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7 International mobility of labor and
capital
Learning objectives By the end of this chapter you should be able to understand:
- how international capital flows reduce differences in returns across countries and raise world output;
- how international flows of labor reduce differences in wages across countries but may reduce per capita income in the host country;
- that a firm may operate in more than one country (as a multinational corporation), either to serve the local market rather than export (horizontal integration) or to source inputs more efficiently (vertical integration).
The previous chapters assume that goods are internationally mobile (i.e. that merchandise trade occurs) but that factors of production are not mobile. The basis of Heckscher–Ohlin trade is precisely that large differences in relative factor endowments produce parallel differences in factor prices; these in turn lead to differences in relative goods
prices, which makes trade based on comparative advantage possible. A country with a relative abundance of labor, for example, will have low wages, which will give it a comparative advantage in labor- intensive goods such as apparel and shoes. Differences in factor prices exist prior to trade results because labor and capital are internationally immobile. Otherwise, labor and capital would relocate to eliminate these differences.
When daily news reports headline the challenges posed by immigration or debate the desirability of allowing foreign investment, we readily conclude that the assumption of completely immobile factors of production conflicts with reality. At least some labor and capital movement occurs between countries, as we document below. Labor migrates, legally or otherwise, from low- to higher-wage countries. International capital flows seeking higher returns are a major element of international finance. Of course, labor mobility is limited by immigration laws, transportation costs, lack of information about job opportunities, and language differences. International investors are deterred by different legal and regulatory environments, discriminatory taxes, potential expropriation, incomplete information, and a variety of risks, including a decline in the value of assets it holds that are denominated in foreign currencies. Nevertheless, concerns over globalization rest on the rapid increases in labor and capital mobility
two-thirds of the way back to reclaiming the title “a nation of immigrants” after a half-century retreat. While the immigration rate is now only a third of that achieved at its peak in the first decade of the 20th century, the contribution of immigration to population and labor force growth is similar because the rate of natural increase has also declined.^1 Within Europe, Germany experienced immigration rates greater than 1.0 percent in the early 1990s due to the opening up of Eastern Europe. 2 Table 7.1 reports the share of the immigrant population in
several OECD countries, a figure that can be measured more accurately from census data than most annual flow calculations are. They show that in most of Europe and in the United States, there has been a noticeable increase in the immigrant share of the population. The rising ratio can be explained by the large role that immigration plays in overall population growth for these countries. For example, between 1999 and 2004 the UK population rose by a little over 1 million people, and the number of immigrants living in the UK rose by a little over 1 million people. Not surprisingly, the immigrant share of the total population rose from 7.6 percent to 9.3 percent. [Table 7. about here]
Capital flows are treated in greater detail in Part II of this book. An important aspect of those flows to note here is the comparison of investment by multinational corporations (MNCs), which is shown in
Table 7.2. The stock of MNC investment as a share of GDP has risen for most countries, both developed and developing. Those increases are not always smooth and predictable, however, and not all countries within the groupings shown fare as well as the average reported. The growing importance of both inward and outward investment is a sign that economies are becoming more interdependent, and the generalization that MNCs must be from rich countries is unwarranted. Another measure of their importance is given by MNC investment relative to total investment in the host economy. For smaller developing countries, MNCs account for an important share of the total. Because the total includes housing construction and government capital formation, where the role of MNCs is minimal, the figures reported here imply that MNCs are a particularly significant source of business investment. While investment by MNCs often is linked to the flow of capital between countries, generally it has even more to do with the flow of ideas and technology between countries. Analyzing the motivation for these various factor flows and assessing their consequences is the focus of this chapter. [Table 7.2 about here]
A basic model of capital mobility
To indicate the consequences of factor movements consider a framework similar to the specific factors model introduced in Chapter
can think of the price reflecting the rental rate received for the leased machines. Or, we can express this return in percentage form as a share of the value of the machine. That form may seem more familiar when we think of financial flows across borders, which then allow borrowers to make investments in plant and equipment. Our model applies to both situations. Suppose capital flows initially are prohibited, and the allocation of capital is given by K 0 where the return in Mexico is r (^) mex and the return
in the United States is rus. If those prohibitions are eliminated, the
higher return in Mexico than in the United States will attract an inflow of capital, K 1 K 0 , which equalizes rates of return in both countries at r (^) w.
The extra output in Mexico is given by the area under the MPKmex
curve, the trapezoid WXK 0 K^1 , but US capital owners only need be paid the rectangle WYK 0 K 1. That results in a gain to the Mexican economy of the black triangle WXY. In the United States, output falls by the area under the MPK (^) US curve, the trapezoid WZK 0 K 1. Because US capital owners gain the rectangle WYK 0 K 1 , the US economy as a whole gains
the hatched triangle WYZ. Capital moves from less to more efficient uses, interest rates are arbitraged together, and total income in both countries increases.
