Inside Outsourcing: More Bad News from Business Regulation?

Pietro S. Nivola
Pietro Nivola
Pietro S. Nivola Former Brookings Expert

November 1, 1996

Businesses that outsource in the global economy can boost productivity and wages—if the outsourcing is driven by market forces, not by a need to game costly laws and lawsuits. But legal and regulatory considerations, not just a quest for cheap labor, sometimes do influence the sourcing patterns of firms, including their contracts with offshore suppliers. Because this process can be inefficient, policymakers need to address it. But pleas for better “corporate citizenship” are no substitute for fundamental correction of the nation’s regulatory programs and legal practices.


Here’s how McDonnell Douglas Corporation is building the MD-95, a new jetliner. The plane will have homemade avionics but British engines, an Italian fuselage, an Austrian interior, a Japanese tail, Korean wings, and Israeli landing gear.

Four years ago, about half of America’s large corporations reported contracting out for at least some services and supplies that were formerly provided in-house. Today, almost nine out of ten report doing so. Increasingly, as these big firms restructure, work is being shifted to independent U.S. contractors or to affiliates and partnerships across borders. Outsourcing is in. It promises lower costs and increased efficiency. Why, then, is it not delivering a rapid rise in the economy’s rate of productivity growth and hence in the real incomes of most Americans?

Regulation and Restructuring

Firms resort to external contracting as a means of cutting labor costs. But there is more to the story. Although corporate restructuring is largely driven by normal competitive pressures, it may also be abetted by other factors. Not the least of these may be policymakers and plaintiffs piling on laws and lawsuits of dubious merit.

Globalization opens new opportunities to downsize and then externalize functions. Increasingly, firms that want to lower their taxes, limit their liabilities, or lighten their regulatory overload are prepared to seize those opportunities. When they do, the real compensation of American workers may suffer. Even a company’s threat to exit can be enough to restrain wages. During a bitter strike at Caterpillar, for example, management bluntly served notice that it might be forced to relocate more facilities and operations “outside.” Outsourcing recently became the principal thorn in contract negotiations at companies like Ford, Chrysler, and Lockheed Martin. At Boeing Company and General Motors, the practice recently provoked full-scale walkouts. The United Auto Workers avoided a collision with Ford by conceding wage parity between the pay scales of the company’s own parts plants and those of external suppliers.

To be sure, most of the offloading of operations by U.S. corporations just transfers jobs to other companies within the United States. Even the expanding share of U.S. sourcing going abroad indirectly does much the same. The domestic jobs it may eliminate or the wages it may depress may be offset by more productive jobs and better paychecks in U.S. businesses whose exports improve. Modern international commerce in manufactures involves extensive intra-industry trade, which in turn brings reciprocal gains. U.S. firms are briskly exporting aircraft parts, semiconductor chips, and automotive components as well as importing them. Both sides of the two-way flow have been beneficial for the U.S. economy, and the relative shares of inputs imported and exported have changed little over recent years.

Still, if imperatives other than those of the marketplace are inducing firms to move work around the global factory, the “creative destruction” in the U.S. labor market may be causing more economic dislocation than it ought to. Contemplate the consequences of the profusion of legalities in the workplace. As mandates and exposure to legal risks multiply in employment relations, so do the inconveniences of maintaining full-time employees. Firms perceive further reason to scale down, to substitute contingent workers for permanent ones, and to shift production to greener pastures. Thus the domestic regulatory environment can begin to act like a tax on wages. When suits at the workplace soared in California during the 1980s, a study by the Rand Corporation estimated that the costs for companies were equivalent to a 10 percent penalty on payrolls. Moreover, as some companies duck underneath the statutory thresholds of employer mandates, they shrink to suboptimal levels. With their retrenchment verging on “corporate anorexia,” many have registered little or no improvement in worker productivity in their U.S. operations, which has meant barely any improvement in domestic wages. A partial survey by the American Management Association found that almost two-thirds of companies that “rightsized” between 1989 and 1994 experienced either no productivity change or an actual decline.

Regulatory Inefficiency

The U.S. economy is in many ways singularly unfettered. Nowhere else in the industrial world is it easier to set up a discount store, start a new airline, or declare a bankruptcy. But extensive economic deregulation—decontrolling prices, entry, and exit in markets—has been matched by more waves of social rules cracking down on businesses. From the surety of shareholder litigation, to blistering penalties for faulty product designs, to the latest doctrines about hostile work environments, entrepreneurs run a gauntlet of legal perils.

The costs of this situation are serious. Each year Americans spend on tort suits the equivalent of Sweden’s entire economic output. Meanwhile, the benefits of our vigilant legalism often prove elusive. In an unusual comparative study of legal cultures, to be published by Brookings early next year, Robert A. Kagan and Lee Axelrad of the University of California at Berkeley found no evidence that the fierce U.S. civil justice system ensures superior deterrence against corporate negligence.

Other mechanisms of social regulation are also malfunctioning. Recently Robert A. Hahn of the American Enterprise Institute examined most of the major rules issued by the Environmental Protection Agency, Occupational Safety and Health Administration, Consumer Product Safety Commission, National Highway Traffic Safety Administration, and Mine Safety and Health Administration. Using the agencies’ own calculations, he discovered that more than half of the final rules promulgated between 1990 and 1995 flunked a cost-benefit test.

That flawed regulations exact a toll is well known. Economic growth is inevitably retarded by legal and regulatory conventions that either impose losses greater than the recognizable gains to society or yield net gains but at an unnecessarily high price. Less well understood is that the deadweight of too much law can worsen in a global economy where it is easier than ever for firms to reposition capital and labor.

