Labor Arbitrage - Impact of Offshoring in the U.S. Labor Market
By
Jorge Malibran
MBA
Indian School of Business, 2012
SUBMITTED TO THE MIT SLOAN SCHOOL OF MANAGEMENT
IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE
DEGREE OF
MASTER OF SCIENCE IN MANAGEMENT STUDIES
AT THE
MASSACHUSETTS INSTITUTE OF TECHNOLOGY
ARCHNVES
MASSACHUSETS INSi
OF TECHNOLOGY
MAY 3 0 2013
JUNE 2013
3R
@ 2013 Jorge Malibran. All Rights Reserved.
~R!E S
The author hereby grants to MIT permission to reproduce and to
distribute publicly paper and electronic copies of this thesis document in
whole or in part in any medium now known or hereafter created.
h'
Signature of Author:
IT Sloan School of Management
May 10, 2013
Certified By:
Nicdas A. Ashford
PhD, JD, Professor of Technology and Policy, MIT
Thesis Supervisor
Accepted By:
(I
Michael A. Cusumano
SMR Distinguished Professor of Management
Program Director, M.S. in Management Studies Program
MIT Sloan School of Management
1
E
2
Labor Arbitrage - Impact of Offshoring in the U.S. Labor Market
By
Jorge Malibran
Submitted to the MIT Sloan School of Management on May 10, 2013 in partial
fulfillment of the requirements for the degree of Master of Science in Management
Studies
Abstract
The rapid growth of offshoring has ignited a contentious debate over its impact on the US labor
market. Between 1983 and 2002, the United States economy lost 6 million jobs in manufacturing and
income inequality increased sharply [Ebenstein, 2011]. Today due to the falling costs of transportation,
coordination and communication this tendency is accelerating affecting both white and blue collar
workers. While there many papers that analyze the productivity increase due to offshoring practices
[Mitra, 2007], [Global Insight, 20041, [Houseman, 2010], most of them just assume that this
improvement is automatically translated into lower prices therefore benefiting consumers. Nevertheless
this assumption only holds in price competitive markets, which is not always the case.
In this paper I will challenge the assumption of price competitive markets and argue how offshoring
increases within-country income inequality. In addition I will analyze the aggregated effect of offshoring
in the U.S. economy through both empirical and theoretical approaches.
Thesis Supervisor: Nicholas A. Ashford
Title: PhD, JD, Professor of Technology and Policy, MIT
3
4
Acknowledgments
First and foremost, I would like to thank my thesis supervisor, Professor Nicholas Ashford, for his
valuable advice, dedication and support during this year. With his guidance, I have been able to navigate
through the vast literature and focus on the key areas for research. His vast knowledge and incredible
insights have allowed me to understand and analyze with much more depth such a complex topic as the
macroeconomic implications of offshoring.
I am also grateful to the MSMS program, in especially to Julia N. Sargeaunt and Chanh Q. Panh, for their
support and encouragement throughout this research process and the whole academic year. Their help
and commitment was inspiring and kept me focused until the last minute. I would also like to thank
them for organizing thesis workshops during their free time, these meetings helped me regain focus and
improve my writing style. I would also like to thank all of the MSMS 2012 students for their support.
It is difficult to overstate my gratitude to Cristina, my wife, for her tireless assistance and unconditional
understanding, her help and support during this year have kept me sane and focused. She has really
been my compass and my support during all this time.
Finally, I owe my deepest gratitude to my parents, Rosa Angel and Jorge Malibran, for encouraging me
and making it possible to pursue this degree, without their support this amazing learning adventure
would not have happened.
5
6
Table of Contents
9
Introduction ..................................................................................................................................................
Evidence from U.S. M anufacturing.............................................................................................................16
Offshoring Productivity Gains..........................................................................................................
...---19
Productivity Gains and CPI......................................................................................................................19
Productivity Gains and W ages ................................................................................................................
21
Productivity Gains and Com pany Profits ............................................................................................
22
M acroeconom ic Im plications......................................................................................................................24
Offshoring - Fading Advantage?..................................................................................................................27
Conclusion...................................................................................................................................................
31
Directions for Further Research..................................................................................................................32
Bibliography ................................................................................................................................................
34
Appendix I: Imports of Goods and Manufacturing Jobs - Correlation Analysis ......................................
37
Appendix II: Personal Incom e vs. Corporate Profit Growth Analysis......................................................
38
7
Table of Figures
Figure 1: Average monthly wage in USD (United Nations' International Labor Organization)..............10
Figure 2: Median programmer annual salary (www.payscale.com)......................................................
10
Figure 3: Worldwide corporate tax evolution (Price Waterhouse Coopers)......................................... 12
Figure 4: Baltic Dry Index 2009-2013 (Bloomberg.com)..........................................................................13
Figure 5: Offshore job loss projection (Forrester Research Inc.)..........................................................
13
Figure 6: U.S total value of imports and exports of goods and services (U.S. Census Bureau)..............17
Figure 7: U.S. manufacturing employment (Bureau of Labor Statistics)................................................17
Figure 8: Industrial production Vs. manufacturing jobs (Bureau of Labor Statistics).............................18
Figure 9: Consumer price index Vs. GDP Deflator (Bureau of Labor Statistics)......................................20
Figure 10: CEO pay vs. company earnings (Forbes.com)......................................................................22
Figure 11: Corporate profit vs. personal income growth (Bureau of Economic Analysis)......................23
Figure 12: Offshoring value potential accrued to the U.S. (McKinsey Global Institute)........................24
Figure 13: Share of income, by income group, growth since 1979 (Congressional Budget Office) .....
