High Tax Burden is Burning Out Local Cannabis Industry

By: Sandra Parhami

After more than a century of prohibition on recreational Marijuana, constituents were hopeful that the passage of Proposition 64, the Adult Use of Marijuana Act (AUMA), approved by voters in 2016, would create state and federal tax revenue, as well as reduce the scope of the unregulated market, or ‘black market’, to ensure consumer safety.

Although Proposition 64 has set the stage for a safer, more regulated distribution of the plant, aspirations to gut a thriving unregulated market and to significantly increase tax revenues have been rebutted by the rising challenges the cannabis industry faces at each level of the supply chain— specifically, with the end of a grace period, in which stricter regulation will begin on July 1st.

Instead of empowering local businesses to hit their stride, thousands of manufacturers, growers, and retailers have lost their licenses amid these tighter regulations.

In light of the growing trend of distributors working without a license and proper regulation, the Santa Cruz County Business Council went to tour a facility that is playing by the book and facing a great financial burden to do so. Council staff witnessed all levels of production of an integrated cannabis business located in Watsonville, hair nets and all, to paint a clearer picture as to how these added regulations impact our local businesses. By outlining the correlated costs and obstacles that are layered within each step of the supply chain, the SCC Business Council hopes to uncover why the Santa Cruz County Cannabis Tax Revenues are falling short and why the unregulated market continues to thrive, today.

So, what are the cultivation tax rates, and who pays them?

In addition to corporate, sales, and the current local tax of 7 percent, Proposition 64 imposes these cultivation tax rates:

• $9.25 per dry-weight ounce of cannabis flowers, and
• $2.75 per dry-weight ounce of cannabis leaves.

Cultivators are responsible for paying the cultivation tax to the distributor, unless the first transfer of unprocessed cannabis is to a manufacturer, in which the manufacturer will pay the cultivation tax to the distributor. Finally, the distributor pays and reports the cultivation tax to the California Department of Tax and Fee Administration (CDTFA).

In sum, these tax layers add up to a whopping 39 percent cumulative tax on cannabis in Santa Cruz County. And, unlike nearly all other industries and businesses, dispensaries and other cannabis businesses are not authorized to file for a variety of tax deductions, such as employee payroll, to lighten the impact of such a tax.

How does this impact the ability of these regulated businesses to compete with the ‘black market?’

Particularly, this compilation of taxes and fees raise the cost of retail marijuana as much as 70 percent.

These fees are a huge hurdle to success in this industry: they raise prices all along the supply chain— making it tough for retailers to turn a profit, and in turn incentivizing consumers to seek out cheaper, illegal alternatives.

In addition to high taxation rates, further complications arise with the addition of a new tracking software, outsourced lab testing on final products, and difficult-to-meet packaging requirements.

How intense are the new tracking regulations on recreational marijuana?

The system, essentially a “track and trace” software (otherwise known as ‘seed to sale’), will monitor the plant’s every move, from the cultivator all the way to the retailer: this includes the weight of the plants when they’re wet, when they’re dry, before and after the leaves are stripped, the weight of the buds after harvesting, and then again during trimming. Once the plant enters its final form, ready for retail, a code goes with them to track the sale. This is a time consuming, labor intensive regulation that doesn’t even exist in the tobacco or wine industry.

In addition to the increase in time and money allocated to labor, profit margins are continuing to erode for local business owners as they grapple with a slower turnover rate for their products.

Once the plant arrives to the distributor, a third party lab is called to do the testing on the product to determine whether it can be authorized for retail. Marijuana involves a timely production cycle. The plant isn’t even ready to be harvested until well over two months, and from there, drying can take weeks. Added to this production cycle are an additional five days needed to quarantine the final products, awaiting the arrival of a third party lab tester.

If the product is deemed below standards, the batch is sent back to the manufacturer to alter the product. Not only has this increased the cost of testing, but factories now have to remediate these products, as opposed to scratching a whole batch in the earlier stages to save time and money spent on labor, packaging, and testing.

The particular site visited by Council staff was unique in that their cultivation license was granted long before the modification of zoning laws in the area. Being grandfathered into their location, and integrating the full supply chain into their business has increased their ability to survive as a local cannabis business— while others have not been as fortunate. It is nearly impossible for a cannabis retailer to survive without access to a significant amount of capital to avoid burning out.

As a result, the number of licensed retailers has plunged from 1,100 under previous regulations to 410, according to BDS Analytics. Growers face a similar fate: about half the state’s approximately 60,000 cannabis farms have been driven out of business by these new rules.

The industry has definitely taken a hit with the reduction in licensed retailers and growers; the rate of regulated consumption is currently on track to be 11.5 percent lower than the state’s estimate for 2018.

Local cannabis businesses are struggling to see the light at the end of the tunnel—the cost of production continues to soar with added regulation, layers of taxes exist at every level of the local supply chain, and market prices are not on par with the total cost of production on top of these fees.

As high as the consumers of these products may be, the taxes levied on legal cannabis may prove to be even higher.