A Key Interaction Between Sales Taxes and Other Taxes on Cannabis Retailers

In this post, we discuss a key interaction between sales taxes and other taxes on cannabis retailers—in particular, local business taxes. Due to this interaction, the overall tax rate on cannabis is slightly higher than it appears to be. Although this opaque, counterintuitive interaction has long applied to all kinds of retailers, it historically has been unimportant because local business tax rates tend to be low. As sales have begun in California’s legal cannabis market, cities have levied business taxes on cannabis businesses at much higher rates than other businesses. As a result, this interaction has become much more important, and we recommend that the Legislature make statutory changes to address it.

Certain State and Local Taxes Apply to Cannabis

Sales Tax. California’s state and local governments levy a sales and use tax (hereafter, sales tax) on retail sales of tangible goods. The rate varies across the state, ranging from 7.25 percent to 10.5 percent, with a statewide average of 8.6 percent. Cannabis products are tangible goods, so their retail sale generally is subject to this tax. Certain sales of cannabis for medical purposes are exempt from the sales tax.

Local Business Taxes. Many cities levy a “business tax” or “business license tax” that applies to a wide range of businesses, including cannabis businesses. The tax rate generally is a specified percentage of sales, also known as gross receipts. For most types of businesses, the tax rate tends to be low—generally less than 0.2 percent. However, local business taxes on cannabis retailers tend to be much higher than on other retailers.

Other Cannabis Taxes. California’s state and local governments levy a variety of taxes on cannabis. The state levies a weight-based cultivation tax and a 15 percent retail excise tax. (Under current law, as described in our recent report, the “retail” excise tax effectively is a wholesale tax with an administratively determined rate.) Cities and counties that allow commercial cannabis activity typically levy taxes on businesses at every stage of the supply chain. We estimate that the average cumulative local tax rate over the whole supply chain—including local business taxes—is roughly equivalent to a 14 percent tax on retail sales. Of this 14 percent total, we estimate that 7 percent (roughly one half) consists of taxes specifically on retail sales.

Interaction Between Sales Taxes and Local Business Taxes

Local Business Taxes Apply to Pre-Sales Tax Gross Receipts. Local taxes on many types of cannabis businesses—including retailers—typically operate through the system of business taxes described above. For these taxes, gross receipts generally include the money that retailers receive from their customers in exchange for the goods they sell. Crucially, the definition of gross receipts generally excludes sales tax. In other words, these local taxes apply to pre-sales tax gross receipts.

Sales Tax Applies to Tax-Inclusive Gross Receipts. Like local business taxes, state and local sales taxes also apply to retail gross receipts. State law, however, does not exclude local business taxes from this definition of gross receipts. As a result, although the two types of taxes apply to conceptually similar taxable events—retail sales—and have the same point of collection, they are based on two substantially different definitions. We are not aware of any policy rationale for this inconsistency.

Resulting Interaction Is Opaque and Counterintuitive. Because the sales tax applies to a tax base that includes local business taxes, these taxes interact multiplicatively, not additively. As a result, it may be difficult for most observers to understand or determine the cumulative tax rate on retail sales. Consider, for example, the City of Los Angeles, which has a 10 percent local business tax on cannabis retailers and a total state and local sales tax rate of 9.5 percent. Based on these tax rates, a casual observer might conclude that the combined tax rate on retail cannabis sales is 19.5 percent. However, due to the interaction between the sales tax and the local cannabis tax, the combined tax rate is roughly 20.5 percent.

Much Bigger Problem for Cannabis Than for Other Products. The interaction noted above technically applies not just to cannabis retailers, but to all retailers located in cities and counties that levy business taxes on retailers’ gross receipts. In practice, however, the consequences of this interaction are significant only for the cannabis industry, because local business taxes on cannabis retailers tend to be much higher than local business taxes on other retailers. For example, although the City of Los Angeles’ business tax rate is 10 percent for cannabis retailers, it is roughly 0.13 percent for most other retailers. As a result, the interaction between local business taxes and sales taxes is much larger for cannabis than for other products.

Statewide Revenue Effects. Across all retailers (cannabis and non-cannabis), we estimate that the interaction described above increases annual state and local sales tax revenue by roughly 0.1 percent (tens of millions of dollars).

Legislative Analyst’s Office Report Recommends Applying State Retail Excise Tax to Pre-Tax Gross Receipts. Our recent report recommends that if the Legislature retains the state’s retail excise tax on cannabis, it should turn it into a true retail tax by collecting the tax directly from retailers. (Under current law, distributors remit the tax.) In light of the interaction described above, the Legislature would need to consider how to define retail gross receipts for the purpose of the state excise tax.

Recommendations

Consider Changing Statutory Definition of Gross Receipts for Sales Tax. As described above, the inclusion of local business taxes in the sales tax base results in an opaque, counterintuitive interaction between the two types of taxes. Although the interaction is not new, it has become more important as cities and counties have imposed much higher business taxes on cannabis businesses than other businesses. We recommend that the Legislature consider addressing this issue by excluding local business taxes from the sales tax’s definition of gross receipts. Such a change could help make these taxes more consistent and less confusing. We estimate that it also would reduce state and local sales tax revenue by roughly 0.1 percent (tens of millions of dollars).

Clarify Definition of Gross Receipts for State Retail Excise Tax on Cannabis. As noted above, if the Legislature retains the retail excise tax, we recommend moving the point of collection of the state’s retail excise tax on cannabis from distributors to retailers. Making this statutory change would give the Legislature an opportunity to further align the definition of retail gross receipts across various taxes. If the Legislature chooses to adopt our recommended change, we further recommend that it exclude other taxes on retail gross receipts—such as local business taxes and state and local sales taxes—from the definition of retail gross receipts for the retail excise tax on cannabis.