April 2016 | By: John Marthinsen and Nestor Azcona

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Offshoring has acquired a bad reputation. Major U.S. concerns are that it’s unfair, takes advantage of artificially low foreign wages, encourages managed exchange rates, and promotes substandard labor conditions. Critics also say it increases the U.S. unemployment rate and reduces the nation’s income. How can one make sense of the issues behind these accusations?

It’s helpful, first, to distinguish between outsourcing and offshoring. “Outsourcing” is a general term that refers to the act of transferring operational (e.g., production) and/or nonoperational (e.g., back office) responsibilities, which were once handled within a company, to outside vendors that might be located at home or abroad. By contrast, “offshore outsourcing” or “offshoring,” refers to transferring operational and/or nonoperational responsibilities that were once handled by domestic workers to companies located in foreign countries.

Perceptions often set up a “domestic-versus-foreign’ (i.e., “us-versus-them”) issue, where we win only if they lose and vice versa. By contrast, domestic outsourcing appears to be more benign because it is perceived as an “us versus us” issue, where “we” both win and lose, resulting a zero net loss to the nation.

Proponents of offshoring argue that it lowers costs and can save thousands of jobs by making struggling companies competitive again and avoiding their failure. Critics say that offshoring is nothing more than the flagrant exportation of U.S. jobs to foreign countries.

Who is right? There are valid arguments on both sides, but analysis shows that the long-term effect is largely beneficial to the U.S. economy—and inevitable.

Let’s look closely at the reasons why:

Does Offshoring Increase the Unemployment Rate?

Although offshoring can cause some workers to lose their jobs, we should take a wider view when considering its effects on the national unemployment rate. The U.S. economy is considered to be at “full employment” when the unemployment rate is close to 5 percent. Normally, an unemployment rate that is lower than that causes bottlenecks in the labor market and inflationary pressures. In January 2016, the U.S. unemployment rate stood at 4.9 percent. Nevertheless, many still worry that the negative effects of the 2007–2009 financial crisis are still with us. And, due to the way labor statistics are calculated, current figures mask the high number of part-time workers, slow growth in middle-class wages, and a low labor force participation rate.

One important counterweight is that, when the unemployment rate rises above its full-employment level, the government and the central bank typically respond by implementing expansionary fiscal and monetary policies to increase demand (e.g. raising government spending, reducing taxes, and/or lowering interest rates). Although it may take awhile, those actions should help bring the unemployment rate back toward the full-employment level. Therefore, goes the argument, any effects that offshoring might have on the nation’s unemployment rate should be temporary. Most workers who lose their jobs due to offshoring (or other causes) should, eventually, find new ones. Of course, the downside is that many of those jobs may not be as fulfilling as the old ones or pay the same salaries. Consequently, for those worried about offshoring, the growing unevenness of income distribution should be a greater concern than unemployment.

Does Offshoring Decrease National Income?

A nation’s income is the sum of the earnings and returns on labor (wages and salaries), entrepreneurship (profits), natural resources (rent), and capital (interest). Let’s use Massachusetts as the sample state for our analysis and assume that 10,000 residents lose their jobs due to offshoring. The U.S. Bureau of Labor Statistics reports that the “overall average” Massachusetts salary in October 2015 was about $58,000. During the same month, the state’s unemployment rate was 4.6 percent, which was close to full employment. Therefore, let’s bias our results against offshoring by assuming that the unemployment rate among those who lost their job due to offshoring was approximately 10 times larger (i.e., 50 percent), and those who found new ones were paid only one-half of what they previously earned. Furthermore, assume that the salary of the workers in the country that “received” the offshored jobs was just 10 percent of the U.S. salary (i.e., $5,800 per year).

Given these highly skewed assumptions, Massachusetts and U.S. income would have increased by $87 million due to offshoring. Here’s why. U.S. income would have fallen by $580 million when 10,000 workers lost their $58,000 jobs due to offshoring, but one-half of them (5,000) would have found jobs at one-half the salary ($29,000), thereby offsetting the decline in U.S. income by $145 million. Finally, profits of the U.S. offshoring companies would have increased by $522 million due to reductions in their expenses. Labor services that formerly cost $580 million now cost only one-tenth of that amount (i.e., $58 million), causing profits to rise by $522 million. The net effect of all these changes is for U.S. income to increase by $87 million. Exhibit 1 summarizes these results. If we had used the average salary for “Computer and Information Systems Managers,” which is $145,000, instead of using the overall average salary of $58,000, the net increase in income would have been $217.5 million.

Exhibit 1: Summary of Results If 10,000 U.S. Workers Lose Their Jobs to Offshoring

Reduced income due to loss of 10,000 jobs: -10,000 jobs × $58,000/job = $580 million
Increased income due to re-employment: +5,000 jobs × $29,000/job = $145 million
Increased business profitability: +90% × $580,000 = $522 million
Net increase in U.S. income: $87 million

Four important conclusions emerge from this example.

  • First, offshoring should increase domestic income and not reduce it, as is commonly assumed.
  • Second, offshoring’s largest potential effect is on the redistribution of income from labor to businesses. If these profits are distributed, they accrue to shareholders as dividends, and if they are retained, shareholders enjoy capital gains. By retaining profits, offshoring companies are able to fortify owners’ equity so that future economic and financial shocks do not pose as great a threat to their solvency.
  • Third, a major concern with offshoring relates to the transition costs borne by laid-off workers while they find new jobs. Therefore, remedies that focus on short-term support for the temporarily unemployed, educational assistance, and scrutiny of tax systems and social welfare programs for income redistribution biases seem to be more productive than trying to hold back the offshoring tide.
  • Finally, the offshoring controversy reminds us of the fact that international trade is not a zero sum game. In short, the gains accruing to foreign nations do not necessarily come at the expense of U.S. residents.

Major national surveys conducted by NBC News and The Wall Street Journal found that more than 80 percent of Americans believe that offshoring is a major cause of U.S. economic problems. These fears seem misplaced because outsourcing and offshoring activities are bound to grow as transportation costs and international trade barriers fall, global deregulation spreads, and commercial risks are reduced by diversification. Therefore, it is important to remember that, along with U.S. offshoring to foreign nations, one also must take into consideration re-shoring (i.e., bringing formerly offshored jobs back the United States) and offshoring by foreign nations in the United States.

Because all these activities are propelled by the same underlying force, which is global competition, regulatory interference will most likely be either ineffective or destructive.

Babson Insight Spring 2016