When the year began, marijuana was supposed to remain the hottest investment opportunity on Wall Street. Canada had legalized recreational weed in Oct. 2018, derivative products were forecast to hit dispensary shelves by Oct. 2019, and a number of U.S. states had been pushing for medical or recreational legalization. The stage appeared to be set for success -- and then someone turned out the lights.

Since the end of the first quarter, virtually no pot stocks have moved higher. Not only are most marijuana stocks down, but most have lost half or more of their value. This train wreck can essentially be boiled down to a handful of factors.

To our north, Canada has been plagued by persistent supply issues and regulatory delays since day one of legalization. Health Canada has been slow to approve cultivation and sales license applications, thereby keeping legal product off the market. All the while, the country's most populous province, Ontario, has just two dozen open dispensaries for consumers to purchase from. Both factors have led to a scenario where black market marijuana has thrived.

A black silhouette of the United States, partially filled in by baggies of cannabis, rolled joints, and a scale.

Image source: Getty Images.

In the United States, the culprit looks to be high tax rates in select states. High levels of taxation make it difficult for legal-channel weed to compete with illicit producers. The higher the tax rate, the wider the price gap, and thus the more likely it is that black market growers will carve out a sizable portion of a state's total marijuana sales.

Exorbitant cannabis taxes are probably the easiest problem to resolve. Unfortunately, California didn't get that memo.

California's ridiculously high marijuana tax is about to grow

On Thursday, Nov. 21, the California Department of Tax and Fee Administration (CDTFA) announced cannabis mark-up and cultivation tax rate changes that'll become effective as of Jan. 1, 2020. Here's the spoiler: Cannabis tax rates are going up!

First off, the mark-up rate will jump from 60% to 80%, based on an analysis of statewide data that the CDTFA does every six months. As noted in the update:

The 15 percent cannabis excise tax is based on the average market price of the cannabis or cannabis products sold in a retail sale. The mark-up rate is used when calculating the average market price to determine the cannabis excise tax due in an arm's length transaction. In an arm's length transaction, the average market price is the retailer's wholesale cost of the cannabis or cannabis products, plus the mark-up rate determined by the CDTFA.

Essentially, this mark-up rate is the basis for the Golden State's 15% excise tax. Keep in mind that this increase isn't arbitrary, but is instead mandated by legislation (Prop 64) that was passed by the state.

A green highway sign that reads, Welcome to California, with a white cannabis leaf in the upper-right corner.

Image source: Getty Images.

Secondly, California's cultivation tax is being adjusted for inflation. The adjustment is as follows:

  • An increase to $9.65 from $9.25 per ounce of dried cannabis flower.
  • An increase to $2.87 from $2.75 per ounce for cannabis leaves.
  • An increase to $1.35 from $1.29 per ounce for fresh marijuana plant material.

These cultivation tax rates are examined once annually by the CDTFA and, in 2020, represent inflationary adjustments of between 4.3% and 4.6%. 

California is rolling out the green carpet for the black market

Now, here's where things get maddening.

California has long expected to be the world's crown jewel of cannabis sales. Although estimates vary, most of Wall Street expects California to generate $10 billion to $11 billion in annual sales by 2030. Yet, in the state's first full year of recreational marijuana sales, California's total pot revenue declined. In 2017, when California only sold medical marijuana, sales hit roughly $3 billion. Then, in 2018, with both recreational and medical cannabis available, statewide sales plunged $500 million to $2.5 billion. A big reason for this drop is that California has been taxing the daylights out of its consumers.

A cannabis leaf lying atop a neat stack of one hundred dollar bills.

Image source: Getty Images.

Here's a snippet of some of the expenses currently being absorbed by California consumers as legal cannabis moves from seed-to-sale:

  • State taxation.
  • Local taxation, which could have a few added percentage points, depending on the city.
  • The aforementioned 15% excise tax.
  • The cultivation tax that's entirely dependent on the stage of plant being taxed.
  • Quality control testing.

Again, while estimates vary, this suggests that the typical Californian cannabis user could be facing a tax rate of between 45% and 80%, once these new increases go into effect on Jan. 1, 2020. That's practically inviting black market producers to undercut legal-channel marijuana, and the 2018 sales figures show it.

And it gets worse.

In addition to turning consumers upside down and shaking out all loose dollar bills and change, close to 80% of the state's municipalities have banned retailers from selling adult-use weed. This allows black-market growers to fill the void in cities where consumers have no readily available purchasing options.

A large marijuana dispensary sign in front of a retail store.

Image source: Getty Images.

California's marijuana miscues are particularly disparaging for pot stocks operating in the state. Cresco Labs (OTC:CRLBF), in particular, made noise in April when it announced what was, at the time, a more than $820 million acquisition of Origin House (OTC:ORHOF) in an all-stock deal. Cresco Labs, which is best known as a multistate dispensary operator, made the deal to buy Origin House in order to gain access to over 500 dispensaries in the Golden State. Origin House is one of a select number of distribution license holders in the state.

However, the Golden State's exorbitant tax rate on legal weed has clearly turned off buyers. When compounded with the fact that most municipalities have banned recreational retail sales, it's created a scenario where companies like Cresco Labs and Origin House aren't guaranteed the success that investors envisioned as recently as seven months ago.

If California doesn't wise up soon, it'll risk doing irreparable damage to its legal marijuana industry.