Trade Liberalization and the Wage Skill Premium: Evidence from Indonesia

Abstract

In this paper, we analyze the effect of reducing import tariffs on intermediate inputs and final goods on the wage skill premium within firms in Indonesia – a country with a high share of unskilled workers. We present a new finding that reducing input tariffs reduces the wage skill premium within firms that import their intermediate inputs. However, we do not find significant effects from reducing tariffs on final goods on the wage skill premium within firms.

Introduction

Most studies find that that globalization increases the wage skill premium in developing countries at the economy-wide level, within industries, and within firms (Goldberg and Pavcnik (2007)). In contrast, we present a new finding that globalization reduced the wage skill premium within firms in a developing country. In this paper, we analyze the effect of reducing import tariffs on intermediate inputs and final goods on the wage skill premium within firms in Indonesia – a country with a very high share of unskilled workers. We find that reducing input tariffs reduced the wage skill premium within firms that import their intermediate inputs. However, we find no significant effect from reducing tariffs on final goods on the wage skill premium within firms.

A key feature that differentiates this study is our focus on one of the most unskilled labor abundant countries in the world, Indonesia, whereas the previous literature on developing economies focused on middle-income countries such as Brazil and Columbia.¹ This is an important difference because even the standard Stolper-Samuelson results do not necessarily predict that globalization would increase the wage skill premium in a middle-income country (Stolper and Samuleson (1941)). For example, in a Heckscher-Ohlin world with more than one cone of diversification, so that there are three groups of countries (high, medium, and low), trade liberalization can increase or decrease the skill premium in the middle-income countries, but is still expected to reduce the skill premium in the least skilled-labor abundant country (Davis and Mishra (2007)).² Indonesia's relative lack of skilled labor can easily be seen in aggregate statistics. According to the Barro and Lee (2010) data set, only 4 percent of Indonesia's population had attained tertiary qualifications in 1995, whereas more than double this number had attained tertiary qualifications in countries like Brazil and Columbia.³ Similarly, 44 percent of the Indonesian population over the age of 25 had no schooling, compared to around 22 percent in Brazil and Colombia.

Even though the theoretical predictions of the HO model are clear for a country with a very high share of unskilled labor endowment like Indonesia, in practice it is difficult to establish a link between tariffs and economy-wide general equilibrium wages, which are at the heart of the Stolper-Samuelson theorem, because of confounding macroeconomic shocks. In Indonesia, for example, trade policies were liberalized at a time when the economy was simultaneously being hit by the Asian crisis, there were large currency swings, as well as pronounced increases in the relative supply of skilled workers. Thus, instead of focusing on economy-wide effects of trade liberalization, this study examines how trade liberalization affects the skilled wage premium within firms.⁴ Nevertheless, a country's relative factor abundance continues to be an important factor as it affects the trading patterns of the economy, and hence shifts in relative demand for skilled labor both across the economy and within firms.⁵

Another important difference from the previous literature is that we consider the separate role of intermediate input tariffs from that of output tariffs on the wage skill premium. Other studies have not considered the effect of reducing input tariffs on the wage skill premium. Instead, prior work only considers the role of output tariffs or trade shares in determining the wage skill premium. We show that once we control for input tariffs, the effect of final goods tariffs on the wage skill premium becomes insignificant. However, the effect of input tariffs on the wage skill premium is positive and significant in all of the specifications. The intuition for these results is as follows. Lower input tariffs make imported inputs cheaper relative to domestically-produced inputs. As firms substitute in-house production of intermediate inputs for imported inputs, their relative demand for skilled labor shifts. And the direction of that shift critically depends on the skill intensities of intermediate inputs relative to the skill intensities of the final goods production. We show that in Indonesia, intermediate inputs are produced with a higher skilled intensive technology than final goods. Thus, when input tariffs are reduced, firms switch from producing high-skilled intensive intermediate inputs to importing them, which reduces the relative demand for skilled workers. ⁶ The insignificant effect from reducing tariffs on final goods may appear surprising. However, the likely mechanism that would drive a within-firm effect from cutting output tariffs is if firms were to shift production between multiple products with different factor intensities. Our data set only lists the main product that the firm produces thus making it difficult to discern this type of effect.

Our finding that trade liberalization reduces the wage skill premium is consistent with broad trends identified in cross-country studies that have found that income inequality has increased mainly in middle and high-income countries, and less so in low-income countries over the past two decades, with declines in sub-Saharan Africa and the Commonwealth of Independent States (IMF (2007)). However, it is difficult for these aggregate studies to link income inequality trends to globalization, since many other liberalizations, such as financial liberalization and technological advancements, are taking place simultaneously. In fact, the IMF study concludes that technological changes were the key drivers of inequality. The few country studies that focus on low-income countries also find that trade liberalization reduces inequality. Kumar and Mishra (2008) found that lower tariffs on final goods reduced the industry wage premium in India, and since tariff reductions were larger in sectors with a higher proportion of unskilled workers, their study suggests that unskilled workers experienced higher wage increases than skilled workers. Studies of other low income countries, such as Vietnam in Brambillia et al. (2008) and McCaig (2011), and China in Zhang and Wan (2006) use household data to show that globalization reduced inequality. These studies are also consistent with our findings but are not directly comparable because of different measures of inequality: the first two measure inequality using farm income and poverty, respectively, while the latter focuses on urban-rural inequality.

