Amazon I N C E P T I O N

Although this is a local issue, it demonstrates some universal issues in economic development. Amazon.com had started building a distribution center in Lexington County, South Carolina with the understanding that they would be exempt from collecting SC state sales tax (international readers, see sales tax primer at end), but a recent vote in the South Carolina House of Representatives quashed that implied promise, and now Amazon.com says it is pulling out of South Carolina...leaving behind a massive, half-built warehouse and an unfulfilled promise of 1200 jobs. I've given this a lot of thought and therefore am somewhat conflicted about the issue on a number Inception-like levels:

LEVEL 1

Since you are reading this on the Internet, you—like I—probably order stuff from online merchants on a regular basis. As such, we probably appreciate that nearly everything we order comes from another state, and therefore is free of sales tax. (Yes, I know I'm supposed to pay “use tax” on out-of-state purchases, but—really—who does that?) So, if Amazon.com came to South Carolina without this concession, everything I buy from Amazon (regardless of which distribution center it came from) would cost an additional 6%. Of course, I would not like that.

LEVEL 2

South Carolina, like every state (and nearly every government in the world) is suffering from budget shortfalls due in part to the recent economic upheaval. As a resident and tax payer, I would like to see more money joining my contribution to the states coffers so we can have “nice things” like other industrious states and countries have such as high-quality schools & universities, roads & other infrastructure, law enforcement, parks, etc. Therefore, at this level, I cringe that we were ready to forfeit this much needed revenue stream. (Granted, Amazon is never going collect or pay sales tax for any state.)

LEVEL 3

This distribution center would employ some 1,250 people in my area, undoubtedly there would also be multiplier effects as allied firms and other online retailers would consider this site, which—admittedly—is a great place for this type of business: minutes away from 3 interstate highways, regional postal, UPS, and FedEx hubs (who would probably also need to beef up their staff) within 5 miles, and plenty land for such expansion. Additionally, real estate values would go up in the area and new housing would probably be built. This would certainly benefit the economy of Columbia and of Lexington County. So, like many of my friends on Facebook and Twitter, I've got to be for that! However, I am not naive enough to think that 1,250 people will remain unemployed now; that's not the way a market economy works—there is no “lump of labor” that you just break a piece off. Lexington County already has one of the lowest unemployment rates in the state and is even lower than the national average.

LEVEL 4

Finally, there is the issue of fairness. Why should Amazon.com be exempt from collecting sales tax from South Carolina customers when all other retail businesses located in the state must do so? This is the argument of the business lobby that defeated this bill, and it is quite understandable. By not collecting SC sales tax, Amazon.com has an unfair competitive advantage.

While small business struggle to get established, nearly all states fight each other to land big businesses that promise to employ hundreds or thousands of its residents with generous concessions. They happily promise to forgo years of tax income, make commitments to upgrade infrastructure, create job training programs, and even loan or grant money and real estate to some firms. This is a legitimate economic development strategy that can create a successful technology cluster such as the one built around the BMW plant in Greenville, South Carolina. However, there is no guarantee of success, as seen by the now abandoned Mac Truck plant in Winnsboro, SC. So the question is, who should evaluate these opportunities? It seems to me that too often the big business draws up its own demands, and the local politicians immediately become cheerleaders regardless of how appropriate the project is for the long-term development of the region.

More importantly, I am interested in why underdeveloped states, regions, countries, or whatever need to prostitute themselves in front of industry in the first place. What disadvantages are otherwise turning away these industries, and what are the root causes of these negative aspects? I don't think that San Mateo and Santa Clara counties in California need to offer any special incentives to get technology firms to locate in Silicon Valley, nor does New York City have to do anything to keep the financial industry from leaving. Regardless of how sweet the incentives, the bulk of professionals in these industries would never move to some stiflingly boring Midwestern or southern state. I have written more about this previously in Promoting Innovation.

So, as I've said, I am conflicted about this; I wish states would collectively agree not to undercut each other, but I know this will never happen, so I guess I've got to pull for the home team and hope that some day in the future we will grow to the point where we don't need to introduce these market distortions.

