By: Counsel Raza Lawrence

In New State Ice Co. v. Liebmann, U.S. Supreme Court Justice Louis Brandeis in 1932 referred to the 50 states as laboratories of democracy, writing:

It is one of the happy incidents of the federal system that a single courageous State may, if its citizens choose, serve as a laboratory and try novel social and economic experiments without risk to the rest of the country.[1]

Cannabis legalization has created a unique opportunity to compare how different states across the country have fared under very different policies in a field where there is zero federal regulation, as all commercial cannabis activity remains illegal under federal law.

While some states’ cannabis operations are flourishing, other states’ legal markets have floundered, with many operators going out of business or struggling to stay afloat, and large illicit markets persisting.

These different results can be explained, at least in part, by the states’ varying decisions on cannabis taxes and regulations. As with any other industry, high taxes and burdensome regulations can add significantly to business expenses.

One frequently stated goal of many states’ cannabis legalization initiatives has been to provide a form of reparations to victims of the war on drugs by encouraging “social equity” candidates to start commercial cannabis businesses.

Extensive taxes and regulations, however, often work against this goal, making it difficult or impossible for smaller or startup businesses to compete with larger, established companies with access to more capital.

Of all the states that have legalized cannabis, California placed one of the greatest tax burdens on its commercial cannabis businesses.

In California, state and local commercial cannabis laws imposed various new taxes on commercial cannabis activity across the supply chain, on top of existing state and local income and sales taxes that were already among the highest in the nation.

California was relatively unique among the states enacting licensing regimes, in that it already had a thriving, established commercial market that had been operating for years under the state’s medical marijuana collective laws.

The introduction of these substantial new taxes undoubtedly discouraged many people from the state’s legacy market from participating in the new licensed regime, and caused many others who gave licensing a shot to withdraw from the market after incurring substantial losses and failing to identify a viable path forward.

California’s politicians appear to be acknowledging their errors. The state recently provided a jolt to its cannabis industry by eliminating its cannabis cultivation tax, effective July 1.[2]

The cultivation tax has, for years, created a drag on California’s licensed cannabis market and caused many businesses to continue operating in the illicit, unlicensed market.

Given that the cannabis cultivation taxes are ultimately passed onto consumers through distributors and retailers, this move will ultimately drive down the cost of retail cannabis.

In turn, this should drive up licensed retail demand and make all types of cannabis businesses more profitable. It could possibly even increase the tax revenues flowing to governments as more licensed sales are consummated.

California has always been a national and international leader in building a legal cannabis industry.

It was the first state in the nation to legalize medical marijuana via Proposition 215 in 1996; the first to recognize legal marijuana sales via S.B. 420 in 2003, allowing nonprofit medical marijuana collectives; and one of the first states to issue licenses to nonmedical, adult-use cannabis businesses via Proposition 64, passed by voters in 2016, allowing businesses to sell cannabis for profit to the general public.

California produces some of the world’s best cannabis flowers, and the most innovative new cannabis products, including cannabis edibles and concentrates. In California, smoking cannabis is more widely accepted and considered less taboo than smoking tobacco.[3]

Throughout most of its history, California’s cannabis market has been unregulated. The state had a thriving, illegal marijuana legacy market for a long time before legal medical marijuana came along, and for years, legal sales of medical marijuana occurred within the context of nonprofit collectives, which were not subject to any licensing or regulation.

When licensing laws came along in 2016, a massive unregulated industry already existed.

Recently, there has been a perception that California’s cannabis industry is slumping, due in large part to overly cumbersome and burdensome taxes and regulations at both the state and local levels.

The recently eliminated cultivation tax required licensed cannabis cultivators to pay $161 to the government for each pound of cannabis flowers provided to cannabis distributors.

As wholesale cannabis prices have dropped substantially in the last year, this cultivation tax created a drag on the entire industry, making many businesses already struggling to get by unprofitable.

In addition to the cultivation tax, California cannabis is subject to a 15% excise tax at the retail level, 7.25% state sales taxes, local sales taxes and often additional local cannabis-specific taxes.

All of this is on top of regular state and federal income taxes owed by cannabis businesses, with Section 280E of the Internal Revenue Code prohibiting businesses from deducting otherwise ordinary business expenses from the gross income associated with selling cannabis on their federal tax returns.

Cannabis businesses are also charged significant licensing fees by both local and state governments, with annual state licensing fees reaching as high as $300,000.

The combination of all these taxes and fees has created an environment where California retains a gigantic unlicensed, unregulated cannabis market, which was valued in a 2019 Statista report at $8.7 billion per year.[4] Licensed California businesses struggle to compete with the unlicensed market, which pays no taxes and does not comply with any regulations.

Other states have taken a substantially different approach, aiming for a lighter touch. For instance, Missouri taxes cannabis sales at only 4%, and Oklahoma taxes cannabis sales at 7%. Missouri and Oklahoma have legalized medical marijuana, but not adult-use, recreational marijuana. Neither state separately taxes cannabis cultivation like California did.

Some have speculated that California’s tax reductions could paradoxically increase tax revenues while also boosting the industry. In economics, the Laffer curve — in the shape of a rainbow — shows the relationship between rates of taxation and the resulting levels of the government’s tax revenues.

