Major Tax Changes Are in the Works for the Biggest Marijuana Market in the World

Although 2019 began well for cannabis stocks and industry hopes were (pardon the pun) high, it ended in disaster.

With Canada having legalized recreational pot in October 2018, growers on track to launch derivative products later in 2019, and legalization momentum remaining strong in the U.S., the forecast was for marijuana stocks to push toward profitability by year's end. However, this didn't happen.

In Canada, supply issues have been persistent since day one of legalization, and the launch of derivatives wound up being delayed by at least two months, until mid-December. Meanwhile, select U.S. states that have legalized recreational pot have been taxing the daylights out of consumers, which has made it virtually impossible to compete with black-market producers on price. In short, illicit growers have been thriving throughout North America.

A tipped over jar packed with cannabis buds that's lying atop a small pile of cash.

Image source: Getty Images.

Cannabis sales are stagnant in the largest pot market, California

Perhaps no disappointment has been greater than that of California, the biggest marijuana market in the world by annual sales. According to an estimate in the "State of the Legal Cannabis Markets" report by Arcview Market Research and BDS Analytics, California was on track for $3.1 billion in legal weed sales in 2019, which is practically quadruple what Canada sold in trailing-first-year sales following the legalization of adult-use weed.

Although $3.1 billion probably sounds like a lot of cannabis being sold, it's best to understand the context of this figure. Total weed sales in 2017 in California were $3 billion. Mind you, recreational pot sales weren't yet legal in 2017, meaning this was being driven entirely by legal medical marijuana sales. In 2018, once the doors were open to adult-use weed, total state sales fell (yes, fell) to $2.5 billion, and are expected to have increased to $3.1 billion in 2019.

How, exactly, does the most lucrative marijuana market in the world stumble so badly in the sales department when there's obvious demand for pot products? All you have to do is look at the state's exorbitant tax rate on cannabis.

On top of already high state and local sales tax rates, California tacks on a 15% excise tax and a wholesale tax that's dependent on the state of the product (i.e., whether it's leaves or flower). Additional expenses, such as laboratory testing, are also factored into the final price of the product. As a result, black-market sales are nearly three times higher than legal sales in the Golden State at the moment.

However, Governor Gavin Newsom, a Democrat, hopes to change this.

A green highway sign that reads, Welcome to California, with a white cannabis leaf in the upper-right corner.

Image source: Getty Images.

California has proposed significant regulatory and tax reforms

A little more than a week ago, Newsom's administration unveiled a number of provisions in the state's annual budget proposal that are designed to simplify the regulatory and tax structure on the pot industry.

For example, Newsom's proposal would create the Department of Cannabis Control by July 2021. This would take three existing licensing entities -- the Bureau of Cannabis Control, the Department of Public Health, and the Department of Food and Agriculture -- and place them all under one roof, the hope here being that a single entity with enforcement and licensing power will more effectively help establish a legal presence and drive illicit producers out of business.

Newsom also aims to simplify the tax-collection process on marijuana. As noted in the released provisions, the administration wants to "move the responsibility for the cultivation excise tax from the final distributor to the first, and for the retail excise tax from the distributor to the retailer." Doing this would mean the California Department of Tax and Fee Administration wouldn't have to adjust the markup rate for cannabis products every six months. 

But the most exciting change might just be that Newsom and his team are taking into consideration the idea of lowering existing tax rates on legal pot products. Right now California-focused pot businesses simply have no chance of competing on price with black-market growers. Substantially lowering the aggregate tax on legal weed would be viewed as a major step in the right direction. 

A drug free zone sign posted in a quiet neighborhood.

Image source: Getty Images.

A big hill to climb

Of course, while an exorbitant tax rate on legal weed is a big problem for California, it's not the only issue.

Like most states that have given the green light to recreational marijuana, California's jurisdictions have the right to decide whether or not to allow cannabis retailers a presence. A little over 80% of the Golden State's jurisdictions have denied retailers the option of selling legal weed in their towns, making it doubly difficult for regulators to effectively drive out the as-of-now dominant illicit presence. As a result, it's the state's retailers that are paying the price.

Perhaps no multistate operator has paid a steeper price for California's struggles than MedMen Enterprises (OTC: MMNFF). MedMen, which has more than a dozen open retail locations in California, has seen sequential quarterly sales growth slow in recent quarters. These slowing sales, coupled with MedMen's aggressive expansion tactics in and outside of California, pushed its operating loss in fiscal 2019 to a staggering $231.7 million.

If California doesn't fix its problems soon, Cresco Labs (OTC: CRLBF) might also regret its acquisition of Origin House, which recently closed. Origin House is one of a select few holders of cannabis distribution licenses in the Golden State. Cresco Labs' all-stock purchase of Origin House gives the company access to approximately 575 dispensaries in the state with which to sell its products. However, if pricing remains a concern due to high tax rates on cannabis, Cresco's ambitions may need to be tempered a bit.

The prospect of regulatory changes being on the horizon is certainly a step in the right direction for California. But I'm not going to be convinced that California-focused marijuana stocks will be better off until the state tackles its ridiculously high tax rates on marijuana.

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Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


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