Sales tax primer: In the United States, each state (and occasionally local governments as well) determines and collects a sales tax from 0% to 10% on all retail purchases (with some exceptions.) Unlike a value-added tax (VAT), this applies only to the final, end-user sale; manufactures don't pay this for raw material, and wholesalers don't collect it for sales to retailers. Also, this tax is only due from residents of the state in which the seller is located. While it is difficult to claim this exemption for small purchases you make when traveling to another state, mail order and e-commerce businesses simply don't charge it when shipping goods to an address outside of their state. (Oh, and to the consternation of foreign visitors, sales tax is almost never included in the posted price.)

Inception primer: The brilliant 2010 film Inception has spawned an Internet meme similar to “mind=blown” or “[insert strange twist], by M. Night Shyamalan” in which—to express how mind-blowing a concept is—you take almost any word that ends in “-ion”, put spaces between the letters, and make it bold. (e.g. Sales tax C O L L E C T I O N )

The film itself only makes sense when you realize [and this is not a spoiler] that the team has successive dreams within dreams, in which time exponentially slows down for each level, and if someone gets killed in a dream this person’s [un]consciousness goes to limbo, where time stretches out even more, such that DiCaprio’s character and wife spend a lifetime there one night many years ago. Also, since his wife has been dead for years, her appearance is merely a figment of his imagination, and thus her sabotage must be his self-flagellation.



UPDATE 5/21/2011: The South Carolina legislature relented and gave Amazon.com their sales tax exemption. Construction of their enormous warehouse (above) is moving along at a brisk pace. I'm happy that this major industry has located here, and I hope this area will become a distribution/logistics cluster. However I'm still uncomfortable that certain companies are allowed to ignore the obligation to collect sales tax from retail sales.

This American Life just had a brilliant show with the Planet Money team titled “How to Create a Job”; the main premise is that despite the big talk from politician and the economic development industry, they almost never create a job, they just shuffle them around from state to state. If you have a free hour, it's certainly worth the listen: (click here)

Promoting Innovation

So, in the previous post, I proposed that the only entrepreneurial enterprises worth pursuing are in innovation; more specifically my advice was to not pursue market-share (large, efficient business will beat you at that game every time) and actually do not pursue a market-enlarging strategy either...because you shouldn't have any noteworthy competitors. If you want to start a successful business, you've got to create a market from scratch (or at least revolutionize an existing one.)

Consider for a moment what Apple did in the last decade: although they were already a fairly large computer maker, they turned the nascent marketplace of MP3 players on its head when they created the iPod (and all the subsequent variations.) As early as the mid-1990s, companies like Rio had introduced similar devices that allow cutting-edge young people who already were storing their music collection on their computers to take at least a part of this collection with them without burning a CD. Granted, the Apple brand and marketing machine had a lot to do with its success, but the iPod really was a revolutionary device with its intuitive and even alluring interface, and an equally slick synchronization application, iTunes. This software, in turn, created the first viable, legitimate digital music sales channel. Today it seems that every young person has (or at least covets) an iPod-like device; 10 years ago, hardly anyone would have imagined they need something like this—Apple created a worldwide market out of thin air!

Nearly everyone agrees this type of business (and the type of jobs that go with it—high tech and knowledge-oriented) is what we want for our community, our state, and our country. So, the question is: how do we encourage this as governments and business communities? This is an important questions by virtue of the fact that nearly every state is trying to create at least one “innovation center” to do just that.

The traditional answer to facilitate job and economic growth has always been to lower taxes and reduce regulations. I recently received a campaign letter from Jim Harrison, who is running for a seat in the South Carolina state house; in this letter he follows the standard Republican line: “The only way our state can recover from the recession is to show the world that we are open for business. To do that, we must create a business-friendly tax environment with smaller, less intrusive state government that allows businesses new and old to flourish.” However, it seems that the most innovative industries have located in the least business-friendly, and in fact the most left-leaning communities in the country such as the San Francisco Bay Area, the Pacific Northwest, New York, Boston, etc. Why the incongruity? Simple: the most innovative organizations are small start-ups who—quite frankly—don’t care about these big business issues; they aren't yet making any real money for authorities to tax, and they generally aren't affected by many regulations. Innovators flock to these decidedly blue innovation centers because that's where the talent (both technical and creative) is, that's where capital sources (VC and angel investors) are, that’s where the infrastructure is, and—just as importantly—these locations are just cool places to live: abundant recreation opportunities, vibrant nightlife, etc.

