California’s Proposition 64 was pitched to the public as a dual-purpose policy: By legalizing cannabis, America’s largest cannabis-producing state would simultaneously smother its illicit market while generating billions of dollars in tax revenue.

But in the year since voters approved the law, it’s become clear that these twin objectives may not be easily compatible.

When you add up all the taxes, they can total as much as 45%, which is too high to out-compete the illicit market.

One month before California’s adult-use market opens, there is growing concern that legalized cannabis could fail to deliver the long-promised knockout blow to the illicit market. Instead, the illicit market will continue to thrive, depriving the state of tax revenues and undercutting efforts to curb underage use, environmentally damaging cultivation, and chemically-contaminated weed.

The reason? Simply put, the tax is too damn high.

The Sweet Spot: 18% to 30%

To beat the illicit market, experts say, the total tax rate for legal cannabis has be somewhere between 18% and 30%, or roughly $6 to $10 extra on the retail price of an eighth of an ounce. Any higher and many consumers won’t bother giving up their various illicit market arrangements.

Under Prop 64, hitting that 18-to-30% sweet spot will be nearly impossible. State taxes alone—which include a 15% excise tax and a cultivation tax of $9.25 per ounce for flower and $2.75 per ounce for leaves, on top of the existing retail sales taxes of up to 9.75%—will total around 25%. (Medical cannabis is taxed at a slightly lower rate.)

The 25% state tax rate isn't outrageous. It's the additional local taxes that are causing concern.

Granted, at 25%, California’s state tax burden isn’t egregiously out of line with other states. In fact, it’s on par with Nevada and actually lower than Washington and Colorado (which just boosted its excise tax from 10% to 15%, to fill a budget hole). But in California, state taxes are only the start. Prop 64 empowers local jurisdictions to levy various excise taxes and fees on cannabis in order to defray the local costs of enforcement and regulation. And while the local tax picture is still murky (not all cities and counties have enacted taxes yet) in some jurisdictions, the total tax hit can be substantial. San Diego, for example, will tack on 15%. Santa Barbara is adding 20%. By comparison, local taxes in other states generally fall within the 2% to 4% range.

All told, consumers in some California markets will pay a tax markup of close to 45%, or almost $16 extra on that $35 bag.

Californians are “looking at a really high price shock on January 1st,” warns Dale Gieringer, director of California NORML. “There is no doubt that consumers, and especially medical patients, who are used to current prices, are going to want alternatives.”

And that could be is bad news, because in California, more than in any other state, consumers will have no shortage of alternatives. The state has tens of thousands of illicit market growers who are presently selling untaxed, unregulated, and pretty inexpensive product and who, come January 1st, will enjoy a sudden, and massive, competitive advantage over their  competitors in the legal market. That’s a serious problem.

People were so hell bent to legalize cannabis that they decided to worry about taxes later. Well, now is the time to worry about taxes.

Right now, California’s illicit market accounts for three-quarters of the cannabis purchased in-state, with the rest coming from the unregulated medical market, according to a report prepared for the state’s Bureau of Marijuana Control by the University of California Agricultural Issues Center.

The hope is that the legal market will bring retail prices down as it matures, softening the tax hit.

Once the legal adult-use market opens, state officials estimate that medical patients will account for 25% of all cannabis sales, and 37.5% of sales will be adult-use purchases made through licensed operations.

That still leaves the illicit market with a significant 37.5% share of all sales.

The hope is that the legal market will bring retail prices down as it matures, softening the tax hit. But because some of the local taxes are generated on a per-square foot or per-pound basis, the positive effects of falling retail prices may be muted.

More to the point, if cannabis advocates are right and California’s tax rate really is too high, the illicit market’s large share might actually remain significant for some time.

Advocates point to Washington State, where cannabis consumers pay around 45% in combined state and local taxes—the highest in the nation—and where the illicit market is still robust. ArcView Market Research estimates that illicit sales in Washington still account for 41 percent of the state’s cannabis market, compared with just 15 percent in Colorado, where the combined tax is around 29 percent. “It’s a price-elasticity issue,” says Tom Adams, ArcView’s editor-in-chief. Cannabis consumers “are price sensitive in most areas, and the less-well off, heavy-using cannabis consumer is extremely price sensitive.”

Click on image to enlarge.

Illicit Sales Don’t Disappear Overnight

Granted, state-by-state comparisons aren’t perfect. Factors other than price could help explain the different rates of decline in states’ illicit markets.

For example, where Colorado allowed medical cannabis users to keep their MMJ status, Washington pushed its medical users into the adult-use market, which may have given an incentive to some patients to access the the illicit market. And, importantly, any state’s illicit market is notoriously hard to measure. For example, some observers in Washington think that state’s illicit market is actually shrinking faster than estimates can capture, in part because the state’s maturing cannabis sector is driving down prices so rapidly.

