Amazon's Sales Tax Reckoning

Half a Penny per Dollar

Amazon's fourth-quarter 2012 earnings told a story of scale without profit: revenue soared to 21 billion dollars, up 22 percent year over year, while net income landed at 97 million dollars, a net margin around half a percent. The numbers evoke the old joke about losing money on every sale and making it up on volume, and they raise the honest question of whether earning half a penny per dollar is acceptable. Jeff Bezos answered exactly that question on a Harvard Business Review podcast, sensibly: "Percentage margins are not one of the things we are seeking to optimize. It's the absolute dollar free cash flow per share that you want to maximize, and if you can do that by lowering margins, we would do that. So if you could take the free cash flow, that's something that investors can spend. Investors can't spend percentage margins."1

Volume as the Strategy

The margin picture also clarified what the company was actually optimizing. Razor-thin pricing was not an accident to be fixed but the moat itself, funding customer growth, scale economics in fulfillment and the data advantages that compound with every order. Investors who demanded margin expansion were asking the company to dismantle its own flywheel, which is why the cash-flow framing mattered: it told the market which scoreboard management would answer to, and dared anyone to bet against the compounding.

No Fool at the Helm

Dismissing the strategy means betting against a formidable operator. Bezos, a former hedge fund manager and Fortune's businessperson of the year, had consistently made bold, industry-altering moves on a long-term horizon and delivered roughly 12,000 percent shareholder return as chief executive. Analysts agreed, reiterating ratings with price targets comfortably above the prevailing 272-dollar share price. The market had learned to trust the cash-flow story, and the trust had paid.

The Subsidy Nobody Named

The sharper question sat in the tax line. Comparing Amazon's half-percent net margin with the average sales tax rate that was not being collected produced an uncomfortable picture: had customers paid sales tax on purchases, would they have bought so much online, and had Amazon hypothetically borne those taxes itself, it would have been unprofitable. The legal backdrop made the arrangement stranger still. Forty-five states carried sales or use taxes that legally applied to online purchases, with either the retailer collecting at sale, which most did not, or the buyer voluntarily remitting on their tax return, which almost nobody did.2 The collection gap traced to the physical-presence nexus doctrine, exempting retailers without in-state facilities from collecting, and state forms proved the obligation was real: Virginia's use tax explicitly covered tangible property consumed in-state when sales tax went unpaid at purchase. Un-fun, and unambiguous.

Amazon Knew, and Lobbied

The company understood the terrain perfectly, maintaining help pages explaining tax mysteries to customers while lobbying against mandatory collection, preferring to leave remittance to consumers who might or might not comply. California forced the issue, and after legislative back-and-forth Amazon began collecting on California purchases in September 2012.3 Consumer behavior around the deadline confirmed what everyone suspected about the tax advantage, as shoppers rushed to stock up before collection began, including one San Diego artist who finally bought the flat-screen television that had waited in his cart for months. Price sensitivity was real, and the tax gap had been part of the price.

The Analyst's Angle

The episode models a due-diligence habit worth keeping: hunt for the regulatory subsidy inside every impressive business model. The questions run in sequence. What advantage does this company enjoy that a rule change could erase, and how much of the margin or growth depends on it? Who is harmed by the current arrangement, and how organized are they, since disadvantaged local retailers plus broke state governments made a formidable coalition? What is the trigger timeline, whether court decisions, legislation or a single large state moving first, as California did? And what does management's lobbying spend say about their own assessment of the risk? A company fighting hard to preserve a gap has quantified what closing it costs. Investors who ran this sequence on the tax question were not surprised by the headwind; they had priced it.

The Inevitable Leveling

The direction of travel was never in doubt. States and municipalities sat dirt poor, tax revenues shrinking and some bonds at junk status, and they argued rightly that collection leveled the playing field for local retailers. Whatever one's fondness for taxes, the law already existed, and the states' practical case was strong: Amazon would collect sales tax far more reliably than millions of individuals tracking purchases and remitting voluntarily on annual forms. For Amazon the change spelled headwind, since collected taxes would dampen sales at the margin. The honest consumer verdict closed the analysis: continued enthusiastic use of the reviews, the marketplace and two-day shipping, paired with disbelief that half-percent margins made a sustainable model, and yet no willingness to bet against Bezos or the stock. No naked calls. The reckoning arrived, the company absorbed it and the lesson generalized: business models built partly on regulatory gaps should plan for the gap to close, because broke governments eventually collect.

• 1HBR Podcasts
• 2Sales taxes in the United States
• 3Amazon tax