How High? Adjusting California’s Cannabis Taxes

How High? Adjusting California’s Cannabis Taxes GABRIEL PETEK LEGISLATIVE ANALYST DECEMBER 2019 analysis full gutter AN LAO REPORT LEGISLATIVE ANALYST’S OFFICE analysis full gutter AN LAO REPORT Executive Summary Report Required by Proposition 64. Proposition 64 (2016) directed our office to submit a report to the Legislature by January 1, 2020, with recommendations for adjustments to the state’s cannabis tax rate to achieve three goals: (1) undercutting illicit market prices, (2) ensuring sufficient revenues are generated to fund the types of programs designated by the measure, and (3) discouraging youth use. This report responds to this statutory requirement and discusses other potential changes to the state’s cannabis taxes. While this report focuses on cannabis taxes, nontax policy changes also could affect these goals. Proposition 64 Created Two State Excise Taxes on Cannabis. Proposition 64 established two state excise taxes on cannabis. The first is a 15 percent retail excise tax, effectively a wholesale tax under current law. The second is a tax based on the weight of harvested plants, often called a cultivation tax. (The measure authorizes the Legislature to amend its tax provisions without voter approval, but the scope of this authorization is unclear.) Analysis Choices About Tax Structure Should Precede Choice of Tax Rate. Before determining the specific tax rates to impose, we encourage the Legislature first to address two critical decisions: (1) choosing what type of tax to impose on cannabis, and (2) choosing which type of transaction to tax (known as the “taxed event”) and who should remit the tax (known as the “point of collection”). These choices can have effects on the three goals identified by the measure as well as other important considerations. Trade-Offs Exist Among Tax Types, but Weight-Based Taxes Generally Weakest. We analyze four types of taxes: basic ad valorem (set as a percentage of price, such as the current retail excise tax), weight-based (such as the current cultivation tax), potency-based (for example, based on tetrahydrocannabinol [THC]), and tiered ad valorem (set as a percentage of price with different rates based on potency and/or product type). Our analysis focuses primarily on three main criteria: (1) effectiveness at reducing harmful use, (2) revenue stability, and (3) ease of administration and compliance. No individual type of tax performs best on all criteria. For example, tiered ad valorem and potency-based likely are best for reducing harmful use, but basic ad valorem is easiest to administer. Given these trade-offs, the Legislature’s choice depends heavily on the relative importance it places on each criterion. That said, the weight-based tax is generally weakest, performing similarly to or worse than the potency-based tax on the three main criteria. Choice of Taxed Event and Point of Collection Depends on Type of Tax. We assess several options for specifying the tax event and point of collection for state cannabis taxes. Tax administration and compliance work best when the connection between the taxed event and the point of collection is very close, when taxpayers are highly visible to the public, and when there is a small number of taxpayers. Rate Changes Would Create Trade-Offs Among Three Goals. Any tax rate change would help the state meet certain goals while likely making it harder to achieve others. On one hand, for example, reducing the tax rate would expand the legal market and reduce the size of the illicit www.lao.ca.gov 1 analysis full gutter AN LAO REPORT market. On the other hand, such a tax cut would reduce revenue in the short term, potentially to the extent that revenue could be insufficient. Furthermore, lower tax rates could lead to higher rates of youth cannabis use. With a thriving illicit market, however, much of the cannabis used by youth could avoid taxation. Where possible, this report provides quantitative estimates of the short-term effects of rate changes. We summarize these estimates—along with assessments of revenue sufficiency—in the figure below. Recommendations Replace Existing Taxes with Potency-Based or Tiered Ad Valorem Tax. We view reducing harmful use as the most compelling reason to levy an excise tax. Accordingly, we recommend that the Legislature replace the existing retail excise tax and cultivation tax with a potency-based or tiered ad valorem tax, as these taxes could reduce harmful use more effectively. If policymakers value ease of administration and compliance more highly than reducing harmful use, however, the Legislature might prefer to keep the existing retail excise tax. In contrast, we see little reason for the Legislature to retain the weight-based cultivation tax. Specify Taxed Event and Point of Collection to Match Type of Tax. After the Legislature chooses the type of cannabis tax it wants to levy, we recommend that it specify the taxed event and point of collection to facilitate tax administration and compliance. For example, for an ad valorem tax (tiered or basic), we recommend levying the tax on the retail sale and collecting it from the retailer. Set Specific Tax Rate. For a potency-based or tiered ad valorem tax, we recommend that the Legislature specify the details of the tax structure in consultation with scientific experts. Such expertise—informed by the state’s track-and-trace data—is crucial for determining key details. Currently available information suggests that a potency-based tax in the range of $0.006 to $0.009 per milligram of THC could be appropriate. If the Legislature prioritizes reducing the illicit market, it may prefer a rate closer to the lower end of this range. If, on the other hand, it prioritizes raising revenues, it may prefer a rate closer to the higher end. If the Legislature decides not to adopt a potency-based or tiered ad valorem cannabis tax, we nevertheless recommend that the Legislature eliminate the cultivation tax. In this case, we recommend that the Legislature set the retail excise tax rate somewhere in the range of 15 percent to 20 percent depending on its policy preferences. Estimated Short-Term Effects of Rate Changes on Legal Consumption and Revenue Likely Short-Term Percentage Change in Legal Cannabis State Cannabis Likelihood Revenue Would Cultivation Tax Retail Excise Tax Consumption Tax Revenuea Exceed Thresholdb Keep at current ratesc Keep at current rate (15%) 0% 0% Very likely to exceed Eliminate Reduce to 11% +6% to +20% -34% to -43% Likely to fall short Eliminate Keep at current rate (15%) +3% to +11% -16% to -25% Roughly equal chances of exceeding and falling short Eliminate Increase to 20% -2% to +1% -5% to +3% Very likely to exceed Keep at current rates Increase to 25% -7% to -22% +18% to +40% Very likely to exceed a Under current law, we expect state cannabis tax revenue to be in the mid-hundreds of millions in 2020-21 and 2021-22. b Some provisions of Proposition 64 imply that revenue below $350 million in 2021-22 would not be sufficient. c As of January 1, 2020, the cultivation tax rates are $9.65 per ounce of dried cannabis flowers, $2.87 per ounce of dried cannabis leaves, and $1.35 per ounce of fresh cannabis plants. 2 LEGISLATIVE ANALYST’S OFFICE analysis full gutter AN LAO REPORT INTRODUCTION In November 2016, California voters approved types of programs designated in the measure, and Proposition 64, which legalized the nonmedical use discouraging use by persons younger than 21 years of cannabis (typically called recreational or adult of age. This report responds to that requirement. use) and created a structure for regulating and Specifically, we provide (1) background information taxing it. Proposition 64 also directed our office to on cannabis and its legalization in California, submit a report to the Legislature by January 1, (2) a discussion of the effects of adjusting the 2020, with recommendations for adjustments to tax rate, (3) an assessment of other potential the state’s tax rate on cannabis to achieve three changes to California’s cannabis tax structure, and goals: undercutting illicit market prices, ensuring (4) recommendations for the Legislature. sufficient revenues are generated to fund the BACKGROUND Understanding the different properties, such as the amount of time until they take effect, the duration of their effects, Cannabis Plant and its Effects the concentration of THC in the product (commonly Cannabis Plant Contains Various Compounds. known as “potency”), and the amount of THC The cannabis plant contains a variety of ultimately absorbed by the body. For example, it compounds known as cannabinoids. While there generally takes longer for users to feel the effects are over 100 known cannabinoids, the most of edible cannabis products than smoked products, well-known cannabinoids are tetrahydrocannabinol and the effects of edibles tend to last longer. (THC) and cannabidiol (CBD). Experts regard Additionally, concentrates are typically much more THC as the primary psychotropic component of potent than flower (on average around 70 percent cannabis, responsible for much of the intoxicating THC compared to around 20 percent THC). Some “high” reported by cannabis users. In contrast, cannabis products contain significant amounts of CBD generally is understood not to be intoxicating. CBD but very little THC. Depending on factors such as the specific strain Cannabis Has Become More Potent Over of the cannabis plant, as well as growing and Time. Evidence suggests that the average potency harvesting conditions, some cannabis plants of cannabis has increased in recent years. There have much higher levels of THC and/or CBD than appear to be two contributing factors to the others. Very low-THC cannabis is often regarded increase in potency. First, cultivators have bred as a distinct crop known as “hemp.” Hereafter, we cannabis plants for higher THC concentrations. use the term “cannabis” to refer to the non-hemp, Second, concentrates and other high-potency generally higher-THC version of the plant, and to products make up an increasing share of the the products made from it. cannabis market. Wide Variety of Cannabis Products Available. Key Effects of Cannabis. Researchers’ current Historically, the most common method for understanding of the health effects of cannabis is consuming cannabis has been smoking the plant’s far from complete. That said, evidence indicates flower. While this is still very common, there also that cannabis provides health benefits to those are a variety of other types of cannabis products. with certain conditions, such as chronic pain and Such products include edibles (such as candy nausea from chemotherapy. However, there also is and beverages), concentrates (such as “wax”, evidence of potential harms from cannabis use. For which has a texture similar to candle wax), vapor example, some research suggests links between cartridges, and topicals. These products have www.lao.ca.gov 3 analysis full gutter AN LAO REPORT cannabis use and psychiatric disorders, such as Proposition 215 (1996) Legalized Medical schizophrenia. Additionally, cannabis use can impair Cannabis. In 1996, California became the driving, particularly when combined with alcohol first state to legalize cannabis for medical use use. In 2017, the National Academies of Sciences, when voters approved Proposition 215. While Engineering, and Medicine assessed the available Proposition 215 legalized the medical use of research on the effects of cannabis. Figure 1 cannabis, it did not create a statutory framework summarizes some of the key findings of that report. for regulating or taxing it. As a result, for roughly The negative effects of cannabis appear to be 20 years after the measure passed, most regulation greatest for high-THC products, high-frequency and taxation of medical cannabis in California use, and use by certain sensitive groups, such as happened at the local level through ordinances youth. and permit requirements. (Like other businesses, medical cannabis businesses were subject to Cannabis Legalization in California broad-based state taxes, such as income taxes Under federal law, it is illegal to possess or use and sales taxes.) In recent years, the Legislature cannabis. Currently, the U.S. Department of Justice passed a series of laws—most notably, in 2015, (US DOJ) does not prosecute most cannabis Chapter 688 (AB 243, Wood), Chapter 689 users and businesses that