But this all sounds tautological: innovators come to these innovation centers where all the cool people are to innovate. So the real question is: what is the underlying reason that these natural innovation centers exist? I think that what you will find at the heart of each is one or more world-class university. Not the kind with a undefeated football team, but the kind that draws the best and brightest young people from all over the country and even all over the world (note the numerous the foreign names in any list of high-tech startup founders.)

A tale of two states
Let me tell you a tale of two states; California and South Dakota. As you probably know, California is on the brink of bankruptcy due to overspending (in large part on education.) South Dakota, on the other hand, has written in their constitution that the state government simply is not allowed to go into deficit spending. In a traditional view, South Dakota is the good, responsible government, and California is completely irresponsible. However, I ask you: what has South Dakota done recently (and I am not picking on SD, you can ask this of most mid-western and southern states.) Can you name one scientific breakthrough or one high-tech startup that has become a household name from there?

In this regard, California has too numerous examples to list; nearly every major computer hardware, software, and accessories company is based in or started in “Silicon Valley.” Then think of the entertainment industry: despite the fact that many movies and TV shows are now filmed elsewhere, Hollywood is still the undisputed global nexus of the motion picture industry. For all the half-serious kidding from southerners and mid-westerners about how we'd be better off it an earthquake would just set California adrift in the Pacific Ocean, the United States of America would be a pale shadow of itself without California; just in strictly monetary terms, if it were an independent country, California would be the 8th largest economy in the world!

So, in an incongruous, “parable of the talents” manner, I say we should actually underwrite the supposedly irresponsible spending of these liberal states (who actually fuel these powerhouses of innovation) at the expense of the “good son” states that have their financial affairs in order, but due to their conservative policies, do not foster innovation! At the federal level, we actually do the opposite: southern and mid-western states generally receive more federal funding than the federal tax revenues collected from the state’s citizens and companies.

Again, I am not denigrating southerns or mid-westerners; I truly believe there are just as many creative and intelligent people (per capita) born in each state, but as they grow to be adults they feel unfulfilled/unchallenged and chafe under the traditional strictures of these states, and move (often for university studies) to a more inviting locales. So, much like the brain drain experienced by under-developed countries, many states and localities are actually shooting themselves in the foot by being financially responsible!

Now, I am not saying that, to become a center of innovation, state and local governments just have to loosen the purse-strings. In fact I don't have the answer to the question how does one foster the creation of innovative companies. Many communities have built business incubators, technology centers, etc. and may have even filled those offices with mediocre startups, but failed to see standout successes that actually leave those "incubators." Again, a large part of attracting creative and intelligent people is being "a cool place to live." As such, no matter what you do, you're never going to attract the best and brightest to Sioux Falls, SD or Cleveland, Ohio, or any number of ordinary cities across this land. Part of the appeal is geographic, and unless you can build mountains and seas, your community is out of luck. (I suppose things like parks, nature reserves, multi-use trails would help somewhat.) The other major contributor is a harder to define characteristic and again somewhat tautological: a community where the "cool kids" already live. This means things like a vibrant music scene and a range of international restaurants (staffed by actual immigrants, of course.) These are the type of things that can't be created in a top-down fashion, but certainly can be quashed by ill-conceived planning policies and various incentives & disincentives.

[UPDATE April 2017] At the moment, I live in Silicon Valley and—in reviewing this post 6+ years later—have to agree with my past self’s assessment. One very important ingredient, which I only mentioned briefly, is money—specifically the venture capitalists (VCs) who make generous bets (6-7 figures) on startups, hoping to hit it big on a very successful one. Along with this goes the valuable advice and encouragement this place is oozing with; everyone has FOMO (fear of missing out) and therefore don't easily dismiss ideas.

I just heard an excellent and relevant story on the public radio show Marketplace called “Will your city be the next tech hub?” that I recommend listening to.

There is no easy Money

It's the universal American dream: to strike out on your own, become your own boss, and—of course—become fabulously wealthy. It is a dream shared by men and women at all levels of society from janitors to executives. I'm convinced it is the reason why many middle income and even lower-middle income people are diehard political conservatives; they truly believe that they are a few steps away from becoming a business owners who, by definition, would be adversely affected by high taxes and burdensome health/safety/labor/environmental regulations.

