1. A survey of the controversy over offshoring: On the one hand, N. Gregory Mankiw’s famous statement that “outsourcing is just a new way of doing international trade.” On the other hand, there is general opposition to offshoring by both political parties.
Note in particular the Obama/Clinton proposal to eliminate tax breaks for firms earning profits abroad: Profit earned by foreign subsidiaries of U.S. firms are not taxed by the U.S. as long as they limit their activities to overseas and are not on the books of the U.S. company. President Obama claims eliminating his tax break would reduce incentives for firms to move jobs overseas. Matthew Slaughter’s response: U.S. multinationals create many jobs at home; their ability to do so depends upon their access to offshoring.
Offshoring is controversial and is often the topic of political debate. In February 2004 the first quote at the beginning of this chapter appeared in the Economic Report of the President. The writer of that sentence, Harvard economist N. Gregory Mankiw, who was chairman of the Council of Economic Advisors, also said that “outsourcing is just a new way of doing international trade. More things are tradable than were tradable in the past, and that’s a good thing.” Those comments were widely criticized by the Democrats and Republicans alike, and Professor Mankiw later apologized in a letter to the House of Representatives, writing, “My lack of clarity left the wrong impression that I praised the loss of U.S. jobs.”
In the Democratic primary elections of 2007 and in the presidential campaign of 2008, this topic came up again. Senators Barack Obama and Hillary Clinton both promised that, if elected, they would end tax breaks for companies earning profits overseas:14
Obama, Nov. 3, 2007: When I am president, I will end the tax giveaways to companies that ship our jobs overseas, and I will put the money in the pockets of working Americans, and seniors, and homeowners who deserve a break.
Clinton, Nov. 19, 2007: And we are going to finally close the tax loopholes and stop giving tax breaks to companies that ship jobs overseas. Enough with outsourcing American jobs using taxpayer dollars.
To what tax breaks were Mr. Obama and Ms. Clinton referring? The United States taxes corporate profits at 35%, a high rate when compared with the corporate tax rates in other countries. Profit earned by overseas subsidiaries of U.S. companies, however, goes untaxed by the U.S. government provided that such a subsidiary stays overseas and does not appear on the books of the parent company in the United States. That tax provision gives U.S. multinational companies an incentive to use these funds overseas for further investment in the subsidiary, but it does not necessarily lead them to move jobs overseas in the first place. Eventually, when these profits are moved back to the parent company in the United States, they are taxed at the normal rate.
President Obama recently announced that he would follow through on his campaign pledge to end the tax break on overseas profits of multinational firms, as indicated by the quotation at the beginning of this chapter: “The American people deserve a tax code that…lowers incentives to move jobs overseas, and lowers tax rates for businesses and manufacturers that are creating jobs right here in the United States of America. That’s what tax reform can deliver.” That change in policy does not have much support from economists. One strongly worded response comes from Matthew Slaughter, Professor at Dartmouth College, in Headlines: How to Destroy American Jobs. He cites evidence that U.S. multinationals have added roughly as many jobs in the United States as they have added abroad, and argues that these jobs in the United States depend on the ability of the multinationals to offshore other jobs.
The chapter has provided an analytical structure to understand offshoring. This assertion may still provoke debate, so this is perhaps a good place to invite class discussion about the merits of offshoring.
In addition to the employment statistics, Professor Slaughter also cites evidence that U.S. multinational firms conducted nearly 90% of all private-sector R&D in the United States, and that these firms account for the majority of U.S. productivity gains.
Direct evidence on the positive impact of offshoring on productivity comes from another source, a 2005 study of the offshoring of material inputs and services by U.S. manufacturing firms in the 1990s.15 Over the eight years from 1992 to 2000, that study found that service offshoring can explain between 11% and 13% of the total increase in productivity within the U.S. manufacturing sector. In addition, the offshoring of material inputs explains between 3% and 6% of the increase in manufacturing productivity. Combining these effects, offshoring explains between 15% and 20% of overall productivity growth in the manufacturing sector. Evidence of this type makes economists reluctant to impose additional taxes on U.S. companies that engage in offshoring, because of the possible adverse effects on productivity here in the United States.