follow state and local (AB 266, Bonta), and Chapter 719 (SB 643, cannabis laws if those laws are consistent with US McGuire)—to provide a statutory framework to DOJ priorities, such as preventing cannabis from regulate medical cannabis. being exported to other states. Despite federal Proposition 64 Legalized Adult-Use law, California and many other states have taken Cannabis. In November 2016, California voters steps to legalize and regulate cannabis in the past approved Proposition 64. At the time, Washington, few decades. However, these states have not been Colorado, Oregon, and Alaska were the only able to include exported cannabis in these efforts states that had legalized cannabis for adult use. due to federal prohibitions. In California, exports Under Proposition 64, adults 21 years of age likely account for a large share of California-grown or older can legally grow, possess, and use cannabis—roughly 80 percent by some recent cannabis for nonmedical purposes, with certain estimates. restrictions. Since the passage of Proposition 64, Figure 1 Summary of Cannabis’ Effects and Associations As Assessed by the National Academies of Sciences, Engineering, and Medicinea Conclusive Substantial Evidence Evidence Effective treatment for: Chemotherapy-induced nausea and vomiting  Chronic pain treatment in adults  Patient-reported multiple sclerosis spasticity symptoms  Statistical association between cannabis or cannabinoid use andb: Development of schizophrenia or other psychoses  Worse respiratory symptoms and more chronic bronchitis episodes (long-term smoking)  Increased risk of motor vehicle crashes  Lower birth weight of offspring with maternal smoking  a Does not include effects and associations that were assessed to have no evidence, limited evidence, insufficient evidence, or moderate evidence. b Statistical association does not necessarily suggest a causal relationship. 4 LEGISLATIVE ANALYST’S OFFICE analysis full gutter AN LAO REPORT the Legislature has passed laws amending the local governments to impose requirements on measure, including Chapter 27 of 2017 (SB 94, cannabis businesses, to limit where they can Committee on Budget and Fiscal Review), locate, or to ban them altogether. Additionally, which brought the state’s medical and adult-use local governments may impose fees and taxes on regulatory structures into conformity. cannabis, which we discuss further below. Current Structure for State Cannabis Legislature May Make Some Changes to the Regulation and Taxation. Under Proposition 64, Measure. The California Constitution does not state agencies issue licenses to several types allow the Legislature to amend a measure passed of cannabis businesses, including cultivators, by the voters unless the measure itself authorizes manufacturers, distributors, testing labs, the Legislature to do so. Proposition 64 authorizes and retailers. (The relationships among these the Legislature to amend the measure’s tax businesses can vary; Figure 2 illustrates an provisions with a two-thirds vote. These changes example.) To hold a state license, cannabis must be consistent with the measure’s intent businesses must pay fees and meet numerous and further its purposes. In many cases, whether other requirements, including ones related to a proposed change to Proposition 64 would security protocols, product testing, and product meet these criteria and, therefore, whether the labeling. For example, cannabis products must be Legislature could enact it without a statewide vote tested for THC and CBD content before the last is unclear. distributor transfers the products to the retailer. State Cannabis Taxes and Revenue Additionally, state-licensed businesses must participate in the state’s “track-and-trace” system Distribution Under Proposition 64 by attaching unique identifier tags (similar to bar Proposition 64 Imposes Two State Excise codes) to each plant and product. These tags Taxes on Cannabis. Like other businesses, allow the state to track the movement of cannabis cannabis businesses generally must pay products through the entire supply chain, from broad-based taxes such as income taxes and sales cultivation all the way to retail sale. taxes. (We further discuss sales taxes on cannabis Local Governments May Regulate, Ban, in the box on the next page.) Additionally, as shown and Tax Cannabis. Proposition 64 authorizes Figure 2 The Cannabis Supply Chain in California Cultivator Manufacturer Testing Lab First Last Distributor Distributor Retailer www.lao.ca.gov 5 analysis full gutter AN LAO REPORT Sales Taxes on Cannabis Sales Taxes Apply to Tangible Goods, Including Cannabis. California’s state and local governments levy a sales and use tax (commonly known as a sales tax) on retail sales of tangible goods. The rate varies across the state, ranging from 7.25 percent to 10.5 percent, with a statewide average of 8.6 percent. Cannabis products are tangible goods, so their retail sale generally is subject to this tax. Legislative Analyst’s Office Definition of Cannabis Taxes Does Not Include Sales Tax. We define cannabis taxes to include taxes or tax rates that apply primarily to cannabis. We chose this definition—which does not include the sales tax—for two reasons. First, as discussed in our 2018 report, Taxation of Sugary Drinks, changes in excise tax rates, such as cannabis tax rates, primarily affect the price of one specific type of good relative to the prices of other items that consumers buy. The sales tax applies to a wide range of goods, so it does not have this property. Second, as described above, Proposition 64 (2016) requires that state cannabis tax revenues be allocated to purposes specified by the measure. In contrast, sales tax revenue goes to the state’s General Fund and to local programs, regardless of whether that revenue comes from cannabis sales or sales of other goods. in Figure 3, Proposition 64 established two state legal responsibility for the initial payment of the excise taxes on cannabis. The first is a 15 percent cultivation and retail excise taxes, respectively. excise tax on retail gross receipts. The second is a However, pursuant to Chapter 27, final cultivation tax on harvested plants. As of January 1, distributors—rather than cultivators or retailers— 2020, the cultivation tax rates are $9.65 per ounce must remit these taxes to CDTFA, resulting in of dried flowers, $2.87 per ounce of dried leaves, a multistep payment process. We explain this and $1.35 per ounce of fresh plants. The California process below and illustrate how it works for a Department of Tax and Fee Administration (CDTFA), hypothetical manufactured product in Figure 4. which administers these cannabis taxes, adjusts • Cultivation Tax. A cultivator determines the cultivation tax rates annually for inflation. the amount of cultivation tax it owes by Distributors Responsible for Remitting weighing the plants it harvests. It then pays State Taxes. Cultivators and retailers bear the this amount to a distributor when it sells or Figure 3 California’s Cannabis Taxes Tax Type Rate on January 1, 2020 State retail excise tax Ad valorem tax primarily on wholesale sales Nominally 15 percent of retail price. In practice: • For most sales, administratively determined percentage of wholesale price (currently 27 percent) • For some sales, 15 percent of retail price State cultivation tax Weight-based tax on harvested cannabis • $9.65 per ounce of dried cannabis flowers • $2.87 per ounce of dried cannabis leaves • $1.35 per ounce of fresh cannabis plant Local taxes Varies; most commonly ad valorem or based Varies—on average, roughly equivalent to a on square footage 14 percent tax on retail salesa a LAO estimate of the average cumulative tax rate, including taxes on cultivation, manufacturing, distribution, testing, and retail. 6 LEGISLATIVE ANALYST’S OFFICE analysis full gutter AN LAO REPORT transfers the harvested plants. In a case in These distributors then remit the retail excise which cannabis travels from the cultivator to taxes to CDTFA. Retailers must make these just one distributor prior to retail sale, that payments before they sell the products to distributor remits the tax to CDTFA. In many consumers, so the tax is based directly on cases, however (such as the case illustrated in the wholesale price (the price that retailers Figure 4), the supply chain is more complex, pay to distributors) rather than the retail price with multiple manufacturers and distributors (the price that consumers pay to retailers). handling harvested cannabis and the products Pursuant to Chapter 27, CDTFA sets the tax derived from it. In these cases, each of those based on its estimate of the average ratio of businesses must transfer the cultivation tax retail prices to wholesale prices—commonly until the final distributor remits it to CDTFA. known as a “markup.” CDTFA’s current • Retail Excise Tax. Retailers generally must markup estimate (as of January 1, 2020) is pay the retail excise tax to final distributors 80 percent. Due to the 15 percent statutory when they make wholesale purchases. tax rate and the 80 percent markup estimate, Figure 4 Cannabis Tax Collection for a Simple Manufactured Product Cultivation Tax Retail Excise Tax Cultivator Manufacturer First Last Distributor Distributor Retailer CDTFA CDTFA = California Department of Tax and Fee Administration. www.lao.ca.gov 7 analysis full gutter AN LAO REPORT the current effective tax rate on wholesale it generally authorizes the administration to gross receipts is 27 percent (15 percent x choose how to allocate funding among various [100 percent + 80 percent]). eligible activities within each of the three Allocation 3 categories (youth substance use Revenues Go to Three Types of Activities. programs, environmental programs, and law The state deposits the revenues from the two enforcement). For example, as shown in Figure 5, cannabis taxes into the Cannabis Tax Fund. in 2019-20, the administration’s largest allocation Proposition 64 continuously appropriates Cannabis within the substance use-related youth program Tax Fund proceeds to fund three types of activities: category was for childcare for children 13 and • Allocation 1—Regulatory and Administrative Costs. First, revenues pay back Figure 5 certain state agencies for any cannabis regulatory and Administration’s Anticipated Allocations of administrative costs not Cannabis Tax Fund Revenues for 2019-20 covered by license fees. (In Millions) • Allocation 2—Specified Allocation 1: Regulatory and Administrative Allocations. Second, after Bureau of Cannabis Control—Equity Programa $15.6 regulatory and administrative Fish and Wildlife 9.2 costs are covered, revenues State Water Resources Control Board 7.4 go to certain research and Tax and Fee Administration 7.3 other programs, such as Employment Development Department 2.5 Pesticide Regulation 2.3 researching the effects of Statewide General Administration 0.2 cannabis and the effects of Total Allocation 1 $44.5 the measure. Allocation 2: Research and Other Programs • Allocation 3—Percentage Go-Biz—community reinvestment $20.0 Allocations. Third, these Public universities—evaluation of effects of measure 10.0 revenues go to three broad Highway Patrol—impaired driving methodology 3.0 types of activities: 60 percent University of San Diego—cannabis research 2.0 for youth programs related Total Allocation 2 $35.0 to substance use education, Allocation 3: Percentage Allocations prevention, and treatment; Youth Education Prevention, Early Intervention and Treatment Account 20 percent for environmental Education—childcare slots $80.5 programs; and 20 percent for Health Care Services—local prevention programs 21.5 law enforcement. (Unlike the Public Health—cannabis surveillance and education 12.0 other allocations, funding for Resources Agency—youth community access grants 5.3 Allocation 3 comes from tax Subtotal, Youth Account ($119.3) receipts from the prior year.) Environmental Restoration and Protection Account Fish and Wildlife—environmental cleanup and enforcement $23.9 Administration Has Discretion Parks—program development, ingress and egress, and restoration 15.9 Within Each Percentage Subtotal, Environmental Restoration and Protection Account ($39.8) Allocation. Proposition 64 does State and Local Government Law Enforcement Account not allow the administration to State and Community Corrections—local grants for public health and safety $26.0 change the share of revenue Highway Patrol—impaired driving and traffic safety 13.8 allocated to each of the three Subtotal, State and Local Government Law Enforcement Account ($39.8) Allocation 3 categories. (The Total Allocation 3 $198.8 measure loosens these restrictions Total Expenditures $278.3 starting in 2028.) However, a Administered by the Governor’s Office of Business and Economic Development (Go-Biz). 