Grower Slash Processor
By allowing cannabis farmers to also apply for a processor license, the state is forcing all farmers to get both.
A brief hypothetical story about three cannabis farmers in the near future in Washington:
Steve the small-time cannabis farmer sets up his farm and jumps through all the hoops to make sure he is legal and profitable. When all is said and done, it costs Steve $4/gram to produce his high-quality, organic cannabis. He marks it up to $6/gram (a healthy, if meager, 50% margin), and sells it to his local processor (in this case, Johnsons Cannabis Distribution Co., or JCDC), applying the 25% state tax on growers, for $7.50/gram.
JCDC pays $7.50/gram for all of Steve’s latest crop at once, then packages it up for retail stores and marks it up to $11/gram (46% margin) to sell to their network of retail stores across the Puget Sound region, applying the 25% tax on processors, for $13.75/gram.
These retailers buy JCDC cannabis for $13.75/gram, and after adding their 45% margin, sell the cannabis to their loyal, local customers for $20/gram. With the 25% tax on retailers, the final price to the consumer is $25/gram.
Grower: ($4 + $2) x 1.25 = $7.50
Processor: ($7.50 + $3.50) x 1.25 = $13.75
Retailer: ($13.75 + $6.25) x 1.25 = $25
Final Price: $25/gram
For Steve’s crop, the effective tax rate to the consumer is 95.3% (25% x 25% x 25%).
Meanwhile, Ballard Aeroworks is a cannabis farm large enough that they applied for the processor license as well as the grower license, and hired a logistics manager to take on distribution directly to local retailers. It also costs them $4/gram to produce their aeroponically grown cannabis. Adding a margin comparable to Steve’s (50%), they sell their crop for $6/gram, or $7.50/gram with the state tax on growers.
Because they also have the processor license, they can offer that price directly to local retailers. Some retailers try to sell it for $20/gram as they sold Steve’s, with a gouging 166% margin, but that fails as competitors with more modest margins, say 45% as above, sell the exact same product for $11/gram, or $13.75/gram with the state tax on retail.
Grower/Processor: ($4 + $2) x 1.25 = $7.50
Retailer: ($7.50 + $3.50) x 1.25 = $13.75
Final Price = $13.75/gram
The effective tax rate on Ballard Aeroworks’ crop is 56.25% (25% x 25%)
Finally, we visit Yes We Cannabis, a local medical marijuana collective that went for-profit once the state legalized cannabis for recreational use. They also applied for both the grower and processor licenses, but with a little bit more experience in the market, went with a different strategy. Their cannabis also costs them $4/gram to make, but they refuse to compete on price, and decide to mark their crops up to $11/gram, selling directly to retailers at $13.75 with the 25% state tax.
The retailers sell their product right alongside Steve’s cannabis for $20/gram, or $25/gram after the state tax.
Grower/Processer: ($4 + $7) x 1.25 = $13.75
Retailer: ($13.75 + $6.25) x 1.25 = $25
Final Price: $25/gram
Yes We Cannabis’ products also have an effective tax rate of 56.25%, but they enjoy insane 175% margins that are not hurt by consumer sticker-shock.
As time passes for these three growers, a distributor, and the retailers, what happens?
- Ballard Aeroponics has the lowest prices to consumers, so they do decently well. Their margins are relatively low so growth is slow, but likely steady. They probably survive just fine, perhaps on a reputation of affordability. They may need to expand based on demand, but struggle to afford the expansion. Most likely, they will see what’s happening and raise their prices.
- As I mentioned, Yes We Cannabis chooses not to compete on price, and with their very strong margins, can ensure the highest quality product to maintain the premium prices they command. They become a dominant brand known for unsurpassed quality, and can ramp up production and innovation faster than anyone else. Even if they don’t have the highest market share, they have the strongest profits.
- Steve can’t compete on price with Ballard Aeroponics, and with his meager margins, can’t hope to compete on quality with Yes We Cannabis. He soon starts to contemplate getting the processor license like the others, so he can retain more of the final price of his product. He can’t afford to hire someone to help, and doesn’t have connections to retailers or know how to negotiate the same deals as Yes We Cannabis. His margins may go up slightly, but his sales decline overall as he can’t sell to as many retailers as JCDC did for him. He gets so overwhelmed trying to sell to individual retailers that his quality declines as he loses focus on his farming. With declining quality and sales, he is forced to shutter his farm and work for Ballard Aeroponics.
- JCDC struggles to hold onto farmers like Steve who see smaller profits than they would on their own. Sure, they provide value by taking so much work off the plate of the farmers, but even if they reduce their margins to help their farmers, the state tax at that point in the channel increases the price to the consumer by over 39% (95.3% - 56.25% = 39.05%). A possible solution to them is to offer their services to grower/processors, without handling the transaction, which basically bypasses the state tax. This runs them afoul of the state and Mike Johnson, the founder, gets arrested and the business shuts down.
- Retailers who liked working with one distributor to get access to dozens of farms from all over the state have to work with more and more famers individually. This complicates their supply chain and accounting processes, and forces them to deal with the idiosyncracies of dozens of suppliers.
- Other processors, who decided to make hash or food products out of the cannabis, are also priced out of the market. They can not apply for both a processor and a retailer license, like the growers can, so their products are prohibitively expensive. Perhaps they can get just the retail license instead and sell their goods directly, but they may not be interested in being a retail store anyway. Additionally, with a limited number of retail licenses being allocated they likely won’t be given a license.
By allowing growers to also get a processor license, and cut out 39% of the effective tax rate, the new rules for legal cannabis cultivation and sales are forcing potential small businesses to take on more effort, and stifling healthy distribution channels. By making processors optional, they have effectively banned them. Growers and retailers will have to pick up the work of managing the supply chain that otherwise would be handled by distributors. If there is healthy demand for processes cannabis, in butter or hash, for example, then that will also be asked of these growers and retailers.
Getting a new small business started in a new industry like this is going to be difficult enough for these companies when they only have to worry about growing a quality product. But now they also have to nail distribution and logistics, as well as possibly hash-making, to succeed in the market. These tasks are big enough challenges to support thriving businesses of their own, that have been stamped out by the processor tax.
This change in rules obviously helps a lot of growers, who of course deserve healthy margins so they can grow a quality product. But it seems unlikely that all farmers will want to get into the sales and logistics side that this change incentivizes.Especially early in the history of this legal market when there are many uncertainties.
So what should the state do? Any of the following:
- Eliminate the tax on processors completely. They are clearly an optional middleman who should not be taxed out of business before they have a chance to help growers and retailers offer better products.
- Tax grower/processors 56.25%. If processors are taxed, then grower/processors need to bear that burden as well.
- Allow processor/retailers, and also charge them 56.25%. Why can’t any retailer, such as a bakery, make its own cannabis butter on-site, and sell infused cookies?
- Remove the option to get a processor license as well as a grower license. Revert the rules to how it was originally written.
#3 doesn’t really solve the problem, but allows retailers to handle some distribution, and/or make their own hash or butter. #4 might clean up the incentives, but would likely upset a lot of farms that do want to work directly with retailers. #1 and #2 seem to be the only real options: make the tax structure fair to all parties.
No government will ever remove a tax unless it truly cripples the industry, so the only realistic option is #2. Grower/processors need to pay both taxes.