26
Figure 14: Baltic Dry Index 2011-2013 (Bloomberg.com).......................................................................28
Figure 15: Manufacturing outsourcing cost index (Alix Partners)..........................................................28
Figure 16: USD/CNY,MXNINR exchange rates (Google Finance)..........................................................29
Figure 17: Companies' intentions to change manufacturing source (The Economist)...........................30
Figure 18: Correlation analysis between imports of goods and manufacturing jobs............................. 37
Figure 19: Capital gains vs. personal income since 1976 (Bureau of Economic Analysis).....................38
Figure 20: Personal income vs. corporate profit growth over time (Bureau of Economic Analysis)..........39
8
Introduction
Offshoring is the term used to describe the relocation by a company of a business process from
one country to another-typically from developed countries to developing ones. The term was originally
used in financial economics, since many offshore financial centers are British colonial islands located offshore of the mainland such as Singapore, Hong-Kong and the Caribbean Islands. Today the term
offshoring has extended from its solely financial meaning to the term goods offshoring and more
recently services offshoring.
It is important to note that offshoring only implies the relocation of a business process to another
country and not contracting out a process to a third party organization, which is the definition of
outsourcing. Therefore there can be two types of offshoring practices:
-
Captive Offshoring (Foreign Direct Investment): production of goods or services effected or
partially or totally transferred abroad within the same group of enterprises. This implies an
enterprise transferring some of its activities to its foreign affiliates. These affiliates may
already exist or have been created from scratch (greenfield affiliates).
-
Offshore Outsourcing: partial or total transfer of the production of goods or services abroad
to a non-affiliated enterprise.
One of the main drivers of Offshoring has traditionally been cost reduction, mainly due to lower labor
cost in developing countries. Companies can immediately reduce their labor cost by laying off
employees at home and hiring workers in developing countries were wages are much lower than in the
U.S1 . (see figure 1). Taking advantage of wage differentials in different countries to reduce labor costs is
denominated "labor arbitrage".
1While average monthly wages do not provide a good estimation of how much a company can save by relocating
to a country, it is useful to illustrate the potential of labor arbitrage.
9
Average Monthly Wage (USD)
3,500
2,5001M-
L
5W
-T
-T
0
Figure 1: Average monthly wage in USD '(United Nations' International Labor Organization)
For example a U.S. software company that decides to offshore the development of their new product to
India, can reduce their development cost by up to 84 percent as the average developer in India earns six
times less than his U.S. peer (see figure 2).
Median Programmer Annual
Salary
70,000
-
60,000
50,000
40,000
30,000
-
2o'000
U.S.
Ireland
China
Russia
India
Figure 2: Median programmer annual salary (www.payscale.com)
While labor arbitrage is the main driver of offshoring, companies also find other benefits from relocating
business process abroad:
10
Access to talent: for certain professions there is a greater availability of workers overseas.
Some countries even promote the specialization of their labor force, very much following
the Ricardian precepts of comparative advantage (e.g., China with manufacturing or India
with IT enabled services).
The lack of skilled workers in the U.S. is becoming an important driver of offshoring. While
the average education of the U.S. workforce is declining, companies require more skilled
workers than ever. According to the Bureau of Labor Statistics the U.S. experienced a
shortage of 7 million skilled workers and this shortage is expected to rise to 21 million skilled
workers by 2020.
Reduction of legal exposure: employing offshore staff reduces legal exposure to
employment liabilities and environmental costs. Developing countries, main offshoring
destinations, usually have laxer regulations and safety standards, allowing companies to
reduce their legal liabilities and compliance costs.
Operational flexibility: offshoring reduces hiring and termination costs, allowing companies
to quickly expand and contract their overseas labor force in accordance with business
cycles.
Lower tax rates: companies can take advantage of lower corporate tax rates overseas to
reduce their tax liabilities. Currently the U.S. is the country with the second highest
corporate tax rate in the world, only after United Arab Emirates, and it has consistently had
higher corporate tax rates than the rest of OECD countries and main offshoring destinations
(see figure 2). Due to this comparatively high corporate tax rate, corporations find incentives
to open subsidiaries in low taxed countries and redirect their profits there.
11
Corporate Tax Rate Evolution
45
40
-US
35
-OECD
average
Global average
-
China
25
20
2006
2007
2008
2009
2010
2011
2012
2013
Figure 3: Worldwide corporate tax evolution (Price Waterhouse Coopers)
-
Proximity to clients: companies may decide go offshore to be closer to their customers. This
proximity allows companies to reduce their shipping costs and improve their time response
serving overseas markets. The high economic growth and increased purchasing power of
these markets are currently driving many offshoring practices.
-
Focus: by offshoring certain processes, companies can free resources to focus on more
valuable activities. This shift towards core competences allows firms to dedicate more time
to their strengths, deriving the maximum benefit from their talents.
Offshoring has been a common practice over the past 50 years. As early as 1960, US forms offshored the
labor-intensive stages of semiconductor manufacturing to Asia in order to make use of low-cost,
unskilled foreign labor [GAO, 2006].
Today the falling costs of transportation are allowing firms to reduce the inherited costs of offshoring
production processes. We can see in the Baltic Dry Index 2, how the average price of shipping dry goods
has been falling for the last five years (see figure 3). Nevertheless several authors [Pasti, 2011],
[McCarthy, 2006] argue that this extraordinarily low transportation costs will not last as energy prices
will rise in the near future.