8 LEGISLATIVE ANALYST’S OFFICE analysis full gutter AN LAO REPORT under ($81 million out of $119 million for this without paying license fees or participating category). in the track-and-trace program. The last Tax Treatment Differs Between Medical temporary licenses expired in August 2019. and Adult-Use Cannabis. State law exempts • Issuing Provisional and Annual Licenses. medical cannabis from certain taxes under two In September 2018, the Legislature passed scenarios. First, under a new law that takes effect Chapter 857 of 2018 (SB 1459, Cannella), January 1, 2020 (Chapter 837, Statutes of 2019 which allowed the licensing departments to [SB 34, Wiener]), medical cannabis products that issue provisional cannabis licenses under businesses donate to consumers free of charge certain conditions. Provisional licensees (and that meet other conditions) are exempt from must pay license fees and participate in the the state’s cannabis taxes. Second, cannabis track-and-trace program, but they do not is exempt from state and local sales taxes if need to show proof of full compliance with purchased for medical use with a valid state the California Environmental Quality Act medical identification card. (CEQA). (Complying with CEQA can involve a lengthy process.) Chapter 40 of 2019 (AB 97, Implementation of Proposition 64 Committee on Budget) extended the period California Still in Early Stages of in which businesses could hold provisional Implementing Regulatory Structure. licenses to no later than January 2023, after Proposition 64 required state licensing agencies— which licensees will need to secure annual such as the Bureau of Cannabis Control—to begin licenses, which require full compliance with licensing cannabis businesses and administering CEQA. Licensing agencies began issuing cannabis excise taxes starting January 1, 2018. annual licenses in October 2018. Given this time frame, implementing departments • Requiring Participation in Track-and-Trace. have taken a multistep approach, starting with As the temporary licenses have expired, temporary actions and then following up with more more businesses have obtained provisional or permanent ones. As shown in Figure 6 (see next annual licenses, a condition of which is that page), these actions include: they enter certain product information into the track-and-trace system. When we prepared • Promulgating Regulations. The licensing this report, the system still contained limited departments promulgated regulations on information. an emergency basis in December 2017 and issued final regulations in January 2019. Local Regulatory Policies Vary by The final regulations specified detailed rules Jurisdiction. Since the passage of Proposition 64, for how licensees must operate, such as cities and counties have taken a wide variety of the security protocols they must follow and approaches to cannabis. Some local governments how they must conduct laboratory tests on have licensed many cannabis businesses. Others cannabis products. These regulations included have taken the opposite approach, prohibiting some key decisions affecting the cannabis all cannabis businesses from locating within their industry. For example, the regulations prohibit boundaries. Finally, some have taken an in-between cities and counties from banning retail delivery approach—for example, licensing only medical of cannabis into their jurisdictions. (Some local cannabis businesses, licensing only certain types governments currently are challenging this of adult-use cannabis businesses, or capping regulation in the courts.) the number of certain types of businesses (such • Issuing Temporary Licenses. In January as allowing only a limited number of retailers). 2018, the licensing departments began Over time, there appears to be a general trend issuing temporary licenses to businesses. towards more local governments licensing cannabis These temporary licenses allowed businesses businesses. to operate on a conditional, limited-term basis www.lao.ca.gov 9 analysis full gutter AN LAO REPORT Local Tax Policies Vary by Jurisdiction. Local many local governments impose higher tax rates on governments also have taken a wide variety of retailers than other types of cannabis businesses. approaches to taxing cannabis. These approaches Third, a few local governments license cannabis fall into three broad categories. First, many local businesses but do not levy taxes specifically on governments impose the same tax rate on all cannabis. Although these three approaches lead to cannabis businesses regardless of type. Second, a wide range of local tax rates, we estimate that the Figure 6 Cannabis Regulation Time Line 2015 September Legislature approves MCRSA. 2016 November Voters approve Proposition 64. 2017 June Legislature approves SB 94, bringing conformity to medical and adult-use regulatory structures and changing points of tax collection. December State licensing agencies promulgate emergency regulations. January State licensing agencies begin issuing temporary licenses and CDTFA begins collecting cannabis excise taxes. 2018 September Legislature approves SB 1459, authorizing state October licensing agencies to begin issuing provisional licenses. State licensing agencies begin issuing annual licenses. November First licensees begin using track-and-trace. January State licensing agencies promulgate final regulations. 2019 August Final temporary licenses expire. All licenses must be provisional or annual. MCRSA = Medical Cannabis Regulation and Safety Act and CDTFA = California Department of Tax and Fee Administration. 10 LEGISLATIVE ANALYST’S OFFICE analysis full gutter AN LAO REPORT average cumulative local tax rate over the whole Cannabis Taxes in Other States and supply chain is roughly equivalent to a 14 percent Canada tax on retail sales. In addition to taxes, many local Nine other states and Canada have passed governments also require cannabis businesses laws taxing adult-use cannabis. We summarize to make other payments—such as fees—as a these taxes in Figure 8 (see next page). The condition of operating. most common type of cannabis tax is an ad Consumer Access Depends on Delivery and valorem (price-based) tax on retail sales, and the Local Licensing. We estimate that one-third of second-most common is a weight-based tax on Californians live in cities or unincorporated areas cultivation. Canada and Illinois have tax rates that with at least one licensed adult-use retail storefront. incorporate information about potency—the amount As mentioned above, however, state regulations of THC in a product. (We further describe the allow retail delivery even into cities and counties different types of cannabis taxes in the text box on that do not authorize cannabis businesses. As page 19.) a result, as shown in Figure 7, we estimate that about 90 percent of Californians live in jurisdictions with access to at least one state-licensed adult-use retailer—either storefront or delivery. Figure 7 Legal Adult-Use Cannabis Is Available to Most Californians Share of California’s Population Living in a City or Unincorporated Area That Has . . . A licensed storefront Licensed storefront Licensed delivery but no licensed delivery and licensed delivery but no licensed storefront No licensed retail of any kind 2% 33% 54% 11% Sources: Licensing information from the Bureau of Cannabis Control; population estimates from the Department of Finance; and delivery availability from selected websites. www.lao.ca.gov 11 analysis full gutter AN LAO REPORT Figure 8 Adult-Use Cannabis Taxes in Other States and Canada Year Key Rate(s) on Jurisdiction Implemented Type(s) of Tax January 1, 2020 Additional Local Taxes Alaska 2016 Weight-based excise tax $50 per ounce of mature flower, Taxes on retail sales $15 per ounce of leaves (no cap on rates) Canada 2019 • For plants/seeds, higher of ad • Ad valorem: 10 percent Varies valorem tax or weight-based tax • Weight-based: roughly $5.40 per • THC-based tax on concentrates, ounce of flower, $1.60 per ounce edibles, and other products of leaves • THC-based: roughly $0.0075 per gram of THCb Coloradoa 2014 • Ad valorem tax on retail sales • Retail: 12.1 percent Taxes on retail sales • Ad valorem or weight-based tax • Cultivation: 15 percent of the (no cap on rates) on cultivation depending on type contract price or the average of transaction market rate per pound Illinois 2020 (scheduled) • Ad valorem tax on retail sales, • 10 percent tax on products with Combined local taxes with rates tiered by potency and less than 35 percent THC of up to 6 percent on type of product • 20 percent tax on products any adult-use business • Ad valorem tax on cultivation infused with cannabis, such as (cities up to 3 percent edible products and counties up to • 25 percent tax on products with 3 percent within city more than 35 percent THC limits) • 7 percent tax on sales by cultivators Maine 2020 (scheduled) • Ad valorem tax on retail sales • Retail: 10 percent None • Weight-based tax on cultivation • Cultivation: $20.94 per ounce of flower, $5.88 per ounce of leaves Massachusetts 2018 Ad valorem tax on retail sales 10.75 percent Taxes of up to 3 percent on retail sales Michigan 2020 (scheduled) Ad valorem tax on retail sales 10 percent None Nevada 2017 • Ad valorem tax on retail sales • Retail: 10 percent None • Weight-based tax on cultivation • Cultivation: 15 percent of the estimated fair market value Oregon 2016 Ad valorem tax on retail sales 17 percent Taxes of up to 3 percent on retail sales Washington 2014 Ad valorem tax on retail sales 37 percent None a Although Colorado’s retail tax rate is nominally 15 percent, cannabis is exempt from the general sales tax rate of 2.9 percent, yielding a net tax rate of 12.1 percent. b Estimated tax rates in U.S. dollars based on current exchange rates. THC = tetrahydrocannabinol. EFFECTS OF TAX RATE CHANGES ON LEGAL AND ILLICIT MARKETS, TAX REVENUE, AND YOUTH USE As noted above, Proposition 64 requires us to generated for the programs identified in the measure, recommend adjustments to the state’s cannabis tax and (3) discouraging use by persons younger than 21 rate to achieve three goals: (1) undercutting illicit years of age. In this section, we discuss the effects market prices, (2) ensuring sufficient revenues are of tax rate changes on these outcomes. 