that its internal tax policies are harming cannabis businesses and an effort is now being made to rectify a tenuous situation. Bills such as AB-1948 are pending in the state house and if passed would provide needed relief to licensed operators in the state. The same is true on a municipal level. Many cities across the state realize that high taxes are only keeping the illicit market alive. The prevailing sentiment has now become a question of how to eradicate the illicit market. Why should cities and the State only derive tax from a small group of law abiding business owners who only control 20% of the states cannabis sales, while the illicit market still has an 80% market share, when remedial measures could be taken to create a more efficient market where the legal licensed operators could pay a lower rate but on a much greater portion of total sales.

The last part of this series will focus on the illicit market itself and the lack of enforcement in it. In order to eradicate the illicit market, the state of California needs to both make it an enforcement priority and create penalties that are severe enough to act as a deterrent. While from a social justice perspective nobody should ever go to jail for a cannabis crime, it is also impossible to eliminate the illicit market if there are almost no penalties for being caught violating the law and if the illicit market remains less expensive than the legal market. In fact, it only serves to encourage the expansion of the illicit market, which is what we will likely see in a post COVID world. Part 1 may be found here discussing licensing issues.