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California is reducing taxes so that licensed cannabis businesses can compete with the unlicensed market. Tax relief without enforcing existing laws will not work. This is not to say that the tax cut is not needed. The tax cut is great and is necessary. However, California can level the playing field by using enforcement powers to seize inventory and impose monumental penalties that will make unlicensed activity unsustainable. The current decentralized approach to enforcement is not working. California must quickly determine who controls cannabis enforcement efforts and how to fund an effective program. Here is our plan for California’s road to eliminating the unlicensed market.
California’s Tax Cut Plan
The California Assembly Committee on Revenue and Taxation released an analysis that shows that Assembly Bill 1948 will cost the state up to $735 million in lost tax revenues. Assembly Bill 1948 temporarily reduces the cannabis excise tax from 15% to 11% and suspends the cultivation tax through 2023.
The Committee’s analysis concludes that the unlicensed market is huge – over $9 billion in 2018. Data cited from Arcview Market Research shows that 11 million out of 13.5 million pounds of cannabis produced by California in 2016 is believed to be shipped to illicit markets. An illicit market differs from an unlicensed market in that commercial cannabis operations are not legal.
The report also estimates that there is a 77% price difference between the licensed and unlicensed markets. The price difference is due to taxes, regulatory compliance, and local taxes.
California’s Legislative Analyst’s Office produced a report cited by the Committee that shows that the tax cut will result in an increase in the licensed market of just 6% to 20% in the short term but that it will be undermined by the higher costs of selling a regulated product. The LAO performed a qualitative analysis to reach this conclusion because there is no information that can be used to quantify the problem.
Proposition 64 required the LAO to submit recommendations for adjusting the state’s tax rates to the Legislature prior to 2020. Any tax rate adjustments must achieve the goals of (1) undercutting illicit market pricing, (2) funding programs, and (3) discouraging cannabis use among youth. Among others, the LAO recommended that the tax rates be lowered in order to undercut unlicensed market pricing. The question is will the tax cut effectively undercut unlicensed market pricing when the overall supply is not reduced and operating cost for unlicensed activity is not increased?
Is a higher price for a regulated product like cannabis bad?
No, the price of a regulated product is generally higher. Regulated products are produced using high standards in order to protect consumers and society. Regulators balance the risk and threat to consumers with the regulatory cost to the marketplace. This is a dynamic process that changes over time. New industries and technologies begin as unregulated products but become more regulated as the market matures. Cannabis is no different.
California’s stringent regulations are costly. However, the regulations meet the standards outlined in the DOJ’s Cole Memo and protect cannabis licensees from federal interference. The state may face federal action if it deregulates the industry.
Businesses must agree to assume the compliance costs in order to receive a license, which is a privilege. This structure works fine so long as the competition also agrees to follow the same rules or gets out of the business altogether. There are many industries where this framework works just fine like alcohol, tobacco, securities, and airline industries. So what is happening with the cannabis industry?
California’s state regulators have not publicly stressed, through speeches, significant enforcement actions or otherwise, the fact that the transition period for the legacy market is over. The transition period ended when California stopped issuing or extending temporary licenses on January 1, 2019. From that time on, businesses can only engage in legal cannabis activity with a license, which is only provided at a higher operating cost.
Following the transition, regulators should have been ready with a hammer of enforcement and high penalties to bring the unlicensed market under control. Lowering the taxes is a band-aid that makes the industry feel better but it does not solve the problem.
What is California doing today?
California relies on the Bureau of Cannabis Control to work with local governments to stop the unlicensed activity. This is not the optimal approach as the BCC is a regulatory agency and not an enforcement agency. The decentralized approach used by the state today is ineffective and activity falls through the cracks. Also, local governments do not have the funds to do this successfully.
The LAO’s report shows that the state allocated $278 million in cannabis revenues for 2019-2020 to 20 programs. Only 9.4% or $26 million of these funds are allocated to local governments to fund public health and safety efforts. Childcare for children received the largest allocation of $80 million.
The Board of State and Community Corrections issued an RFP on February 14, 2020 to award this $26 million to local county and city governments that submit applications by April 3, 2020. The state will only provide up to $1 million to those cities and counties that allow storefront retail and cultivation businesses. Non-participating cities and counties receive no enforcement funds.
Regulators and the industry cannot expect local governments to raise taxes in order to fund efforts to get rid of the unlicensed market. California should adopt a centralized approach that is similar to the federal government’s oversight of the tobacco and alcohol industries.
How do Alcohol and Tobacco industries Control the Unlicensed Markets?
A huge difference between the cannabis, alcohol and tobacco markets is that the federal agency, the Alcohol and Tobacco Tax and Trade Bureau, oversees alcohol and tobacco with the states. Federal agencies are well funded and use dedicated enforcement arms to get rid of bad actors.
California is not as well funded, and enforcement is lacking. State regulators must adopt the same enforcement efforts for cannabis that is used by the federal government to oversee the alcohol and tobacco markets. California must impose large fines and implement an enforcement program with teeth. Enforcement is good for the legal market as it will increase prices in the unlicensed market.
Unless California is relying on the DEA to cover enforcement, it should allocate all tax revenues for a dedicated enforcement arm with the sole mission of getting rid of the unlicensed market. After it is under control, California can charge the high taxes the state receives from alcohol and tobacco to fund its social programs.
Should regulators and the industry support the tax cut?
Regulators and the industry should support the tax cut but recognize that it is a band-aid that is helping businesses through a period in which the unlicensed market holds the majority of market share. Regulatory reform and deregulation is not an option until the unlicensed market is under control.
The state must answer very quickly who is in charge of enforcement and how will it be funded. The transition is over. This is not a war on drugs. This is showing the world that cannabis is like any other industry, and treating it as such, by enforcing the laws.