2The
Baltic Dry Index (BDI) is an assessment of the average price to ship raw materials (such as coal, iron ore,
cement and grains) on a number of shipping routes (about 50) and by ship size. It is thus an indicator of the cost
paid to ship raw materials on global markets and an important component of input costs.
12
Figure 4: Baltic Dry Index 2009-2013 (Bloomberg.com)
In addition the internet has also reduced coordination and communication costs, allowing firms in rich
countries to fragment their production process and offshore an increasing share of the value chain to
low-wage countries.
This increase in offshoring practices has been documented by U.S. institutions. In their last research for
the U.S. Bureau of Labor Statistics, Forrester Research Inc., projected a total of 3.3 million jobs offshored
in 2015 (see figure 4).
While it is difficult to estimate the exact numbers, there is no doubt that
offshoring has a significant impact on U.S. labor market.
Offshore Job Loss Projection
2003
2004
2005
a Number of US Jobsmoving
2006
2007
offshore by 2015, in millions
2008
2010
2015
0
1
2
3
4
Figure 5: Offshore job loss projection (Forrester Research Inc.)
13
The rapid growth of offshoring practices has ignited a contentious debate over its impact on the U.S.
economy and more specifically on the U.S. labor market. This public debate motivated U.S. Congress to
take action. On October 22, 2004 the Congress passed the "American Jobs Creation Act of 2004" which
contains a provision to encourage profit repatriation back to the U.S. by domestic multinationals. Yet the
evidence linking offshore activities with falling domestic demand due to reductions in U.S. purchasing
power is still under dispute.
Several studies argue that there are no employment losses due to offshoring activities. Borga in her
paper "Trends in Employment at U.S. Multinational companies" [Borga, 2006] and Desai, Foley and
Hines in "Foreign Direct Investment and Domestic Economic Activity" [Desai, 2005] argue that expansion
of U.S. multinationals abroad stimulates job growth at home. In the same line, Mankiw and Swagel
concluded that foreign activity does not crowd out domestic activity [Mankiw, 2006].
A second group of studies reached the opposite conclusion. Brainard and Riker found evidence that
foreign affiliate employment substitutes at the margins for U.S. parent employment, and that there is
much stronger substitution between workers at affiliates in alternative low wage locations [Brainard,
2001]. Muendler and Becker reach similar conclusions analyzing German manufacturing industry
[Muendler, 20061.
These studies and many others focus their research on the macroeconomic implications of offshoring
practices. Most of their arguments can be grouped under one of the following categories:
Positive effects of offshoring on employment:
-
Growth in consumers' disposable incomes: by offshoring certain business processes
companies can reduce their operating costs and improve total factor productivity. In price
14
competitive markets these costs reductions could be translated into lower prices for final
goods and services, therefore increasing consumers' surplus.
The growth in consumers' surplus could increase consumption which will have a positive
impact on employment if it is mainly oriented towards demand for goods and services
produced in that same country. It is important to note that the new jobs created due this
increased demand may be completely different to the ones offshored.
Improved competitiveness and productivity in enterprises: the productivity increases due
to offshoring help enterprises become more competitive in the global market. Thanks to the
earlier mentioned cost reductions companies can decide to either reduce their prices to
serve a bigger market, or maintain previous prices and increase their profit margins. Both
strategies will have a positive effect on their profits.
The impact on employment will depend greatly on the strategy adopted by the enterprise
and the macro-economic environment.
Export growth: offshoring practices could influence exports in two ways. Empirical studies
show that foreign investment often complements trade and generates additional exports,
and indirectly job creation [Fontagn&, 1999]. In addition, the growth in incomes in the
offshore countries can create demand for products produced locally, affecting exports and
local employment.
Control of inflation: the costs reductions due to offshoring, if transferred to final prices, can
contribute to better control of inflation and a reduction of consumer prices. This control
over inflation allows flexible monetary policies and lower real interest rates which indirectly
stimulate investment and job creation.
15
Negative effects of offshoring on employment:
-
Fall in real wages: companies deciding to offshore certain business processes could see their
bargaining power increase when negotiating with local workers. Local labor will now need to
compete with their overseas counterparts, usually low-wage countries.
-
Deterioration in terms of trade: offshoring generally helps the economy of a country to the
extent that it leads to a fall in the price of imported goods or services. Nevertheless, this
could cause a deterioration of that country's terms of trade, mostly if the exported goods or
services are in a similar range.
-
Loss of tax revenues: companies who decide to offshore operations will stop generating
income taxes at home. In addition companies with operations overseas can move profit to
their subsidiaries in countries with lower corporate taxes, through appropriate price transfer
strategies.
-
Regional effects: even when offshoring has a minor effect at national level, it can have
serious consequences to particular regions, especially when its activity is the major
economic driver of the region. In this case workers will need to transition to other industries
or business with a possible reduction on their real wages [Ebenstein, 2011].
Evidence from U.S. Manufacturing
Arguably the most important development for the U.S. manufacturing industry in recent years
has been the rapid growth of trade. After being almost flat during the 1990s, the total value of imports
and exports of goods and services jumped from roughly 22 percent of GDP to 29 percent in 2010 (see
figure 5). Most of this increase is attributable to the growth of nonoil good imports.