At a certain point, after going over the top of the rainbow, increasing tax rates decrease tax revenues, because the increased tax rates eliminate some sales that otherwise would have occurred. At high enough tax rates, licensed sales will drop to zero, and the government will collect no taxes.

While California’s elimination of the $161-per-pound cultivation tax may not transform the industry overnight, it is a welcome sign for a beleaguered industry, as legal cannabis gains increasing acceptance across the country.

According to a Rasmussen poll, 62% of U.S. adults, including 54% of Republicans, now support national marijuana legalization,[5] and politicians from both major political parties have proposed and supported national cannabis legalization initiatives.

Accordingly, federal cannabis legalization is likely coming soon, and by reducing its taxes, California not only bolsters its in-state cannabis market, but also sets its cannabis businesses up for future success in the likely upcoming legal national — and international — markets.

California’s about-face on cannabis taxation provides an important perspective for federal lawmakers to consider as they debate federal legalization.

Remarkably, although licensed cannabis sales in the U.S. are expected to top $32 billion in 2022 — and annual black-market sales are estimated at $100 billion — any sale or cultivation of marijuana remains a felony under federal law, which trumps any conflicting state law due to the Supremacy Clause of the U.S. Constitution.

Lawmakers have discussed various proposals for federal legalization, including the Marijuana Opportunity Reinvestment and Expungement, or MORE, Act, which passed the House of Representatives in April, but did not have sufficient support to pass in the Senate.

Notably, the MORE Act included a new 8% federal cannabis excise tax that would be applied to cannabis businesses on top of all the existing state and local taxes. This new layer of taxation, while cannabis companies are already struggling under burdensome local and state taxes, appears to have caused some Republican lawmakers otherwise friendly to legalization to withhold their support.

After the MORE Act stalled out, Senate Majority Leader Chuck Schumer, D-N.Y., introduced a new federal legalization bill, the Cannabis Administration and Opportunity Act, in July.

The proposed law would decriminalize marijuana at the federal level and allow states to set their own marijuana laws, which is essentially how the regulation has already evolved in recent years, with states creating their own cannabis licensing systems while ignoring the federal ban.

Schumer’s bill, however, would ultimately impose a new nationwide federal excise tax of up to 25% of sales prices — on top of existing state and local sales and excise taxes.

Industry officials have argued that Schumer’s proposed new excise tax would be very burdensome for licensed operators and would make it difficult for them to compete with the black market.

In contrast to the Democratic legalization bills, Rep. Nancy Mace, R-S.C., recently introduced a cannabis legalization bill named the States Reform Act,[6] which imposes a new federal excise tax of only 3% on cannabis and includes a 10-year moratorium on excise tax increases. This relatively low tax rate would make it more viable for licensed operators to complete with the black market.

President Joe Biden proposed during his last campaign to move cannabis from Schedule 1 to Schedule 2 on the federal controlled substances list, which would place it in the same category as fentanyl and mean that it could only be produced and sold by pharmaceutical companies as an FDA-approved prescription drug.

Following his election, Biden has not taken any steps to move this proposal forward, and it has not received much support from either Democrats or Republicans.

By stripping burdensome taxes and regulations from federal legalization proposals, legalization advocates could likely draw bipartisan support, in addition to creating an environment where new companies can get off the ground and thrive, providing new employment and establishing a robust tax base.

California provides a vivid real-world example illustrating that steep new taxes can choke a new licensed industry out of existence.

As California has shown, a more reasonable approach would be to initially tread lightly with taxes and regulations to allow startup businesses to get off the ground and to encourage as many black-market operators as possible to migrate to the licensed market.

Then, tax rates can be adjusted going forward to ensure that governments are receiving their fair share of revenues, and that unduly high taxes are not driving companies out of business or back into the black market.

Thanks to trial and error at the state level, we have seen what works — and how to build an industry that will best support the people and the government.

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*Article originally published here at Law360.com
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] New State Ice Co. v. Liebmann, 285 U.S. 262, 311 (1932).

[2] California Assembly Bill No. 195, signed June 30, 3022, amending section \34012 of the California Revenue and Taxation Code.

[3] See, e.g., California Department of Public Health, Key Findings from the Online California Adult Tobacco Survey: 2019-2020 Results, available
at https://www.cdph.ca.gov/Programs/CCDPHP/DCDIC/CTCB/CDPH%20Document%20Library/ResearchandEvaluation/
FactsandFigures/OnlineCATS2020Factsheet_Aug2021.pdf (finding that the rate of recent cannabis use among California adults is two to three times the rate of recent cigarette use).

[4] https://www.statista.com/statistics/1075946/legal-vs-illicit-cannabis-sales-california- us/.

[5] See Rasmussen Reports, Support Grows for Legalizing Marijuana, November 4, 2021, available
at https://www.rasmussenreports.com/public_content/lifestyle/general_lifestyle/october_20 21/support_grows_for_legalizing_marijuana.

[6] See https://mace.house.gov/sites/evo-subsites/mace.house.gov/files/evo-media- document/SRA%20Policy%20Brief.pdf.