Ideas & Insights

Where is the “Pot” of Gold?

Where is the “Pot” of Gold?

California’s Cannabis Tax Revenue: Expectations vs. Reality

By: Scott Johnson

Cannabis tax revenues have fallen short, much to the chagrin of state and local governments who were relying on higher revenues. The California Department of Tax and Fee Administration (“CDTFA”) reported that between January and March the State earned $60.9 million in tax revenue from California’s legal adult-use and medical cannabis industry. The $60.9 million figure does not include local tax revenue collected by cities and counties. The breakdown of revenue was as follows:

  • Excise Tax: $32 million
  • Cultivation Tax: $1.6 million
  • Sales Tax: $27.3 million

While $60.9 in new tax revenue may seem like a lot, the figure falls well short of the pace predicted by Governor Jerry Brown’s 2018 budget proposal. That forecast predicted up to $175 million in State cannabis tax revenues between January and June of 2018.

The relatively low level of tax revenue aligns with industry reports that cannabis sales in California have been lagging since legalization on January 1, 2018. For example, in April, the Sacramento Bee reported that the cannabis industry generated an estimated $339 million in retail sales for the first two months of the calendar year. That is 13 percent less than state projections. The state would need $383 million in retail sales every two months for the remaining six months of this year in order to meet the budget forecast of $1.15 billion.

Typically, cannabis sales are slower in the winter and spring months than summer, and state and local governments should expect a noticeable increase in revenue now that summer has begun. However, weather can only account for a percentage of the shortfall. There are a number of other fundamental issues limiting the cannabis industry’s growth in California. A number of obstacles have emerged that are impeding the California cannabis industry.

Delays in Licensing Preventing Business Operation

California launched a new licensing system with the advent of adult-use legalization and there have been issues. The state’s multi-tiered system requires permission from the local city or county before a business can earn a license from the appropriate state authority. While MGO has helped some cities and counties through that process, others are experiencing delays in issuing permits, throwing another wrench into the already complex process.

Delays and difficulties in licensing have prevented some businesses from beginning operation and some existing businesses are operating in a legal “grey area.” Meaning that in many cases, they were legal cannabis businesses under the pre-1/1/2018 laws, but with the onset of the new licensing process, have not been able to acquire licenses to operate. In early April, the Bureau of Cannabis Control sent out nearly 1,000 cease-and-desist letters to cannabis businesses they determined were operating without licenses.

Across California, new and established cannabis businesses are waiting as they seek to operate within regulations. Once the kinks in the licensing process are ironed out, and hundreds, if not thousands, of businesses join the regulated cannabis market, tax revenue will surely rise.

High Cannabis Tax Rates Credited for Boom in Black Market

Another unexpected obstacle is wide-ranging reports that cannabis legalization in California has actually resulted in a boost to black market operators. This seeming contradiction is attributed to the comparatively high tax rates of California cannabis. Between the 15% excise tax, the cultivation tax, sales tax, and local taxes, the tax rate of cannabis is estimated to be up to 45% in some areas. As a result, cannabis business operators must charge inflated prices for product to maintain profit margins, prices easily undercut by black market operations.

High tax rates incentivize illegal activity. California has a markedly higher tax rate than other states with legal adult-use cannabis markets. In addition, Colorado, Washington, and Oregon have all taken steps to reduce their initial cannabis tax rates, precisely as a response to persistent black market operators.

While California lawmakers rejected AB 317, legislation that would lower the effective tax rate and eliminating the cultivation tax for three years, MGO is currently consulting with local municipalities on possible adjustments to their taxes and fees to discourage black market operators. In addition, as we work with local agencies to access the industry’s compliance with local regulations and taxes, one of the most common areas of feedback we hear from industry is how difficult it is to compete while non-legal businesses are operating in direct competition within a local jurisdiction. Legal businesses are at a market disadvantage, Illegal cannabis markets rob the state and local governments of tax dollars, drive up policing and incarceration costs and pose a public safety risk to communities. It is important that the State and local agencies work together to either close down or get these illegal businesses into compliance to level the playing field.

Not all California Municipalities Have Accepted the Cannabis Industry

A key component of Prop 64 was the ability for cities and counties to determine how cannabis legalization laws would be enforced within local jurisdictions. Over the past year, each city and county across California has begun the process of developing local laws. A report by the OC Register in early April found a “crazy quilt of policies” across the state. Less than one in three cities in California (144 out of 482) allow any kind of cannabis industry operation, and only 18 of 58 counties allow cannabis business operations in unincorporated areas.

This patchwork mix of laws and regulations governing the cannabis industry has created a complex environment for both businesses looking to get off the ground, and potential customers, who oftentimes must look hard, or travel, to gain access to “technically” legal cannabis.

How Will California Respond to Low Cannabis Tax Revenue?

It is important to express that the “growing pains” illustrated above are far from disastrous. Each state that has legalized cannabis has experienced issues and obstacles. There is no formula for creating a cannabis regulatory framework, and the economic, geographic, social and population factors unique to California assured that the system established here would be the first of its kind.

Another, simpler explanation, could be that the State’s budget projections were simply too optimistic for a new emerging industry. Even so, the cannabis industry may still meet, or even exceed, those projections by years end.

California’s legal cannabis market is in its infancy, and certain difficulties are inevitable. No real judgements about revenue, reporting, or even the efficacy of tax rates can be made until the state licensing authorities, and local jurisdictions, have their regulatory systems fully in place and operational.

What can Local Agencies do?

As local agencies consider new cannabis regulations or tweak their existing cannabis ordinances, MGO offers the following suggestions and solutions:

  • Proactive collaboration between regulators, industry, and the community
  • Outreach and education for the industry and community
  • Diversity in the number of cannabis businesses types
  • Support compliance-centric standard operating procedures
  • Early internal collaboration
  • Establish a proactive monitoring and compliance program

Scott Bio:
Scott Johnson, CPA, cities, counties and state agencies - consulting and advisory services, marijuna tax and complianceScott is a partner at Macias Gini & O’Connell (MGO), a CPA and advisory firm. He leads MGO’s state and local government advisory services. Scott has over 30 years of high-level organizational management and leadership experience. He is nationally recognized as a leader in managing city finances, investments, and budgets. Scott has been an active participant with CSMFO and is a past president (2011). Scott’s areas of expertise include fiscal and internal operations of large multi-billion dollar government organizations, as well as medium sized local governments such as the cities of Santa Clara, Milpitas, San Jose, Oakland and Concord, and the County of Santa Clara. He has served as the Assistant City Manager, Assistant City Administrator, Director of Finance, and Controller-Treasurer.

In the area of Cannabis, Scott led the effort in the City of San Jose to implement a marijuana business tax; including drafting a ballot measure, developing an outreach and training program for medical marijuana businesses; working with the police and planning departments and the City Attorney’s office on regulations and enforcement; and developing an audit program to audit compliance of the City’s medical marijuana dispensaries on state and local medical marijuana laws. In addition, Scott has been working with numerous local and state agencies on compliance issues in the cannabis industry.

As a leading provider of audit and advisory services to California’s largest government entities, MGO is uniquely qualified to help organizations navigate the challenges that public sector executives and elected officials are facing.

Beyond traditional views of assurance and advisory services, we see ourselves as an extension of the client team – rolling up our sleeves, embracing challenges and implementing solutions.

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