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California Drops Cannabis Cultivation Tax, Aims to Bolster Licensed Market

California recently provided a jolt to its cannabis industry by eliminating its cannabis cultivation tax, effective July 1, 2022.  The cultivation tax has, for years, created a drag on California’s licensed cannabis market and caused many businesses to continue operating in the illicit, unlicensed market.  Given that the cannabis cultivation taxes are ultimately passed onto consumers (through distributors and retailers), this move will ultimately drive down the cost of retail cannabis.  In turn, this should drive up the licensed retail demand and make all types of cannabis businesses more profitable.  It could possibly even increase the tax revenues flowing to governments as more licensed sales are consummated.

California has always been a national and international leader in building a legal cannabis industry.  It was the first state in the nation to legalize medical marijuana (via Proposition 215, in 1996), the first to recognize legal marijuana sales (via Senate Bill 420, in 2003, allowing nonprofit medical marijuana collectives), and one of the first states to issue licenses to non-medical, adult-use cannabis businesses allowed to sell cannabis for profit to the general public (via Proposition 64, passed by voters in 2016).  California is widely viewed as producing some of the world’s best cannabis flowers, and the best innovative new cannabis products including cannabis edibles and concentrates.  For quite some time in California, smoking cannabis has been more widely accepted and considered less taboo than smoking tobacco.

For most of its history, California’s cannabis market has been unregulated.  The state had a thriving marijuana legacy (illicit) market for a long time before legal medical marijuana came along, and for years, legal sales of medical marijuana occurred within the context of “collectives,” which were not subject to any licensing or regulation. When licensing laws came along in 2016, a massive unregulated industry already existed.

Recently, there is a perception that California’s cannabis industry is slumping, due in large part to overly cumbersome and burdensome taxes and regulations at both the state and local levels.  The recently-eliminated cultivation tax required licensed cannabis cultivators to pay an extra $161 per pound of cannabis flowers provided to cannabis distributors.  As wholesale cannabis prices have dropped substantially in the last year, this cultivation tax created a drag on the entire industry, making many businesses already struggling to get by unprofitable.  In addition to the cultivation tax, California cannabis is subject to a 15 percent excise tax  at the retail level, and 7.25% state sales taxes, local sales taxes, and often additional local cannabis-specific taxes.  All this is on top of regular state and federal income taxes owed by cannabis businesses, with Section 280E of the Internal Revenue Code prohibiting businesses from deducting otherwise ordinary business expenses from the gross income associated with selling cannabis on their federal tax returns.  Cannabis businesses are also charged significant licensing fees by both local and state governments, with annual state licensing fees reaching as high as $300,000.

The combination of all these taxes has created an environment where California retains a gigantic unlicensed, unregulated cannabis market, which was valued in a 2019 Statista report at $8.7 billion per year.  Licensed California businesses struggle to compete with the unlicensed market, which pays no taxes and does not comply with any regulations.

Other states have taken a substantially different approach, aiming for a lighter touch.  Missouri taxes cannabis sales at only 4%, and Oklahoma taxes cannabis sales at 7%.  Neither state separately taxes cannabis cultivation like California did.  Some have speculated that California’s tax reductions could paradoxically increase tax revenues – while also boosting the industry.  In economics, the “Laffer curve” – in the shape of a rainbow – shows the relationship between rates of taxation and the resulting levels of the government’s tax revenues.  At a certain point, after going over the top of the rainbow, increasing tax rates decreases tax revenues, because the increased tax rates eliminate some sales that otherwise would have occurred.  At high enough tax rates, licensed sales will drop to zero, and the government will collect no taxes.

While California’s elimination of the $161-per-pound cultivation tax may not transform the industry overnight, it is a welcome sign for a beleaguered industry.  Many people believe that federal cannabis legalization is coming soon, and by reducing its taxes, California not only bolsters its in-state cannabis market, but also sets its cannabis businesses up for future success in the likely-upcoming legal national – and international – markets.

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