12 LEGISLATIVE ANALYST’S OFFICE analysis full gutter AN LAO REPORT Effects of Tax Rate Changes Illustrated With quantify the long-term effects of rate changes on Four Examples. By “effects,” we refer to the those outcomes, nor the short-term or long-term difference between two outcomes: (1) the outcome effects of rate changes on other outcomes related that would occur under a given policy choice, and to the statutory goals, such as the size of the illicit (2) the outcome that would occur under the current market and youth use. Instead, we discuss these policy, all else equal. (Effects does not refer, for effects qualitatively. example, to year-over-year changes in outcomes. Effects on Size of We elaborate on this point in the Appendix.) To make our discussion of short-term effects Legal and Illicit Markets concrete, we provide estimates for four examples Basic Relationship Between Taxes and of potential rate changes. These examples reflect Relative Prices. Cannabis tax rates directly affect recent proposals considered by the Legislature and the costs that legal cannabis businesses incur for other options to provide a better sense of potential selling cannabis. For example, if the state cut the effects of changes. tax rate, it would become less costly for those • Example 1: Eliminating Cultivation Tax and businesses to sell cannabis. As a result, consumers Reducing Retail Excise Rate to 11 Percent. would pay lower prices for legal cannabis. (The Bills introduced in 2018 (AB 3157, Lackey) magnitude of this price change would depend and 2019 (AB 286, Bonta) proposed these on market conditions.) In contrast, the change in rate changes. tax rates would have no direct effect on the cost of selling cannabis in the illicit market. (The illicit • Example 2: Eliminating Cultivation Tax and market consists of commercial cannabis activity Keeping Retail Excise Rate at 15 Percent. that does not comply with the regulatory structure In 2019, the Legislature discussed required in law.) Consequently, a change in tax amendments to AB 286 that would have rates would affect the difference between legal and enacted this change. illicit prices, with a tax cut making legal cannabis • Example 3: Eliminating Cultivation Tax and more competitive with illegal cannabis compared to Raising Retail Excise Rate to 20 Percent. what would be the case in the absence of a cut. As discussed below, we estimate that this What Does it Mean to “Undercut” the Illicit change likely would be roughly revenue neutral Market? One of the goals listed in Proposition 64 is in the short term. to undercut illicit market prices. However, under • Example 4: Keeping Current Cultivation current market conditions, changes in the state Rates and Raising Retail Excise Rate to tax rate likely would not make legal cannabis less 25 Percent. To illustrate a range of options, expensive than illicit cannabis. Even if the state we round out the list of examples with a net eliminated its cannabis taxes entirely, other costs— tax increase. such as regulatory compliance costs and local Effects Uncertain, Particularly in the Long taxes—likely would keep legal cannabis prices Run. Adult-use cannabis legalization is a relatively higher than illicit market prices. (This could change new phenomenon, so useful evidence on the if legal prices decline, as they have in other states.) effects of changing cannabis tax rates is limited. Accordingly, we instead consider competition As a result, these effects are uncertain to varying between the legal and illicit cannabis markets degrees. As described below, we have estimated more broadly. Even if legal cannabis remains more the likely short-term effects of rate changes on two expensive than illicit cannabis, any price change outcomes related to the statutory goals described will affect some consumers’ choices, which in turn above—the size of the legal cannabis market and affect the sizes of the legal and illicit markets. cannabis tax revenues. (“Short-term” refers to the In Short Term, Tax Cuts Expand Legal Market. first year or two after the rate change. We discuss Our analysis of competition between the legal our estimation methods briefly in the Appendix.) and illicit markets starts with estimation of the However, available evidence does not enable us to likely short-term effects of tax rate changes on www.lao.ca.gov 13 analysis full gutter AN LAO REPORT the amount of cannabis purchased from the legal state’s tax system, under current federal policies, market. As illustrated by the examples in Figure 9, California cannot bring exported cannabis into the tax cuts would expand the legal cannabis market, state’s legal market. while tax increases would shrink it. Long-Term Effects Highly Uncertain. The Tax Cuts Reduce Illicit Market, but Size of long-term effects of rate changes on the size Effect Is Uncertain. Ideally, we would be able of the legal and illicit markets, while important, to identify what proportion of the increase in are highly uncertain. In theory, these long-term legal consumption of cannabis would be due to effects could be substantially different from the reductions in illicit consumption (substitution) short-term effects. One reason is that changes in as opposed to increased cannabis use overall. state tax rates could affect cities’ and counties’ Unfortunately, while we suspect that tax cuts would licensing and taxation choices, which in turn would increase substitution from the illicit market more affect the size of the legal and illicit markets. than they would increase actual consumption, we Suppose, for example, that the state reduces its have found no evidence that would enable us to tax rate. On the one hand, local governments quantify these effects. Thus, while a tax cut clearly could respond by raising their tax rates, partly would reduce the size of the illicit market to some offsetting the effects of the state tax cut. On the extent (and a tax increase would expand it), we other hand, local governments could respond to cannot quantify the extent of this effect. the potential for generating greater tax revenue by Taxes Likely Have Little Effect on Exports. licensing more cannabis businesses, amplifying the The illicit market for California-grown cannabis market-expanding effects of the state tax cut on consists of two parts: (1) cannabis sold in legal consumption. California and (2) cannabis exported out of the Effects on Tax Revenue state. In-state sales likely account for a small share of California-grown cannabis. Crucially, Tax Cuts Reduce Revenue in the Short Term. exported cannabis does not compete directly with Figure 9 displays our estimates of the short-term California’s legal market, so changing the state’s revenue effects of the four rate changes described cannabis tax rate likely would have little effect on it. above. As directed by Proposition 64, our revenue Additionally, as mentioned previously, a key federal estimates focus exclusively on state cannabis tax enforcement priority is preventing the export of revenues. Overall, reducing cannabis tax rates cannabis to other states. Accordingly, California would reduce revenues in the short term, while and others states that have legalized cannabis do raising rates would lead to higher revenues. (Under not allow licensed cannabis businesses to export current law, we expect state cannabis tax revenue cannabis out of state. Thus, regardless of the to be in the mid-hundreds of millions of dollars in Figure 9 Estimated Short-Term Effects of Rate Changes on Legal Consumption and Revenue Likely Short-Term Percentage Change in Legal Cannabis State Cannabis Likelihood Revenue Would Cultivation Tax Retail Excise Tax Consumption Tax Revenuea Exceed Thresholdb Keep at current ratesc Keep at current rate (15%) 0% 0% Very likely to exceed Eliminate Reduce to 11% +6% to +20% -34% to -43% Likely to fall short Eliminate Keep at current rate (15%) +3% to +11% -16% to -25% Roughly equal chances of exceeding and falling short Eliminate Increase to 20% -2% to +1% -5% to +3% Very likely to exceed Keep at current rates Increase to 25% -7% to -22% +18% to +40% Very likely to exceed a Under current law, we expect state cannabis tax revenue to be in the mid-hundreds of millions in 2020-21 and 2021-22. b Some provisions of Proposition 64 imply that revenue below $350 million in 2021-22 would not be sufficient. c As of January 1, 2020, the cultivation tax rates are $9.65 per ounce of dried cannabis flowers, $2.87 per ounce of dried cannabis leaves, and $1.35 per ounce of fresh cannabis plants. 14 LEGISLATIVE ANALYST’S OFFICE analysis full gutter AN LAO REPORT 2020-21 and 2021-22.) Although tax cuts would raise actual prices paid by youth, they very likely expand the legal market, this effect would not would have little effect on youth use. That said, if be anywhere near large enough to fully offset the the illicit market becomes less active over time—for revenue loss. Modest rate increases, on the other example, as a result of more active enforcement— hand, would raise revenue in the short term. (We taxes could become a reliable tool for reducing estimate that extremely large rate increases—such youth use. as an increase in the retail excise tax rate from Tobacco taxes provide a reference point for 15 percent to 80 percent—likely would reduce the relationships among tax rates, illicit trade, and revenue.) The long-term revenue effects of rate youth substance use. Research shows that tobacco changes are highly uncertain, for the same reasons taxes raise tobacco prices despite significant illicit that the long-term effects on legal and illicit markets tobacco trafficking, thus reducing youth tobacco are uncertain. use. Illicit sales currently play a much bigger role in What Are “Sufficient Revenues”? California’s cannabis market than in typical tobacco Proposition 64 does not define what constitutes markets, likely making illegal cannabis accessible sufficient revenues. However, the measure requires to youth even in a scenario with relatively high tax the California Highway Patrol (CHP) to receive rates. That said, total elimination of illicit cannabis at least $50 million from Allocation 3 (starting in markets likely is not a prerequisite for higher 2022-23). Because many other programs must cannabis taxes to reduce youth cannabis use. receive funding prior to this allocation, we estimate Other Key Effects of Rate Changes the state would have to collect at least $350 million in revenue in 2021-22 to meet the CHP funding Analysis of Harmful Use and Medical Use requirement. Accordingly, it is reasonable to Similar to Youth Use. In addition to the three assume that 2021-22 revenue below $350 million criteria laid out in statute, we encourage the would not be sufficient. Beyond this requirement, it Legislature to consider two additional major criteria is difficult to determine what level of revenue would as it weighs potential adjustments to cannabis be sufficient. (We discuss these difficulties further in taxes: the box on pages 16 and 17.) • Harmful Use. Excise taxes can reduce not Much Lower Rates Might Not Yield Sufficient just youth use of cannabis, but harmful use Revenue. Under the current tax rates, we more generally. As noted in the Background estimate that revenues are very likely to exceed section, evidence suggests that cannabis the $350 million revenue threshold in 2021-22. use can have some negative effects, such Figure 9 lists brief descriptions of the likelihood as increased risk of motor vehicle crashes. that revenues would exceed this revenue threshold As with youth use, however, the effects under the four examples of potential rate changes. of cannabis taxes on harmful use likely Youth Use depend on the extent to which illicit cannabis remains a readily available substitute for Higher Taxes Could Reduce Youth Use, legal cannabis. As long as illicit consumption Depending on Availability of Illicit Cannabis. As remains common, consumers of all ages face discussed above, higher taxes would reduce legal a variety of health risks due to the unregulated cannabis consumption, but we do not know how nature of those products. Also, as we discuss much of this reduction would consist of substitution in the next section, the effects of cannabis to the illicit market and how much would consist of taxes on harmful use depend not only on the reductions in actual consumption. This uncertainty tax rate, but also on the type of tax. extends to the effects of changes to cannabis taxes • Medical Use. As described in the Background on youth use. If youth easily can acquire cannabis section, cannabis can be useful for addressing from the illicit market, tax increases on legal certain ailments. Consequently, an ideal cannabis might not substantially raise the actual system of cannabis regulation and taxation prices that youth pay. If taxes do not substantially www.lao.ca.gov 15 analysis full gutter AN LAO REPORT would enable the state to tax cannabis used taxes both types similarly. As a result, higher for medical purposes at a substantially lower cannabis taxes have the potential to reduce rate than cannabis for adult use. (We further not just youth and other harmful use, but also compare taxes on cannabis and on medicine medical use. in a recent online post, Comparing Taxes Changing Tax Rates Would Involve on Cannabis to Taxes on Other Products in California.) However, distinguishing medical Trade-Offs Between Statutory Goals cannabis products and customers from adult In Short Term, Rate Cuts Help Address Illicit use is difficult in practice. This is because Market but Reduce Revenue. In light of the above (1) similar products can be used by medical analysis, the Legislature faces trade-offs when and adult-use users, and (2) cannabis can considering adjustments to the state’s cannabis tax be used to treat a variety of conditions, rate. Any tax rate change would help the state meet some of which can be difficult to verify (such certain goals while likely making it harder to achieve as chronic pain). Due in large part to the others. On one hand, for example, reducing the challenge of distinguishing medical cannabis tax rate would expand the legal market and reduce from adult-use