Amazon and the state of Illinois play a game of chicken over online tax collection

Yesterday, Illinois passed the so called “Amazon tax,” a measure to collect sales tax on online commerce. If signed by Gov. Pat Quinn, the plan would require online retailers, such as Amazon.com and Overstock.com, to collect a 6.25 percent sales tax.

Currently only companies with a physical presence in Illinois are taxed for their online commerce. Under this measure, any online retailer with a commissioned affiliate, like Amazon.com, would classify as having a physical presence and hence would subject to tax.

To bring the story home, since I live in Illinois, and this blog includes an occasional affiliate link to Amazon, the new law interprets Amazon as having a physical presence in the state, and hence all of their sales are subject to state tax. This sets up a very interesting game theory situation.

Why Illinois did this

From a simple decision theory view, the law sounds like a great idea for Illinois. It is believed $150 million of sales tax (stated here) are lost in online commerce, and collecting this money would alleviate the state debt and avoid raising other taxes. Plus, the law touches on a local matter as it “levels the playing field” with brick and mortar stores.

It comes as little surprise the bill was very politically popular and it passed the Senate and House quickly.

But will the law work out?

It depends on how others will react. There is still the matter of Gov. Pat Quinn signing the measure into law. And this gives Amazon a last chance to react. And they are putting up a fight.

Amazon plays hardball

It’s exceedingly naive to expect Amazon to simply accept this deal. The law strikes at one of their competitive advantages, namely, their website affiliate program which generates many sales and impressions. Also, accepting the Illinois tax sitting down might give other states the same idea.

So Amazon is fighting back at Illinois with a threat. Amazon has emailed its commissioned affiliates the following message:

We regret to inform you that the Illinois state legislature has passed an unconstitutional tax collection scheme that, if signed by Governor Quinn, would leave Amazon.com little choice but to end its relationships with Illinois-based Associates. [emphasis mine]

The following logic seems to explain the motive. If Amazon ends its affiliate relationships in Illinois, then it would have no physical presence in the state, and hence it would get around the bill.

The email levies harsh criticism at Illinois and is meant to garner sympathy. In reality, the move is calculated and strategic.

Amazon is threatening all affiliates on purpose – even though it doesn’t have to. Here is an interesting tidbit the Chicago Tribune reported:

The bill applies only to affiliates that have at least $10,000 a year in revenue. But if large retailers, such as Amazon, cut off all affiliates in Illinois, it would end commission streams to small Web sites, such as bloggers, who might sell Amazon goods at their sites. Amazon could not be reached for comment.

Amazon is playing a classic retaliatory strategy. If Illinois wants to pass this law, then it will do everything to hurt the state and even otherwise innocent and small-time bloggers, who might decide its time to complain to Gov. Pat Quinn.

Amazon is telling Illinois that it will do everything to avoid the sales tax, and it will even go further to stop the program for smaller guys (perhaps it’s not worth their time?).

What might happen? Let’s think about the incentives of the situation.

The game of chicken

The retaliatory threat sets up an interesting game of chicken between the state and Amazon. Here are the possible outcomes:

–If neither flinches, then Illinois enacts the tax and Amazon ends its affiliate program. In this case both parties “crash” and lose. Illinois does not get extra revenue from Amazon, but Amazon loses out on its affiliates who generate traffic and sales.

–If either flinches, then the other side wins. If Illinois does not pass the law, then Amazon wins huge in maintaining the status quo. If Amazon keeps its affiliate program, then it will get taxed and it will have to worry other states will pass similar laws.

–If both flinch, then both lose some face and credibility. Illinois would look weak for bowing to a commercial giant, and Amazon would lose some goodwill from affiliates who felt unnecessarily threatened at losing their commissions.

One might hope that both sides take the route of avoiding conflict. But that’s not what history suggests.

Colorado passed a similar law last in March, and Amazon did end its affiliate relationships then.

In Illinois, the law would affect some big websites like FatWallet and BradDeals. These sites have already stated they would relocate to other states since they cannot afford to lose Amazon commissions.

Time will tell what happens in this horrible game of chicken. It won’t affect me too much but I feel annoyed at the seemingly inevitable dismal outlook where Illinois gets little extra tax revenue and I lose out on some modest Amazon commissions.

Who knows, maybe other states will follow. Amazon can’t avoid sales tax or discontinue every affiliate site if every single state enact such a law, can it?

Of course, that would require a level of cooperation among states and politicians never seen before. I’ll let you mull over the game theory on that one.