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Staff work in a marijuana grow room at a Canopy Growth facility in Smiths Falls, Ont.Sean Kilpatrick/The Canadian Press

Prices of legal cannabis are falling as supply surges, which is good news not just for pot smokers, but for regulators who hope to roll back the black market.

But that is trouble for small pot producers, particularly small-scale operations, are being squeezed between declining revenue and a three-year-old tax structure that is taking an increasingly bigger bite out of their shrinking margins.

When recreational cannabis was legalized three years ago, Ottawa put in place an excise tax that was the higher of $1 a gram or 10 per cent of the wholesale price. The structure of the tax hints at where regulators thought prices would end up – hovering at $10 a gram, if not higher.

That (implicit) optimism has turned out to be dead wrong. Prices were indeed high in the early going as producers struggled to ramp up supply, but they have dropped sharply. That has meant the $1-a-gram minimum tax is taking up a larger share of producers’ margins.

Dan Sutton, chief executive and founder of Vancouver-based Tantalus Labs Ltd., said his company garnered a wholesale price of up to $9 a gram in the early days of legalization. With those prices, the $1-a-gram federal tax accounted for 11 per cent of gross revenue at the small-scale cannabis producer.

Fast forward to today and wholesale prices have plunged. Tantalus gets an average of just $4.50 a gram, so the excise tax now eats up 22 per cent of gross revenue. In some months, Mr. Sutton said, his company’s excise tax bill is larger than labour costs. “It’s really close.”

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Adding to that tax burden are several Health Canada regulatory fees and, at a retail level, sales taxes. (None of which, of course, are a cost of business for illegal dealers.)

The tax burden is a problem afflicting the entire industry, but it is hitting small producers the hardest. Large producers can, at least in theory, make up for compressed margins through volume. And small producers aren’t likely to have retail arms that can capture downstream profits.

Mr. Sutton and other operators have launched a letter-writing campaign to highlight the issue the industry faces, urging Ottawa to scrap the $1-a-gram minimum and replace it with a straight 10-per-cent excise tax, then reduce that rate according to the size of the licensed producer.

There’s no indication Ottawa intends to move in that direction. The only mention of cannabis taxation in the April budget was a nod to the government’s desire to give First Nations the ability to introduce their own levies. Health Canada has launched a limited review of regulatory charges, but that exercise doesn’t extend to excise taxes.

Michael Armstrong, an associate professor at Brock University’s Goodman School of Business, said the structure of cannabis taxation reflects two conflicting impulses within government. On one hand, there is a push to squeeze the black market, which would mean leaning toward lower prices. But there are also public-health goals, including limiting the growth in new users of cannabis, he noted.

The federal Finance Department declined to comment on whether changes to the cannabis excise tax are needed. But in one sense, at least, legalization and the existing tax structure are working: The black market is losing ground to the legal industry.

Data from the Ontario Cannabis Store, the provincially owned cannabis distributor, also show a steep drop in prices that have put the legal market in contention with its illicit competition. As the chart below shows, legal prices in Ontario were much higher than the black market for most of the year after legalization in October, 2018.

But prices have dropped sharply since, with OCS data showing that the agency’s online price has fallen significantly below the cost of illegal pot. As a result, OCS data show, legal vendors in Ontario grabbed nearly half the market for the three months ended March 31, 2021, as the chart below shows.

The woes of small producers, however, cast some doubt on how sustainable those gains could be. The classic arc of a new industry typically sees oversupply and low prices followed by consolidation, retrenchment in production and higher, more stable prices. If that were to happen in the cannabis industry, illegal cannabis sellers would be in a position to grab back market share.

Karine Cousineau, co-chair of the national cannabis working group at the Canadian Chamber of Commerce, says Ottawa needs to start looking at the industry through an economic lens in addition to its health and legal policy goals. Otherwise, she said, the industry’s sustainability and long-term success are at risk.

She and co-chair Nathan Mison point to a broader concern than the size of the domestic black market, namely the ability of Canada’s cannabis industry to compete globally as other countries opt for legalization. Without tax reform, they warn, this country’s industry could be forced to forfeit the head start granted by Canada’s early move to legal pot.

“We need a taxation regime that makes sense,” Mr. Mison said.

Tax and Spend examines the intricacies and oddities of taxation and government spending.

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