cannabis, the state generally SUFFICIENT REVENUES UNDER PROPOSITION 64 Proposition 64 (2016) requires our office to make recommendations on adjustments to the tax rate in order to ensure sufficient revenues are generated for the programs identified in the measure, among other goals. As we discuss below, there are a few key reasons why it is difficult to determine what constitutes sufficient revenues. Some of these challenges include the administration’s flexibility in choosing which programs to fund, the lack of a clear definition of “sufficiency,” and revenue uncertainty. Additionally, the way the measure restricts the allocation of revenues—with fixed percentage allocations and no discretionary reserve—makes it more difficult for the state to fund programs sufficiently with a given amount of revenue. Challenges in Determining Sufficient Revenues Measure Provides Administration Discretion to Allocate Funds to Programs. The first step in determining sufficient revenue would be to identify the list of specific programs that would need to be funded. The measure, however, does not enable us to define such a list. Instead, it describes some broad program categories, and it generally authorizes the administration to allocate funding to a variety of possible programs within those categories. Accordingly, in practice, the administration may spend these funds on a wide range of activities. Additionally, the administration may adjust the amount of funding provided to each activity at any time. As a result, the amount of funding required could vary dramatically depending on the specific programs the administration chooses to fund. Measure Lacks Direct Guidance on Sufficiency. The measure provides no direct guidance on what constitutes sufficient revenues. For example, the measure does not identify specific goals for the youth substance use programs, such as the number of programs funded, the number of individuals treated, or the reduction in youth substance use disorders achieved. Accordingly, even if the administration’s future funding allocations could be predicted with certainty, there still could be a variety of reasonable perspectives on what constitutes sufficient revenues for those programs. 16 LEGISLATIVE ANALYST’S OFFICE analysis full gutter AN LAO REPORT the size of the illicit market. On the other hand, participating in the illicit cannabis market, additional such a tax cut would reduce revenue in the short state or local resources devoted to enforcing state term, potentially to the extent that revenue could be laws, changes in state licensing requirements, considered insufficient. Furthermore, lower tax rates changes to local governments’ authority to ban could lead to higher rates of youth cannabis use— cannabis businesses, and resources devoted to particularly if the state makes progress towards youth education on the effects of cannabis use. reining in the illicit market. For instance, enhanced enforcement would make it more difficult and costly for businesses to operate Importance of Nontax Policies in the illicit market. This likely would shift activity Nontax Policies Also Affect Legal and Illicit from the illicit market to the legal market, thereby Markets, Revenues, and Youth Use. The scope increasing tax revenues. Additionally, it likely would of this report is limited to state cannabis taxes. affect youth use by making it more difficult and These taxes, however, are only one of many state expensive for them to access cannabis through the policies that could affect revenue, the illicit market, illicit market. and youth use. Examples of other such policies include increased criminal or civil penalties for Future Revenues Uncertain. Another complicating factor is that, even absent changes in tax rates, future cannabis tax revenues are uncertain. Accordingly, even if the Legislature could direct funds to programs that target the goals specified by the measure—youth substance use programs, environmental programs, and law enforcement—and even if those goals were clear, there would be significant uncertainty regarding the tax rate that would be needed to meet these goals. Challenges in Achieving Sufficient Revenues Restrictions in Measure Make it More Difficult to Achieve Revenue Sufficiency. Proposition 64 restricts the use of state cannabis tax revenues. These restrictions make it more difficult for the state to fund programs sufficiently with a given amount of revenue, primarily for two reasons: • Percentage Allocations Remain Fixed. Although Proposition 64 gives the administration discretion to allocate funds within each of the three percentage allocations (youth substance use, environmental, and law enforcement), it does not authorize changes to the 60-20-20 split itself. If, for example, overall cannabis revenue provided sufficient funding for two of those three categories but not the third, neither the Legislature nor the administration could reallocate cannabis revenue to the area of greatest need. • No Discretionary Reserve. Proposition 64 does not authorize the Legislature or the administration to maintain a discretionary reserve for the Cannabis Tax Fund. Such a reserve could help the state maintain sufficient programmatic funding if revenue were to decline in some years. Other Funds Could Help Address These Challenges. Proposition 64 asks us to assess revenue sufficiency based only on the revenue raised by the state’s cannabis taxes. From a broader perspective, the state could address the challenges described above by supplementing the funding for these programs with other revenues, such as General Fund revenues. www.lao.ca.gov 17 analysis full gutter AN LAO REPORT CONSIDERING OTHER POTENTIAL CHANGES TO CANNABIS TAXES Basic Tax Policy Choices Should Precede CONSIDERING THE TYPE OF TAX Changes to Tax Rates. The prior section focuses narrowly on our statutory charge of assessing the Types of Taxes to Consider. We have effects of adjusting tax rates, taking the existing identified four types of cannabis taxes that the tax structure as given. As discussed in that Legislature may wish to consider: basic ad valorem, section, changing cannabis tax rates could help weight-based, potency-based, and tiered ad the Legislature make progress towards some of valorem. We describe these taxes further in the the measure’s goals, though there are trade-offs nearby box. involved. The Legislature could make further Criteria to Consider When Choosing Type of progress towards those goals and others by Tax. Key criteria to consider when selecting the making changes not only to the tax rates, but also type of tax include: to the basic structure of the taxes. As summarized • Harmful Use. As noted in the “Background” in Figure 10, we encourage the Legislature to section, the negative effects of cannabis use approach cannabis tax policy in three steps: first, seem to be particularly high for high-potency choosing what type of tax to impose on cannabis; products, high-frequency use, and youth second, choosing the taxed event and point of use. To score well on this criterion, a tax collection for the tax; and third, choosing the tax should impose higher costs on more harmful rate. Figure 10 Setting the Cannabis Tax Rate X First Decision: What Type of Tax Should the State Levy? • Basic ad valorem tax • Weight-based tax • Potency-based tax • Ad valorem tax with rate tiers based on potency and/or type of product X Second Decision: What Should the Taxed Event Be, and Who Should Remit the Tax? • Taxed Event Options: − Sale/transfer from cultivator to first distributor − Sale/transfer from last distributor to retailer − Sale from retailer to consumer • Point of Collection Options: − Cultivator − First distributor − Last distributor − Retailer X Third Decision: What Should the Rate Be? • Goals That Favor Low Rates: − Undercutting illicit market prices − Increasing access to medical cannabis • Goals That Favor High Rates: − Ensuring sufficient state cannabis tax revenue − Discouraging youth use and harmful use (particularly if state makes progress towards reining in illicit market) 18 LEGISLATIVE ANALYST’S OFFICE analysis full gutter AN LAO REPORT purchases and lower costs on less harmful low-THC cannabis products and similar hemp purchases. (As noted above, diminished illicit products; (3) the difficulty of implementing the market activity would help make the tax more change. useful for this purpose.) • Raising Stable Revenues. For any type of Assessment of Tax Types tax, the Legislature can set the rate to raise a Figure 11 (see next page) summarizes our particular amount of revenue (up to a point) in assessment of the four types of cannabis taxes an average year. However, the revenue raised based on the three main criteria identified above. by some types of taxes could grow at rates As we discuss below, each type of cannabis that vary unpredictably from year to year, while tax has strengths and weaknesses, and no other taxes could raise more stable revenues. individual type of tax performs best on all criteria. The latter types score better on this criterion Accordingly, the Legislature’s choice depends than the former. heavily on the relative importance it places on each • Administration and Compliance. To score of these criteria. That said, the weight-based tax is well on this criterion, a tax should be relatively generally weakest, performing similarly to or worse straightforward for tax administrators and than the potency-based tax on the three main taxpayers to implement and enforce. criteria. • Other Criteria. In addition to the three main Reducing Harmful Use. We rate the criteria identified above, the Legislature also potency-based and tiered ad valorem taxes as may wish to consider other criteria, such as: having the greatest potential to reduce harmful use. (1) the extent to which a tax could help the legal market compete effectively with the illicit • Potency-Based Could Reduce Harmful market; (2) the extent to which a tax would Use Very Effectively. The negative effects create arbitrary cost differences between very of cannabis appear to be linked in large TYPES OF CANNABIS TAXES TO CONSIDER • Basic Ad Valorem Tax. Under a basic ad valorem tax, the amount of tax due is a percentage of the price. The sales tax and California’s current retail excise tax on cannabis are examples of ad valorem taxes. • Weight-Based Tax. Under a weight-based tax, the amount of tax due is based directly on the weight of the product. The rates can vary depending on the part of the plant (for example, flower or leaves) or its condition (for example, dried or fresh). California’s current cultivation tax is an example of a weight-based tax. • Potency-Based Tax. Under a potency-based tax, the amount of tax due depends only on the potency of the cannabis product. For example, Canada’s cannabis tax system includes a rate of $0.01 Canadian (roughly three-quarters of a cent U.S.) per milligram of tetrahydrocannabinol (THC) in certain types of cannabis products. Hereafter, we use “potency-based” primarily to refer to this simple THC-based structure. However, potency-based taxes could take a variety of forms—for example, incorporating other cannabinoids in addition to THC. • Tiered Ad Valorem Tax. A tiered ad valorem tax is similar to the basic ad valorem tax, but with multiple rates. These rates could depend on potency and/or the type of product. For example, Illinois has set three different ad valorem tax rates on cannabis based on potency and product type: 10 percent on cannabis flower and other products with THC concentrations below 35 percent; 20 percent on cannabis infusions, such as edibles; and 25 percent on products with THC potency above 35 percent, such as concentrates. www.lao.ca.gov 19 analysis full gutter AN LAO REPORT Figure 11 Comparing Different Types of Cannabis Taxes Scale From (Worst) to (Best) Basic Tiered Ad Valorem Tax Weight-Based Tax Potency-Based Tax Ad Valorem Tax Reducing Harmful Use Raising Stable Revenue Administration and Compliance part to the potency of the products used. directly target high-potency products and Accordingly, a potency-based tax is a direct, other products associated with harmful consistent way to use taxes to discourage use. Accordingly, they score less well on harmful use, so it scores well on this criterion. this criterion. Weight and price are related • Tiered Ad Valorem Also Could Reduce to harmful use, but these relationships are Harmful Use Very Effectively. While