Certainly there are possibilities for the meteoric rises from “rags to riches” that we all celebrate, such as the orphaned, high-school dropout Dave Thomas, who went on to create a world-wide restaurant chain: Wendy's. However, we must remember these are exceptions; we can't base policy decisions on a few outliers. Without outside influence, people generally stay in the socio-economic class that they were born in, which—at best—is a little better than their parents. These non-contiguous jumps in success that we all dream of, whether in business, sports, or entertainment, are actually extremely rare. When it comes to small business, we must acknowledge the fact that the vast majority of them fail within the first few years, and not only dwell on a few success stories.

This is why I've become convinced that—just as it is foolhardy (and cruel) to pump up poor, inner-city youths with dreams of becoming basketball or rap stars—it is cruel to even tacitly encourage a friend who, with little more than contempt for his employer, wants to strike out on his own. A friend should be the voice of reason in these circumstances, and test the budding entrepreneur’s commitment, knowledge, discipline, and capabilities in this area. Someone who is really intelligent and capable enough to succeed in this respect will have no problem answering the tough questions, starting with how he (or she) is going to support himself, and what evidence there is that this will actually attract customers and make money.

Although there are thousands of self-described independent business people and even more business licenses & incorporation filings, most are not successful—even if they do show some kind of profit. To be a successful entrepreneur, first of all you have to make enough from your salary and/or profit to at least equal your previous job. Too often I hear self-employed friends talk about how much they made in that one good week or month, but are silent about their yearly income. Later, when they run out of money, I often hear they went back to their old job…apparently their business wasn’t as successful as they made it out to be.

The next measure of success is return on investment (ROI) or return on assets; if you already have (or inherited) buildings/facilities/real estate, vehicles, and equipment, you must consider the value of these in any calculation. There is an opportunity cost for these items; could these items could be sold or leased if you were not utilizing them? If so, then this must be determined and subtracted from your profit statement.

There are many other ways of measuring financial success, but my final question would be: how much would someone buy your business for? Obviously part of the equation is the value of cash, inventory, and assets (minus depreciation, of course), but a successful business is really measured by how much money it makes (and is expected to make in the future), and this is where it often becomes sticky for sole proprietors who do not recognize all their cash income and mix business and personal expenses. If I want to buy your business, and you say, “Well, I receive a lot more income than I report on my taxes” then I must trust your word on how much you actually make, since you certainly wouldn’t risk keeping separate books reflecting this additional income (because that would guarantee a conviction in a tax evasion case.)

Too often entrepreneurs end up buying themselves a low-paying job (especially considering the long hours involved) for tens or hundreds of thousands of dollars and only seem to be successful because they own or control significant assets, while their spouse is actually earning the family’s income from a conventional job.

Corporate rip-off
I will come back to possibly successful entrepreneurial business ideas, but first I want to address why you can’t beat the big guys in the consumer retail sector by defending supposedly evil corporate bad guys against incessant criticism from consumers and small businessmen. I am blown away when I hear local would-be entrepreneurs declare how they could bring goods and service to customers at a lower price than large corporations…who, then by definition, are ripping us off. Their unsophisticated analysis show they do not understand the efficiencies, especially in supply chains, that large corporations have, and ignore the overhead costs in delivering goods & services (I’ve even heard redneck business owners claim to have “low overhead” without realizing that they actually have higher overhead per unit!)

Likewise nearly everyone complains about how cable TV, satellite, and mobile phone companies are ripping them off. The assumptions is that, as an intangible good, data must have a marginal cost near zero, so why should they be getting dinged tens of additional dollars every months for overages and arcane fees for using these services? What is forgotten is the capital tied up in infrastructure and ongoing expenses in maintenance of these massive networks. This reality is divorced from what the advertising/marketing department must do to increase market share: namely get customers to sign contracts for $x9.95/month with—of course—an asterisk at the end! Recently I’ve watched a nearby AT&T tower go up (easily a 7-figure project) and watched dozens to hundreds of UTMS cabinets being assembled for installation around the state as AT&T upgrades their network for 3G. Now I understand why they need $70 a month for the unlimited iPhone data plan.