16
U.S. Total Value of Imports and Exports of Goods and Services
32.00%
5,000,000
-
4,500,000
30.00%
4,000,000
28.00%
3,500,000
1 3,000,000
"
----
---
2,500,000
E
26.00%
-
-
2,000,000
Total Value in
-
%ofGDP
$millions
24.00
24.00%
--
L500,000----
-
22.00%
500,000
20.00%
0
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Figure 6: U.S total value of imports and exports of goods and services (U.S. Census Bureau)
This increase of nonoil imports explains why the U.S. manufacturing industry has lost more than six
million jobs in the last 30 years (see figure 6). Even after the 2001-2002 recession, manufacturing
employment declined by 20 percent, while manufacturing's share of employment in the economy fell
from 14 percent in 1997 to 9 percent in 2010.
Manufacturing Employment
20000
19000
1800
17000
16000
15000
14000
13000
-
--
Manufacturing Jobs in
thousands
12000
1J0u
G o8VA1;s
OG
10000
PT
M~~~
M
~ nMMMcn0
~ M; Ch
W-4"~ V-1M(
araq~o
V4 ol
r-4
a
Figure 7: U.S. manufacturing employment (Bureau of Labor Statistics)
Indeed the correlation between the total value of imports of goods and the number manufacturing jobs
is highly negative, -0.67. A more detailed analysis, including a simple regression model can be found in
Appendix 1.
17
This exodus of manufacturing jobs has also put significant downward wage pressure on U.S.
manufacturing workers, who now have to compete in a global market. In a recent study using current
population surveys, Avraham Ebenstein et al. calculated that a ten percent point increase in occupationspecific exposure to offshoring in low-wage countries is associated with a 0.73 percent decline in real
wages for workers performing routine tasks [Ebenstein, 2011]. In this same study the authors found that
when workers relocate from manufacturing to the service sector, they experience a significant wage
loss, between two and eleven percent.
While the U.S. manufacturing industry saw steep employment declines and significant downward wage
pressure, it also recorded strong output growth (see figure 7). This increase of production was due to
notable gains in manufacturing productivity.
Industrial Production Index Vs. Manuf 3cturing Jobs
,
20%
110
100
- - -
---
18%
- --------
-
-
-
-
-
-
90
80
---
-
162%
16%
--- 4
70
60
10%
-
Manu icturing Employment as
percen tage of all jobs
-- Industrlal Production Index
---40
6E
%
5
I(
bbN0A 45S
0 I
2
.0
20
41'
Figure 8: Industrial production Vs. manufacturing jobs (Bureau of Labor Statistics)
In conclusion, while U.S. manufacturing companies increased their productivity due to offshoring
practices, U.S. manufacturing workers were relegated to other industries. This displacement affected
their average income, lowering it, between two and eleven percent [Ebenstein, 2011]. The question is
who benefits from these productivity increases and how does this displacement of jobs overseas affect
the U.S. economy.
18
Offshoring Productivity Gains
Many studies have demonstrated the positive impact of offshoring practices on companies'
productivity and cost savings. Byrne et al. find sizable cross-country differences in the prices of
semiconductors with identical specifications [Byrne, 2009]. On average, they found that compared to
the U.S., prices were 40 percent lower in China and 25 percent lower in Singapore. Klier and Rubenstein
provided evidence that offshored aluminum production in Mexico was 19 percent cheaper than in the
U.S. [Klier, 20091. Nevertheless, it is not clear how these productivity increases are then propagated to
the economy.
Productivity Gains and CPI
Many studies [Mitra, 20071, [Global Insight, 2004] assume that the cost reductions due to
offshoring processes overseas are mostly translated into lower final product prices. These lower prices
affect equally all consumers who will then translate these savings into the economy in the form of new
consumption. Nevertheless, this assumption only holds for price competitive markets, less
commoditized business find less incentives in propagating this cost reduction into final prices.
Using a hypothetical example; a U.S. phone manufacturer decides to offshore part of its
production to China where wages are 50 percent lower. Because most of the demand for the
phone is local, the company has to ship back all parts manufactured in China, but even
considering the shipping and managing cost the company is able to produce the phones at a 10
percent discount. This cost reduction allows the company to reduce the phone price and at the
same time maintain their margins. This decision would benefit all consumers who will see their
purchasing power increase and will consume more of other local goods and services, which
indirectly will have a positive impact on local employment. But why the company would decide
to reduce the price of the phones? The phone manufacturer is a market leader, the brand
19
provides enough value to de-commoditize the terminal and the pricing has been set to capture
the maximum consumer surplus. Under these circumstances the company has few incentives to
propagate their cost savings into prices.
While commoditized business, like semiconductors or metal parts, were the pioneers of offshoring
practices, today business of all industries are looking to fragment their production process and offshore
an increasing share of the value chain. The offshoring of these decommoditized businesses will have
little impact on consumers surplus and therefore on employment generation. Even if some of the
corporate savings are translated into price declines, this would still not necessarily lead to higher living
standards for American households.
A good indicator of the continued lagging of growth in labor compensation behind growth in
productivity is the persistent gap between inflation in the prices of goods consumed by American
households (CPI) relative to the price of goods produced by American workers (GDPD).
Consumer Price Index Vs. GDP Deflator
800.0
-
------
700.0
50.0
'5400.0
-
300.0
--
C
GDPD
200.0
100.0
O.O
--
19671969197119731975197719791981198319851987198919911993199519971999200120032005200720092011
Figure 9: consumer price Index Vs. GDP Deflator (Bureau of Labor Statistics)
If we analyze both indexes normalized to 1967 price levels, we can see that prices of products produced
overseas and consumed by American families are rising more sharply than the GDPD, which is highly
correlated with U.S. worker wages, over the last three decades. This means that American households
20
tend to consume goods whose prices are rising relatively rapidly and therefore they could reduce their
living standards if the relative consumption of offshored to local products increases.
