As most of us were still figuring out our New Year’s resolutions, cannabis was already on the agenda for 17 additional states to be legalised further. Legislators in eight states had declared their intent to join the crowd, while voters in nine additional states had placed cannabis legalisation on their autumn ballots. With 2020 being a presidential election year with predicted high voter turn-out, even further ballot initiatives were expected.
But then COVID.
Once the pandemic struck, state legislatures ground to a halt and focused solely on getting states through the pandemic and beyond. Even federal efforts to allow legal cannabis industry participants to utilise the US banking system got stuck in the mud. The Secure and Fair Enforcement (SAFE) Banking Act, which appeared to be heading for assured passage, has not made it through the legislative process… yet.
The irresistible tax revenue promise of cannabis legalisation
The pandemic has sparked wide-ranging budget shortfalls in the United States. As most states grapple with those shortfalls, it is clear that state legislatures will be looking to boost revenue in the upcoming fiscal years. Businesses remain closed, tens of millions of citizens are out of work, and there is no clear end to the pandemic.
Preliminary estimates from the Center on Budget and Policy Priorities project state budget shortfalls to reach almost 10% in the current fiscal year and about 25% in fiscal year 2021, while the National Conference of State Legislatures projects that 10 states will experience at least 16% decline in revenue for fiscal year 2021.
As the country is still in the midst of controlling the spread of the virus, state governments do not know how much their revenues have truly fallen and will fall in the next 18 months. Since it is unlikely the federal government will bailout all states, lawmakers will have to look towards broad budget cuts, cuts to individual departments or programmes, or to raise revenue through increased taxes.
Since tax increases after the pandemic will be politically challenging to pass, new sources of revenue will become of great interest to lawmakers. And cannabis has proven to be a strong excise tax revenue producer during the economic downturn.
In fact, eight of the 11 states that issued stay-at-home orders in March 2020 deemed cannabis retailers as ‘essential businesses’. That same month, weekly sales in California, Washington, Nevada, and Colorado grew to $134 million. According to a CNBC.com article, this was a 17% increase from the weekly average in 2019. Colorado alone raked in $25.6 million in taxes and licensing fees in March of this year (as reported by the state government).
For states and legislators starved for revenue, such excise tax numbers are likely to be irresistible for many. And since they are taxes for a completely new product, the political pushback is likely to be minimal.
The unintended consequences of legalisation
While state legislators might be quick to investigate cannabis legalisation, focusing primarily on the perceived revenue, they will be wise to investigate the potential (and unfortunately likely) unintended consequences legalisation might bring.
Cannabis has a complicated history in the United States. It has been illegal in most US states for most of its history. California legalised medical cannabis and it took until 2012 before Colorado and Washington were the first states to legalise cannabis for recreational use.
Yet, despite state efforts in cannabis legislation and regulation, cannabis remains illegal under federal law. It is still a ‘Schedule I Controlled Substance’. As a result, industry participants operating in states that have legalised cannabis are still violating federal law.
While US federal law enforcement, such as the Drug Enforcement Administration, have been practicing enforcement discretion and deferments, former US Attorney General Jeff Sessions had vowed to return to more stringent enforcement.
This legal limbo has made it difficult for states to effectively implement legalisation, since former illegal ‘participants’ might be hesitant to join the legal community if the fear of federal enforcement continues to exist. As the presumptive Democratic candidate Biden and President Trump are both firmly in opposition of legalisation, it appears this limbo will continue.
The lessons learned from states that have implemented cannabis legalisation show that it is difficult to strike a balanced, nimble, and robust regulatory framework. If state legislators move too quickly, ultimately the illicit market for cannabis might increase rather than decrease with legalisation.
The imbalance results in lack of revenue for states. For example, high taxes on cannabis drive the cost of legal cannabis. If legal cannabis is more expensive than illicit cannabis, consumers will not switch to the legal product, resulting in tax revenue shortfalls.
State regulators must consider how to build a licence structure in which all businesses, from growers to retailers, can enter the legitimate market easily. High startup costs and high licensing fees make it difficult for cannabis businesses to compete with illicit products sold on the street, online marketplaces, or at unlicensed dispensaries.
For example, according to a 2019 Politico.com article, Los Angeles, California has approximately 1,000 dispensaries and only around 200 are licensed.
Further, cities across states that have legalised cannabis often need to allow for retail cannabis. Only about a quarter of towns and cities allow cannabis retailers and there are different speeds at which cities issue licences. Just because states legalise cannabis clearly does not mean that all residents have equal access to the legal system.
Besides access to legal cannabis, consumers need to be able to find quality and purity of cannabis legally. Massachusetts advocates estimate that 80% of the market is still illicit and many customers at the legal dispensaries are from out of state.
Contrastingly, Oregon did not limit licences and established simplified regulations. This created high-quality, cheap, legal cannabis. However, Oregon had a large unaccounted surplus of product and growers were found illegally selling to consumers in other states, while avoiding tax payments.
Until all states have uniform legalisation standards and harmonised state taxes, this cross-border smuggling will only increase, akin to how cigarette smuggling is driven by the difference in taxation across states.
Finally, state governments must realise the black market will not go away until cannabis is legalised under federal law and the state’s black market itself may increase even after legalisation.
