LAO Report: California’s Taxes and Rules Mean Legal Marijuana Can’t Compete With Black Market Prices
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Commentary

LAO Report: California’s Taxes and Rules Mean Legal Marijuana Can’t Compete With Black Market Prices

"Even if the state eliminated its cannabis taxes entirely, other costs— such as regulatory compliance costs and local taxes—likely would keep legal cannabis prices higher than illicit market prices.”

Taxes assessed on legal marijuana products in California are too high and the taxing mechanisms are inefficient.  Those are the points Reason Foundation and others have made, noting that high taxes are largely to blame for the widespread persistence of California’s huge black market for marijuana.  Now, we can officially add the state’s Legislative Analyst’s Office to those who hold this view.

Proposition 64, the initiative that legalized adult-use marijuana in California in 2016, required the Legislative Analyst’s Office (LAO) to produce a report recommending adjustments to the state’s tax rates by January 2020.  The report was to consider three distinct goals of legalization:

  1. Eliminating black markets;
  2. Ensuring sufficient revenues to fund the programs created by the initiative; and
  3. Discouraging youth use.

The LAO report was released over the holidays and included some scathing criticisms of the current tax regime.

It’s worth noting that two of the most common motivations for marijuana legalization frequently conflict.  Since legal and illegal marijuana are substitutable goods, high taxes driving up the prices of legal marijuana may induce people to continue getting cannabis on the black market.  Yet, some lawmakers may have supported legalization primarily because they want to generate new tax revenues.  This conflict has spurred debate about how high marijuana taxes can get before producers and consumers alike flee to the black market.

The LAO report acknowledges this conflict, concluding that “a change in tax rates would affect the difference between legal and illicit prices, with a tax cut making legal cannabis more competitive with illegal cannabis compared to what would be the case in the absence of a cut.”

LAO’s overall conclusions are ominous for those hoping to see the ongoing growth of the legal marijuana market in California.  “Under current market conditions,” warns LAO, “changes in the state tax rate likely would not make legal cannabis less expensive than illicit cannabis. Even if the state eliminated its cannabis taxes entirely, other costs— such as regulatory compliance costs and local taxes—likely would keep legal cannabis prices higher than illicit market prices.”

LAO finding that the costs of regulatory compliance and licensing fees are so high that legal marijuana could have a hard time competing with illegal marijuana even if the state ditched its cannabis taxes entirely doesn’t bode well for the long-term health of legal cannabis businesses.

But that’s not all. LAO also worries that if California reduces state taxes on marijuana, local governments will simply step in and raise their own tax rates.  Theoretically, that fear could be averted with a statewide limit on the taxes local jurisdictions could charge.  Most states, including neighboring states Nevada and Oregon, already set such limits as part of their adult-use marijuana laws.

Although the LAO was required to provide recommendations only about tax rates, its report also dedicates significant space to the tax structure, and with good reason.  After the passage of Proposition 64, the legislature passed the Medicinal and Adult-Use Cannabis Regulation and Safety Act to consolidate California’s medical and adult-use initiatives.  That law designated licensed marijuana distributors as the parties responsible for collection and payment to the state of both wholesale and retail marijuana taxes.

Distributors are essentially middlemen within the state’s regulatory structure who purchase wholesale marijuana from growers and package it for resale to dispensaries.  Growers are responsible for paying California’s cultivation tax, which is assessed as a fixed rate per pound of marijuana, but distributors are responsible for collecting and remitting that tax to the state.  This process gets even more complicated since marijuana may pass through multiple licensees’ hands in the supply chain before it ultimately is delivered to a dispensary. It is the final distributor who is supposed to remit the tax.  In practice, this constant pass-along of the tax liability makes it difficult for both licensees and tax authorities to determine who owes the money.

To make matters worse, the final distributor is also responsible for collecting and paying the state’s retail excise tax.  The distributor must calculate and remit this tax before a consumer ever purchases a final product from a dispensary.  Instead, the state simply assumes the retailer will mark up its wholesale prices by a given amount—currently 80 percent—and requires the final distributor to remit retail excise taxes based on this assumed price.

This final sale may never materialize.  For instance, the products could spoil before a sale is made or a retailer could decide to sell it at a lower price.  That’s why sales taxes are normally calculated at the point of sale and remitted to the state directly by the retailer. This oddity within California’s commercial marijuana structure has virtually no equivalent in other industries or other state marijuana programs.

As LAO observes, “For most taxes, a single entity—a taxpayer—participates in the taxed event, collects the original tax payment, and remits the tax to the state.”

LAO ultimately recommends both a drastic simplification of the tax structure—moving only to a single level of taxation at retail—and an overall rate reduction, dropping the total tax to “somewhere in the range of 15 to 20 percent.”

“Our recommended range of tax rates reflects the three goals outlined in statute: undercutting illicit market prices, generating sufficient revenues, and discouraging youth use,” LAO states.

These recommendations comport strongly with those made previously by Reason Foundation and legislators would be wise to take LAO’s advice.

Geoffrey Lawrence is a senior policy fellow at Reason Foundation.