How Outsourcing Creates Jobs

by Mark Thornton
by Mark Thornton

Greg Mankiw, the Chairman of President Bush’s Council of Economic Advisers, said that outsourcing is good for the economy, but he quickly retreated from that comment and never fully explained how foreign outsourcing would help the economy. The former Chairman, Dr. Glenn Hubbard, recently tried to explain the benefits to Lou Dobbs, but Hubbard’s explanation was weak and Dobbs remains unenlightened and unconvinced. While the number of jobs that have been outsourced to "cheap foreign labor" is relatively small, it is still worthwhile to show just how this type of outsourcing contributes to job creation in our country because further expansions of the protectionist trade war could ignite an economic disaster.

Outsourcing both creates and destroys jobs, in that someone is getting a job and someone is surrendering a job. This type of contracting goes on all the time, in a multitude of forms. Think of a Korean automobile factory in the U.S. It outsources work to U.S. companies, who in turn outsource to other foreign and domestic companies. The Korean factory also relies on the home corporation in Korea for design and engineering services, and other factories in Korea and Japan for parts and accessories. These factories in turn outsource work to other companies in Korea, Japan, Germany, and the U.S. Government regulation or taxation of this process would create havoc and chaos.

Recently outsourcing has become big news because white-collar jobs in areas such as telecommunications and information technology have been outsourced to foreign workers. American workers with high-paying easy jobs have had the proverbial rug pulled out from beneath them and are crying foul, far and wide. It is quite natural that they would not be interested in the economic fact that such outsourcing is vital to the economy and their own long-run economic interest. Outsourcing, both foreign and domestic, is crucial not only for saving current jobs, but also for new job creation.

Job creation is the number-one issue in the Presidential election. And yet, the creation of jobs is a mysterious, little understood process – especially among politicians. Even the best minds in the history of the world have addressed the topic and have usually come up with the wrong answer. Job training programs, for example, have been an abysmal failure. This article will provide you with the secrets of job creation and explain how outsourcing is a vital key to increasing the number of jobs, particularly good-paying ones.

Let us start with some of the easy "keys" to job creation. Anything that makes hiring an employee more expensive will discourage job creation. Taxes and the overall tax burden make job creation more difficult and work less rewarding. If you lower taxes and the size of government, then job creation becomes easier and work is more rewarding. You have to reduce the real burden of government to improve employment. Gimmicks in the tax code and promises of future cuts just will not do.

For every 1% increase in job creation, there would be approximately 250,000 additional jobs created in the United States over the next ten years. A study by the International Monetary Fund suggests that, based on past experience, cutting government spending and taxation by 10% of output would add more than one million jobs in the U.S. economy over the next decade, over and above the amount that would normally be created (approximately 20 million). This upward expansion in job creation further increases the output of goods and services, puts upward pressure on real wage rates for everyone in the economy, and, by reducing the tax burden, would mean an increase in take-home pay for all. Bigger cuts in government would result in reports of labor "shortages," unfair wage and benefit demands by employees, and possibly even calls for maximum-wage laws.

Many of the other keys to job creation will appear counterintuitive, especially if you come from the perspective of labor, rather than that of the employer (i.e., the person who actually creates jobs). For example, good unemployment benefits are bad for job creation and result in higher levels and longer durations of unemployment. When government provides generous unemployment benefits, it increases the cost of creating jobs and decreases wage flexibility. People living on unemployment insurance, and all types of welfare, will typically not obtain new employment until the benefits run out.

Unemployment insurance is both irrational and unnecessary. It could be abolished altogether and replaced with a system by which workers could save part of their paychecks – before taxes – and then draw down their account balances if they became unemployed. This approach would offer no incentive to avoid finding a job and would provide those who remained employed an extra retirement savings account.

Unions are also bad for labor because they reduce job creation. Unions demand higher wages and benefits, better working conditions, and a labor-regulated workplace. This sounds good on the surface, but people do much better economically in right-to-work states where unions have less political power. Compared to pro-union states, right-to-work states have created double the rate of private-sector jobs, higher incomes and homeownership, less poverty, and an increase in manufacturing establishments, where pro-union states have seen an actual decline.

Most counterintuitive of all is the effect of employment protection policies on job creation. One might think that protecting jobs by preventing or delaying employees from being fired would be good for labor, but the exact opposite is the case. Employment protection does diminish job dismissals, but it also reduces job creation so that over time there are fewer jobs in the economy. Where employers find it difficult to dismiss workers, they will create fewer jobs because of the risks attached to hiring employees who might become unruly, unproductive, unnecessary, or uneconomical over time. In this case, jobs will be moved across the border to employer-friendly environments, or the employer will substitute more capital and technology for labor.