complex. For example, the production of measured THC potency is a very important high-potency products, such as concentrates, determinant of harmful use, it is far from the tends to require greater quantities (and only one. Other key factors include the share thus weight) of cannabis. However, since of THC absorbed by the body, as well as other weight-based taxes apply the same tax rate to health risks (such as pulmonary risks from cannabis flowers regardless of their potency, smoking). The Legislature could use a tiered they tend to encourage the cultivation of ad valorem tax to set higher rates not only on higher-potency cannabis. Additionally, some more potent products, but also on specific evidence suggests that more potent products product categories—such as certain types (and products with high THC absorption of concentrates—regarded as particularly rates) tend to be somewhat more expensive harmful. In this way, a tiered structure could than less potent products. However, for a account for some of these other harmful given type of product, heavy users might pay attributes, and thus also have the potential lower prices—and proportionally lower ad to be very effective at reducing harmful use. valorem taxes—than infrequent users. This That said, the relative effectiveness of this could happen, for example, if heavy users tax depends heavily on the rate differences tend to obtain bulk discounts or if they tend between tiers. Suppose, for example, that to be more price-sensitive than infrequent a consumer is choosing between a more users. Furthermore, price declines—discussed harmful product and a less harmful product in more detail below—could reduce the that fall within the same rate tier. For this effectiveness of an ad valorem tax at reducing consumer, the tiered ad valorem tax does not harmful use over time if the state does not reduce harmful use any more effectively than a adjust the rate accordingly. basic ad valorem tax. Stable Revenues. We rate the weight-based • Weight-Based and Ad Valorem Likely and potency-based taxes as most effective at Worse for Reducing Harmful Use. Weight-based and ad valorem taxes do not 20 LEGISLATIVE ANALYST’S OFFICE analysis full gutter AN LAO REPORT providing stable revenues. We discuss each of the Administration and Compliance. We rate options from least effective to most. the basic and tiered ad valorem taxes as best for administration and compliance. • Ad Valorem Likely Least Stable, Though Adjustments Could Help. We think that • Basic Ad Valorem Best for Administration cannabis prices in California likely will decline and Compliance. The basic ad valorem in the coming years as the cannabis market tax is easier for CDTFA to administer than matures, consistent with other states’ weight-based taxes and potency-based experience. These potential near-term price taxes. CDTFA has considerable financial declines would tend to slow the growth of expertise as well as direct experience revenues generated from an ad valorem tax. implementing ad valorem taxes, such as We expect that price declines would coincide the sales tax. Similarly, CDTFA already has with increases in the quantity of cannabis an administrative structure for auditing and purchased, which would somewhat offset their enforcing payment of ad valorem taxes, which effects on ad valorem revenues. Furthermore, makes it easier for the department to ensure the state could address this weakness of compliance. Furthermore, basic ad valorem the ad valorem tax by adjusting the tax taxes can make taxpayer compliance relatively rate frequently to reflect price changes. For straightforward, as they often do not require example, the Legislature could direct CDTFA businesses to collect much information to adjust tax rates automatically based on beyond what they track during their normal changes in average cannabis prices. While course of business. this type of adjustment could help improve • Tiered Ad Valorem Also Good for the stability of ad valorem taxes, it would be Administration and Compliance. A tiered imperfect because it would take some time ad valorem tax would be somewhat more to adjust the rate, and Proposition 64 does complicated to administer than a basic ad not allow for reserves to help smooth out valorem tax. However, as long as the number spending in the interim. of rates were relatively small, a tiered ad • Tiered Ad Valorem Also Relatively Volatile. valorem tax should not be overly difficult Like a basic ad valorem tax, a tiered tax to administer. Notably, CDTFA has some could raise volatile revenues. However, if experience implementing tiered ad valorem the trend towards higher-potency products rates for the alcoholic beverage tax. (We continues, then revenue from the tiered tax discuss comparisons between cannabis taxes could grow accordingly, perhaps somewhat and other excise taxes—including alcoholic offsetting revenue slowdowns resulting from beverage taxes—in greater detail in an declining prices. Like the ad valorem tax, the accompanying online post, Comparing Taxes state could address this weakness of the on Cannabis to Taxes on Other Products in tiered ad valorem tax by adjusting the tax rate California.) frequently to reflect price changes. • Administration and Compliance • Weight-Based and Potency-Based Best for More Difficult for Weight-Based and Generating Stable Revenues. Based largely Potency-Based. CDTFA does not have much on other states’ experiences, we generally expertise regarding the weight or chemical expect total plant weight and THC produced composition of products. While data entered in the legal cannabis market to be less volatile into the track-and-trace system could help than prices. Accordingly, weight-based and taxpayers and the department implement a potency-based taxes likely would raise more weight-based or potency-based tax, these stable revenues than an ad valorem tax (basic taxes likely still would be more difficult for or tiered). the agency to administer than an ad valorem tax. Potency might seem like a more exotic www.lao.ca.gov 21 analysis full gutter AN LAO REPORT tax base than weight, but it is not clear cannabis tax could make these cost that it would be more difficult to administer. differences much smaller than a weight-based This is in part because a potency-based tax or an ad valorem tax. tax has two key advantages with regard • Bigger Changes Would Be Harder to to administration and compliance. First, Implement. Implementing major changes testing labs verify the potency of cannabis could involve a variety of challenges during products. (As we understand it, these tests the transition to the new tax structure. For rarely find substantial differences between example, the transition to a potency-based tax labeled and actual cannabinoid content. More would be more difficult for tax administrators commonly, products fail lab tests for other and taxpayers than a minor adjustment to one reasons, such as high levels of pesticides.) of the existing taxes. In contrast, the state has not established any mechanism for consistent, direct third-party Number of Taxes to Levy verification of the weight of harvested plants. Second, THC content appears on the labels The Legislature faces trade-offs in deciding how of all cannabis products, allowing for further many cannabis taxes to levy. If multiple taxes have verification opportunities upon retail purchase. highly complementary strengths and weaknesses, In contrast, once a cannabis product has then a carefully chosen combination of taxes could entered the manufacturing process, there is have the potential to achieve better outcomes no way to verify the weight of the raw plant than one of them alone. However, our assessment material used to make it. suggests that such a combination might not exist in practice, limiting the gains from levying more Other Criteria. Below, we discuss how the than one type of tax. Additionally, levying more various types of taxes perform on some additional than one type of tax makes tax administration criteria. and compliance more burdensome and complex. Accordingly, on balance, we do not think there • No Clear, Major Differences in Competition is a strong rationale for levying multiple types of With Illicit Market. As discussed above, cannabis taxes. higher tax rates reduce the size of the legal cannabis market and expand the illicit market. CHOOSING THE TAXED EVENT However, we do not anticipate any similarly clear, major effects of the type of tax on the AND POINT OF COLLECTION relative strength of the legal and illicit markets. After the Legislature decides what type of tax As discussed above, compliance could be it wants to levy on cannabis, the next step is more difficult for some types of taxes than to choose both the taxed event and the type of others, but the resulting effects on the size business that will remit the tax (also known as the of the legal and illicit markets likely would be “point of collection”). small. Taxed Event Options. The Legislature may wish • Potency-Based Would Reduce Cost to considering levying a cannabis tax at any of Differences Between Cannabis and Hemp three points in the supply chain: Products. The state’s cannabis taxes apply to cannabis and all of the products derived • The sale or transfer of harvested cannabis from it, regardless of their THC content. from the cultivator to the first distributor. However, these taxes do not apply to hemp • The sale or transfer of cannabis products from or to the products derived from it. As a result, the last distributor to the retailer. these taxes could create large, essentially • The sale of cannabis products from the retailer arbitrary cost differences between low-THC to the consumer. cannabis-derived products and similar hemp-derived products. A potency-based 22 LEGISLATIVE ANALYST’S OFFICE analysis full gutter AN LAO REPORT Point of Collection Options. The Legislature relationship with tax administrators, and is may wish to consider assigning tax remittance familiar with the record-keeping practices responsibilities to the cultivator, the first distributor, needed to pay taxes accurately and comply the last distributor, or the retailer. with audits. Criteria to Consider When Choosing Taxed • Number of Taxpayers. All else equal, tax Event and Point of Collection. Below, we identify administration is more cost-effective when some key criteria to consider when choosing the there are fewer taxpayers. In Figure 12, we taxed event and the point of collection, roughly compare the current number of taxpayers to in descending order of importance. These criteria the estimated number of taxpayers under two reflect conditions conducive to effective tax alternative points of collection. As shown in administration and compliance. the figure, we estimate that collecting taxes from retailers would result in a significantly • Nexus Between Taxed Event and Point of smaller taxpayer population than collecting Collection. For most taxes, a single entity—a from cultivators or last distributors (the current taxpayer—participates in the taxed event, point of collection). collects the original tax payment, and remits • Credit Constraints. As noted above, many the tax to the state. In other words, there is a cannabis businesses have limited access very close nexus between the taxed event and to financial services—including credit. As the point of collection. In contrast, California’s a result, it could be difficult for some of cannabis taxes split these responsibilities these businesses to set aside money for between multiple businesses. This separation tax payments before consumers purchase of taxpaying responsibilities weakens each their products. To address this concern, the business’s incentive to ensure that the correct Legislature could levy cannabis taxes as late amount of tax is paid. An additional concern in the supply chain as possible. arises because many cannabis businesses have limited access to financial services due to Figure 12 federal criminalization. The Estimated Number of Taxpayers by Typea current split of taxpaying responsibilities often involves 2,000 cash changing hands multiple 1,800 times, leading to problems 1,600 with security, compliance, and 1,400 enforcement. Furthermore, 1,200 distributor remittance of the 1,000 retail excise tax requires a markup calculation that 800 makes the tax more difficult 600 to administer. 400 • Taxpayer Characteristics. 