Click here for PDF

We recently wrote about the massive disparity between California’s estimated tax revenue from legal cannabis ($185 million) and its actual revenue ($84 million), here1. We opined that the shortfall was likely the result of consumers balking at California’s exorbitant taxes on cannabis sales and deciding to remain in the familiar black market, where they had purchased cannabis before legalization.

It appears that California officials recognize there is a problem. But it also appears that they have not properly identified the source of that problem (the tax rate). As a result, California is poised to return to the expensive and ineffective enforcement model that failed to stem the cannabis black market during decades of prohibition.

The problem is not enough people are purchasing cannabis on the legal market.

One of the driving factors for cannabis legalization has always been that people inclined to use cannabis will do so whether it is legal or not. So rather than accept a black market that enriches bad actors and results in violence and other criminal activity, states have started to embrace the legalization of cannabis to both eliminate the deleterious side effects of the black market and reap the benefits of tax revenues from legal sales. For legalization to succeed, however, a substantial percentage of cannabis users need to decide that they prefer the legal market to the black market.

The data from California indicates unequivocally that, at least so far, Californians are deciding against a move to the legal market. According to an estimate from New Frontier Data, at least 80% of cannabis sold in California is on the black market. That amounts to $3.7 billion in black market sales. Given that massive market, it is no surprise that bad actors, including cartels, continue to invest heavily in unlicensed cannabis cultivation and sales.

The solution is less taxes, not more enforcement.

California recognizes it has a problem; the Cannabis Advisory Committee recently issued a report identifying “a thriving environment for the unregulated ‘underground market.’” And while that is a positive start, it does not appear that California recognizes the source of its problem or how to fix it.

The Cannabis Advisory Committee report blames “fragmented and uncoordinated” enforcement for the thriving black market. Governor Gavin Newsom agrees; he recently proposed that 150 California National Guard troops be redeployed from the U.S.-Mexico border to assist in enforcement activities. He has also asked the federal government for additional funds for a Counterdrug Task Force. And his 2019-2020 budget calls for $40 million to fund enforcement efforts.

Past experience suggests that these increased enforcement efforts will be fruitless. For decades, the federal and state governments tried to root out the black market for cannabis and other drugs with very limited, if any, success. As long as there are people interested in purchasing cannabis on the black market, there will be bad actors willing to grow it and sell it.

The answer to California’s problem is not more enforcement, but less taxes. In some California counties, the effective tax rate is 45% on cannabis sales. This includes a state-wide 15% excise tax. It is basic economics that if you tax something more, consumers will buy less of it. So if you tax soda, consumers will buy less soda.

When applied to cannabis, however, that model does not work the same way. The more taxes states impose on cannabis, the less legal cannabis consumers will buy. Yet in contrast to other consumer goods (like soda), there has long been a thriving cannabis black market ready and able to serve cannabis consumers. So rather than not buying cannabis to avoid the higher taxes, consumers simply avail themselves of the available black market. That appears to be what is happening in California—higher taxes are keeping consumers from transitioning to the legal market.

If California wants to seriously shrink the black market, it should consider cutting taxes, and cutting them significantly. Lower taxes will bring more consumers into the legal cannabis space, which will not only increase state revenues but also slowly disincentive illegal cultivation and sales. It may take a while for the black market to contract significantly, but if the history of alcohol is a guide, it can happen.

Fortunately, some California officials recognize this; lawmakers recently proposed Assembly Bill 286, which would temporarily reduce the excise tax from 15 to 11 percent and suspend the cultivation tax. That is sound public policy, but it appears that effort is taking a backseat to increased enforcement. California officials should worry more about incentivizing cannabis consumers to transition into the legal market and less about keeping bad actors out of the illegal market. Take care of the former, and the latter will take care of itself.

1. ‎In our previous QuickStudy, which has since been corrected, we indicated that California had passed ‎emergency cannabis tax relief. In fact, and as discussed in this QuickStudy, California lawmakers have ‎proposed temporary cannabis tax relief, but that legislation has not yet passed.