California Could Tax the Daylights out of Marijuana Consumers

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You'll have to pardon the apropos pun, but the marijuana industry is truly budding. Marijuana Business Daily's newest annual report, "Marijuana Business Factbook 2017," predicts annual legal weed growth in the U.S. of 30% in 2017, another 45% in 2018, and an aggregate of 300% between 2016 and 2021, leading to a market generating approximately $17 billion in annual sales. This growth is a big reason why investors simply can't get enough of marijuana stocks.

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Underlying this organic and expansion-based sales surge is a decisive shift in the way the public thinks about cannabis. Gallup, which has conducted surveys on pot since 1969, found that a record number of people (64%) favored the legalization of marijuana in its October 2017 poll. That's up from just 25% back in 1995, the year before California became the first state to legalize medical cannabis for compassionate use. This shift in opinion has been the key to marijuana's two-decade-plus expansion in the U.S.

Today, there are 29 states that have legalized medical weed, and since November 2012 we've witnessed residents in eight states vote in favor of a recreational marijuana initiative. Colorado, which was among the first states to legalize adult-use weed and was the very first to allow the sale of recreational marijuana in licensed dispensaries, generated more than $1.3 billion in sales from cannabis in 2016, and nearly $200 million in tax revenue. This represented more than 30% sales growth from 2015. 

California's marijuana tax could push consumers back to the black market

But the kingpin for the pot industry is California, which in November 2016 voted to legalize adult-use weed via Proposition 64 by a vote of 56% in favor to 44% against.  Legalizing recreational pot in California is expected to bring the largest economy in the U.S. an additional $1 billion in tax revenue per year. While that's not going to resolve California's seemingly constant budget issues, it's a step in the right direction.

However, recreational weed, which is set to go on sale in California in 2018, may not be as popular a product as some pundits have suggested. The reason is the state may wind up taxing the daylights out of its consumers, pushing them back to the black market, which is already well-established in California.

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Proposition 64, which voters overwhelmingly passed, will add two additional taxes to cannabis in the state. First, growers will pay a state cultivation levy of $9.25 per ounce of cannabis flowers, or $2.75 per ounce of cannabis leaves. Secondly, there's a 15% excise tax added on to the final product. Mind you, this comes on top of the highest base sales tax rate in the country at 7.5%. And we're still not done! According to a report from credit ratings firm Fitch Ratings, 61 cities and counties have approved local business taxes ranging from 7.75% to 9.75%.

Fitch Ratings believes that this combination of state, local, and excise taxes could push the aggregate tax on cannabis to more than 45% in some parts of California. "High tax rates raise prices in legal markets, reinforcing the price advantage of black markets," the report said, via the Los Angeles Times

California should look to Canada for guidance

Of course, California isn't the only major economy trying to implement legal weed into the mix. Our neighbor to the north, Canada, is aiming to become the first developed country in the world to legalize recreational marijuana by July 1, 2018. While Canada has leaned on the expertise of states like Colorado, Oregon, and Washington in crafting its recreational weed legislation, it set its tax policy in marked contrast to these states.

According to Canadian officials, the proposed tax rate would be $1 per gram, or $0.78 in U.S. dollars, on marijuana sales costing up to $10 a gram (or $7.80 U.S.). For more expensive marijuana, the tax is a flat 10%. This actually works out to a lower tax rate than on alcohol in Canada, and it winds up pricing legal marijuana very similarly to black-market weed. Prime Minister Justin Trudeau understands that the best way to remove the black market element is to be competitive on pricing, which he's done with this proposal. 

Not surprisingly, Canadian-based marijuana growers have arguably been the top-performing pot stocks. Companies like Aphria (NASDAQOTH: APHQF) and Aurora Cannabis (NASDAQOTH: ACBFF) are investing in massive projects designed to boost their growing capacity. Aphria's Phase IV expansion will cost in excess of $100 million and increase its grow capacity to 1 million square feet, yielding about 100,000 kilograms of dried cannabis a year. Meanwhile, Aurora Cannabis is aiming for the same annual dried cannabis yield with its technologically advanced and highly automated 800,000-square-foot Aurora Sky project. Canada's low tax rate is giving added hope to these cannabis growers that demand will be exceptionally strong should the country legalize by next summer.

But therein lies the difference between the U.S. and Canada. For the U.S., marijuana is a new source of needed tax revenue, whereas Canada doesn't view legalization as much of a revenue driver at all.

It remains to be seen if Californians, who are used to paying a premium for most everything, will be willing to absorb up to a 45% tax rate, or if they'll shun the legal market and head back to the black market.

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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.