Amazon Won't Stop Evading Sales Tax, No Matter How Much It Hurts Itself

For Amazon (AMZN), aggressively dodging sales tax collection has become nearly as de rigeur as selling Kindles. In the most recent example, the company dropped about 10,000 of its California affiliates -- people or companies who post Amazon shopping links for their readers -- because the state passed a new law requiring online retailers with a physical presence in the state to collect sales tax.

In an email to its California affiliates, indicating that they were now out of the program, Amazon called the new law "unconstitutional and counterproductive." The unconstitutional part may be a stretch -- the Supreme Court never addressed whether having subsidiaries in a state as Amazon does in California constitutes a physical presence for the parent company. But what's really counterproductive is Amazon's reaction. Not only is management on a path to forgo significant amounts of revenue, but it's strategy is likely to fail anyway.

They make money from affiliates, don't they?
The Amazon Associates program is more than a gimmick -- it's a strategic part of Amazon's marketing strategy. Although the company doesn't publicly announced what it makes from it, various sources offer clues:

• the number of affiliates that Amazon has,
• anecdotal evidence from people in the Associates program,
• Associates program fee rates, and
• Amazon's 2010 annual report.

Clearly not all affiliates make significant sums. Most probably make next to nothing. But people who seriously undertake affiliate programs as a business rate it as one of the most profitable. Some report monthly five-figure income on a consistent basis.

That particular affiliate received an 8.25 percent commission, so the paycheck of $19,023.09 for a single month represented $223,801.06 in sales for November 2010. Even if only 2 percent of affiliates do serious business, the total could easily run into millions of dollars a month. Associate fee rates range from as high as 15 percent for some items down to 4 percent, so many affiliate sales may be more profitable to the company.

There's no way to know exactly how financially important the Associates program is to Amazon, but in its 2010 annual report, the company wrote this about marketing expenses:

We direct customers to our websites primarily through a number of targeted online marketing channels, such as our Associates program, sponsored search, portal advertising, email marketing campaigns, and other initiatives. Our marketing expenses are largely variable, based on growth in sales and changes in rates. To the extent there is increased or decreased competition for these traffic sources, or to the extent our mix of these channels shifts, we would expect to see a corresponding change in our marketing expense.The increase in marketing costs in absolute dollars in 2010 and 2009 compared to the comparable prior year periods is primarily due to increased spending on online marketing channels, such as sponsored search programs and our Associates program, and, in 2010, on television advertising.

In other words, dropping a large number of affiliates is a likely problem for Amazon. California affiliates alone represent 1.1 percent of its last reported total, and Amazon has been dropping affiliates in other states, as well.

Short term strategy for a long term problem
Cutting affiliates has been nothing more than another strategy Amazon has used as a weapon against state legislatures that try to make the company collect state tax. But doing things like dropping large numbers of affiliates or moving distribution centers hurts Amazon both on the top line (lost revenue) and the bottom line (increased costs, like transportation of products).

It's not as though Amazon pays for the tax out of its own pockets. All it has to do is collect the taxes, which consumers pay. Why is it fighting so desperately? The answer has nothing to do with constitutionality or real worries about efficiency. Amazon has an effective perceived price advantage over physical stores and other online retailers that have points of presence in states.

To avoid giving that up, Amazon plays hardball. There's just one problem: states are in terrible financial shape and need revenue to close deficits. The threat of losing jobs becomes less of an issue when officials start to calculate how much each of those jobs costs the state in lost taxes, to say nothing of sales going out of state. Even chain retailers spend a lot to maintain and staff stores, so if profits go out of state, a lot of money remains.

Not only is Amazon dropping sales, but its strategy rests on the assumption that it will always be able to move facilities to other states. That's not necessarily a given. When Amazon threatened to pull a distribution center out of Texas, it could have, presumably, built one in southern Oklahoma. But California has the highest population of any state. The further away a distribution center, the more expensive logistics -- and fulfillment costs for every in-state sale -- become. That hits Amazon's margins.

Also, at what point do so many states call Amazon's bluff that the company drops the majority of its affiliates and has to operate out of small, restricted geographies -- creating even more inefficiency as it does? Eventually, either Amazon will find that financial prudence is the better part of strategic valor, or it will make room for such competitors as Wal-Mart (WMT), Apple (AAPL), Barnes & Noble (BKS), and Target (TGT), all of whom have mastered the art of making money even while collecting sales tax.

Related:

• Twitter and Zynga Grow Up -- and Now Want Tax Dodges and Keys to the Car
• E-Tailers vs. the States: The Sales Tax Man Cometh
• How Google Hides Its Profits From the Tax Man