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California: High taxes and potconomics

California’s strategy of heavily taxing cannabis is backfiring. Recently released data for 2018 raises a number of red flags offering a lesson in Potconomics. Other states better to take notice.

Within the next few years, virtually every state will legalize cannabis for recreational usage. That may sound foolishly naive to any seasoned investor. The reason for such confidence has to do with the way states spending is regulated. Unlike the Feds in Washington, each state must balance spending against revenues.

Politicians are elected by promising sweeping (and costly) programs that benefit every voter. If elected, those promises usually translate into increased spending. User taxes have become the preferred way to burden voters without them feeling the pinch. The explanation is always the same. If you want to avoid the tax, don’t buy the product.

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Solid thinking when it comes to taxes on cigarettes, gas or property. But what about cannabis?

Anyone with an internet connection has heard politicians promise riches from the cannabis boom. Legalize it, tax it, and start counting the billions.

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California and potconomics

It has been just over a year since California legalized cannabis and the data tells a very clear story about the economics of cannabis (potconomics) is different than cigarettes, gas, or property. This week, the California Department of Tax and Fee Administration announced figures for 2018.

Going into year one, the government (read Gov. Newsom) projected cannabis tax revenues of roundly $1 billion. More recently he projected a 2019 increase of 45 percent. Considering the source of these projections, the governor may have been having a THC moment.

Results for last year were published on February 19. They fell far short of $1 billion coming in at just $345 million. Let’s take a close look at the quarterly numbers on a sequential basis: Q1 $60.9, Q2 $80.2 Q3 $100.8 Q4 $103. This paints a digital picture of cannabis acceptance in the state.

The second quarter sequential gain of 30 percent marked the high point of the year. After that, the rate of gain slowed dramatically. In fact, in the recently ended Q4 the rate dropped to just 2 percent.

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Now contrast these figures with companies like Aurora (NYSE:ACB) and Canopy Growth (NYSE:CGC). These two Canadian companies recently reported their first-quarter results since Canada legalized cannabis. In these cases, the sequential revenue growth of more than 50 percent was recorded.

What does this all mean?

According to MarketWatch, someone from the governor’s office explained that the tax revenue shortfall was due in large part to the continued presence of the black market. When California has some of the heaviest cannabis taxes anywhere, is it any surprise the black market continues to thrive.

California’s tax revenue shortfall doesn’t mean that cannabis is not selling well. It is simply an example of Potconomics working in the same way it was explained in econ 101. When butter becomes too costly, consumers switch to margarine (in the case of millennials, from organic butter to extra virgin olive oil).

California’s results should send a signal to other states like New Jersey, New York, and Michigan. Each of these states is seeking ways to bring cannabis to economically weak areas while promising a windfall from the cannabis boom. But if taxes are too high, politicians will become familiar with something economists call price elasticity: the degree to which demand is impacted by a change in price.

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Let’s go back to California for a final look. Last year the state spent $133 million on cannabis regulation. If tax revenue projections had been accurate, the governor would have had somewhere around $875 million of gross proceeds. His 2019 budget calls for a 51 percent increase to just over $200 million to be spent on regulation. Annualizing fourth quarter 2018 tax revenues amount to $412 million. So unless something changes, instead of having $875 million to play with, he will have $212 million.

In the state of California where the budget is over $200 billion, $212 million is chump change. Other states take note.

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