On the other hand, changes in economic conditions that lead firms to voluntarily bring some activities back home would be viewed favorably by most economists. There is some evidence that economic conditions have changed in that direction, as described in Headlines: Caterpillar Joins “Onshoring” Trend. In 2010, General Electric joined this trend by moving the manufacturing of a water heater from China to Louisville, Kentucky, and in late 2012 Apple Computer announced that it would be bringing some jobs back to the United States by building some Macintosh computers locally.16 A combination of higher wages in China, higher transportation costs due to rising oil prices, and U.S. unions that are more willing to compromise with management, has led these and other companies to “onshore” their activities back to the United States. This trend has also occurred because companies are finding that communication with overseas suppliers can be slow and costly.
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Slaughter’s editorial in the WSJ.
This article argues that offshoring by multinational companies supports an increase in jobs at home, and that these jobs would be lost by policies to restrict offshoring.
Deep in the president’s budget released Monday [February 1, 2010] appear a set of proposals headed “Reform U.S. International Tax System.” If these proposals are enacted, U.S.-based multinational firms will face $122.2 billion in tax increases over the next decade. This is a natural follow-up to President Obama’s sweeping plan announced last May [2009] entitled “Leveling the Playing Field: Curbing Tax Havens and Removing Tax Incentives for Shifting Jobs Overseas.”
The fundamental assumption behind these proposals is that U.S. multinationals expand abroad only to “export” jobs out of the country. Thus, taxing their foreign operations more would boost tax revenues here and create desperately needed U.S. jobs. This is simply wrong. These tax increases would not create American jobs, they would destroy them.
Academic research, including most recently that done by Harvard’s Mihir Desai and Fritz Foley and University of Michigan’s James Hines, has consistently found that expansion abroad by U.S. multinationals tends to support jobs based in the U.S. More investment and employment abroad are strongly associated with more investment and employment in American parent companies.
When parent firms based in the U.S. hire workers in their foreign affiliates, the skills and occupations of these workers are often complementary; they aren’t substitutes. More hiring abroad stimulates more U.S. hiring. For example, as Wal-Mart has opened stores abroad, it has created hundreds of U.S. jobs for workers to coordinate the distribution of goods worldwide. The expansion of these foreign affiliates—whether to serve foreign customers, or to save costs—also expands the overall scale of multinationals.
Expanding abroad also allows firms to refine their scope of activities. For example, exporting routine production means that employees in the U.S. can focus on higher value-added tasks such as R&D, marketing and general management. The total impact of this process is much richer than an overly simplistic story of exporting jobs. But the ultimate proof lies in the empirical evidence.
Consider total employment spanning 1988 through 2007 (the most recent year of data available from the U.S. Bureau of Economic Analysis). Over that time, employment in affiliates rose by 5.3 million—to 11.7 million from 6.4 million. Over that same period, employment in U.S. parent companies increased by nearly as much—4.3 million—to 22 million from 17.7 million. Indeed, research repeatedly shows that foreign-affiliate expansion tends to expand U.S. parent activity….
The major policy challenge facing the U.S. today is not just to create jobs, but to create high-paying private-sector jobs linked to investment and trade. Which firms can create these jobs? U.S.-based multinationals. They—along with similarly performing U.S. affiliates of foreign-based multinationals—have long been among the strongest companies in the U.S. economy.
These two groups of firms accounted for the majority of the post-1995 acceleration in U.S. productivity growth, the foundation of rising standards of living for everyone. They tend to create high-paying jobs—27.5 million in 2007…. And these firms also conducted $240.2 billion in research and development, a remarkable 89.2% of all U.S. private-sector R&D.
To climb out of the recession, we need to create millions of the kinds of jobs that U.S. multinationals tend to create. Economic policy on all fronts should be encouraging job growth by these firms. The proposed international-tax reforms do precisely the opposite.
Source: Matthew J. Slaughter, “How to Destroy American Jobs,” Wall Street Journal, February 3, 2010, p. A17.
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An example of a U.S. firm bringing its production back home.
Some American companies have found it advantageous to take activities they had previously shifted overseas and move them back home, in what is called “onshoring.”
Caterpillar, Inc. is considering relocating some heavy-equipment overseas production to a new U.S. plant, part of a growing movement among manufacturers to bring more operations back home—a shift that will likely spark fierce competition among states for new manufacturing jobs. The trend, known as onshoring or reshoring, is gaining momentum as a weak U.S. dollar makes it costlier to import products from overseas. Manufacturers are also counting on White House jobs incentives, as well as their ability to negotiate lower prices from U.S. suppliers who were hurt by the downturn and willing to bargain.