But keep in mind that in California, angst over the illicit market isn’t simply about high cannabis taxes. It’s about high cannabis taxes combined with an illicit market that is not only much larger and more mature than in other states, but which is also far more deeply entrenched in mainstream consumer culture.

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Simply put, California’s producers and consumers have been doing business off the books literally for generations. If the state’s consumers think the taxes in the new legal market are too high, it’ll be much easier for them to stay in the shadows and continue doing what most of them have been doing for years.

In California, “we’ve already got a not-paying-our-taxes problem,” says Hezekiah Allen, executive director of the California Growers Association and a fierce critic of the state’s tax rates. “It’s a pre-existing condition here.”

Tax Rates Affect Cole Memo Compliance

Looming above all of this, of course, is the extra risk of a federal crackdown.

One reason for the federal government’s tolerance of legalization in California is the promise that legalization would end California’s illicit market exports. Those exports are estimated to account for 75% of all illegal cannabis consumed in the United States. That look-the-other-way policy, codified under the US Department of Justice’s Cole Memo, is one of the main reasons California and other states—not to mention tens of thousands of cannabis companies and investors—have been willing to move as quickly as they have on legalization.

But if California’s efforts to shut down its exports should appear to falter—say, because its taxes are too high—the fear is that the feds could charge California with a violation of one of the Cole Memo’s fundamental demands, which is that legal states prevent cannabis from leaving the state.

Max Mikalonis, an industry consultant and former legislative staffer who helped craft the state’s cannabis policy, summarizes the widespread anxiety. If California’s current tax regime isn’t adjusted, he says, “excessive taxation would directly feed non-compliance with the Cole Memo.”

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Yes, There Is a Fix

Here’s the good news: California’s tax mess is fixable.

That fix won’t be easy, though, and it will likely take years to achieve.

The most logical fix would be a cut in the state excise tax from 15% to 10% or less.

The most logical solution would start with a cut in the state’s 15% excise tax, which some advocates say should be slashed to 10% or even lower.

Prospects for a quick cut of any size are dim. State law requires a change like that to be put before voters in another ballot initiative, which, observers say, the legislature has no interest in pursuing, given the state’s perilous finances. State lawmakers are simply “too hungry to get the funding that Prop 64 is supposed to be providing,” says NORML’s Geiringer. So while the legislature has made small tweaks (such as giving cannabis farmers a longer window between harvest and the cultivation tax deadline), a major cut in the excise tax isn’t in the cards, at least in the short term.

As a result, tax-cut advocates are shifting their attention to local governments, which have more flexibility in setting rates. But here, too, the law’s incentives aren’t exactly aligned in favor of lowering taxes.

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The Parlier Way: Ban Retail, Embrace Farming

Take the example of the Central Valley town of Parlier, in Fresno County. Like many farming communities, Parlier struggles with a lagging economy, low tax revenues, and a drug problem.

Parlier’s future: Grow , don’t sell. (www.parlier.ca.us)

Town officials in Parlier see legalized cannabis as a potential cash cow, but also a social risk. Parlier has banned the sale of cannabis, although the city is eager to allow large-scale commercial cultivation, and they clearly see those farms as means to pay for additional law enforcement and regulation.

That’s not unusual. Prop 64 specifically allows cities and counties to enact a local excise tax to pay for local enforcement. The problem is that few cities actually know what the full cost of cannabis enforcement is going to be. The natural impulse is to err on the side of caution and push for higher taxes, even if doing so may indirectly encourage the very illicit market that these cities want the extra cannabis taxes to combat.

When I asked Parlier city manager Sam Escobar how the city would balance the need for more enforcement revenue against the risk of a larger illicit market, he made no bones about Parlier’s priority: “Making sure we generate enough revenue to protect our city.”

Regulation Costs Money

In some ways, this top-to-bottom push to maximize revenues was inevitable. With so many California towns struggling economically, and with the state budget in perpetual crisis, cannabis was always going to be seen as a source of revenue.

State officials assume that consumers will shift to the legal market. 'That's a big assumption in California,' says one lobbyist.

Prop 64 actually encourages local governments to seek higher taxes by addling them with extra regulatory expenses. For example, because California is eager to persuade its tens of thousands of small cannabis growers to go legit (by giving regulatory breaks to small-scale operators) the legal market will see a much larger number of smaller operators than would otherwise be the case.

That means many local governments will be tasked with monitoring a lot of smaller players. That extra work is going to take more money, which local governments expect to get through taxation.

