A New Report Explains How California Screwed Up Marijuana Legalization

Heavy regulation, high taxes, and local bans combined to cripple the legal cannabis industry, which accounts for just a third of the state's pot market.

Six years after California legalized recreational marijuana, the black market still accounts for roughly two-thirds of the state's cannabis sales. Since legalization was supposed to eliminate the black market, that embarrassing situation represents a stark failure to fulfill the promise of Proposition 64, the 2016 ballot initiative that allowed recreational consumers to buy marijuana from state-licensed retailers.

Regulatory costs, high taxes, and local bans on retailers are the main factors impeding the transition to a legal market, according to a new report from Reason Foundation, the organization that publishes this website. The report, written by Geoff Lawrence, the foundation's managing director of drug policy, focuses on the latter two issues. It recommends tax relief, which Lawrence shows would be compatible with continued growth in state marijuana revenue, and incentives aimed at encouraging local governments to allow retail sales.

The tax burdens for California marijuana businesses are complicated and daunting. One problem that's not unique to California is Section 280E of the Internal Revenue Code, which prohibits cannabis suppliers from deducting standard business expenses on their federal tax returns. Because of that restriction, Lawrence notes, marijuana businesses "may only deduct the costs directly incurred to purchase or produce inventory," a.k.a. the "cost of goods sold."

The upshot is that marijuana businesses can owe money to the IRS even when they don't turn a profit, while those that do make money are subject to much higher effective tax rates than other businesses are. In one hypothetical example offered by the cannabis consulting firm Greenleaf HR, an ordinary business pays an effective tax of 30 percent, while a marijuana business with the same gross income and expenses pays an effective tax of 70 percent.

While California legislators have no control over federal tax law, they do decide how much the state will collect from marijuana producers and sellers. In addition to state income taxes, which currently average nearly 9 percent of net earnings for corporations, the state levies include a cultivation tax of $10.08 per ounce of flower and $3 per ounce of leaves (both of which are indexed to inflation), plus a 15 percent retail excise tax. The state also collects a general sales tax of 7.25 percent, which rises to an average of 8.82 percent when local levies are included. And the state allows local governments to impose additional taxes on growers, manufacturers, distributors, and retailers.

All told, Lawrence calculates, the effective tax rate on marijuana in California ranges from $42 to $92 per ounce, depending on the jurisdiction, compared to an estimated wholesale production cost of $35 per ounce. California's taxes are notably higher than those collected by other states that have legalized marijuana. "Colorado and Oregon both exempt cannabis transactions from general state sales taxes," Lawrence notes. "Colorado assesses a 15% wholesale transfer tax and a 15% retail excise tax while Oregon assesses only a 17% retail excise tax." A 2020 Reason Foundation report calculated that total taxes amounted to $526 per pound in Colorado and $340 per pound in Oregon. In California, Lawrence found, the total burden per pound "ranges from $677 to $1,441."

Those taxes, along with state and local regulations, give black-market dealers a clear advantage over legal sellers. "Even if illegal suppliers demand a risk premium to engage in criminal activity, which drives upward the prices of illegal products," Lawrence says, "these illegal suppliers evade tax and regulatory costs imposed on their legal competitors." The taxes alone create "a significant disadvantage that may overwhelm the risk premium demanded by illegal producers and retailers."

The impact of these disadvantages is reflected in state-licensed marijuana sales. Judging from survey and sales data, Lawrence says, legal sales account for about one-third of California's total marijuana market, which is consistent with other recent estimates.

Data from drug use surveys suggest that, other things being equal, per capita spending on legally sold marijuana should be about 20 percent lower in California than it is in Colorado and Oregon. Yet sales data indicate that "residents in Colorado and Oregon spend roughly 3.35 to 3.78 times more than California residents on legal cannabis products per capita." Those states clearly have been more successful at displacing the black market, and lower taxes seem to be a major reason for that.

Lawrence argues that California should not be collecting cultivation taxes at all, since such levies are "hidden from the ultimate consumer," "difficult to administer and audit," and "pyramid up the supply chain." Based on estimates of how  consumers respond to price changes, he projects what would happen to state revenue in six scenarios where legislators eliminate the state's wholesale taxes and either leave the retail tax the same, reduce it by various amounts, or scrap it entirely. In that last scenario, the state would still be collecting revenue from the general sales tax.