Nevertheless it is important to note that it is difficult to measure the real impact of offshoring in the CPI
as price declines associated with the shift of production to low-cost countries is only partially captured
in price index [Houseman, 2010]3.
Productivity Gains and Wages
Companies could decide to use the productivity gains achieved due to offshoring practices to
increase their employees' salaries. While plausible there is no economic reason for companies to
increase their employees' wages and we definitely see no evidence of it. Indeed the opposite seems to
be true. Workers at home will now need to compete at a global scale with their overseas counterparts.
This new competition from low wage countries will put downward pressure on local wages.
The same U.S. phone manufacturer who already has offshorde part of its production to China
reducing their operating cost by 10 percent is now evaluating the possibility of offshoring their
quality control process to the same Chinese region. They estimate they can reduce the cost of
this process by 10 percent but they fear the lack of skilled labor in the region so they postpone
the decision. Several months after their U.S. quality control employees ask for their yearly salary
increase but the direction now has fewer incentives to agree to their request. They can just
threaten them with offshoring the whole process to China.
In his book offshoring of American jobs Jagdish Bhagwati and Alan Blinder analyze the impact of
offshorability on occupation wages. By classifying professions by Blinder's offshorability index [Blinder,
Susan N. Houseman et al. in their paper "Offshoring and the State of American Manufacturing" analyzed how
price indexes like CPI do not fully capture the reduction in prices due to offshoring practices. This bias to the input
price indexes is proportional to the growth in share captured by the low-cost supplier and the percentage discount
offered by the low-cost supplier.
3
21
2008] and running a simple wage regression they found out that workers in the most offshorable jobs
were already paying an estimated 13 percent wage penalty, given their educational attainments
[Bhagwhati, 2009].
Companies may also use these productivity increases to increase their executives' compensation, but
again we see no economic reason for it and an analysis from Forbes by Scott de Carlo showed no
evidence, at least in the last decade (see figure 9).
60%
CH$ANGE N TOTAL PAY
s0
40
30
20
t0
0
-to
-20
-30
-40
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Figure 10: CEO pay vs. company earnings (Forbes.com)
Productivity Gains and Company Profits
Companies could use these productivity gains to increase their profits, and either distribute
them to their shareholders in the form of dividends or keep them in the form of retained earnings.
Companies as profit maximizers would not reinvest the profits acquired due to offshoring practices if
their return over investment is not higher than their cost of capital. Therefore using the productivity
increases to increase profits would be their option by default.
The phone manufacturer has been able to save up to $100 million in operating costs due to the
relocation of its production in China. The CEO is extremely happy and is thinking on how to invest
this money. They already evaluated the possibility of reducing the phone price and increasing
wages, but the CEO finds no incentives in doing that. They do not need to increase production as
22
they do not foresee a rise in demand. He thinks about giving an extraordinary dividend to the
shareholders of the company but as his CFO does not recommend it because in that case he will
need to repatriate these profits and pay an extra 10 percent in taxes, he finally decides to keep
this money abroad and leave it in its Chinese subsidiary balance sheet in the form cash
equivalents, until it is reinvested in places other than the U.S.
The degree to which productivity gains go to enhanced corporate profits is difficult to estimate.
However, there seems to be evidence that companies are using most of their offshoring gains to
improve their bottom lines. Reviewing data from the Bureau of Economic Analysis we can see how
during the last decade corporate sector profits grew three times faster than personal income (see figure
11). While this entire shift in the income distribution is surely not driven by offshoring, this data is
exactly in line with what one would expect if offshoring was already a major feature of the U.S.
economy. A more detailed analysis of this tendency can be found in Appendix II.
Corporate Profit vs. Personal Income Growth
18.00%16.00-14.00%12.00%6
--
10.006
a Corporate
Profit Growth
n Personal Income Growth
8.00%
0.%
1975-2000
2000-2011
Figure 11: Corporate profit vs. personal income growth (Bureau of Economic Analysis)
23
Another useful indicator that can be explained by this lack of reinvestment of corporate profits is the
amount of cash in companies' balance sheets. According to JP Morgan during 2012 companies in the
S&P 500 have increased their cash balances by 14%, reaching a historic high of $1.5 trillion. While this
increase in companies' cash balances is mainly driven by the economic deceleration and financial
instability, it also affected by the use of the profits due to offshoring practices.
Macroeconomic Implications
Many studies have documented the positive impact of offshoring practices on productivity
[Mitra, 2007], [Global Insight, 2004], [Houseman, 2010]. However there is little consensus about how
these productivity gains affect the U.S. labor market. One of the most cited reports, "Offshoring: Is it a
Win-Win Game?" from the McKinsey Global Institute [MGI, 2003] estimated the return over investment
of every dollar offshored between 12 and 14 percent (see figure 11).
Value polentMi to the U.S. from $1of spend offshored to Iada 2002
Dollars
Further value ceation potential through
Increased global competitiveness of
US. business
Multiplier effect of increased national savings
-1.12-1.14
0.4-GA?
0,67
i
0.58nrr,
Savings accrued
to U.S. investors
andor
customers
Import of U.S
goods and
services by
providers in
india
r--A
- -
Transfer of
profits by US.
providers In low*age country
to parent
Tota direct
benefit retained in the US.