For example, the Rocky Mountain High Intensity Drug Trafficking Area (HIDTA) Colorado Task Force reported that the number of completed investigations rose from 163 in 2016 to 257 in 2018 with an equal rise in organised crime investigations. The number of plants seized rose from 43,786 to 60,091 in 2018, pounds of bulk marijuana from 3.5 tonnes to 6.1 tonnes, and pounds of concentrate from 232 to 319 from 2016 to 2018.
Criminal networks are well established and will not go out of business as states adopt legalisation of cannabis. Individuals can easily cross state lines in which cannabis is legal and sell in a state that still categorises cannabis as illegal. Additional funding must be given to enforcement while mandating those involved throughout the supply chain to comply with tracking cannabis from seed to sale. Robust enforcement must be in place to offset the illicit market.
The challenges in implementing the sale of cannabis may ultimately result in consumers relying on the illicit market and states losing potential tax revenue. California continues to be a cautionary tale of stumbling legalisation implementation, when the state projected one billion in revenue for 2018 but only collected slightly more than a third (source: politico.com).
Implications for the industry
The likely growth of the cannabis industry in the United States and across the globe will provide new challenges for governments, law enforcement, industry and technology providers alike. Driven by government’s desire for tax revenue and fueled by a populace looking for recreational choices many governments will be spurred into action soon and for years to come.
However, as discussed above, the siren song of easy tax revenue also lures the criminal element into the open. Reports from law enforcement about increased seizures and involvement by organised crime groups are indicators that criminals have noticed the new easy money to be made. And rightfully so, the state of Colorado reports that it now collects more from cannabis-related tax then tobacco-related tax, after just legalising it in 2012.
As a result, governments would be wise to evaluate several legislative, policy, regulatory, enforcement and technology considerations, as they advance with legalisation proposals:
Learn from your predecessors: states looking to legalise should learn from states that have gone before and study best practices on regulation, licensing, taxation, enforcement and technology. Elected leaders are well advised to talk to government officials, law enforcement, industry participants and consumers in those states, to learn what has worked and what hasn’t.
Comprehensive, flexible and sensible regulatory and licensing scheme: legalisation, by its very nature, has to be a different regulatory scheme than for other excise products. The purpose of regulation needs to be to bring as much of the current illicit market into the legal market, encourage new participants into the legal market, while discouraging participants not willing to play by the rules.
This includes a rigorous, but not arduous, licensing scheme with background checks, physical location, inspections and ongoing reporting, but considers how to protect state registrants from federal overreach. Best practices also include licensing the whole distribution chain from seed to consumer to ensure product safety, product quality and compliance.
Appropriate and rigorous enforcement mechanisms: as discussed above, the trade in cannabis has attracted – and will continue to attract – the criminal element, especially when tax evasion provides an even greater incentive. Any legalisation effort needs to include funding mechanisms to create new enforcement units within each government. Simply including or subsuming cannabis within enforcement structures is likely to lead to scope creep and a lack of enforcement due to inadequate resources.
Establishing and funding dedicated departments and enforcement personnel will ensure that adequate resources and manpower are allocated to ensure compliance and suppress illicit activity. Legislative proposals need to include appropriate fines, penalties and sanctions for participants not playing by the rules, while acknowledging that due to its nature there is a learning curve involved, which will require leniency in the beginning.
Sophisticated technology to aid enforcement, tax collection and consumer safety: these growing markets will have needs for many new technology products in the area of authentication, tax collection and consumer safety.
As a black market is made legal, consumers will look for ways to authenticate their purchase, tax collectors will want to track and trace product from seed to consumer to ensure that all taxable product is accounted for, while law enforcement will look for ways to quickly spot illicit product and trace diverted product back to its last legal source across state lines. This will require all technology providers to re-evaluate their current technology offers or develop technologies from the ground up to serve this new diverse market.
20 states have implemented unique tax stamps* for cannabis (see https://norml.org/laws/tax-stamps). Retailers are legally required to purchase and affix state-issued stamps to cannabis or will face fines and/or criminal sanctions. These penalties are not consistent across the country, however.
For example, Georgia imposes no fines but individuals can receive a misdemeanour for failure to comply, whereas Utah imposes a penalty of 200% of tax and third degree felony for failure to utilise tax stamps on cannabis. It is difficult to ascertain how these stamps are authenticated or enforced across the country, but different US licensees are clearly faced with varying enforcement actions.
Existing stamp, marking and label technologies might not be ideal for the tracking and tracing of an agricultural product. Packaging uniformity does not exist, making the application of tax stamps impractical and burdensome. On the flip side, technologies that were dismissed in the past might all of a sudden experience a new renaissance.
For instance, RFID technology designed to tag plants and with the ability to audit vast growing operations instantaneously will suddenly become ROI-positive. Custom-built track and trace applications like Metrc demonstrate how such technologies can quickly penetrate a new market. Metrc is already in use in 13 states and is quickly establishing a dominant foothold in an emerging industry with its purpose-built technology designed to solve the issue of tracking, tracing, trending and reporting. The Metrc API (application programming interface) is customised to comply with each states’ regulations. Purpose-built authentication apps are also another very powerful tool to help reassure consumers about the safety and quality of their purchase.
The next green wave of cannabis legalisation is about to emerge. Legislators, policy makers, law enforcement, industry participants and technology providers will be well advised to study existing markets now to ensure legalisation can be achieved to supply sustainable tax revenue, while avoiding the unintended illicit trade consequences.