Taxing Internet Retailers Like Brick-and-Mortar Stores

State governments go looking for revenue from online retailers

When someone from the government says, “The Internet has added complexity to…” you can bet it will usually be followed by an attempt to justify a new tax.

According to legislators in California and at least four other states, the Internet has muddled the role of brick-and-mortar retailers. Customers travels to brick-and-mortar stores, select merchandise from a shelf or rack, and pay for it at a counter. For sales tax purposes, a judge would call the shop a “nexus,” that is, a physical location where business occurs.

Under current law, online retailers are only required to collect sales taxes on their merchandise if they have a nexus in the state where the transaction was initiated. This law dates back to 1992, when the U.S. Supreme Court ruled that sales tax collection constituted an onerous burden on out-of-state retailers and violated the commerce clause of the Constitution. As a result, Internet purchases remain largely tax-free. For example, only Washington state residents pay sales tax on purchases, because that’s where Amazon has its nexus.

Internet sales are estimated to be around $200 billion a year in the U.S. The loss in tax revenue from these sales has irked state governments for some time, and legislators in an increasing number of states are now trying to workaround federal law by creatively redefining a “nexus.” California sought to join New York, North Carolina and Rhode Island in passing legislation that would define any Web site that accepted sales commissions from Internet-based retailers as an in-state “nexus” of that retailer that is subject to sales taxes. The bill stalled in Sacramento in the face of strong opposition from online retailers and a veto threat from Gov. Arnold Schwarzenegger, but its backers, which include Berkeley Assemblywoman Nancy Skinner, promise they will try again next year.

While the bill’s supporters acknowledge the “nexus” rule, their argument hinges on the idea that the Internet has changed the definition of “physical presence” or “brick-and-mortar.” Online affiliates of out-of-state retailers, they say, should count.

An affiliate is someone with a contractual agreement to advertise an online business. For example, a Californian who blogs about hiking could recommend trail guides to readers and provide a link to If a sale results, Amazon pays the blogger a commission. According to the Sacramento Bee, legislative analysis of the bill found that alone has “hundreds, if not thousands” of affiliates in California who receive commissions on sales. This doesn’t count other Web retailers, such as, that use similar models.

Fortunately, most people don’t think a button or banner on a Web site is equivalent to a brick-and-mortar store, on which rent is paid and in which inventory is stocked. Common sense may be the main reason the bill has had spotty success. In addition to California, similar efforts failed in Hawaii and Minnesota.

But the idea that an online affiliate is a nexus is wrong-headed for a number of other reasons. It’s likely unconstitutional, given the 1992 Supreme Court decision. On these grounds, Amazon and Overstock, along with the non-profit Performance Marketing Alliance, which was formed to represent affiliates of online retailers, have asked a New York state court to overturn the law there.

Then there are the practical problems. The tax punishes in-state businesses that are affiliates of out-of-state retailers, while doing little to actually capture a tax. Since the tax is only assessed on affiliate clickthroughs, state residents can easily avoid the tax by going directly to the retail site. According the blog, Marketing Pilgrim, some New York state affiliate marketers lost upwards of 80 percent of their income after the law was passed. Amazon severed ties with its affiliates in North Carolina and Rhode Island in order to avoid charging sales tax to its customers in those states.

Finally, the law creates technical problems. It can be very difficult for online retailers to determine exactly where their affiliates are located. A California resident may be an Amazon affiliate, but what if his blog is housed on a Web server in Texas? Where’s the actual nexus? It’s an important legal question. For example, California cannot collect sales taxes from a store in Reno, Nevada, even if its owner lives in nearby Lake Tahoe, California.

The Internet creates no confusion about a physical nexus. Brick-and-mortar is brick and mortar. The Internet is bits and bytes. The only “confusion” about their meanings is being created by tax-and-spend legislators in a grab for more money.

Steven Titch is a policy analyst at Reason Foundation.