Last week Governor Schwarzenegger vetoed a budget measure that would have cut off the livelihood of thousands of California’s small Internet businesses. As the state faces a $26 billion budget deficit and record high unemployment, Schwarzenegger declared that “we should be doing everything we can to keep jobs and create jobs in California.”
Legislators estimated this measure would raise $150 million over the next two years, even as mounting evidence suggests it will not raise a penny. Though California consumers must pay sales tax on every purchase they make, a 1992 U.S. Supreme Court decision forbids states from forcing out-of-state companies to deduct these taxes automatically on consumers’ behalf. Unless the company has a physical presence within the state, known as “nexus,” consumers are responsible for paying the tax themselves. Frustrated by low compliance, lawmakers sought to expand the definition of nexus.
Many e-commerce leaders, such as Washington-based Amazon.com and Utah-based Overstock, place advertisements on the Web sites of California small businesses. The legislature passed a measure declaring that such relationships constitute nexus. Because the Internet allows data to flow seamlessly across state borders, these companies don’t have to advertise on California websites to reach California customers. As a result, they could simply stop paying California small businesses to run their advertisements. That is exactly what happened when other states took this approach.
Both Amazon and Overstock recently terminated their advertising relationships with businesses in North Carolina, Rhode Island, and Hawaii. Similarly, Overstock immediately ceased advertisements in California after the Legislature’s recent action, and Amazon warned Gov. Schwarzenegger that “if this new tax collection scheme were enacted, Amazon would have little choice but to end its advertising relationships with California-based participants.” Not only would this lead to no new sales tax collection, but it would also cost the state considerable income tax revenue.
The Performance Marketing Alliance estimates that 25,000 California small businesses earned $1.3 billion in 2008 from advertising relationships with out-of-state companies. If advertisers terminated these relationships, the state could lose $123 million in income taxes. Because advertising income drives the creation and growth of countless online services, this sudden loss of income could devastate Silicon Valley and compromise California’s status as a leader in high-tech innovation.
Therefore, expanding the definition of nexus results in no benefit for the state, but incurs considerable harms. Desperate to end the budget crisis, the legislature advanced this proposal as a fix existing only on paper. By insisting on budget figures that accurately reflect reality, the Governor has made an important commitment to find enduring solutions that “keep jobs and businesses in California.” After rejecting the nexus measure, Schwarzenegger personally contacted Overstock’s CEO and convinced him to reinstate all advertising relationships with California businesses.
California should work to address its failure to collect taxes equally on in-state and out-of-state purchases. As long as this inequity remains, businesses selling to Californians will be unfairly penalized for having a physical presence within the state. While few consumers report their out-of-state purchases, most remain unaware that such a requirement exists. Better education and auditing could significantly boost compliance.
In addition, the U.S. Supreme Court does not categorically reject forcing out-of-state companies to collect sales tax, but only taxes that “unduly burden interstate commerce.” If California lawmakers first initiated a comprehensive effort to reform and simplify the state’s tax code, a proposal to level the playing field between in-state and out-of-state businesses may pass Constitutional muster.
In a time of crisis, Governor Schwarzenegger should be applauded for having the vision to reject dangerous threats to California’s high-tech competitiveness. California is already the world’s nexus of online innovation, and the state needs policies that attract and foster Internet entrepreneurs, not put them out of business.