200 An ideal taxpayer plays Cultivators Last Distributors Retailers a consistent role in the (Current Taxpayers) (Storefront and Nonstorefront) supply chain, is readily a For last distributors, estimate is the current number of registered taxpayers. For cultivators identifiable and visible to and nonstorefront retailers, estimate is number of unique business names among current tax administrators and the licensees. For storefront retailers, estimate is number of unique premises addresses among current licensees. public, has an established www.lao.ca.gov 23 analysis full gutter AN LAO REPORT Best Taxed Event and Point of CHOOSING TIMING OF CHANGES Collection Vary by Type of Tax Historically, the Legislature has adjusted excise For each type of tax, there are trade-offs among tax rates very infrequently. If this experience is a different taxed events and points of collection. guide, the Legislature might want to think carefully Below, we summarize the main trade-offs and about the timing of any changes to the state’s assess the best taxed event and point of collection cannabis tax structure and rates. On one hand, the for each type of tax. sooner the Legislature changes the state’s cannabis Ad Valorem (Basic and Tiered): Tax Retail taxes, the sooner the state will realize any benefits Sales and Collect Tax From Retailers. Compared associated with those changes. On the other to distributors, retailers play a more consistent hand, as discussed below, there are advantages to and public-facing role in the supply chain, and waiting until more information is available and the they already interact with CDTFA through the market is more stable. sales tax. Additionally, moving tax payments to • Full Implementation of Track-and-Trace the retail level could address concerns related to Could Provide Valuable Data. Information credit constraints. Accordingly, we view retail sales that licensees enter into the track-and-trace and retailers as the best taxed event and point of system could be very helpful for estimating collection, respectively, for both types of ad valorem the effects of potential changes to the cannabis taxes. (As discussed in our related online state’s cannabis taxes. We anticipate that post, A Key Interaction Between Sales Taxes and track-and-trace system data collection will Other Taxes on Cannabis Retailers, moving the ramp up considerably in the coming months, point of collection to the retail level could give the since all licensees are now required to state an opportunity to create a uniform tax base participate. Additionally, we expect that the across multiple retail taxes.) data in the system will improve over time as Potency-Based Tax: Two Reasonable Options. licensees become accustomed to using it and Many of the reasons for levying ad valorem taxes administering agencies have time to validate at the retail level also apply to potency-based the data. taxes. As shown in Figures 2 and 4, however, lab • Current Law Limits Researchers’ Access testing of cannabis products occurs shortly before to Track-and-Trace. Chapter 27 of distribution from the last distributor to the retailer. 2017 imposes strict limits on access to Accordingly, there is a close nexus between the last track-and-trace data. Specifically, the statute distributor and the initial measurement of the tax allows access only for authorized state base for a potency-based tax. Overall, a reasonable and local government employees pursuant case could be made to (1) levy a potency-based to certain laws. While there are legitimate tax on the retail sale and collect it from the retailer, reasons—such as privacy concerns—for or to (2) levy a potency-based tax on the last restricting access to track-and-trace data, distribution and collect it from the distributor. these restrictions makes it difficult for our Weight-Based: Tax Sale or Transfer to office or other researchers to use the data to First Distributor and Collect Tax From First help inform the Legislature’s policymaking. Distributor. The only practical opportunities to • Scientific Understanding of Cannabis’ weigh cannabis plants occur early in the supply Effects Will Improve. Although there is some chain, around the time of sale or transfer from useful research on the effects of cannabis, the cultivator to the first distributor. Accordingly, federal criminalization of cannabis has this sale or transfer is the best taxed event for impeded research progress. For example, a weight-based tax, and the point of collection researchers have had to purchase cannabis should be one of the two businesses involved in the from one supplier and have not had access transaction—the cultivator or the first distributor. to the full range of cannabis strains and products that are available in the marketplace. 24 LEGISLATIVE ANALYST’S OFFICE analysis full gutter AN LAO REPORT Accordingly, there are still significant gaps in • Regulatory Environment and Industry scientific understanding of the health effects Are Still in Flux. California’s legal cannabis of various cannabis products. Over time, industry is still in the early stages of its we anticipate that research will fill some of development, making it difficult to predict these gaps and scientific understanding what the industry will look like in the future. of the effects of cannabis will improve, The long-term effects of tax policy changes particularly if the federal government loosens would depend on industry growth, licensing its restrictions. This improved understanding requirements, market structure, prices, could help the Legislature create a tax potency, product mix, and many other factors structure that more effectively addresses that could change considerably in the coming the harmful aspects of the plant or more years. effectively differentiates between medical and adult use for tax purposes. RECOMMENDATIONS As described further below and summarized to match the type of tax chosen; (3) setting the in Figure 13, we recommend that the Legislature tax rate to match the Legislature’s policy goals; make various changes to cannabis taxes. These and (4) taking some related actions, such as changes—which could be complemented clarifying access to track-and-trace data and by changes to nontax policies—include: crafting the definition of gross receipts carefully. (1) replacing the state’s existing cannabis taxes We recommend that the Legislature enact these with a potency-based or tiered ad valorem tax; changes soon given the benefits they could yield. (2) choosing the taxed event and point of collection Additionally, we recommend that the Legislature Figure 13 Summary of Recommendations X Replace the Existing Cannabis Taxes With Potency-Based or Tiered Ad Valorem Tax • These taxes could reduce harmful use more effectively than other types of taxes. • Could consider keeping basic ad valorem instead, but recommend against weight-based. X Specify Taxed Event and Point of Collection to Match Type of Tax • Potency-based tax: tax retail sale and collect from retailer, or tax wholesale sale and collect from last distributor. • Ad valorem tax (tiered or basic): tax retail sale and collect from retailer. • Weight-based tax: tax sale or transfer from cultivator to first distributor and collect from either of those businesses. X Set Specific Tax Rate • For potency-based or tiered ad valorem tax: set specific structure in consultation with scientific experts. Potency-based rate between $0.006 and $0.009 per milligram of THC could be appropriate; specific rate depends on policy priorities. • For basic ad valorem retail tax: set rate between 15 percent and 20 percent. Choose specific rate based on policy priorities. • Consider ongoing rate adjustments. X Take Related Actions • Clarify statutory authority to access track and trace data. • Craft definition of gross receipts carefully. www.lao.ca.gov 25 analysis full gutter AN LAO REPORT revisit cannabis taxes periodically to see if further cultivation tax or the ad valorem retail excise tax. changes are warranted in light of new information If the Legislature, nevertheless, chooses to retain from track-and-trace and from scientific research the cultivation tax, we recommend that it move on the effects of cannabis. the point of collection to the cultivator or the first distributor. If it chooses to retain the ad valorem Change Type of Tax to Account for retail excise tax, we recommend it levy the tax on Potency and/or Product Type the retail sale and collect the tax directly from the retailer. As discussed in our 2018 report, Taxation of Sugary Drinks, we view reducing harmful use as Set Rate to Match Policy Goals the most compelling reason to levy an excise tax. A potency-based or tiered ad valorem tax could We recommend that the Legislature set the tax reduce harmful use more effectively than a basic ad rate to match its policy goals. Below, we provide valorem tax or a weight-based tax. For this reason, specific recommendations for each type of tax. we view these types of taxes as worthwhile even Setting Tax Rates for Recommended Tax though they would be harder to administer than a Types. If the Legislature adopts a potency-based basic ad valorem tax. Accordingly, we recommend or tiered ad valorem tax as we recommend above, that the Legislature replace the state’s existing we recommend that the Legislature specify the cannabis taxes with a potency-based or tiered details of these tax structures in close consultation ad valorem tax. However, if policymakers place with scientific experts. Such expertise is crucial different weights on the criteria we identified, they for determining key details, such as setting the could select a different type of tax. In particular, if cutoffs between tiers for a tiered ad valorem tax. they value ease of administration and compliance As the Legislature sets specific tax rates, we more highly than reducing harmful use, they may recommend that it consider the goals identified prefer to keep the existing retail excise tax, which in the measure—competition with the illicit is a basic ad valorem tax. (We do not recommend market, revenue sufficiency, and youth use—as keeping the weight-based cultivation tax, since it is well as other policy considerations, such as generally the weakest type.) other harmful use and medical use. Notably, as the Legislature considers the effects of such Choose Taxed Event and Point of changes, it will be important to have reliable Collection to Match Type of Tax data on the types of cannabis products sold in California and their potencies. We expect that We recommend that the Legislature choose the data from the track-and-trace system could be taxed event and point of collection to match the used for this purpose in the near future—perhaps type of tax it has selected. As described in our sometime in 2020. Currently available information assessment, these changes could improve tax suggests that a potency-based tax in the range administration and compliance. of $0.006 to $0.009 per milligram of THC could Choosing Taxed Event and Point of Collection be appropriate, depending on how policymakers for Recommended Tax Types. If the Legislature weigh the importance of reducing the illicit market adopts a tiered ad valorem tax, we recommend it versus raising revenues. For a tiered ad valorem levy the tax on the retail sale and collect the tax tax, the average rate across tiers should reflect directly from retailers. If the Legislature adopts a the Legislature’s policy priorities, in line with our potency-based tax, we recommend that it either discussion of the basic ad valorem tax below. (1) levy it on the retail sale and collect it from the Adjusting Tax Rates for Other Types of retailer, or (2) levy it on the last distribution and Taxes. If the Legislature decides not to adopt a collect it from the last distributor. potency-based or tiered ad valorem cannabis tax, Choosing Taxed Event and Point of Collection we nevertheless recommend that the Legislature for Other Types of Taxes. As noted above, we eliminate the cultivation tax. In this case, we do not recommend retaining the weight-based recommend that the Legislature set the retail 26 LEGISLATIVE ANALYST’S OFFICE analysis full gutter AN LAO REPORT excise tax rate somewhere in the range of 15 to practice of infrequent excise tax rate adjustment 20 percent. This is because a 15 percent rate suggests that it might prefer the administrative would result in a very substantial risk of falling approach. below the $350 million