In Silicon Valley, "Disruptive" Is Another Word For Regulatory Arbitrage

Amazon initially built its business by driving mom-and-pop booksellers out of the retail business and then destroying the big chain book stores. From there it expanded into retailing just about anything and everything. There is no doubt that we all enjoy the ease and service that Amazon provides. But the company had plenty of help in becoming the retailing behemoth that it is.

A recent study by the non-profit Institute for Local Self Reliance (ILSR) has released a study that Amazon received a minimum of over three quarters of a billion dollars in tax breaks from 2005 to 2014. That amounts to over 15% of the firm's profits during that period. Admittedly, Amazon spent many of those years unconcerned about profits as it tried to build near monopoly control of online retailing.

Initially, Amazon located its distribution centers in remote rural locations which allowed its customers in denser, more affluent states to avoid paying sales taxes on their purchases, creating a competitive advantage over local retailers, whether online or not. The company was fixated on tax avoidance as that was its greatest advantage, reducing costs between 7% and 10%. In the mid-2000s, having driven much of the local competition out of business, Amazon changed its strategy and began moving its distribution centers closer to major cities. Amazon demanded that the in-state sales tax be waived when it built new warehouses in these states and sometimes also received an additional tax incentive for building those warehouses and the resulting jobs as well. And it was constantly flirting with sales tax avoidance. In 2008, it had to pay a fine of over $250 million to the state of Texas for running a warehouse under the name of a subsidiary in order to avoid paying the in-state sales tax. In 2013, sales tax avoidance by online retailers cost states around $23 billion. Money like that would have certainly helped many states that were struggling to balance their budgets in the wake of the Great Recession. And just imagine how many jobs were lost as states lost the brick and mortar stores that Amazon drove out of business. For example, in 2014, Amazon sold over $2 billion worth of goods in the state of Illinois without employing a single person and without paying a dime in sales tax.

Ever since the success of Amazon, many other Silicon Valley companies have essentially tried to duplicate their success and use Amazon's tactics to do so. Take a look at Uber, a company that I readily admit I have no love for. In 2015, Uber reported an operating loss of over $2 billion. But, like Amazon in its early days, the point is not to make money now. The point is to drive as many competitors as it can out of the business and, when it has a near monopoly presence, the profits will come. In Uber's case, that means that customers currently pay only 41% of the true cost of the ride. In addition, the company continually flouts local government rules that cover taxis and other livery services and avoids the costs associated with a traditional employee by calling its drivers "contractors". In addition, they are already trying to squeeze those "contractors" by shrinking the percentage they receive. All this is designed to drive out as many competitors as Uber can and hope that monopoly and profitability will follow.

Airbnb follows a similar playbook which relies on ignoring or avoiding the rules and regulations that normally cover hotels, bed and breakfasts, and other similar establishments. In this case, it may be that the hotel industry has just too much power for Airbnb to dislodge. Cities in this country are cracking down on the company and restricting what units can actually be rented. In New York City, it is illegal to rent an apartment for under 30 days, a law that Airbnb originally flouted. The state eventually passed a law that would impose a fine of $7,500 for the illegal rental of an apartment using Airbnb or another online rental agency. Airbnb went to court to fight that law but eventually agreed to drop the suit in return for New York City agreeing to enforce the fine against the host listing the rental and not Airbnb itself. That shows how much the company cares about the hosts who drive its business.

These days, when Silicon Valley talks about a "disruptive" new business, it usually does not mean that there is any breakthrough technology or idea. It merely means the company has found new way to avoid the rules and regulations that cover an existing business and will exploit that loophole to gain a competitive advantage, drive the competitors out of the space even if it means running at a loss for an extended period, and then hoping that resulting near monopoly or highly scaled business will turn a profit. In my day, this was called regulatory arbitrage; these days, it's called innovation.