Employment-protection legislation is anything that relates to the hiring and firing of employees, such as defining and regulating what is an "unfair" dismissal, job termination for economic reasons, minimum notice periods, severance payments, and requirements for prior consultations with trade unions. The Worker Adjustment and Retraining Notification Act (1989) is one example of such legislation, but all types of labor laws such as the Americans with Disabilities Act (1990), Family and Medical Leave Act (1993), and many others, reduce job creation.

Labor legislation has the goals of fairness and job stability, but the more "protective" the legislation, the less efficient labor markets become. Anyone familiar with academic tenure or government employment knows that well-protected jobs also mean low productivity and limited flexibility. The IMF study found that employment protection legislation was a primary factor in job creation. Where protection is strong, new job creation is almost nonexistent (.25%), but where job protection is relatively weak, job creation is five times greater (1.50%).

Where it is easy to fire employees is precisely where you will find the higher rates of job creation because employers face a lower cost and risk when they hire a worker. Freedom in the labor market keeps employees productive because they know that employers can easily fire them. However, it also makes for better employers because workers in countries like the United States and Australia can readily obtain new jobs if they are mistreated or are paid below-market wages.

I will admit that many managers and employers can be "out of touch," heartless, unfair, shortsighted, and just plain stupid. The market has a way of dealing with them – in the long run they will be replaced or driven out of business. In the short run, most American workers simply get a better job or accept bad management until something better comes along. Job creation and a flexible labor market are the keys to this type of labor protection. If no jobs are being created, you will be stuck with bad managers indefinitely (i.e., it would be like working at a government university).

Outsourcing is a vital link to efficiency and labor market flexibility. The freedom to outsource is important because the target of outsourcing changes over time. Photocopying may go from in-house production, to outsourcing, back to in-house production depending on costs, wages, rental rates, demand conditions, etc. The same is true for secretarial support, janitorial services, warehousing, distribution services, IT, even production and marketing. The more technical and complex production becomes, the more important outsourcing will be.

Employers that offer good, high-paying jobs can establish their operations anywhere on the planet. Traditionally the U.S. has been one of the best options, but more and more countries have learned the benefits of market economies and have improved their business climates. If an employer is looking at two similar locations, A and B, where B allows its companies to outsource work to A, but A does not allow its companies to outsource to B, then the employer is most likely to choose location B, rather than A. By outlawing or restricting the outsourcing of jobs to cheap foreign labor you would greatly discourage the establishment of new jobs in the U.S. and encourage current employers to move overseas.

Outsourcing can save on cost, improve efficiency, increase company flexibility, improve company "focus," and for smaller companies it helps to level the playing field with big corporations and reduce business risks. However, there are also negative aspects to outsourcing such as a lack of oversight and quality control. Selecting vendors and the other costs of transition from in-house production to outsourcing are real and they are generally higher with foreign outsourcing. Just about everything could be outsourced, but it just not efficient to do so. Less than 25% of all major corporations do any foreign outsourcing, and the majority of major corporations are suspicious of using foreign outsourcing due to such things as concern for quality control and protection of intellectual property.

Despite these natural limitations on foreign outsourcing, if we were to reverse this form of outsourcing, the U.S. economy would be dealt a major blow. Prohibiting new foreign outsourcing would also be a big blow to the economy and our future. There have been several suggestions for curtailing foreign outsourcing involving regulations and changes in the tax code, but most of these would have the effect of stopping most foreign outsourcing altogether.

Former Secretary of Labor Robert Reich has promoted the idea that corporations not be allowed to claim outsourcing expenses for purposes of the corporate income tax. He should know full well that such a move would amount to a virtual prohibition on foreign outsourcing. All outsourcing decisions, foreign and domestic, are matters of percentages, not windfalls, and the much lower wage rates of foreign workers are partially offset with other costs. Reich himself previously recognized that such protectionism was not rational.

Putting limits on foreign outsourcing will make the U.S. a less desirable location for employers and would put American companies at a disadvantage compared to their foreign competitors in Europe and Japan, who can continue to rely on the low-cost advantages of foreign outsourcing. As such, the ability to outsource work to other countries is crucial for both new job creation and saving current American jobs from foreign competition. The current economic weakness in the U.S. economy is clearly the result of cyclical and financial factors, not offshore outsourcing. Our economy is the number-one beneficiary of open trade and technology – 5% of American workers are employed by foreign companies. Any attempt to curtail outsourcing would harm the economy directly and further push us toward a disastrous protectionist trade war.

April 11, 2004

Mark Thornton [send him mail] is an economist who lives in Auburn, Alabama. He is author of The Economics of Prohibition, is a senior fellow with the Ludwig von Mises Institute, and is the Book Review Editor for the Quarterly Journal of Austrian Economics. He is co-author of Tariffs, Blockades, and Inflation: The Economics of the Civil War.

Copyright © 2004 LewRockwell.com

Mark Thornton Archives