Domestic outsourcing is on the rise. What happens when the practice is banned?

Does the company name on your paycheck matter? Most of us probably think that how much we make is a function of the type of work we do: Teacher or doctor, bus driver or airline pilot. And that certainly matters. But economic research shows that the firm you work for matters too.

The rise of domestic outsourcing—that is, when a company obtains employees through a subcontracting firm rather than hiring the workers directly—is a defining feature of many economies over the past 20 years, including the United States. No single authoritative source tracks outsourced workers, but one careful study found that the share of outsourced workers in cleaning, logistics, and security in the U.S. increased from less than 10 percent in 1950 to more than 20 percent by 2015.

Outsourcing is prevalent in high- and low-paying jobs, for support functions as well as companies’ core activities. For instance, Google garnered bad press in 2021 for its “two-tier work force of generously compensated full-time employees and less expensive temps and contractors,” while health care workers employed by Kaiser Permanente went on strike in 2023 in part due to the health care giant’s outsourcing of critical health care duties.

“Understanding labor arrangements like gig work and domestic outsourcing can yield important cues about the future of work and how regulations might affect workers’ compensation and rights,” said Institute Senior Economist Illenin Kondo, who studies outsourcing policy in a new Institute working paper.

Same job, less pay

As domestic outsourcing has increased in prevalence, so too have the economic studies about the practice. Research analyzing the effect of outsourcing on wages in three different countries—the United States, France, Germany—all concluded that outsourced workers earn less than workers who are doing the same jobs but who have not been outsourced.

One reason companies use domestic outsourcing, then, is to minimize labor costs and maximize profits. This motivation seems particularly strong in Mexico. Kondo and his co-authors focus specifically on Mexico’s manufacturing sector, which made up almost one-quarter of the country’s GDP in 2023. In manufacturing, domestic outsourcing ballooned from 5 to 20 percent between 2000 and 2020.

As in the United States, Mexican firms owe payroll taxes on their employees, including a social security tax, which are set as a percent of the employee’s wages. Unlike in the United States, firms are also required by law to share 10 percent of their profits with their employees. Add in the right to unionize and the three months’ severance, and the bottom line is: In Mexico, employees are expensive.

In April 2021, the Mexican government passed a law requiring companies to directly hire all employees engaged in a company’s core business operations. The law also established effective monitoring of outsourcing and imposed heavy penalties for violations.

The new law quickly had its intended effect. From its high of over 20 percent in 2019, the share of the manufacturing workforce that was outsourced dropped to around 2.1 percent in 2023 (see figure).

Labor moves in, wages go up

Moving from staffing agency to manufacturing firm would not be much of a victory for workers if wages stagnated or many workers lost their jobs. Happily for workers, the economists find that wages went up after the new law—by a lot. The average wage for manufacturing workers increased by about 35 percent relative to average wages before the new law. Firms’ social security payments, benefits payments, and profit-sharing payments all went up, too. The reform appears to have brought more people into a higher-paying part of the economy.

In addition, the economists find that neither employment levels nor other inputs to the production process, such as purchases of raw materials or energy, declined after workers were “insourced.” With these inputs holding steady, so too did manufacturing firms’ output.

The economists interpret these findings as evidence that prior to the reform, Mexican manufacturing firms had a great deal of power in the labor market. They had been able to pay workers less than what they were “worth”—that is, less than what they were contributing to the productivity of the firm.

“One way to think about this type of firm power is that firms are not employing as many workers as they would in a competitive market, out of a desire to reduce their wage bill,” Kondo said. “The more workers the firm demands, the more wages go up, and so firms think maybe they should pull back a little bit because then they make more profit.”

The ban did lead to a few negative outcomes for firms. After the reform, the probability that a firm would close shop increased by 1 percentage point. In addition, firms’ capital expenditures declined by 2.8 percent. These effects appear fairly small relative to the impact on wages. However, the reform is still new, and it will be worth studying how the economic outcomes evolve over time.

Domestic outsourcing and the changing American workplace

While the economic environments of Mexico and the United States differ, there are indications that labor is on the back foot in both countries. “The decline in worker power [is] one of the major structural trends in the U.S. economy,” economists Anna Stansbury and Lawrence Summers, former Secretary of the Treasury, wrote in 2020.

One indication of this decline is that the share of economic output that goes to workers in the form of wages has been falling since the 1980s while the share that goes to owners of capital has increased. According to one estimate, in 2022, labor’s share of income in the U.S. hit its lowest level since the Great Depression.

Another workplace trend that economists have observed is that workers are being “sorted” by wages: More and more, higher-wage and lower-wage workers are employed at different companies. This trend affects what workers are paid because some firms are simply more prestigious and productive than others, and these profits are shared with employees. “When janitors work at Goldman Sachs as Goldman Sachs employees, they tend to share in the firm’s huge productivity benefits,” former Institute advisor Lawrence Katz said in a 2017 interview. “But if they work for Joe’s Janitorial Services, they no longer share in those rents.”

Workers employed directly at Goldman Sachs also enjoy the company’s generous benefits packages. Both for legal reasons and to meet employees’ perceptions of fairness, firms cannot have 170 different benefits packages for 1,700 employees. Productive, prestigious firms tend to offer generous packages to attract and retain their high-paid employees—but then these benefits must be offered to other employees as well. Contracting out some types of jobs allows the firm to decrease what it pays in benefits.

Union-negotiated wages and benefits packages may also help explain why some workers are paid more for the same job. This was a part of the story behind wage disputes at Harvard in the early 2000s, where Katz has been a professor of economics since 1986. “The driving force was that Harvard had been contracting out a lot of janitorial work, security guards, food services. Part of that was to undercut the union wage and to get out of paying the same benefits that were really expensive,” Katz said in the 2017 interview.

All these factors affect the balance of power between workers and their employers. “To me, all this points ultimately to which workers are included and which workers are not included,” Kondo said about the role of outsourcing. “Does this boundary between staff and non-staff, between insourced and outsourced, does it potentially change the bargaining position of the worker vis-a-vis the firm?”

When outsourcing works

While outsourcing appears to have some harmful effects for workers, it is not wholly black and white. According to Katz, many workers in alternative work arrangements (including temporary help agency workers and contract company workers) appreciate the flexibility to choose their work and their schedule. Some may even see their wages increase. On the firm side, outsourcing may allow firms to respond more quickly and flexibly to changes in demand for their products or services, which could help the economy recover following recessions, a benefit for workers too.

And sometimes, outsourcing may be the least-worst option for firms facing labor shortages, the situation that some hospitals in the Twin Cities find themselves in. With difficulty filling open positions for sonographers, MRI technicians, nurse anesthetists, and other jobs, a St. Paul hospital has had to supplement in-house recruitment by temporarily filling these vital health care roles via staffing agencies, according to a senior recruiter at the hospital. It is an expensive solution, but the other options are reducing care or overburdening existing staff. And while the hospital hopes to reduce its use of outsourcing, there are some advantages, such as the ability to temporarily bring in more experienced nurses than the hospital could afford to hire outright. These nurses can provide training to others as well as critical care for complex procedures.

Understanding the various factors that lead to outsourcing as well as the diverse effects on employees will help inform policies that promote a strong, inclusive labor market for firms and workers.

This article is featured in the fall 2024 issue of For All, the magazine of the Opportunity & Inclusive Growth Institute