Taxes and the Outsourcing of U.S. Jobs

July 27, 2012

International business taxation and its role in outsourcing are heating up as major election-year political issues. At a campaign stop in Cincinnati last week, President Obama cited a new report as evidence that Mitt Romney’s territorial tax reform proposal would push jobs abroad:

“By eliminating taxes on corporations’ foreign income, Gov. Romney’s plan would actually encourage companies to shift more of their operations to foreign tax havens, creating 800,000 jobs in those other countries.”

As we outlined last week, the referenced study by Kimberly Clausing does not indicate that any U.S. jobs would be displaced. The calculation assumes that territorial taxation would make employment more responsive to tax rates, that tax rates would not be lowered, and that firm behavior would reflect behavior from 1982-2004. With these specifications, she finds that the policy change would increase foreign employment levels. Any suggestion that new jobs abroad means fewer jobs at home is only conjecture, because the calculation does not consider firm employment effects in the U.S.

The real problem with the President’s statement is the notion that operations and jobs are drawn to tax havens. Though the Clausing study finds a statistical relationship between foreign employment and tax rates, the most recent data from 2009 by the Bureau of Economic Analysis (BEA) indicates that U.S. companies overwhelmingly employ where they are selling in local markets.

The first chart below shows a roughly one-to-one relationship between the share of employment abroad by U.S. companies and the share of sales, and the cross-country variation in sales explains 63.9 percent of the variation in employment.  Compare this to the second chart, which shows no clear relationship between effective corporate tax rates and employment.  Only 0.2 percent of the variation in employment is explained by effective tax rates.

In Figure 1, the three outliers in the direction of greater employment-to-sales ratios are developing countries with low labor costs: Mexico, China, and India. The outliers with low employment-to-sales ratios actually include Ireland, Singapore, and Switzerland, which are frequently cited as tax havens. Global companies tend to shift their profits to these haven countries, but employment is much less sensitive.

Granted, in this rudimentary analysis we have not controlled for any other factors that might affect employment abroad.  Clausing controls for GDP, GDP per capita, and distance from the U.S.  While these are plausible factors, our analysis indicates that the most important factor is sales.  To illustrate with the obvious, shipping hamburgers across the Pacific makes little sense for McDonald’s when they can simply open a franchise in China.  Or take Otis Elevator, whose customers are almost exclusively abroad.  To deliver goods to market efficiently, they need to hire in those markets—positions in management, legal, accounting, sales, manufacturing, maintenance, and so on. This activity is not “outsourcing” or “offshoring,” but is rather satisfying previously unsatisfied demand.

Outsourcing is the more notorious arrangement by which a company sets up part of the production process abroad to achieve cost savings of some kind. However, it is not clear that even this type of arrangement displaces jobs in the U.S., and in fact the evidence points in the opposite direction.  For example, Desai, Foley, and Hines find that among U.S. manufacturers a 10 percent increase in investment abroad is associated with a 2.6 percent increase in domestic investment, and a 10 percent increase in foreign employee compensation is associated with a 3.7 percent increase in domestic employee compensation.

As Brad DeLong notes, “it is a safe bet that outsourcing in general raises U.S. GDP” and “increases the total size of the economic pie.” This happens as resources shift from import-competing low-value enterprises to high-value manufacturing and services, where U.S. workers excel. This does not mean that government policy should subsidize outsourcing, but policy should also not constrain U.S. business ambitions abroad. As the charts show, firms largely employ where they can sell. When they can’t sell, they fail.

If job creation is public policy agenda Number One, the place to start is lowering the corporate tax rate—which is now the highest rate in the industrialized world. A transition to territorial taxation accompanied by a reduction in tax rates would make the U.S. more attractive as a place for investment and as a domicile for global companies, and would unlock up to $1.4 trillion in business income trapped abroad to flow back into the U.S.  That is, it would grow the economic pie domestically.

Follow William McBride on Twitter @EconoWill

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