Sizable income redistribution effects exist, however. Capitalists in Mexico previously earned the rectangle XCOmexK 0 , but now only receive
YDOmexK 0 , a loss of XCDY. If labor is the other factor used in production
and it is fixed in suppy, labor gains this rectangle as well as the triangle WXY, a benefit from the inflow of capital that makes labor more productive. In Mexico capital loses and labor gains. The redistribution in the United States is in just the opposite direction. US capital owners previously earned the rectangle BZK 0 OUS , but now earn
AWK 1 OUS from the portion of their capital that remains in the United States and WYK 0 K 1 from the portion now utilized in Mexico. Thus, US
capitalists gain the rectangle AYZB. US labor now has less capital with which to work and the income it receives falls by the trapezoid AWZB. US capital gains and US labor loses.
International factor mobility produces the same dilemmas as does free trade. Total output and incomes clearly rise, but income is redistributed in ways that may be painful and politically controversial. From the perspective of Mexican labor and US capital, the process described here should be encouraged, but US workers and Mexican owners of capital will have the opposite view. Political conflicts over immigration laws and policies affecting international capital movements are likely to reflect these differing interests.
percent. International capital flows do increase efficiency, as does a system of granting foreign tax credits, but the flows may not benefit both the investing and the host country.
The implication that host countries will choose to tax foreign capital to capture such gains in public revenue conflicts with headlines of tax competition and a “race to the bottom” regarding tax rates levied by potential host countries.^3 To evaluate that rationale, extend the model above to consider a world with many potential investment sites and the possibility that a higher rate of return can result in a larger capital stock in a country through greater domestic saving. Figure 7.2 shows the effect of a tax levied by a country too small to affect the rate of return internationally. The supply of capital to it from the rest of the world is horizontal at the world rate of return, r (^) w. If the revenue from the tax is not used in a way that creates benefits to capital owners, a country that levies a higher tax on capital than its competitors will experience a capital outflow. Capital will flow out of the country until the before-tax return is high enough to yield the same after-tax return available elsewhere in the world. In this case, the economy loses K 1 K (^0)
of capital. Note that the domestically provided capital, K (^) d, has
remained unchanged, while all the loss is accounted for by a smaller inflow from the rest of the world. [Figure 7.2 near here]
Again, we can use this diagram to demonstrate distributional effects of the tax on capital used in the country. The demand curve for capital is based upon the extra output produced by an additional unit of capital. The output of the economy for the capital stock of K (^) 0 is given by the area under the demand curve, r*aK0. Total payments to capital are represented by the rectangle given by r (^) w times K (^) 0. The portion left
over for immobile labor is the triangle given by r*ar (^) w. Now note what
happens to this area when the tax is levied. Because the before-tax return to capital rises, the triangle representing the return to labor and land declines to r*br (^) w*. The burden of the tax on capital has been shifted entirely to the immobile factors of production, labor and land. 4 In fact, the loss to them is greater than the gain to the government due to the loss of the shaded triangle in Figure 7.2. The less efficient allocation of resources leaves less capital to work with labor and land. For a country that is too small to affect prices of goods or returns to mobile capital internationally, taxing portfolio capital reduces national income and is less desirable than taxing land and labor directly.
Perhaps in recognition of this principle, most developed countries do not levy a high withholding tax on interest income earned by foreign lenders, and many, such as France, Germany, the United Kingdom and the United States, impose no tax at all. Many developing countries, however, impose withholding rates of 10 to 15 percent, and cite the
and vice versa, as a result of these gains from diversification. That topic is covered in Part Two. The model assumed in Figure 7.1 best applies to net flows of capital.
Our capital flow model abstracts from another aspect of capital mobility that was a feature of the 1990s: financial instability. If lenders reassess the attractiveness of providing capital to foreigners, the adjustment in the case of financial flows is not as simple as a leasing company bringing its equipment home. Rather, the desire of lenders to withdraw funds may require borrowers to sell assets that have few alternative uses. Over-reliance on short-term debt to finance long-lived assets results in the borrower becoming particularly vulnerable to unexpected bad news. Determining a firm’s appropriate financial strategy to avoid such problems is another important topic in international finance.
Issues raised by labor mobility
The one-good model with capital flows represented in Figure 7.1 can be applied to the case of labor mobility, too, if we assume that labor moves while capital remains fixed. The implications are straightforward: immigration will cause the wage to fall in the country that initially has the higher wage and to rise in the country that initially has the lower wage. Capital and other fixed factors gain in the former
country and lose in the latter country. Income for each country, including remittances, rises.
Are those predictions born out in empirical studies? We consider below some of the potentially offsetting factors that make it surprisingly difficult to demonstrate such outcomes. When the amount of labor that comes into a country is large relative to any other changes that may be occurring at the same time, however, then those predicted wage effects can be observed. Williamson cites evidence from the four decades before 1913: in Australia the wage rental ratio fell by 75 percent, in Argentina by 80 percent, and in the US by more than 50 percent, while it rose by a factor of 2.7 in Britain and 2.3 in Denmark and Sweden.^5 A more recent example is the influx of Soviet Jews into
Israel in the 1990s, which resulted in a 20 percent increase in the labor force and a 10 percent fall in wages below their trend value.
