California’s Big Deal Bought on Amazon

All eyes are on the California statehouse today. On the table is a deal between online retail juggernaut Amazon and California lawmakers to postpone a major tax increase until fall 2012. Unfortunately, the compromise would mark a turning point in the online sales tax wars and pave the way for higher taxes nationwide.

California lawmakers and online retailers have been battling for years. In June, the state enacted a law requiring out-of-state online retailers to collect sales taxes on Californians’ purchases. To avoid the tax collection requirement, Amazon severed ties with its California-based affiliates. The retailer has even been working aggressively behind the scenes on a state ballot initiative to block implementation of the law.

If the compromise goes through, however, Amazon will reportedly drop its ballot initiative in exchange for lawmakers postponing implementation of the sales tax law for twelve months.

This would mark a major shift for Amazon, who has led the opposition among online retailers to tax laws such as California’s. Earlier this year, Amazon published an open letter condemning the law as “unconstitutional and counterproductive,” arguing that retailers with no physical presence in California should not be forced to collect taxes on the state’s behalf. Amazon also argued that the tax would distort the retail market and unfairly punish suppliers worldwide.

Taxing out-of-state retailers violates the Constitution because in 1992, the U.S. Supreme Court ruled in Quill v. North Dakota that a state may only collect state sales taxes on companies with a physical presence in that state. Online retailers such as Amazon and Overstock have no California presence, but they both have relationships with California-based affiliates.

According to Veronique de Rugy, a senior research fellow at the Mercatus Center at George Mason University, if California-based retailer sells a product to a California consumer, the state is allowed to require the retailer to collect sales taxes. “If a Virginia resident buys a book from Amazon, which is based in Washington state, he pays no sales tax,” Rugy points out, “but if he buys the same book from store in Virginia, the transaction is taxed.”

California has managed to bring Amazon to the table because it is a large state with a huge retail base. While Amazon may have threatened to relocate its affiliates, the magnitude of the California market weakened the retailer’s resolve. Other, smaller states will not have such a strong pull. Other states have enacted similar laws, only to find Amazon cutting off local affiliates.

This is truly what Amazon referred to in its letter as “counterproductive.” If states across the country decide to impose similar laws, small businesses and consumer will suffer. California lawmakers did not see this threat when they passed this law – they only saw a potential $317 million payout.

There is a smarter way to tax Internet sales: Congress should enact legislation that provides for origin-based taxation. Such a system would make tax collection contingent on a retailer’s principal place of business, rather than the buyer’s location. This would ensure lawmakers are accountable to those they tax. Meanwhile, lawmakers should resist the temptation to strong-arm a company that has transformed the online retail market and revitalized millions of small businesses in California and around the world.