Vertical Specialization in Multinational Firms Gordon H. Hanson University of California, San Diego and NBER Raymond J. Mataloni, Jr. U.S. Bureau of Economic Analysis Matthew J. Slaughter Tuck School of Business at Dartmouth and NBER

Introduction The expansion of multinational firms has contributed to the dramatic recent growth in world trade. Multinationals create trade in part by setting up global vertical production networks. In semiconductors, firms perform R&D in US, fabricate silicon wafers in Taiwan, and assemble chips in China. In autos, firms produce high-end components in US and locate downstream tasks near markets in S. America, Asia, and Europe. This vertical specialization accounts for one-third of recent growth in world trade (Hummels et al., 2001). Parts and components are responsible for 30% of world trade in manufactures (Yeats, 2001).

Introduction Why do multinationals vertically fragment production? Low import tariffs, transport costs. In theory, low trade costs make back-and-forth trade feasible between parents and their foreign affiliates. Implies that small reductions in tariffs can boost trade by a large amount (Yi, 2002). But previous empirical research suggests that tariffs raise FDI by inducing firms to replace exports with production abroad by foreign affiliates (Brainard, 1997; Carr et al., 2001). International differences in wages. In theory, firms prefer to locate labor-intensive tasks in low-wage countries, skill-intensive tasks in high-wage ones (Helpman, 1984). But previous empirical work (see above) suggests that large local markets, and not low wages, are what attract multinational firms.

Regional Shares of Employment by Foreign Affiliates of US Multinational Firms (%)   OECD Mexico Other East Middle Europe & Asia Latin Asia & East & Canada America China Africa 1989 62.7 7.3 6.4 12.4 2.9 1998 57.3 6.9 9.7 10.8 11.1 2.3

Table 2: Share of Imported Inputs in Total Sales of US Foreign Affiliates (%)   Region World OECD Canada Mexico East China Industry Europe Asia All Manuf. 13.6 5.6 10.4 38.7 36.7 15.2 11.2 Machinery 11.0 8.2 7.4 37.2 44.2 8.6 3.8 Electronics 17.4 9.8 17.9 20.2 40.8 27.0 20.5 Transport 21.4 2.3 5.1 50.4 45.7 6.2 -- Equip.

Our Paper We use BEA firm-level data on US multinationals to analyze a direct measure of vertical specialization: The demand for imported intermediate inputs (for further processing) by foreign affiliates in manufacturing in 1994. We are able to measure the extent to which foreign affiliates specialize in processing inputs supplied by their US parents. We estimate the sensitivity of demand for imported inputs to host-country tariffs, wages, and taxes. Previous work uses aggregate data on multinationals and so may miss how production is organized in foreign affiliates.

Preview of Empirical Findings A prominent role for tariffs in vertical specialization. Trade in imported intermediate inputs is greater where host-country tariffs are lower. Sensitivity of vertical specialization to host wages. Input trade is greater where wages for low-skilled workers are lower and wages for high-skilled workers are higher. Impact of other host policies, characteristics. Input trade is greater where corporate tax rates are lower, free trade zones exist, and host countries are smaller.

Empirical Framework Consider a US multinational firm at a point in time that is deciding how to organize production in its foreign manufacturing affiliates. For simplicity, assume production involves two stages: input manufacturing and input processing. The US parent chooses between fragmenting these two stages across borders (vertical specialization) or co-locating them at home and abroad (vertical integration). Our framework captures the role of trade costs, labor costs, and other factors in this decision.

Empirical Framework Using a cost-minimization framework, we derive a foreign affiliate’s demand for imported intermediate inputs (from US parent and other entities). The greater are imported intermediate inputs as a share of total costs the more vertically specialized is the affiliate. According to theory, input demand will be a function of: Host-country import tariffs and transport costs. Host-country wages for low-skilled and high-skilled labor. Host-country corporate taxes. Other host-country policies and characteristics.

Estimation Issues We do not observe transaction prices that affiliates pay for inputs that they import from their parents. We control for input prices by decomposing them into a parent-industry fixed effect (to capture price in US of inputs parents supply to their affiliates) and host-country trade costs. Parents may manipulate input prices they charge affiliates in order to shift income between tax jurisdictions. The incentive to transfer price is influenced by: the foreign tax credit status of the US parent (captured by parent-industry fixed effects), and the corporate tax rate in the host country. Other estimation issues: Zero values for dependent variable, how to measure wages, whether other host-country characteristics matter.

Summary of Estimation Strategy To explain the variation in imported intermediate inputs across foreign affiliates (of same parent), we estimate the responsiveness of processing imports to wages, tariffs, tax rates, and other variables. From coefficient estimates, calculate elasticities of input demand w.r.t. trade costs and factor prices.

Data Description We use data on majority-owned foreign affiliates of US multinationals in manufacturing for 1994. Sample: 4,285 affiliates that belong to 640 US parents. Variables: Imported intermediate inputs for further processing as a share of total sales, capital stock, total output, average earnings of high-skilled labor and low-skilled labor. Other data: Trade costs: tariffs, NTBs, freight costs, distance, language. Corporate income taxes: statutory rate, effective average rate. Wages for skilled, unskilled workers; market size; EPZs; exchange rate policies; host-country institutions.

Table 1: Summary Statistics   Variable Mean (s.d) Imported-Input Share in Costs 0.110 (0.176) More-Skilled Wages ($) 28,647 (17,173) Less-Skilled Wages ($) 14,408 (7,927) Tariff Rate (%) 5.4 (5.2) Freight Costs (%) 4.9 (14.1) Average Corporate Tax Rate (%) 25.7 (9.8)

Main Empirical Results The share of imported intermediate inputs in total costs is higher for affiliates in countries with Lower tariffs and lower freight rates. Membership in NAFTA. Lower wages for low-skilled labor. Higher wages for high-skilled labor. Lower corporate income tax rates. Export processing zones and smaller domestic markets.

Interpreting the Results A reduction in imports tariffs from 15% to 5% (from two σ’s above the mean to the mean): Raises demand for imported intermediate inputs by 18%. A reduction in average wages for low-skilled labor from US levels ($15,540) to Mexico levels ($4,622): Raises demand for imported intermediate inputs by 41%. A reduction in the statutory corporate tax rate from 55% to 26% (from two σ’s above mean to mean): Raises demand for imported intermediate inputs by 10%.

Robustness Checks Drop observations with high tariff values. Tobit estimation with industry dummy variables. Control for country-specific fixed effects. Change variable definitions.

Conclusion In this paper, we examine trade in imported inputs for further processing between US parent firms and their affiliates in foreign countries. These shipments of intermediate inputs provide a direct measure of vertical specialization within the global production networks of multinational firms. We find input processing by foreign affiliates to be driven by trade costs, factor prices, and other host-country policies and characteristics.

Conclusion Where to locate processing of intermediate inputs: Multinationals appear to prefer countries with abundant low-skilled labor, low tariffs, low corporate taxes, good access to the US, and small domestic markets. This is not the message of previous research, which emphasizes desire of multinationals to locate behind tariff walls in order to serve large, local markets. As low-wage countries continue to lower trade barriers, we expect them to play a larger role in the vertical production networks of multinational firms.