Value from U.S.
labor
reemployed*
(conservathe
estirnate)
_y-Current direct benefit*
Potential for
total value
creation in the
U.S. economy
(conservative
estimate)
Potential
future benefit
Estimated based on historical roornploment trends from job b"s through trade in the U.S. economy
Source: McKinsey Global tastitute
FIgure 12: Offshoring value potential accrued to the U.S. (McKinsey Global Institute)
24
The detailed breakdown of these benefits in McKinsey's report is the following:
-
Fifty-eight cents saved in corporate costs: cost savings represent the largest form of
economic value captured. A more competitive cost position will lead to higher profitability,
increased valuations and help keep U.S. companies highly competitive in the world
economy.
-
Five cents due to the U.S. exports to the country where employment has been offshored:
for every dollar of spend offshored, offshore services providers buy an additional goods and
services from the U.S. economy, thereby creating exports and extra revenue for the U.S.
economy. Providers in low-wage countries require U.S. computers, telecommunications
equipment, other hardware and software.
-
Four cents repatriated to U.S. multinationals from the offshored location: Several
providers serving U.S. offshoring market are incorporated in the United States. These
companies could repatriate their earnings back to the U.S. Nevertheless companies find few
incentives for repatriating offshore profits, mainly due to the high corporate tax rates in the
U.S. A good proof of it is the recent debate on tax holidays for corporate profit repatriation
and the more than a $1 trillion of offshore earnings sitting in tax havens based on
Bloomberg's estimations.
-
Forty-six cents on average due to the re-employment of U.S. workers whose jobs have
been offshored: As low value-added service is sourced from overseas, U.S. workers
previously engaged in providing those services are freed up to take other jobs. McKinsey
argues that there is empirical evidence that that services workers find employment more
quickly than do manufacturing workers, primary affected by offshoring practices, and
therefore the shift towards a service oriented economy generates additional value.
25
Although, as services offshoring gains relevance the value due to worker re-employment can
be significantly reduced.
While MGI report is one of the most referenced analyses it fails to demonstrate how the firm-level
benefits due to offshoring practices are translated into net economy-wide gains.
First the numbers of the analysis are most probably biased as it is based on a proprietary data set of selfselected firms that have chosen to offshore some processes specifically because offshoring provided
clear economic gains. Second, the report does not recognize that American workers appear as net
losers. Only if 80 percent of the savings accrued to U.S. companies is transferred to price reductions,
U.S. workers will maintain their purchasing power and as I have discussed in the previous section there
is no evidence that such amount of savings to companies is been translated into lower consumption
prices.
Furthermore, the cost savings in the form of lower wages, economies of scale and proximity to new
markets due to offshoring to low-wage countries is 58 cents, while U.S. workers receive only 47 cents in
labor earnings after the process. This implies a total loss of 11 cents for labor earnings for each dollar of
production that is offshored, money that represents a redistribution of income away from U.S. workers.
This redistribution is in line with the income inequality increase in the U.S. (see figure 12).
Share of Total After-Tax Income, by Income Group, growth since 1979
14(100%
.2
6000%-21st
Lowest Qintile
t8Ofth Percentiles
40A00
81st to 99th Percentiles
-Top
1 Percent
ore%
-20.00%#
-40.00%
-60.00%
Figure 13: Share of Income, by income group, growth since 1979 (Congressional Budget Office)
26
The MGI report also fails to account for the increased imports resulting from offshoring. This is of crucial
importance as the U.S. economy needs to finance these new imports by increasing exports, which could
be instead employed to promote U.S. consumption or investment. By focusing only on the positive
effects of offshoring on companies MGI ignores how the net increase in imports entails hidden costs to
the economy derived from transferring domestic resources to finance increased imports.
Like the MGI, many studies ignore the aggregated effect of increased imports due to offshoring
practices. This increase in imports does not only affect U.S. balance of payments, like Nobel Laureate
Paul Samuelson explained in the Journal of Economic Perspectives, a rapid increase in productivity in
offshore countries can result in a reduction of U.S. income through the terms of trade 4 [Samuelson,
2004].
Offshoring - Fading Advantage?
There has been some discussion recently about the fading benefits of offshoring. In "The
Economist" January 2013 edition there are several articles asserting that companies are rethinking their
offshoring strategies due to lower benefits from offshoring practices. The Economist argues that the
rising shipping costs and the diminishing wage differentials between the U.S. and main offshoring
countries make offshoring practices less appealing and companies are even thinking about reshoring
their offshored business processes. Nevertheless there seems to be little evidence of these phenomena.
The Baltic Dry Index, an indicator of the cost paid to ship raw materials on global markets and an
important component of input costs, is on a downward trend since 2008 and in the last three years it
The "terms of trade" refer to the prices overseas purchasers pay for U.S. exports relative to the prices U.S.
residents pay for imports. If U.S. exports increase prices on foreign markets or U.S. import prices drop, the terms of
trade for the U.S. improve, consumers in the U.S. are able to buy more goods given its current income and
productivity. If on the other hand U.S. exports decrease or imports become more expensive, U.S. terms of trade
deteriorate and therefore U.S. consumers see their purchasing power reduced given current income and
productivity.
4
27
has dropped by 75 percent (see figure 14). This means that the price of shipping goods across the globe
has been decreasing at least during the last three years.
.212
OCT
AM
21R.
AI
CT
K12
APR
.222?
OCT
211
APR
Figure 14: Baltic Dry Index 2011-2013 (Bloomberg.com)
In addition the Economist uses production costs predictions from the 2011 Alix Partners "U.S.