On the left/green front, some assert that the local & organic food movement stands to gain efficiencies (and reduce carbon footprint) by not transporting food hundreds (or even thousands) of miles across the country or world as the incumbent, industrial food/agriculture industry does. Their childish logic implies that these giants are transporting goods over long distance for no good reason. In fact, large concerns such as Wal-Mart are very careful to minimize the carbon footprint of each product; they just don’t call it that, but use a perfect proxy: money! The less money they spend on diesel fuel, the more profit they make; this is why they pack their 18-wheelers to the roof and use all kinds of logistics experts and computer software to minimize transportation cost (and therefore carbon footprint as well.) Although your local organic farmer doesn’t move his produce as far, it is likely that, on a per pound or kilogram basis, it could actually have a bigger carbon footprint!

Finally, corporations exist in a marketplace of competitors and potential competitors, which—in the long term—make any advantage temporary. Regardless of how much or little they pay their executives, large corporations—across the board—generally make single-digit (percentage) profits. In industries/niches where profits are higher, more players naturally enter the market and dilute any above-average profits.

Send $199.95 for my unique system for making easy money
I don’t necessary disbelieve the get-rich-quick crowd’s claims of how much money they have made; however, what each one fails to disclose is that they now have a new money-making scheme: selling get-rich-quick books, recordings, and training. They may have very well discovered a lucrative arbitrage opportunity some years ago, but it has since dried up or been diluted by new entrants. Now they are essentially selling nothing more than their life’s story to suckers whom they have convinced can repeat their success. Now, this view is only the most charitable possibility; actually I do believe that most of these charlatans go way beyond exaggeration and embellishment to outright deceit.

Innovative niche entrepreneurship
So, in what field is it prudent to become an entrepreneur? First of all, it has to be a niche that is not adequately served now. Even in the mature economies of the west, there are products and services that a small businessperson can provide other businesses (generally never to consumers) that provide such a great value, they practically sell themselves. With the application and integration of modern technology, it is possible to revolutionize tedious business processes that organizations would like to outsource anyhow. A startup based on the founder(s) competencies/expertise in a given field, and the development of innovative software and/or other systems for several client businesses is a great start. However, notice it must be in your field of expertise. If you haven’t already been working in a particular business or sector for many years, you are simply not qualified to start a business in that area. You can’t just dive in the deep end and expect to learn as you go. If, for example you a machinist who is tired of getting oil under your fingernails, and decide you’re going to change directions and teach yourself computer programming in order to start a business, then you are certainly doomed to fail. (Incidentally, it should go without saying that unless you’ve been a general manager of a restaurant for several years, you should never consider opening a restaurant—even if you have this experience, the odd are against you as an independent restaurant, bar, cafe, etc.) If you really want to make a big change in your professional life, you’re better off going back to school to learn a new profession, work in this new profession for a few years and only then think about starting a business in that area. [UPDATE 7-29-2010] Two researchers from the Haas School of Business at UC Berkeley, Pino Audia and Chris Rider published a paper debunking the "myth of the garage", that is, the humble & isolated beginnings of many tech startups. It turns out that most successful startups leaned heavily on information, skills, and networks established while working with their previous employers. (FastCompany article)

I am sorry for sounding so negative, especially now that I am considering starting my own business, but I’ve written this in part to sharpen my own view on the issue. I’m just tired of conversations about entrepreneurship focusing only on the best-case scenarios, while ignoring the significant costs involved that often are never recouped. Whenever someone whispers, “you know, there’s good money in x” I reply, “yes, there is good money in everything.” Every potential investment or business idea requires a comparable mix of capital, risk, and plain old hard work to produce a comparable income. For example, being a landlord is an excellent way of building wealth, since your tenants are paying the mortgage—building your equity in the property. However, it also means you’ve got to deal with collecting rent, fixing broken plumbing, etc. If you decide to hire a management company so that you don’t have to worry about these things, you will find (with the management fee deducted) your investment now returns about the same as if you just bought stock in a REIT (real estate investment trust.) This is how a capitalist system works; the market determines the value of all inputs through their reward. If an opportunity temporarily returns better than expected returns, then more people will flock to it and dilute the returns.