What Corporations Do

Legal and bureaucratic vexations in the United States seldom are the primary cause for relocation of whole enterprises. Larger considerations—proximity to big markets, quality of the infrastructure, political stability, and exchange rates—are the chief determinants.

At the same time, it is simply wishful thinking to assume that, in the complex calculus of direct overseas investment, a nation’s regulatory climate never exerts much influence on the sourcing or contracting behavior of firms. The business press brims with stories reporting the response of large companies to the costs and rigidities of labor regulations in Germany. In the past five years, the likes of Bayer, BMW, and Siemens have invested three times more capital outside that country than inside. The exodus is only an extreme rendition of what is happening in most other globalizing economies, including our own.

A number of U.S. multinational corporations now deploy a majority of their assets abroad. Examples are Gillette (66 percent), Mobil (63 percent), IBM (55 percent), Bankers Trust (52 percent), and Citicorp (51 percent). Overall, foreign affiliates of U.S. parent companies have come to account for more than a quarter of their total employment. This is a conservative estimate. For some familiar nameplates, the figures are much higher. Fully half of Xerox’s 100,000 employees, for instance, are now situated on foreign soil.

Not every bit of this pattern is just the invisible hand at work. More than a few firms, instead of exporting, have gone abroad to make and market products in order to extricate themselves from the U.S. liability maze and regulatory delays. A recent survey of 500 U.S. medical equipment manufacturers found that more than 60 percent planned to commercialize advanced devices overseas before introducing them, hypercautiously, if at all, in the United States. More than 90 percent of the companies cited the long FDA product review requirements. In a 1994 survey by the American Electronics Association, 22 percent of medical device companies said they had already moved jobs offshore for the same reason. Similarly, the General Accounting Office tracked a score of sizable furniture manufacturers in California that had relocated all or parts of their operations to Mexico between 1988 and 1990. Seventy-eight percent of these companies gave as an explanation the EPA’s strict air pollution standards.

Or witness the perverse incentives of the government’s fuel economy mandates for the automobile industry. For a time, this cumbersome method of forcing auto manufacturers into producing energy-saving cars drove at least one company, Ford, to produce abroad and then import more than a quarter of the parts of certain models of vehicles. The tactic helped Ford meet the gas mileage standards for its overall fleet but at the expense of U.S. autoworkers’ jobs.

Among the first to decamp may be foreign investors, many of whom are most likely to be caught off guard by idiosyncratic strictures in the U.S. market. When foreign companies such as Sanyo and JVC sack thousands of U.S. workers and move their North American production of television sets or microwave ovens to Tijuana, are they only parrying lowball competition from Korea or exploiting Mexico’s “pauper labor”? Or, plausibly, are they also shedding some excess legal freight—like the probability of being sued for racism, sexism, “ageism,” disability discrimination, or other alleged biases or insensitivities in personnel management? “There’s no question that the American legal system is a minefield for anybody doing business there,” recounts the chairman of a Canadian company. “I am not aware of anything comparable to the American system in another democratic country.”

Getting Real

There are ways government can encourage companies to become less mean, if not less lean, but the latest Washington fad—alternately brow-beating business and dangling tax preferences for good “corporate citizenship”—is an evasion. Instead, the first thing to do is get serious about regulatory relief. Three sorts of steps are essential.

For starters, abolish senseless rules.

Headway is being made here, though much more is needed. Over the past couple of years, the Delaney amendment, with its zero-risk requirement for food additives, was finally revoked. So was the EPA’s costly (and environmentally hazardous) ethanol mandate for reformulated gasoline. Even some abuse-ridden affirmative action programs have ceased to be sacred cows. The Supreme Court concluded that the rationale for federal set-asides was not ‘compelling.’ No elaborate cost-benefit analysis was needed to make these determinations, only common sense and political spine.

Find constructive substitutes.

Abolitionism has limits. Some regulatory functions, after all, are a legitimate public responsibility. For example, key resources, such as water and some forms of energy, are still priced below their true economic value in certain parts of the country, leading to excessive consumption and serious environmental degradation. Where the use of these resources is inadequately rationed by market forces, additional restraint may be necessary.

In these cases, however, simulating market incentives can be both less intrusive and more cost effective than bureaucratic edicts enforced by prosecutions, fines, and jail terms. The 1990 Clean Air Act is full of “technology-forcing” commandments that will impose compliance costs of $30 billion a year while generating estimated benefits only half that large. A provision that is working wonders, however, is the allowance-trading process for sulfur dioxide emissions. By inducing the development of cleaner coal blends and improved stack scrubbers, the trading program has cut the costs of pollution abatement dramatically.

Similarly, a reputable study of alternatives to electric car mandates suggests that a marketable-permits approach to auto emissions could achieve the desired results while saving $10 billion.

Substituting a price mechanism (a modest increase in the much-maligned gasoline tax) for the federal fuel economy controls on automobile manufactures would conserve an equivalent amount of oil but at a third the social cost.

Set reasonable standards for civil jurisprudence.

Despite recent revisions of tort laws by various state governments, more than a million cases a year are still being filed in the nation’s courthouses. The rampant legal wrangling continues to consume an extraordinary, and inordinate, share of GDP (see figure above). Congress proposed some basic reforms last year. A compromise bill to discourage frivolous class-action suits by shareholders managed to hurdle President Clinton’s veto. Another of his vetoes, however, spiked a modest bipartisan plan to restrain punitive damages in product liability cases. At a minimum, this measure needs to be revived—and enacted with or without the administration’s support.