Taxes and Red Tape Hobble California's 'Legal' Marijuana

Legalizing a market isn’t enough; you have to set the participants free.

Marijuana has been legal for both medical and recreational use in California for years, but now comes word illegal producers and vendors dominate the industry. How can that be? Government officials, it turns out, have so burdened cannabis with red tape that it continues to be cheaper and easier for customers to make purchases on the black market. In a pattern seen earlier with regard to tobacco and alcohol, politicians are discovering that when they only grudgingly "legalize" a popular product, the public will take their business wherever it's convenient.

"Rather than make cannabis a Main Street fixture, California's strict regulations have led most industry operators to close shop, flee the state or sell in the state's illegal market that approaches $8 billion annually, twice the volume of legal sales," Politico's Alexander Nieves reported over the weekend.

The Politico piece followed on a boastful press release from California Attorney General Rob Bonta announcing "the eradication of nearly 1.2 million illegally cultivated marijuana plants and the seizure of more than 180,000 pounds of illegally processed marijuana." 

That was a remarkable law-enforcement "victory" against a product that is supposed to be legal to cultivate and sell throughout the state of California. The passage in 2016 of Proposition 64 was billed as permitting recreational marijuana after two decades of availability for often loosely defined medical use. The problem, though, is that the industry is so heavily regulated and taxed that legal operations are challenging and retail prices remain uncompetitively high.

"The implementation of Proposition 64 has resulted in inconsistencies between different jurisdictions, particularly with tax rates, licensing procedures, and land use regulations," according to a 2020 market analysis by Applied Development Economics. "With these inconsistencies, the illegal market continues to make up a large majority of the cannabis sales in California." That is, despite legalization, barriers to above-board sales remained so high that "the illegal cannabis market makes up about three-fourths of the existing cannabis sales in California."

A year later, Politico points out that "68 percent of California cities ban cannabis retail, including wide swaths of the Central Valley." Even where it's legal, "the price of cannabis products sold in legal dispensaries can be two to three times higher than nearly identical items sold in unlicensed shops, which aren't subject to cultivation or excise taxes that drive up costs for retailers."

If only politicians had known that hobbling a "legal" industry would have roughly the same effect as imposing prohibition in terms of driving it underground. That's especially true when the industry spent decades operating in the shadows and both vendors and consumers are accustomed to ignoring the law. But, of course, politicians should have learned from earlier examples.

Canada went down this path not so long ago, also burdening newly legal marijuana dealers with taxes and red tape.

"I did $1.4 million in sales, which is the highest sales of any retailer in Newfoundland, as far as I know. And I'm just barely scraping by," one vendor told the CBC in 2019. He complained of a commission set by law that was trimmed by taxes and credit card fees. As a result, the illegal market remained five to seven times larger than the legal market in terms of sales.

Before that, Washington state also created a legal-ish market with deliberately restrictive rules that were intended to be inconvenient.

"The free market is an excellent system for maximizing consumption. That's why I don't want it to apply to this product," huffed public policy professor Mark Kleiman, who consulted on the state's marijuana regulators. "I wouldn't want that system for alcohol either, but we lost that battle."

"Regulations are typically imposed on legal suppliers with the aim of preventing criminal activity in the licensed system and preventing over-consumption to protect public health," noted the Washington State Institute for Public Policy in a report on ways to curb the thriving illicit market. "Such regulations —including excise taxes, limits on cultivation capacity, and traceability monitoring of legal production—may reduce the competitive advantage of legal suppliers, thereby providing support to the illicit market."

"We found little to no evidence of effective methods for suppressing illicit markets in this context," the report's authors added.

Even earlier, the alcohol market (that Kleiman so regrets) demonstrated that high taxes and tight regulations drive customers to black market vendors for products other than marijuana.

"Alcohol is much more expensive in Illinois than it is in Indiana," reported a Chicago ABC affiliate in 2015. "And it is even pricier in Cook County, where the tax rate on liquor is more than five times higher than it is in the Hoosier state." The result was a steady flow of booze smuggled across the border from Indiana for sale to bargain-seekers in Illinois.

"Anytime you order a cocktail or buy a bottle of liquor in New York, there's a one in four chance that the booze has been smuggled in from out of state," Crain's New York Business estimated in 2016, largely as the result of the state's high taxes.

Cigarette taxes are also higher in New York than most other places, with predictable results.

"In 2018, New York was the highest net importer of smuggled cigarettes, totaling 53.2 percent of total cigarette consumption in the state," according to the Tax Foundation. The organization also points out that "banning flavored tobacco products … may result in much lower revenue from the cigarette tax by driving consumers to procure their cigarettes illegally or from jurisdictions without bans."

All too often, public policy experts have to rediscover the fact that "legal" and "illegal" aren't necessarily opposites; they exist along a spectrum. Something can be banned, with the law so ignored that people forget it's there. And something can be permitted, but so restricted that underground business remains the only practical access.

With burdensome taxes and regulations, California officials created a market for legal marijuana that is less attractive than flexible and cheaper illegal competition. If they want that legal market to be competitive, they'll have to actually set the participants in that market free.