Manufacturing-Outsourcing Index" [Alix Partners, 20111. The index forecasts that the manufacturing in
China will be as expensive as manufacturing in the U.S. by 2015 (see figure 15), eliminating any labor
arbitrage opportunity. Nevertheless these forecasts assume a 30 percent annual wage rate increase in
China, a 5 percent annual appreciation of the Renminbi against the Dollar and a 5 percent annual
increase of shipping costs. While plausible it seems unlikely that all these assumptions will hold for the
next three years.
o
90%
U
o
90%
70%
60%
-
-+.-
U.'(as
200
2006
e
-de- Mexco
23,7 2Y0
..-
Chra
-
-
a
2009 2C!3 2011 202 201 204 2I
Figure 15: Manufacturing outsourcing cost Index (AlIx Partners)
28
Furthermore, even if Chinese manufacturing costs reach U.S. levels by 2015, Axis Partners forecast that
production costs in Mexico and India will remain stable at 80 percent U.S. costs, making them still
attractive as offshoring destinations. Axis Partners report does not analyze manufacturing costs in even
lower wage countries like Vietnam, Indonesia and the Philippines, and even if they have not achieved
the scale, efficiency and supply chain yet, they are becoming popular offshoring destinations.
It is important to note that currency exchange rate, the most sensitive variable on Alix Partners model,
has been favoring U.S. international competitiveness in the last four years. The U.S. Dollar has
depreciated against the Mexican Peso and Chinese Renminbi by 10 percent since 2009 (see figure 16),
making U.S. labor more competitive in the international landscape. Nevertheless this devaluation, fueled
by an extraordinary low interest rate and three rounds of quantitative easing, it is not likely to continue
in the long term.
*USocNY -9,
eU SDMXN te7%
7
15%
10%
2010
2011
2012Z
Figure 16: USD/CNYMXN,INR exchange rates (Google Finance)
To exemplify this new reshoring interests, The Economist uses the example of General Electric, who will
hire 1,100 IT engineers for its Michigan office to be closer to their business user and to develop new
applications for customers more quickly. Nevertheless this decision of hiring local teams to work closely
with business users is by no means enough to sustain that General Electric is redefining their offshoring
strategy as they still develop half of their ITwork by outside providers, most of them located in India.
29
The Economist also uses the example of General Motors, who decided to reverse its rule of outsourcing
90 percent of its IT work, because "IT has become more pervasive in our business and we now consider
it a big source of competitive advantage". Nevertheless the decision of cancelling several of their
outsourcing contracts with Indian providers does not necessarily mean that those jobs are going to be
reshored. Indeed many companies are opening their own IT hubs in India, where they can get the
advantages of a proprietary technology division, an important technology ecosystem where they can
easily find skilled workers and the lower costs associated with a developing country.
Finally the economist uses a survey from Alix Partners, McKinsey and Hackett to show that companies
today are less willing to offshore manufacturing processes compared to three years ago (see figure 17).
Nevertheless this small change of only three percent together with the punctual reshoring actions may
also reflect an attempt to placate public opinion as the offshoring debate is hurting companies image.
Furthermore the percentage of companies willing to offshore their production is still higher than the
percentage of companies thinking about reshoring.
Companies' intentions to change manufacturing source, worldwide, %of capacity
2009-11
26%
2012-1'
1 6%
23%19%
9_/
6%
Movebeen
high-costcountries
#eshore
9%
Figure 17: Companies' Intentions to change manufacturing source (The Economist)
It is also interesting to note the significant increase of companies thinking about moving their
production between low-cost countries. As countries like Vietnam, Philippines or Indonesia start to
consolidate as offshoring destinations, we can expect an important shift due to even lower production
costs. This competition between low and lower-cost countries will be a interesting phenomenon to
follow in the next years.
30
Conclusion
Over the last years there has been a public debate about the possible effects of increased
offshoring practices on the U.S. economy and more specifically on the U.S. labor market. This public
debate motivated U.S. Congress to take action. On October 22, 2004 the Congress passed the "American
Jobs Creation Act of 2004" which contains a provision to encourage profit repatriation back to the U.S.
by domestic multinationals. Yet the evidence linking offshore activities with falling domestic demand is
still under dispute.
While most there is significant evidence that offshoring has provided substantial cost savings and
improved profits for companies engaging in this practices, it is still not clear how these benefits are
propagated into the broader economy. Many authors [Mitra, 20071, [Global Insight, 20041, assume that
these cost savings are mostly transformed into lower consumption prices, benefiting equally all
consumers and increasing their purchasing power. This theoretical increased purchasing power would
have a positive impact in employment if oriented towards demand for local goods and services.
Nevertheless a careful analysis of the increasing gap between inflation in the prices of goods consumed
by American households (CPI) relative to the price of goods produced by American workers (GDPD)
provides evidence against this theory (see figure 9). The fact that prices of products produced overseas
and consumed by American families are rising more sharply than the GDPD over the last three decades
is also consistent with the data about corporate sector profit growth (see figure 11) as corporate sector
profits grew three times faster than personal income.
If productivity gains are not transferred into final lower prices, U.S. workers become net losers in
offshoring practices as they see their wages decrease [Ebenstein, 2011]. In addition this decrease on
offshorable worker wages will also increase within-country income inequality. This prediction is aligned
with Stolper-Samuelson theorem "Trade increases the real return to the factor that is relatively
31
abundant in each country and lowers the real return to the other factor" [Samuelson, 1941]. This means
that in the U.S., with an abundance of skilled unoffshorable labor, wages of workers should increase
relative to unskilled and offshorable workers and inequality should rise with offshoring.
The issue of offshoring requires a careful response from policy makers as its potential benefits are not
being equitably distributed among firms and workers. Any policy response must therefore be well
informed about the costs and benefits of offshoring practice and a new social contract needs to be put
given to U.S. workers to ensure they take advantage of the benefits of offshoring.