If wages in the high-wage country fall, the median voter model discussed in Chapter 6 suggests that high-wage countries may consider more restrictive immigration policies in spite of the rise in national income. Additionally, such immigration does not necessarily increase per capita income, because the receiving country’s population grows. If the immigrants are unskilled and bring little or no capital with them, they are likely to lower US or European per capita output. This outcome can be demonstrated as follows:
Furthermore, an influx of immigrants can affect welfare in the host country when it leads to congestion in the use of public goods and services, such as roads, parks, and schools, or greater demand for transfer payments to cover expenses of housing, food, and medical care. The net fiscal balance from immigration depends upon taxes paid versus the extra demands for services and transfers created. The situation summarized above suggests why industrialized countries may not find it in their interest to allow unlimited immigration. While total output would rise in the industrialized countries, output per capita would not. Conversely, labor abundant developing countries may view emigration as a vital safety valve that raises national income. A UN study estimates that restriction on migration from developing countries reduces their income by $250 billion a year. 6 Even among developing
countries, migration occurs, as Indonesians migrate to Malaysia and Guatemalans migrate to Mexico. Negotiations to allow freer movements of labor internationally have made little progress, in part due to these opposing and conflicting interests.
Mitigating Factors
The scenario sketched above is not the only possible outcome. Some of the factors held constant in that analysis may in fact change. A
concentrated impact within the host country is often not observed where immigrants settle, because there is offsetting movement of the native population away from those regions. The Mariel boatlift of emigrants from the jails of Cuba to Miami is one example of this effect, where no negative effect on wages in Miami occurred. The migration out by previous residents results in a pattern of adjustment that spreads any downward pressure on wages over a larger labor market. Any change in wages is less visible. Furthermore, there may not be a reduction in wages if not only labor moves, but also capital. Any tendency for labor to drive down wages and costs of production in that location and to raise the return to capital may attract a capital inflow. If both capital and labor increase by the same proportion, the ratio does not decline, and labor productivity does not fall as assumed above.
The assumption that only one good is produced also affects the outcome. In the H–O model with two produced goods, an influx of unskilled labor leads to a shift in output toward goods that require unskilled labor intensively, such as apparel. At unchanged prices, there is no reason for wages to fall. Capital can be attracted out of capital- intensive sectors, whose output will fall, to be reallocated to the expanding labor-intensive sector. With no decline in the capital-to- labor ratio, wages are not driven down. That is the Rybczinski result
labor is an important one to make with respect to comparative advantage and trade, and it is important in the case of immigration, too. Which groups of workers are most likely to immigrate, and how do the consequences differ? Economists have found that the poorest workers are not necessarily the most likely to emigrate, even though their wage gap may be the greatest, because the economic and psychic costs of emigration exceed their ability and willingness to pay. The greater the distance to travel, the higher will be the proportion of skilled immigrants. Host countries often encourage the most educated to immigrate, because the human capital they bring means the capital/ labor ratio can rise and output per capita can increase. 8 Also, skilled
immigrants will be net fiscal contributors in providing public goods. The immigration policy of countries such as Australia and Canada provides a large role for a merit-based point system that rewards education. For the EU and the US, non-economic factors such as family reunification or admission of refugees and asylum seekers play a bigger role. Nevertheless, Docquier and Marfouk compile data for the 1990-2000 period in OECD countries that show legal immigration of the highly skilled has exceeded that of the low skilled.^9 When illegal
immigration is considered, however, the US position is more bimodal, a result that shows large numbers of skilled and unskilled immigrants. Brain drain and brain gain concerns
The United States benefited enormously from the arrival of large numbers of scientists and engineers fleeing Europe before World War II, as it is benefiting today from the talented people migrating from a variety of developing countries. Scientists from East and South Asia have become a major force in US high-technology industries. The European Commission Green Paper on immigration policy raises several fundamental questions over the harmonization of immigration policies by its member states, and it particularly notes the advantage of a policy that would avoid “potentially harmful competition between Member States in the recruitment of certain categories of workers.” 10
The benefits to receiving countries of attracting high-skilled workers seem clear.
Conversely, source nations that lose their skilled workers to others worry about a brain drain. Just as the US lost tax revenue in the case of capital mobility treated above, source nations face a similar loss when skilled workers emigrate, even if world welfare rises. The problem is compounded because much of the education of these individuals is paid for with public funds. The benefits of providing more education simply spill over to the rest of the world. Although some countries have imposed exit taxes on those emigrating, some commentators instead call for payments by the wealthy host countries to compensate for this loss of revenue.