The current dash for cash was also spurred by Prop 64’s initial emphasis on revenue generation, which many legalization advocates felt was based on faulty expectations. The state’s assumption was “that most people were going to buy in the regulated market, as opposed to staying in the illicit market,” recalls Tim Cromartie, a lobbyist with the League of California Cities and a veteran of the legalization debate. “That’s a huge assumption in a state like California.”

Despite those concerns, Prop 64’s backers saw the heavy emphasis on revenue as key to building broad political support for the measure. As Cromartie recalls, “people were so hell bent for leather to get cannabis legalized that they basically decided, ‘Well, we won’t worry about the details now.’” But as those details have become clearer, so has the state’s dilemma: players at all levels have been encouraged to grab the largest possible slice of the cannabis tax pie, and have few incentives to back down.

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Tally the Saved Costs

Escaping that dilemma requires changing the revenue-maximizing mindset.

One approach, says Allen, with the California Growers Association, is for cannabis advocates to persuade local officials to see legalization less as a means of raising revenue and more as a way to cut the costs associated with the illicit market. For Allen, than means reminding city officials and law enforcement officials of all the ways that the illicit market is already hitting their budgets.

He tells them: “You’re already seeing the costs of the illicit market. You’re seeing teenagers getting high and mixing it with alcohol and getting into accidents. You’re seeing the robberies.”

“This is about owing the crisis,” he adds. “There are unregulated growers who are doing tremendous environmental damage. There are unregulated retailers that are selling unsafe products or products that are laced with other substances. It’s a mess out there. And [legalization] isn’t about making the state and local governments wealthy. It’s about cleaning up a mess.”

Economic Development Deals Are Out There

Allen admits that this grass-roots campaign will be slow going. In the meantime, advocates will need to rely on other leverage. One promising possibility: cannabis companies looking for new production and processing sites are sometimes able to lobby local governments to drop their tax rates.

'There is no magic number. We know what's too much for us, and cities know what tax breaks are not worth it for them.'
Randi Knott, Director of government affairs for Genezen

“Sometimes they go a little overboard,” says Randi Knott, director of government affairs for Genezen, which is considering projects in more than two dozen local jurisdictions. But, she adds, even the more enthusiastic taxers will generally agree to a lower rate when they see what companies need to make a profit. “There is no magic number,” Knott says. “But we know what is too much for us, and the cities know what is not worth it for them, and there’s a sweet spot in the middle.”

Case in point: The city of Parlier initially wanted to charge cultivators a fee of 10% of gross sales, but lowered it to 2% on large-scale projects after Genezen showed how the higher rate made their project a non-starter. Parlier can still raise the percentage later, Escobar says, if expenses justify it, “but we wanted to give [Genezen] a shot to actually get started here and establish their business, and then work from there. We want to be partners.”

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A Shift in Bargaining Power

In theory, cities may become even more partner-like as the legal industry matures. Right now, the relatively small number of jurisdictions that are licensing cannabis—currently, less than one in four statewide—means cannabis businesses have fewer choices of where to operate, and thus less bargaining leverage on local taxes.

But as more cities and counties license cannabis, and businesses have more choices, each jurisdiction’s bargaining power will fall. “The market pressure will force more reasonable rates,” says Mikalonis, the consultant. “The jurisdictions that have been able to call the shots [on taxes] won’t be able to continue in the same fashion.”

Ultimately, even state lawmakers may come under a similar downward pressure. Because high tax rates are likely to discourage illicit market farmers from entering the legal market, the state’s total tax take could well be lower than anticipated. That, coupled with the extra social costs that come from a larger-than-anticipated illicit market, could persuade lawmakers to undertake the politically complicated process of a ballot measure to cut the state excise tax.

Change Is Coming in…2019?

How quickly that might happen is anyone’s guess. Next year is probably out. The state won’t know how well the current tax structure is working until midway through year, leaving far too little time for a November measure.

If and when lawmakers do get around to revising the law, advocates may try to push for something that is more than just a quick fix. Cromartie, the lobbyist with the League of California Cities, says the goal should be a ballot measure that not only lowers the tax rate (he’d like to see it at 10 percent) but also gives the legislature the authority to adjust that rate in the future, based on the situation in the marketplace, without having to go back voters each time.

The initiative process may have been essential to getting cannabis legalized, but as Cromartie grouses, it’s “absolutely the worst way to craft a tax policy.”

 

Top photo: Customers gather around a counter to take advantage of special deals celebrating the 4/20 holiday at ShowGrow, a medical marijuana dispensary in downtown Los Angeles on Thursday, April 20, 2017. (Richard Vogel/AP)