Directions for Further Research
Off-shoring is a difficult and complex phenomenon. It produces many and widespread economic
impacts, with U.S. employment and workers' wages being among the most sensitive. One of the main
difficulties stems in measuring the extent of offshoring in the U.S. Yet No comprehensive data exist on
the number workers who have lost their jobs as a result of the movement of work outside the U.S. The
only regularly collected statistics on jobs lost due to offshoring come from the U.S. Bureau of Labor
Statistics series on extended mass layoffs. Nevertheless these statistics underestimate the number of
jobs lost to offshoring as they exclude small companies and only focus on large layoffs. In addition it is
difficult to quantify the benefits accrued to a company from the enhanced competitiveness due to
offshoring practices, and how they are distributed among the different parties involved: consumers,
shareholders, employees of the firm and retained earnings.
To gain more insight about how this enhanced competitiveness is distributed among consumers,
shareholders and employees it would be interesting to select an industry and compare a set of
companies that significantly rely on offshoring practices against a set that does not. If we can isolate the
productivity gains due to offshoring we can then find out how they are distributed; in the form of lower
32
product prices which benefits consumers, in the form of higher profits which benefits shareholders, or in
the form of higher wages which benefits employees.
Furthermore it would be interesting to analyze the drivers of this behavior to develop the appropriate
regulatory and policy responses. Corporate taxes will have a significant influence on companies' decision
of reinvesting abnormal profits obtained abroad, but there may also be other factors that will shape
companies' behavior like market growth, labor availability and wages among others.
33
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36
Appendix I: Imports of Goods and Manufacturing Jobs - Correlation
Analysis
Correlation between Good Imports and Employment
17000
$2,200,000
16000
$2,000,000
14000
-
-
$1,800,000
13000
CL
E $1,600,000
12000
_
--
'$1,400,000
-
----
11000
-
-1--
-4 $1,200,000
-
Total Value of Imports of Goods
--
Manufacturing Jobs
9000
80oo
$1,000,000
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Figure 18: Correlation analysis between imports of goods and manufacturing jobs
Table 1: Linear Regression Analysis for number of manufacturing mobs
18000
.4i
Unear Fit
Manufactuling Jobs = 20214.336 -0.0036545*Total Value of
Imports of Goods
17000-
J
16000 -
summary of Fit
15000-
RSquare
-RSquare
0.448242
Root Mean Square Error
Mean of Response
Observaticns (or Sum Wgts)
i
0t
1300012000 -ak
11000
1100000
0.498402
Adj
14000-
I
1300000
1500000
1700000
Total Value of
Impods of Goods
1900000
2100000
1368.323
14507.51
12
4AnalyssofVarance
Source
Model
Error
C. Total
OF
1
10
11
Squares Mean Square
18603806
18603806
18723090
1872309
37326896
Term
Intercept
Total Value of Imports of Goods
F Ratio
9.9363
Prob3-F
0.0103*
Esanate Std Error
20214.336 1853122
-0.003654 0.001159
t Rato Pro"pit
10.91 <.0001*
-315 0.0103*
37
Appendix II: Personal Income vs. Corporate Profit Growth Analysis
We can see how corporate profit growth was very much aligned to personal income growth between
1976 and 2000. Nevertheless since 2002, corporate profits grew at a much higher rate, increasing the
gap between wages and corporate profits.
Personal Income vs. Corporate Profit Growth
1400.00%
-
1200.00%
1000.00%
-
-
-
800.00%
-
Personal Income Growth Since
1976
-0.%
Corporate Profit Growth since
1976
-
400.00%
200.00%
0.00%
Figure 19: Capital gains vs. personal income since 1976 (Bureau of Economic Analysis)
To corroborate the reliability of this analysis we need to find if the correlation between personal income
and corporate profit is significant. For that purpose I have analyzed the correlation analysis between
corporate profit and personal income growth. As wages are stickier than corporate profits I have
introduced time delays.
0 years delay
1 year delay
2 years delay
3 years delay
0.019
0.418
0.227
0.090
As we can see the highest correlation appears when we compare corporate profit growth with personal
income growth of the next year.
38
Personal Income vs. Corporate Profit Growth
40.00%
30.00%
20.00%
-5 10.00%
-Personal
Income Growth
0.
U.LAJW
Corporate Profit Growth
0
r-J
-10.00%
-20.00%
-30.00%
Figure 20: Personal Income vs. corporate profit growth over time (Bureau of Economic Analysis)
A simple linear regression shows that there is a statistically significant correlation between the two
variables.
15.00%
d: Linear Fit
-
Personal Income Growth = 0.0554633 + 0.1011947*Corporate
Profit Growth
10.00%-
,a Summary of Fit
RSquare
RSquare Adj
Root Mean Square Error
0
5.00%-
(L
Mean of Response
Observatons (or Sum Wgts)
C
0.00%-
it
Analysis of Variance
Source
-5.00%-20.0%
30.0%
0.0%10.0%
Growth
Profit
Corporate
0.175067
0.150804
0.0302
0.063728
36
Model
Error
C. Total
SUm of
DF
Squares Mean Square
0.006581
1 0.00658092
0.000912
34 0.03101001
35 0.03759093
FRatio
7.2155
Prob F
0.0111*
a, Parameter Estmates
Term
Intercept
Corporate Profit Growth
Estimate
Std Error
0.055433
0.1011947
0.005899
0.037673
t Ratio Prob>lti
9.40
2.69
<.0001*
0.0111*
39