The only studies of middle-income countries to find that the wage skill premium falls with trade liberalization are Robertson (2005) on Mexico and Gonzaga et al. (2006) on Brazil. These papers adopt the mandated wage approach, which essentially tries to link changes in output tariffs to an economy-wide wage under the assumption that price equals unit costs. However, more disaggregated studies that focus on a within-firm or within-industry effect found an increase in the skill premium in Mexico following a large currency depreciation (see Verhoogen (2008)), and no association between skill premiums and trade policy in Brazil (see Pavcnik et al. (2004)). To overcome the problem of separating multiple economy-wide factors from tariffs that affect the average wage, Goldberg and Pavcnik (2005) use the variation in industry level tariffs in Colombia as their identifying assumption, recognizing that this approach cannot identify the economy-wide effect which is captured by the year dummies. We follow Goldberg and Pavcnik (2005) in relying on the variation in industry level tariffs to identify the effects of tariff cuts on the wage skill premium; however, we do this at the firm level instead of the industry level. This has the advantage of allowing us to control for firm characteristics such as firm size, foreign ownership and skill shares that could also affect wages. Another benefit of conducting the analysis at the firm level is that we can allow for differential effects between domestically-oriented firms and globalized firms. Studies by Bernard and Jensen (1997) and Verhoogen (2008) show that there are significant differences in the wage skill premium paid by exporters and nonexporters. Following this line of research, we also allow for changes in tariffs to affect globalized firms differentially from domestically-oriented firms. We find that the effects on the wage skill premium are mostly concentrated among firms that import their intermediate inputs.

The importance of liberalizing input tariffs on other firm-level outcomes has been highlighted in previous studies. For example, Amiti and Konings (2007) show that liberalizing input tariffs has a much larger positive effect on productivity than liberalizing final goods tariffs. Similarly, Amiti and Davis (forthcoming) show that lower input tariffs and lower output tariffs increase wages in importing firms relative to domestic-oriented firms. Giovannetti and Menezes-Filho (2006) consider the separate effects of input tariffs and output tariffs on employment of different skill levels in Brazil. We extend this literature by focusing on the effects of reducing both input tariffs and final goods tariffs on the wage skill premium within firms.

We draw on a rich data set from Indonesia that provides firm-level data for a census of manufacturing firms that employ at least 20 employees for the period 1991 to 2000. These data include information on wages and employment of production and nonproduction workers, our measure of unskilled and skilled workers, respectively. They also provide employment details by education attainment for the years 1995 to 1997 and we use these to show that the nonproduction/production breakdown is a good proxy for skill, and to show that compositional shifts in education are not driving our results. The data also include information on firm-level exports and imports.

Our sample period is one of extensive tariff reform. In 1995, Indonesia became a member of the World Trade Organization (WTO), which involved giving various commitments to liberalize trade over a 10 year period. Output tariffs in Indonesia fell from an average of 22 percent in 1991 to 8 percent in 2000, and over this same period input tariffs fell from an average of 14 percent to 6 percent (see Table 1). There is also large variation in both input and output tariffs across industries, with output tariffs higher than 100 percent in some industries, for example on motor vehicles. The variation in tariffs across industries and over time allows us to identify the effect of tariff cuts on the wage skill premium. We regress the log of the firm-level ratio of the wage of nonproduction to production workers on 5-digit ISIC industry level input tariffs and output tariffs. All the equations include year fixed effects, so if trade liberalization only affects the economy-wide wage then this would be absorbed and the coefficients on the tariff variables would be insignificant.

The results provide evidence of a strong link between lower input tariffs and a fall in the wage skill premium. First, the most robust and strongest effects are within firms that import their inputs. A 10 percentage point fall in input tariffs reduces the skilled wage premium by 10 percent for the average importing firm, with the effects larger the higher the share of imported inputs. This is consistent with importing firms substituting imported inputs for in-house production of skill-intensive intermediate inputs. Given that importers account for 50 percent of total employment in the sample, these findings suggest that there could potentially be pronounced economy-wide effects of trade liberalization on the relative wage of unskilled workers.

Second, there are no statistically significant within-firm effects on the wage skill premium from reducing output tariffs.⁷ These results have parallels with the empirical literature on developed countries that mostly found no effect of globalization on the skilled wage premium (see, for examples, Krueger (1993), Lawrence and Slaughter (1993), and Berman et al. (1994)). However, Feenstra and Hanson (1999) show that outsourcing of intermediate inputs − the less-skill intensive production stages in U.S. manufacturing − significantly contributed to the increased wage skill premium in the U.S. in the 1980s. Our findings on input tariffs, though at the firm rather than economy-wide level, can be viewed as the flip-side of the Feenstra and Hanson result.⁸

The rest of the paper is organized as follows. Section 2 provides an overview of wage movements in Indonesia. Section 3 describes the estimation strategy. Section 4 describes the data, and measurement of key variables. Section 5 presents the results and Section 6 concludes.