After a decade of rapid globalization, economists say companies are seeing disadvantages of offshore production, including shipping costs, complicated logistics, and quality issues. Political unrest and theft of intellectual property pose additional risks. “If you want to keep your supply chain tight, it’s hard to do that with a 16-hour plane ride from Shanghai to Ohio,” said Cliff Waldman, an economist with the Manufacturers Alliance/MAPI, a public policy and economics research group in Arlington, Virginia.
General Electric Co. said last June it would move production of some water heaters from China to its facility in Louisville, Kentucky, starting in 2011. A GE spokeswoman said a 2005 labor agreement under which new employees would be paid $13 an hour, [instead of the] nearly $20 an hour [they once made], “enabled us to be more competitive.”
Source: Kris Maher and Bob Tita, “Caterpillar Joins ‘Onshoring’ Trend,” The Wall Street Journal, March 11, 2010, p. A17. Reprinted with permission of The Wall Street Journal, Copyright © (2010) Dow Jones & Company, Inc. All Rights Reserved Worldwide.
2. The Future of U.S. Comparative Advantage
The flip side of offshoring is that U.S. firms find it advantageous to keep other activities at home. This means that the threat of offshoring is overstated, since it supports employment in other domestic production activities.
Just as in our model of this chapter, the recent “onshoring” trend shows that companies usually avoid offshoring all activities from the United States: the extra communication and trade costs involved need to be balanced against the lower foreign wages to find the right amount of offshoring. Most often companies find it advantageous to keep some activities in the United States (such as those using more highly skilled labor or relying on close communication with customers) and move other activities abroad (using less skilled labor and involving more routine activities). The fear sometimes expressed in the popular press that offshoring threatens the elimination of most manufacturing and service jobs in the United States is overstated. The ability to offshore a portion of the production process allows other activities to remain in the United States.
A good example to illustrate this point is the offshoring of medical services. The transcription of doctors’ notes from spoken to written form was one of the first service activities offshore to India. Since then, other types of medical services have also been offshored, and a New York Times article in 2003 identified the reading of X-rays—or radiology—as the next area that could shift overseas: “It turns out that even American radiologists, with their years of training and annual salaries of $250,000 or more, worry about their jobs moving to countries with lower wages, in much the same way that garment knitters, blast-furnace operators and data-entry clerks do…. Radiology may just be the start of patient care performed overseas.”17
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It turns out, however, that the types of radiology jobs that can potentially be transferred overseas are very limited.18 Radiology is a high-paying profession precisely because the reading of X-rays is difficult and takes years of training and practice to perfect. X-rays are normally analyzed in the same hospital where the patient is being treated. In a few cases of specific diseases, such as the reading of mammograms for breast cancer, it is possible that the work can be outsourced (i.e., performed outside the hospital), either domestically or offshore. Firms known as “nighthawks” already provide some outsourcing services to hospitals, principally during nighttime hours. Nighthawk firms are headquartered in the United States but have radiologists at offshore sites, including Australia, Israel, Spain, and India. These nighttime services allow smaller hospitals that cannot afford a full-time night radiologist to obtain readings during evening hours, and allow the nighthawk firms to keep their radiologists fully employed by combining the demand from multiple hospitals.
The offshoring to nighthawk firms is a natural response to the round-the-clock demand for hospital services but less-than-full-time demand for radiologists on-site. Often these nighttime services are used only for preliminary reads, leading to immediate treatment of patients; the X-ray image is then read again by the staff radiologist in the United States the next day. That is, in many cases, the services being outsourced are not directly competing for the daytime jobs but, instead, are complements to these U.S. jobs.
Radiology is under no imminent threat from outsourcing because the profession involves decisions that cannot be codified in written rules. Much of the radiologist’s knowledge is gained from reading countless X-rays with complex images and shadows, and the ability to recognize patterns cannot easily be passed on to another person or firm. It follows that the work cannot be offshored except for the nighttime activities of nighthawk firms, which actually work in conjunction with the daytime activities in major hospitals.
In every profession there will always be jobs that cannot be performed by someone who is not on-site. For many of the service activities listed in Table 7-2, the United States will continue to have comparative advantage even while facing foreign competition. In many manufacturing industries, the United States will continue to maintain some activities at home, such as R&D and marketing, even while shifting a portion of the production process abroad. Finally, we should recognize that the ability to offshore to Mexico or India ultimately makes the U.S. companies involved more profitable and therefore better able to withstand foreign competition.