The current economic climate in California simply cannot afford to put 25,000 small businesses at risk. Yet a current proposal within the budget process will do just that.  Legislators are debating an ‘Affiliate Nexus Tax’, a sales tax scheme that has enticed legislators because on the surface it looks like free money for the struggling state economy. However, in fact, it has a design flaw that will threaten thousands of small California businesses, at the same time netting the state zero dollars in new sales tax revenue. We know this for a fact because it was passed in New York, North Carolina and Rhode Island with disastrous results.

It starts with the legislature’s desire to get out-of-state Internet retailers to collect sales tax for purchases made online by California consumers. As defined by the Commerce Clause of the U.S. Constitution, only retailers who have a physical presence in California, known as ‘nexus’, are required to collect sales tax. This applies if you purchase something online, via a catalog, from an infomercial or shopping channel.

The affiliate nexus tax attempts to circumvent the US Constitution. But even aside from that, it is conceived with a massive flaw.  This flaw targets how online retailers advertise, and it threatens the California businesses who place online ads, called ‘Affiliate Marketers.’

In California there are 25,000 affiliate marketers who earn their incomes from ads on their websites. Affiliate websites range from blogs for special-needs families and online newspapers, to shopping comparison websites with coupons and money-saving tips, just to name a few.

This ‘affiliate nexus tax’ has risen out of mistaken claims that affiliate websites, if the owners reside in California, establish nexus for out-of-state retailers who advertise with them.
First of all, placing ads on California-based websites (or television or radio stations or newspapers) does not establish nexus. Affiliate websites advertise, pure and simple. They aren’t employees of the out-of-state retailers, they don’t sell any products, they usually don’t even know who clicks on their ads. Under no definition do affiliates establish nexus for out-of-state retailers.

Second of all, and here’s the design flaw: if advertising on California-owned affiliate websites creates nexus for out-of-state retailers, then out-of-state retailers will simply terminate their California affiliates, and place their ads on affiliate websites in other states. It’s a simple business decision when you consider that people visit websites based on their interests, not geographic location of the site owners.

And people go in droves to affiliate websites. Affiliate marketers in California earned $1.6 billion in 2009, and they paid $124.5 million in California state income tax. For that same period, the advertising industry declined 18 percent but advertising through online affiliates rose 1 percent It is a small business success story in one of our worst economic downturns.  

If the affiliate nexus tax is passed, out-of-state retailers will make the easy decision to terminate their California affiliates, devastating the incomes of 25,000 small businesses who rely on their advertising dollars. But those out-of-state retailers will still reach California consumers by advertising on affiliate sites located in different states. And those out-of-state retailers still won’t be collecting sales tax on those purchases. The state will gain zero new sales tax revenue.

This isn’t a prediction, it happened when the affiliate nexus tax was passed in New York, North Carolina and Rhode Island. Hundreds of out-of-state retailers terminated their NY, NC and RI affiliate marketers, causing those small businesses to collapse overnight. And, as expected, the states saw no new sales tax revenue.

At the end of the day, the affiliate nexus tax is a losing proposition:  25,000 small businesses in California, in an industry that is growing, providing jobs and paying its fair share in income tax, employment tax, and property tax, will be devastated when their out-of-state retailers terminate them. All with the end result that the state still won’t collect any additional sales tax.  It’s all loss and no gain for the state.