Because cutting taxes would boost licensed sales by reducing prices, Lawrence finds, state revenue would continue to rise, although it would be lower than it would be under current rates in each of the scenarios. "If the cultivation tax is eliminated and no other changes are made," Lawrence says, "total monthly state revenue from taxes on cannabis transactions by December 2024 will be more than double their March 2022 level." Cutting the retail tax while eliminating the cultivation tax, he says, "could lead to much faster growth of the legal market and displacement of the illegal market."

Lawrence says his analysis "shows that a reduction in taxes can make legal products more price-competitive with illegal products and lure more consumers into the
regulated market." The resulting market growth "will quickly displace the lost revenue resulting from a reduction in tax rates."

To be clear: The state could still expect more revenue at current rates. But as Lawrence notes, tax revenue is not the only measure of success.

"High taxes on legal products, combined with a paucity of legal retailers in many regions of the state, encourage consumers and producers to frequent the illegal market," Lawrence writes. "Transactions on the illegal market are unregulated and may be a threat to public safety. Illegal products are untested and may be contaminated. Participants in illegal markets have no legal recourse to peaceably resolve disputes and sometimes resort to violence. International drug cartels may become prominent suppliers of illegal products in extraordinarily high-tax areas or those without legal retailers."

The "paucity of legal retailers" that Lawrence notes is a result of local bans, which Proposition 64 allows. The overwhelming majority of local governments in California have decided to prohibit marijuana sales. While Colorado has "one legal retailer per 13,838 residents" and "Oregon boasts one retailer per 6,145 residents," California has "one legal retailer per 29,282 residents, indicating a dramatic undersupply of legal retailers in the Golden State."

Sales bans are concentrated in certain parts of California. "More than half of the 929 storefront dispensaries are located in just 18 cities," Lawrence notes. While "an additional 402 delivery-only licensees may make deliveries to customers beyond their home jurisdiction," he says, "most deliver only within regional metropolitan areas and none deliver to all locations in California." The result is "massive cannabis deserts" where "consumers have no access to a legal retailer within a reasonable distance of their home." In those areas, even consumers who would not be deterred by the higher prices in state-licensed shops may find it much more convenient to buy marijuana from unlicensed dealers.

California legislators could curtail the authority of local governments to regulate marijuana sales. Lawrence notes that "several states allow local governments only to reasonably regulate the times and manner of cannabis enterprise operations without imposing outright bans." If legislators are not prepared to copy that approach, he suggests, they could still give counties and cities an incentive to allow marijuana sales by promising them a share of the resulting state tax revenue.

"At the same time," Lawrence says, "state lawmakers should seek to limit the additional layers of taxation assessed by local governments because these taxes compound to make legal products uncompetitive on a price basis with illegal products. In other words, the state may be able to creatively displace local government tax revenues such that a reduction in state taxes is not offset by further increases in local tax rates."

The report does not discuss regulatory reforms. But in the foreword, Dale Gieringer, California director of the National Organization for the Reform of Marijuana Laws, suggests that regulations are another ripe target for policy makers who want to reduce the disadvantages of playing by the rules.

Gieringer originally anticipated that marijuana prices would plummet after legalization. But "it turned out that I had vastly underestimated the cost of the regulations imposed by the new law," he writes. "In addition to state and local licensing fees, there were elaborate rules on cultivation, retailing, transportation, manufacture, testing, facility siting, ownership, security, storage, on-site consumption, wholesale distribution, seed-to-sale tracking, waste disposal, labeling, packaging, environmental compliance, water usage, etc. ad nauseam."

Proposition 64 also included "an ambitious package of cultivation and excise taxes aimed at raising some $1 billion per year for various state programs, and local governments were authorized to levy even more taxes on their own." The situation was exacerbated, Gieringer says, by "local dispensary bans and licensing delays, which left the state with half as many adult-use dispensaries as there were medical collectives before Prop. 64 was passed."

Because of all these barriers and burdens, Gieringer writes, "California's legal industry has been hard pressed to compete with untaxed, unregulated providers on the underground market." The current situation is "so dire," he says, that "advocates now fear that the cannabis industry in California faces an 'existential crisis' in the absence of meaningful tax reform."

California, in short, has done just about everything it could to ensure that legalization would fail to achieve one of its main goals. There is no shortage of solutions to that problem. What's required is the political will to implement them.