Why Legal Cannabis is Losing the War to Illegal Product

The market for legal cannabis is growing, and California, the largest regulated cannabis market in the United States, ranks first among states that are taking in more cannabis taxes than alcohol taxes.

Having said this, this young, burgeoning market is facing serious challenges, reports the Los Angeles (LA) Times.

The biggest challenge is competition from illegal cannabis. The LA Times’ best estimate is that roughly three quarters of cannabis currently sold to consumers in California is illegal (meaning it is not licensed by the state).

When California voters passed Proposition 64 in 2016 to legalise recreational or ‘adult use’ cannabis, they also approved a complex state-run system for licensing, regulating and taxing it. This new system, which took effect in 2018 and replaced the mostly unregulated medical cannabis market, made legal product much more expensive than illegal product.

Under Proposition 64, legal cannabis businesses must first obtain approval from local authorities, which is impossible in many parts of California. The lucky ones that do get local approval must then apply and pay for a state licence. This two-step process can take years and consume hundreds of thousands of dollars in legal, consulting and licence fees.

Legal businesses must also register with the state every gramme of cannabis that’s grown, sold or transferred between locations through what LA Times refers to as a ‘complicated track and trace system’. Managing this process alone can cost tens of thousands of dollars per month in software and labour costs. Of course, none of these costs are faced by illegal producers or sellers.

Furthermore, legal cannabis must be tested by a state licensed independent testing lab for potency and certified as being free from more than 100 different microbial ‘contaminants,’ including more than 60 pesticides.

Next come the taxes. In California, this begins with a state ‘cultivation tax’ paid by the grower, which in 2022 increased to about $161 per pound (one pound equals 454 grammes). The state excise tax, paid on top of the cultivation tax, is now 15% of the projected retail price. Then there are additional taxes of up to 15% imposed at each stage, from farm to retail, by local municipalities.

And there’s also California’s standard 8% to 9% sales tax. All these taxes are paid by legal cannabis businesses and passed along to legal buyers. None of them is paid by illegal businesses. (Governor Gavin Newsom is now proposing to eliminate the cultivation tax as a part of a cannabis tax simplification package).

Add up all these licensing costs, taxes and regulatory burdens, and the LA Times estimates that California consumers often end up paying about twice as much for a package of legal product as for a comparable package of illegal product.

But not even the most experienced cannabis connoisseurs can tell, just from sampling the product, whether it came from a licensed or unlicensed seller. The only difference is in the packaging, labelling and testing certification, which are evidently not important to most consumers.

Most consumers won’t pay twice as much just to know that its producer paid their taxes and followed the rules.

In California, many of the operations that made a good-faith effort to go legal and follow the rules have gone out of business from underestimating their costs or overestimating the size of the legal market. A legal system works well when people and businesses are rewarded, not punished, for following the rules, remarks the LA Times.

Rather than ramping up enforcement against illegal cannabis, the best way forward is for policymakers to take a practical view about the real-world effects of regulations and taxes. Some careful cost-benefit analysis could yield a set of pared-down regulations that maintain the most effective health and safety rules while loosening up on some unnecessary restrictions that are strangling the young industry before it is up and running.

For instance, track and trace requirements could be relaxed, local taxes could be capped at 3% (as Massachusetts has done), and tolerance levels for microbial substances could be re-evaluated.

Realism means acknowledging that taxed and regulated legal cannabis may always be a bit more expensive than illegal product, and that illegal product may never completely disappear. But in the long run, easing some of the many pressures on people who are trying their best to follow the rules could help legal cannabis win, concludes the LA Times.

California’s Track and Trace System

California’s state-level cannabis track and trace system is provided by Metrc, which has been partnering with California since 2017, and which provides similar systems under 21 different government contracts nationwide to support the regulation of the cannabis market.

The RFID-based system tracks product through the supply chain, establishing a chain of custody from ‘seed’ (a small plant) to ‘sale’ (final product). Every mature plant in a licensed cultivation facility must bear an individual Metrc RFID tag, and the information on the tag is entered into a central database for tracking the plant through to harvest.

Once harvested, all usable product is individually packaged and assigned another RFID tag, again linked to the central database, as well as to the original plant tag.

RFID technology was chosen because of the sheer number of plants needed to be tracked simultaneously. The system allows growers and enforcement personnel to simply download all data for a densely stacked growing room to a handheld device, making the system more time- and labour-efficient than scanning individual plant tags.

Notably absent from this system, however, are any physical security features on the label. The label might have covert features, which have not been revealed to the public, but the label clearly has no overt features.

Unlike tax stamps, the Metrc tracking labels themselves do not denote any tax value paid, but rather create a data infrastructure designed to provide such information.