The Black Market

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A few years
back, on a trip to some Third World nation, I remember asking a
successful businessman why more small businesses are not public.
His response was sublime. “I keep two sets of books – one
for the government and a real one for myself. I am not showing anyone
the real books. If I have shareholders, what will I show them? I
will never get fair value for my business if I show them the fake
numbers.” Welcome to the black market.

Let’s
face it, no one enjoys paying taxes. In many countries, you have
a bifurcation. Large companies can use their clout with the government
to get special exemptions from various taxes and regulations. As
long as the campaign contribution is smaller than the tax, most
companies pay it. Smaller companies are less fortunate. They cannot
afford protection and so they chose to operate more in the shadows.
They do not report certain income and they over-report expenses.
In some countries, this is so prevalent that it has become an u201Cacceptedu201D
practice.

In many countries,
avoiding taxes and stupid regulations is just part of doing business.
How can you blame them? The danger is that this limits the ability
of these companies to access the capital markets for debt and particularly
for equity funding. Without growth capital, there is no growth in
your economy. Even worse, many of these companies take their unreported
profits and deposit them in overseas banks out of the reach of the
taxing authority – which further stymies growth. No country
wants to create a black market – it forms naturally out of
desperation because of bad governance. Businessmen rarely want to
do business in the shadows as there are hidden costs to this sort
of business – however, sometimes they have no choice.

Large companies
can pay for lobbyist to protect them. Smaller companies are stuck.
They can follow asinine rules, or they can ignore the rules. What
do you think they will do? Currently in America, it’s better
to be honest, but there is a tipping point. I’m scared that we are
nearing that point in time, along with the consequences from it.

The more I
travel, the more amazed I am at how compliant Americans seem to
be when it comes to paying taxes. Many of us do not even use all
our legitimate deductions. I think it comes down to a simple principle.
Taxes are the cost of civilization and as Americans, we all understand
that we must do our part. As long as we view our tax system as just,
we grit our teeth and pay the tax. However, there does come a time
when people begin to lose faith in the system and opt out. In many
Third World countries, this is because the people resent paying
money to corrupt politicians and stupid entitlement programs.

In our country,
half of all citizens are now net recipients of tax revenue. No one
wants to give money to a political class that is created to use
the wealth created by the other half. I’ve read multiple studies
that show that the vast majority of all tax revenue is now paid
by just ten percent of the population. That ten percent has the
money to pay excessive taxes, but will they continue to have the
will to pay them? It’s one thing to be successful and pay more
of the tax pie; it’s another thing to pay all of the pie.

I do not want
to make this into a political website to debate the u201Cfairness of
various taxes,u201D but I can see the direction things are going with
taxes and social programs. Every time a country has tried this sort
of wealth redistribution, it has ended the same. The richest few
percent take their liquid wealth overseas to avoid taxation, the
next wealthiest tier made up of small businessmen join the black
market and job growth disappears which hurts everyone else. You
end up with a squeezing out process. Those who want to do things
honestly cannot compete with those who chose to join the black market
and out of desperation, everyone joins the black market. Government
revenues get squeezed and the government gets more desperate for
revenue to pay for whatever crazy social programs have been dreamed
up. The end result is a hallowing out of the economy followed by
a bankruptcy.

We are seeing
the beginnings of this process here in America. Have you ever read
the income statements of some of the largest companies in the US?
Despite reporting record profits, these companies have found ways
to shield their income using offshore entities and compliant congressmen.
If you have a thousand employees in America and three lawyers in
Ireland, are you an Irish company that should pay no taxes in the
US? I find these schemes enraging because I pay my fair share of
taxes as do most people I know. I’m stuck in that middle tier
of small businesses that cannot escape taxes and government regulation.
Will another round of investor protection aimed at hedge funds do
anything but increase the expenses that I pass onto my investors?
I mean, the SEC had the Madoff case spoon fed to them, but they
were apparently too
busy downloading reams of pornography to do anything about it
.

Look at Sarbanes-Oxley
as just one silly rule that does a disservice to everyone. It does
absolutely nothing to stop fraud. It creates an additional level
of compliance for little companies to jump through and it adds significant
cost for doing business. No wonder so many companies are now listing
in Canada or London to avoid this u201Ctaxu201D on public companies in America.
There are hundreds of these silly rules – every congress enacts
new ones.

What does this
mean for capital formation in America? If little companies decide
to join the black market, they will cease to be public. They will
no longer take in outside capital and the economy will not grow.
We need functioning capital markets. Third World nations are mired
in Third World status because their governments work against capital
formation. I am not sure why our leaders are trying to do this to
our country, but they are. Black markets are never good for anyone.
Neither is a two-tiered capital market where only the biggest most
politically connected businesses have access to capital.

The more I
think about what’s going on here in America, the less inclined I
am to invest my capital here. There are countries where the leadership
gets it and your money is well treated. I am increasingly interested
in learning about those places and investing there. It’s hard to
make money in a country where the government does not respect you
or want you to succeed.

Reprinted
with permission from Adventures
in Capitalism
.

October
2, 2010

Harris
Kupperman has been successfully investing in the markets for over
a decade. He blogs at Adventures
in Capitalism
.

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