threshold, while a rate of Other Recommendations 20 percent would result in a low risk of falling below the threshold. The Legislature’s specific choice Clarify Statutory Authority to Access within this range would depend, in large part, on Track-and-Trace Data. Since current statutes how it weighs the revenue sufficiency goal against provide very limited access to track-and-trace data other goals, such as competing with the illicit that could be valuable for setting tax rates—or market and discouraging youth use. This choice making other policy decisions regarding cannabis— additionally would depend on the Legislature’s own we recommend that the Legislature broaden assessment of the sufficient level of revenues and the explicit statutory authorization to access its tolerance for risking falling short of that level. track-and-trace data to allow our office, academic Consider Implementing Ongoing Rate researchers, and state agencies to conduct this Adjustments. If the Legislature selects a basic type of research. Such access could be structured or tiered ad valorem tax and is concerned about to address confidentiality concerns. declines in the tax’s effectiveness due to potential Craft Definition of Gross Receipts Carefully. price declines, we recommend that it consider As discussed in our related online post, A Key implementing ongoing rate adjustments. For Interaction Between Cannabis Taxes and Sales example, the Legislature could consider directing Taxes, there is an opaque, counterintuitive the administration to adjust the rate periodically interaction between sales taxes and other taxes based on a predetermined formula that takes into on retail gross receipts, such as local cannabis account changes in average prices. Alternatively, taxes. Due to this interaction, the overall tax rate the Legislature could respond to price changes—or on cannabis is slightly higher than it appears to market conditions more broadly—by changing the be. As discussed in the post, we recommend that rate in statute. While the statutory approach would the Legislature craft the definition of retail gross help the Legislature maintain a more active role in receipts carefully to minimize such interactions. setting the tax rate, the Legislature’s longstanding CONCLUSION In this report, we analyze several decisions tax is worth considering. We further recommend regarding potential changes to California’s changes to the way the state collects cannabis cannabis taxes. The first and most basic decision taxes (the taxed event and point of collection) and is what type of tax to levy. We recommend to the tax rate itself. Our recommended range of that the Legislature replace the state’s existing tax rates reflects the three goals outlined in statute: cannabis taxes with a tax designed to reduce undercutting illicit market prices, generating harmful cannabis use more effectively—namely, a sufficient revenues, and discouraging youth use. potency-based tax or tiered ad valorem tax. That In pursuit of these goals, we also encourage the said, if the Legislature prioritizes administration Legislature to consider complementing tax changes and compliance more highly, a basic ad valorem with nontax policies. www.lao.ca.gov 27 analysis full gutter AN LAO REPORT 28 LEGISLATIVE ANALYST’S OFFICE analysis full gutter AN LAO REPORT APPENDIX Approach to Estimating Effects of for four examples of such rate changes, but we also examined a variety of other possible Rate Changes changes. In this Appendix, we describe our • Consumers and the cannabis industry respond methodological approach to estimating the to the change in the tax rate. The model effects of cannabis tax rate changes on legal uses two numbers to characterize these consumption and tax revenues. Additionally, we responses: (1) the extent to which changes use an example to illustrate some problems with in tax rates would result in changes in retail using simple metrics—such as before-and-after prices, and (2) how strongly consumers comparisons—to estimate the effects of rate respond to changes in retail prices. For changes retrospectively. example, consumers’ price sensitivity could Reviewed Research and Data. We reviewed depend on their willingness to substitute economic research on legal cannabis markets in between legal and illegal cannabis. These two California and other states and examined data on numbers determine the changes in prices and market conditions in those markets. To assess quantities that result from the change in the the usefulness of each study as it might apply to tax rate. California, we considered the quality of its methods • The changes in the cultivation tax rate and and data, the degree of similarity between the the amount of cannabis harvested lead to study’s setting and present-day California, and the changes in cultivation tax revenue, while the applicability of the study to changes in California’s changes in the retail excise tax rate, prices, cannabis tax rates. (To the extent that there were and sales volume lead to changes in retail key differences between the study’s setting and excise tax revenue. present-day California, such as price differences, we tried to adjust the study’s estimates to account Approach Acknowledged Some Key for those differences.) We determined that this Uncertainties. The effects of changes in cannabis body of evidence could support estimates of the tax rates are uncertain in many respects. In short-term effects of tax rate changes on legal recognition of these uncertainties, some pieces of consumption and tax revenues, but not estimates our model were statistical distributions rather than of longer-term effects or effects on other outcomes. single points. In particular, based on the data and (We list some key studies in the Selected studies we reviewed, we considered distributions of References section on page 31.) possible values for: Set Up Structure of Model. We created a simple • Near-future retail prices for legal cannabis in model connecting changes in tax rates to changes California. in key market outcomes, ultimately resulting in • Near-future quantities of cannabis purchased changes in tax revenue. In particular, our model from California’s legal cannabis market. considers the following sequence of events: • The extent to which changes in tax rates • First, we adjust for various changes—such as would result in changes in retail prices. price declines—that could occur in the legal • The average retail markup over wholesale cannabis market between the most recent prices. data available and the time when tax rate • The magnitude of the consumer response to changes could go into effect. changes in legal retail prices. • Next, we assume a change in tax rates. • The share of wholesale inventory ultimately Figure 9 in this report displays our estimates sold to retailers and consumers. (Such sales www.lao.ca.gov 29 analysis full gutter AN LAO REPORT would not occur, for example, if the products Using Simple Metrics to Estimate Effects: could not pass the required laboratory tests.) A Cautionary Example. Many factors affect tax • The cost of complying with the cultivation tax. revenues, and it can be difficult to disentangle any given factor from the others. Consequently, simple Other Notable Assumptions. The model metrics—such as the difference between revenue incorporated several other specific assumptions, before and after a change in tax rates—can most notably: produce misleading estimates about the effects of the rate change. For example, state cannabis tax • Changes in tax rates affect legal cannabis revenue in the first half of calendar year 2019 was consumption and prices only through their roughly twice as large as revenue in the first half effects on tax liability and compliance of calendar year 2018—a 100 percent increase. costs. These policy changes do not convey This strong revenue growth occurred while state significant information about future policies, cannabis tax rates remained constant. Suppose, social norms, or other factors that could affect hypothetically, that the Legislature had cut the cannabis markets. Under this assumption, tax rate instead of holding it fixed. Additionally, for example, the industry does not interpret suppose that this tax cut reduced 2019 revenue, a tax cut as a harbinger of additional policy making it 25 percent lower than it would have changes that would reduce costs for cannabis been otherwise. This revenue loss would have businesses. offset just half of the year-over-year increase; • Consumers and businesses respond to 2019 revenue still would have been 50 percent the current tax rate but not to anticipated higher than 2018 revenue. In this example, a rate future rate changes. Under this assumption, change reduced revenue, but a simple comparison for example, consumers do not stockpile of revenue before and after the change would have cannabis prior to a tax increase, nor do they suggested otherwise. delay their purchases until after a tax cut. • As noted in the “Background” section, a state regulation prohibits cities and counties from banning retail deliveries of cannabis into their jurisdictions. Our assessment of revenue sufficiency assumes that these deliveries continue despite a current legal challenge to this regulation. If cities and counties could prohibit these deliveries, California’s legal cannabis market would be smaller and cannabis tax revenue would be lower. 30 LEGISLATIVE ANALYST’S OFFICE analysis full gutter AN LAO REPORT Selected References Davenport, Steven (2019). “Price and Product Variation in Washington’s Recreational Cannabis Market.” International Journal of Drug Policy. ERA Economics, LLC (2017). Economic Impact Analysis of CalCannabis Cultivation Licensing Program Regulations. Standardized Regulatory Impact Analysis performed for the California Department of Food and Agriculture. Escudero, Matias (2018). “Rule-of-Thumb Pricing: Retail Cannabis in Washington State.” Mimeo, Northwestern University. Hansen, Benjamin, Keaton Miller, and Caroline Weber (2017). “The Taxation of Recreational Marijuana: Evidence from Washington State.” National Bureau of Economic Research Working Paper 23632. Hollenbeck, Brett and Kosuke Uetake (2019). “Taxation and Market Power in the Legal Marijuana Industry.” Mimeo, UCLA. Khan, Muhammad, Paul Thompson, and Victor Tremblay (2019). “Marijuana Tax Incidence, Stockpiling, and Cross-Border Substitution.” International Tax and Public Finance. Miller, Keaton and Boyoung Seo (2019). “Tax Revenues When Substances Substitute: Marijuana, Alcohol, and Tobacco.” Mimeo, University of Oregon. National Academies of Sciences, Engineering, and Medicine (2017). The Health Effects of Cannabis and Cannabinoids: The Current State of Evidence and Recommendations for Research. Washington, DC: The National Academies Press. Prieger, James, Samuel C. Hampsher, Pat Oglesby, Steven Davenport, Clarissa Manning, and Richard Hahn (2019). Cannabis Potency Tax Feasibility Study. Report prepared for the Washington State Liquor and Cannabis Board. Smart, Rosanna, Jonathan P. Caulkins, Beau Kilmer, Steven Davenport, Gregory Midgette (2017). “Variation in Cannabis Potency and Prices in a Newly Legal Market: Evidence from 30 Million Cannabis Sales in Washington State.” Addiction. Thomas, Danna (2018). “License Quotas and the Inefficient Regulation of Sin Goods: Evidence from the Washington Recreational Marijuana Market.” Mimeo, Columbia University. University of California Agricultural Issues Center (2018). Economic Costs and Benefits of Proposed Bureau of Cannabis Control Regulations for the Implementation of the Medicinal and Adult Use Cannabis Regulation and Safety Act (MAUCRSA). Standardized Regulatory Impact Analysis performed for the Bureau of Cannabis Control. www.lao.ca.gov 31 analysis full gutter AN LAO REPORT 32 LEGISLATIVE ANALYST’S OFFICE analysis full gutter AN LAO REPORT www.lao.ca.gov 33 analysis full gutter AN LAO REPORT LAO PUBLICATIONS This report was prepared by Seth Kerstein and Helen Kerstein, and reviewed by Brian Brown and Carolyn Chu. The Legislative Analyst’s Office (LAO) is a nonpartisan office that provides fiscal and policy information and advice to the Legislature. To request publications call (916) 445-4656. This report and others, as well as an e-mail subscription service, are available on the LAO’s website at www.lao.ca.gov. The LAO is located at 925 L Street, Suite 1000, Sacramento, CA 95814. 34 LEGISLATIVE ANALYST’S OFFICE