Lessons in Marijuana Legalization for Illinois (Part One of Two)

 
 
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“...in this world nothing can be said to be certain, except death and taxes.” 
- Benjamin Franklin
...and the law of supply and demand.

The March primary election presented Illinois with the opportunity to weigh in on legalizing recreational marijuana. Voters responded with a resounding ‘yes’ by a roughly two-thirds majority. While non-binding, the advisory referendum served notice to Springfield that state residents support "the cultivation, manufacture, distribution, testing, and sale of marijuana and marijuana products for recreational use by adults 21 and older.” 

Democratic gubernatorial nominee J.B. Pritzker took the strongest pro-legalization stance in the run-up to the primaries. A win in November positions Pritzker to expand Illinois’ medical marijuana program if not move forward on legalization entirely. While campaign promises should be taken with a grain (in Illinois, a tablespoon) of salt, marijuana legalization has followed an upward, albeit uneven, trajectory for several years. The trend began in 2015 when Governor Bruce Rauner piloted (and subsequently expanded and extended) a medical marijuana program. Recreational use will be legal at some point in the future. The question of when, and some predict sometime soon, shouldn’t be the key point of debate. How Illinois institutes a legal recreational marijuana program should command the most attention. Investors, entrepreneurs, and policy makers should look West to California for an instructive example of rolling out legalization, what can go wrong, and what can be learned.

The following explores lessons from California's legalization process. A follow-up companion piece will delve into recommendations to be applied in Illinois.

How Recreational Legalization Came About in California

In November 2016, California voters approved the Adult Use of Marijuana Act (Proposition 64), leading to the legalization of recreational marijuana sales. Thus ended the slow build to full legalization begun in 1996 with the Compassionate Care Act. Under Proposition 64, legal sales were set to start January 1, 2018. In the intervening time, Prop 64 tasked the Bureau of Marijuana Control and other state bodies to institute new guidelines on cultivating, distributing, and selling cannabis. California was poised to legalize the state’s long-established grey and black market for cannabis. 

All well and good. Following a waiting period for the state to get its act together, the public got what it wanted. As The Law of Unintended Consequences would have it however, Prop 64 triggered an unexpected chain reaction. What follows describes the clash between intent, the power of market dynamics, and the consequences of poor execution.

Marijuana, Meet Microeconomics 101

Everyone expected recreational marijuana sales in California would skyrocket as of January 1. Leading up to 2018, analysts projected 2018 sales for recreational marijuana at anywhere from $3.7 billion to $5.1 billion. However as of late May, analysts across the board dropped the annual sales estimate by roughly $2 billion. (For example, a firm that projected $3.8 billion now has the figure at $1.9 billion.) Why? On May 11, the state reported $60.9 million in taxes for the first quarter, well off pace to hit the annual target. Governor Jerry Brown’s budget estimated the state would receive $175 million in the first six months and $643 million for the year. The shortfall in state taxes quantified what many had already realized: the roll-out of legalization has been botched. Retail sales and accompanying tax revenues are nowhere near the forecasts used to create the state budget. What went wrong?

When any market malfunctions, start with the usual suspects: regulations and taxes . In California, taxes by far have been the primary culprit. Exorbitant taxes are driving prices higher for legal operators already pressing for margin.

Consider this rundown of costs cited by an Oakland dispensary owner of higher rates and new taxes:

  • Oakland city tax on marijuana: 10%
  • County sales tax: 3.25%
  • State sales tax: 6%
  • State excise tax on recreational marijuana sales: 15%

For example, a consumer making a $50 purchase in Oakland prior to full legalization would have paid an additional $3.88 in tax at the time. As of January 1st, that same purchase incurs $11.93 of taxes (per Civilized). Lawmakers have begun to realize the punitive nature of the state excise tax. A bill introduced in March would have lowered the excise rate to 11% and suspended all cultivation taxes. (Growers pay anywhere from $1.29 to $9.25 per ounce in cultivation taxes.) By late May however, the state assembly had scuttled the bill. The chair of the committee responsible claimed, seemingly without irony, the hit on state income was “really expensive”. While tax reduction efforts are underway in certain counties, the legal market will continue to sputter without tax relief at a state level.

