Offshoring and Labor Income Risk

The paper contributes to the analysis of how offshoring has an impact on labor market outcomes in terms of labor income. Special attention is given to the link between offshoring and income risk - an aspect of income volatility that has scarcely received attention in the previous literature. Permanent income risk is defined as variance of shocks to income that do not fade out over time and are assumed to be not self-insurable. These so-called permanent income risks are clearly welfare relevant as they affect risk-averse individual’s decisions on consumption and savings. The aspect of income risk adds to the literature in an important way. While most studies deal with level effects on income, we complement the analysis with a look at volatility. Naturally, for risk-averse individuals, the volatility of the long-term income process is a crucial aspect on top of considerations regarding the level of their earnings. We are also the first to provide an analysis for Germany; a large trading economy with exceptional reliance on international integration. Our analysis proceeds in three steps. First, the unpredictable part of individual income is estimated as the residual term from wage regressions based on individual-level data. Second, values for permanent income risk at the sector level are estimated as the variance of persistent shocks to this unpredictable component. Equipped with income risk estimates for several German manufacturing sectors for the years between 1991 (or 1999) and 2005, we links these to offshoring in a panel framework in step three. Offshoring at the sector level is understood as the amount of intermediate inputs imported from the same industry abroad divided by industry output. We do not distinguish between within-firm versus arm’s length transactions as we consider our offshoring variable to approximate the outcome of any make-or-buy decision. We do, however, treat offshoring to non-OECD countries with special attention since this is usually the type of production relocation which stirs up the most anxiety among the public. It is also the type of cost-savings driven offshoring modeled in most of the theoretical literature on the topic.

Our results are quite remarkable: an increase in offshoring in a given sector correlates with a decrease in permanent income risk in that sector. Offshoring to non-OECD countries has a particularly strong impact. We attribute this offshoring related decline in income risk to the fact that, in countries with relatively rigid labor markets, firms tend to offshore volatile production intensive parts of their undertakings which leaves the remaining tasks less volatile on average. Overall, a decrease in income risk provides a channel through which offshoring can be welfare enhancing. Of course, this only holds true if wage and employment levels are not negatively affected by offshoring. Given the literature’s recent results of no large influence of offshoring on absolute employment and wage levels in OECD economies, we are indeed leaning towards an optimistic conclusion.

Hogrefe, Jan and Yao Yao (2012), Offshoring and Labor Income Risk, ZEW Discussion Paper No. 12-025, Mannheim.