Wage inequality and offshoring: are they related?

Author:Ghosh, Koushik


The objective of this paper is to investigate the impact of offshoring on wage inequality and labor productivity in the U.S. Short-run and long-run data tests are undertaken to analyze the relationship among offshoring, wage inequality, and labor productivity in the U.S. Cointegration tests indicate that these three variables are related in the long-run. The main contribution of this paper lies in its focus on the short-run investigation of the relationship among these three variables. This investigation is conducted using the vector error correction (VEC) testing framework. VEC tests indicate that offshoring has had a statistically significant impact on both labor productivity and wage inequality in the U.S.

Key Words: offshoring, wage inequality, and labor productivity.

JEL Classification: F16


    Analyzing and explaining the causes of wage inequality have long been focuses of economic inquiry. Although this issue has been addressed thoroughly in both theoretical discussions and empirical research, there is no commonly accepted explanation of the causes of changing wage inequality. The beginning of this discussion can be traced to the writings of Adam Smith (1776) who outlined how trade and specialization can transform societies. Since the first industrial revolution, which transformed agricultural societies to manufacturing ones, there have been two more such events. The second revolution was characterized by a movement from manufacturing to service industries. Currently most countries are experiencing the third industrial transformation which is characterized by, among other things, offshoring (commonly referred to as outsourcing). One of the key concerns of this latest economic development is its impact on income distribution and wage inequality in all of the countries operating in the global market place. While the analyses of the effect of increased offshoring on wage inequality are potentially ambiguous, this issue remains vigorously alive due to a paucity of empirical studies and theoretical discussions.

    Offshoring typically involves trade in tasks and goods among participating countries. Trade in tasks occurs when one or more portions of the production process are offshored. This type of international trade can have a negative or positive impact on the wages of low-skilled workers in countries where tasks are outsourced abroad. Grossman and Rossi-Hansberg (2006 and 2008) defined this issue elegantly. Their analysis invites further empirical research that can shed additional light on the impact of offshoring on wage inequality. The authors point out that trade in tasks rather than trade in goods characterizes the above mentioned new industrial revolution. They suggest that such trade is not necessarily detrimental to wages of low-skilled workers. The authors also point out, however, that their empirical analysis is relatively crude and should be fine-tuned.

    Clearly, controversies surround the issue of the impact of offshoring on income inequality in countries that participate in international trade. In order to assess this impact, it is important to outline initially the key features of the new industrial revolution that is characterized by trade in tasks. Offshoring has important effects on U.S. imports and, thereby, it can impact income distribution in the U.S. It affects not only the volume of U.S. imports, but also their content. Using OECD data, Grossman and Rossi-Hansberg (2006 and 2008) have calculated the estimated share of imported inputs in total inputs used by all goods-producing sectors in the United States. Their estimates indicate that the share of imported inputs in the gross output of these sectors has been growing steadily over the last three decades. They find evidence of an acceleration of this trend after 1995.

    Trade in tasks, that is to say offshoring, has played an increasingly important role in international trade. (1) This type of trade can have a considerable impact on the wages of skilled and unskilled workers. The primary objective of this paper is to analyze the impact of offshoring on income inequality in the U.S. This category of trade is likely to grow even more in the coming years, as more "routine" cognitive tasks are increasingly exported overseas [Autor, D., Levy F., and Murnane, R (2003)]. Offshoring has become an important feature of today's global economy, and it will continue to be so. How offshoring affects wages and income inequality in trading countries is unclear. Only empirical research, such as the present study, can provide some answers to this critically important and not yet resolved issue.

    In order to understand better the impact of offshoring on income inequality, it is also essential to analyze the potential effects of offshoring on the labor supply. Learner (2006) and others have described how increased opportunities for offshoring can lead to an expansion in the world supply of low-skilled labor. Citing the properties of the Heckscher-Ohlin (1933) model with incomplete specialization, Grossman and Rossi-Hansberg (2006 and 2008) develop a simplified version of their general equilibrium model that eliminates the relative price effect of trade. The two authors suggest that the expansion in the world supply of low-skilled labor may not affect factor prices, since factor growth can be accommodated without an impact on factor prices. Thus, there need not be a depressing effect on domestic wages of low-skilled workers, even if Leamer's (2006) hypothesis is correct.

    Grossman and Rossi-Hansberg (2006 and 2008) outline a new paradigm in trade theory. As mentioned previously, the two authors suggest that international trade theory should focus on trade in tasks rather than trade in goods. Given this assertion, they investigate the impact of offshoring on wages of high-skilled and low-skilled labor. The two authors suggest that as the cost of offshoring decreases, firms move L-tasks (low-skill tasks) abroad, thus increasing both productivity (due to the decreased costs associated with the already offshored L-tasks) as well as the supply of low-skilled labor in the economy. Productivity improvement is primarily due to the decreased costs associated with the already offshored L-tasks. The authors further suggest that the positive productivity effect on demand for low skilled labor that raises their wages may indeed dominate the negative labor supply effect on these wages. This would then imply that the wages of low-skilled workers would not be affected negatively by the decrease in offshoring costs. This would also mean that offshoring would not worsen wage inequality. In their 2006 empirical analysis, the authors conclude that "the data leave room for a positive effect of offshoring on wages" (p. 30). These observations notwithstanding, the authors point out that there are several omitted factors in their analysis, and that their conclusions "be taken with a grain of s alt until a more thorough empirical study can be performed." (p. 31).

    In this paper, we accept the above stated empirical challenge and subject the Grossman and Rossi-Hansberg (2006 and 2008) hypothesis to empirical tests using both long-run and short-run analyses of wage and trade data. The novelty of our empirical inquiry lies not only in its focus on analyzing the long-run as well as short- run relationship among wage inequality and international trade, but also on its analysis of the impact of offshoring on labor productivity. Therefore, the present paper provides empirical evidence for both key issues raised by Grossman and Rossi-Hansberg: the effects of offshoring on labor productivity and on wage inequality.

    There is one additional important objective of our present research. Our paper is an extension and a further refinement of our previously published research on the relationship between trade, wage inequality, and productivity in the U.S. [Ghosh, Saunders, and Biswas (2000), and Ghosh, Saunders, and Biswas (2002)]. The objective of our 2000 paper was to investigate the relationship between wage differentials of unskilled and skilled labor (approximated by the differences between the median incomes of males who completed high school and the median incomes of four-year college graduates) and trade (approximated by net exports). We found that trade in the U.S. is negatively impacted by wage inequality. In our 2002 paper, we expanded our investigation into the relationship between trade and income inequality in the U.S. by including the effects of labor productivity (measured by the output per hour of all persons in the non-farm business sector) on these variables. We found that while wage differentials and net exports had a statistically significant impact on labor productivity, wage inequality was not impacted by the combined impact of trade and labor productivity. While our present paper is a natural extension of our previously published research, it adds two new important dimensions to our previous empirical analyses. First, the focus is on analyzing the effects of offshoring on wage inequality and labor productivity/Second, by expanding our empirical analyses throughout 2011, it is possible to find out whether the basic relationships between trade, productivity, and wage inequality have changed in the U.S. in the last decade.

    All of the objectives described above are accomplished within a trivariate time-series testing framework. Our empirical investigation, below, is divided into four sections. In section II, a thorough literature review concerning the effects of trade and other factors on wage inequality is undertaken. In section III, the data and the methodology used to investigate the relationship among these variables are outlined. The test results are described and analyzed in section IV. Section V concludes our paper with final remarks about the relationship between offshoring, wage inequality, and labor productivity in the U.S.


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