In addition to levying high taxes, a bevy of new regulations have throttled growth. The over-regulation is most apparent in the costly application process and Byzantine upfront requirements faced by cultivators. For example, growers must submit a Cultivation Plan documenting compliance with an alphabet soup of state bodies: the State Water Resources Control Board (SWRCB), Department of Pesticide Regulation (DPR), and the Department of Fish and Wildlife (DFW). A quick glance at the FAQs on applications is enough: there is a thicket of red tape. The steep punishments for violating the demanding regulations also discourage underground growers from going legit, further blunting the impact of legalization.

 To confuse matters further, local governments have enacted a mishmash of their own regulations. Take two communities in LA county: Culver City allows everything (medical and recreational sales, indoor cultivation, you name it) short of outdoor cultivation. Fifteen minutes away in Santa Monica only medical marijuana is permitted. Much of the public seems to have voted “yes” to legalization with an unspoken “...but not in my backyard”. On net, roll-out and acceptance of Prop 64 has been slow at best. (For a deep dive into local regulations, The Cannifornian has done yeoman’s work to assemble a comprehensive database on the dizzying state of affairs across California.)

Having failed to roll back taxes or restore sanity to regulations, the authorities have turned from the carrot to the stick.  Governor Jerry Brown has allocated $14 million for a new task force to run “complex, large-scale financial and tax evasion investigations” targeting the marijuana black market. Never mind that the state purse is over $100 million light already. The crackdown can’t fix the budget shortfall. High profile busts may score points with the public,  but won’t solve the structural problems. 

Finally, conflicting dynamics in the newly legalized market are creating unintended consequences that have caught many off guard. Legalization has accelerated environmental damage, opened the door for organized crime, and led to an increase in police presence and enforcement. The inclusive language of Prop 64 has given way to grim conversations statewide.   

Take the environmental issues at play. Prop 64 addresses the environmental impact of cannabis cultivation, such as the use of pesticides. Licensed growers must play by those rules while black and grey market growers continue to employ illegal pesticides and other damaging practices. Product leaks into the legal market,  leading to problems throughout the supply chain and health concerns by end consumers. Pushback from longtime cultivators in the so-called “Emerald Triangle” of Northern California exemplifies the issue. Despite local attempts to work with black and grey market cultivators, “the onerous criteria for state and local compliance and the punishing fees for applications, inspections, and property upgrades are serving as a huge obstacle for farmers.” According to industry sources, as few as six percent of growers in the state have made the leap into the legal market. If the promise of legalization fails to entice illegal growers, contaminants (such as those detailed by Wired in February and in The Atlantic last March) will continue to taint California’s waterways, wildlife, and worry consumers. 

Unscrupulous real estate agents may be the only locals celebrating another unwelcome development. Under the  guise of legitimate investments, foreign cartels have snapped up residential properties to operate illegal grows. Human traffickers bring over immigrants to operate the grows, providing a cheap and disposable labor force beholden to the mobsters. In April, local and federal agents seized 74 properties in Sacramento operating as illegal grow houses for Chinese organized crime.  Although growers supply more than enough to satisfy local demand, the market for California cannabis outside the state has always provided lucrative return for those willing to export to Midwestern and East Coast states.  

Perhaps the most dispiriting unexpected outcome has begun to play out over recent weeks. On the supply side, licensed dispensaries have started ratting out grey and black market competitors. Such mercenary tactics would have been anathema to the cannabis community in the past. Now snitching may be the only protection against "immediate risk financial of serious loss at the least – and, at the worst, failure” for legal businesses, says industry analyst John Schroyer.

To be continued in Part Two

 
Mike Luce