“Investors hate ‘employment’ because it seems like a fixed cost, even though most companies have no reluctance to get rid of employees, and many keep contractors around as long as their average employee,” says Cappelli, director of Wharton’s Center for Human Resources. “Even though it is typically more expensive per hour to hire contractors, it shows up on different budgets. But it also reflects a general short-term view of strategy: Rather than getting really good at something, which requires investing in competencies, we are going instead to just find new opportunities quickly.”

There are, however, costs to contracting out, and those costs are becoming increasingly hard to ignore. Lack of institutional memory and slowed organizational momentum are obvious deficits to relationships with contract workers. More important, by not investing in the individual, companies are also simply shifting costs.

“I think more than short-termism, this is a classic example of a so-called negative externality,” says Wharton professor of management Claudine D. Gartenberg. “By that I mean, here’s a series of decisions taken by companies — and not just for-profits, but universities, hospitals and across the non-profit sector, as well — that often benefits the organizations financially, but may have serious social consequences that are not borne by the organizations but by workers and society as a whole.”

Moreover, there is reason to believe that just as contract work is not a panacea for workers, it is also not a panacea for companies. “Contract workers have a fundamentally different relationship with the companies they work for than employees do,” says Gartenberg. “Just as companies under-invest in contractors, there are ample studies that suggest that contractors likewise under-invest in the companies. This could definitely hit the bottom line in areas like innovation and customer service.”

If we are in fact in the process of solidifying two distinct classes of workers — one employee in which firms invest, and another that is in a sense more disposable — what are we as a society losing?

“A lot,” says Gartenberg. “This is what the American Dream is built on — upward mobility. Contract work and outsourcing, among other factors, appear to be disrupting that engine, and it is not clear what the best policy response, if any, should be.”

“Investors hate ‘employment’ because it seems like a fixed cost, even though most companies have no reluctance to get rid of employees, and many keep contractors around as long as their average employee.”–Peter Cappelli

A Cost Masquerading as a Savings

While contract workers look good for the bottom line, that’s not the end of it. “It’s great having these people who aren’t part of the headcount, but then you discover all of these hidden costs,” noted Wharton management professor Matthew Bidwell during a recent appearance on the Knowledge@Wharton show on SiriusXM channel 111. (Listen to the full podcast using the player at the top of the page.) “Turnover is higher; often you have to pay them more because they need some premium in order to come to work. And it’s quite disruptive. When contractors move out, you have to move somebody else in and train them up again.”

The introduction of second-class status for some employees also changes the workplace dynamic. “It’s a big deal,” says Bidwell. “Whenever you start designating different groups it creates friction. We worry that contractors can feel threatening to regular employees — there is a sense of, ‘Is my job going to be next to be contracted out?’”

Contracting also appears to have a deleterious effect on one’s career arc. “One big issue is training,” notes Bidwell. “As an employee, your employer may pay to train you and keep you up to date on new technologies. They will also give you a chance to try new kinds of work and learn that way. As a contractor, nobody is paying for you to learn. They only want to hire you to do things that you have already demonstrated you can do elsewhere. That means you have to pay for your own training. You also suffer a Catch-22 when it comes to doing new kinds of work. People won’t hire you to work on different stuff until somebody else has already hired you to do it.”

Bidwell and Wharton doctoral student Tracy Anderson are working on a study that looks at MBA alums who work as contractors, and, in analyzing career trajectories, they find that people who spent time as a contractor seemed to suffer a career penalty later on. “The contractors also said that future employers didn’t take their contracting experience seriously. I think these challenges are particularly severe for contractors in managerial work,” Bidwell said.

Still, contracting out appears to be growing. Exact numbers are elusive because job categories are often only loosely defined. But the percentage of workers engaged in alternative work arrangements of various types — temp agency workers, on-call workers, contract workers, and freelancers — rose from 10% to nearly 16% between February 2005 and late 2015, according to Lawrence F. Katz of Harvard and Alan B. Krueger of Princeton. The percentage of workers hired out through contract companies showed the sharpest increase — from 0.6% in 2005 to 3.1% in 2015.

“A striking implication of these estimates is that all of the net employment growth in the U.S. economy from 2005 to 2015 appears to have occurred in alternative work arrangements,” write Katz and Krueger in “The Rise and Nature of Alternative Work Arrangements in the United States, 1995-2015.”

“Here’s a series of decisions taken by companies … that often benefit the organizations financially, but may have serious social consequences….”–Claudine D. Gartenberg

The consequences are rippling out. Large U.S. firms have played a big role in reducing wage dispersion, therefore helping to mitigate inequality, according to Wharton management professor Adam Cobb and University of Texas at Austin sociology assistant professor Ken-Hou Lin. But that is less the case now, they argue in “Growing Apart: The Changing Firm-Size Wage Premium and Its Inequality Consequences,” published in Organization Science in May, 2017.

Using data from the Current Population Survey and the Survey of Income and Program Participation, Cobb and Lin find that in 1989, although all private-sector workers benefited from a firm-size wage premium, the premium was significantly higher for individuals at the lower end and middle of the wage distribution compared to those at the higher end. But between 1989 and 2014, the average firm-size wage premium declined markedly. Significantly, the decline was exclusive to those at the lower end and middle of the wage distribution — while there was no change for those at the higher end. They conclude that the uneven declines in the premium across the wage spectrum could account for about 20% of rising wage inequality during this period.

“While large firms still compress the wage distribution, they do so to a much lesser degree than in the past. This suggests that although large U.S. firms in our observation period lowered wage inequality, their role as an inequality-mitigating institution has diminished considerably over time,” they write.

Can the Pendulum Ever Swing Back?

In fact, the spread of alternative work arrangements has resulted in “downward pressure on earnings and the shifting of basic risks onto workers and their households,” wrote David Weil, author of The Fissured Workplace, in the Huffington Post recently. Weil, who led the Wage and Hour Division of the U.S. Department of Labor during the Obama administration and is now dean and professor at the Heller School of Social Policy and Management at Brandeis University, is arguing for a number of interventions: Creating greater transparency on wages and working conditions, drastically reducing the use of non-compete and mandatory arbitration clauses by employers, creating greater access to skill enhancement, and fostering more varied methods of third-party worker representation (including, but not limited to, unions).

A few trends and forces could slow the use of contract workers, says Gartenberg. “The first is the rise in data analytics within firms. Firms have long suspected the costs of employee disengagement. Gallup estimates $500 billion in lost productivity per year from low employee engagement, and another study shows the bottom-line benefits of having employees feel a strong sense of purpose, which contractors likely do not share,” she notes. “But until a clearer case can be made firm-by-firm, it is hard to justify a change. A range of new technologies for measuring employee productivity, innovativeness, and linking those outcomes to happiness may well help companies make the case to in-source and re-invest in employees.”

“This is what the American Dream is built on — upward mobility. Contract work and outsourcing, among other factors, appear to be disrupting that engine.”–Claudine D. Gartenberg

Another possible impetus for change could come via the decline in publicly traded firms and the increase in institutional common ownership of those that remain. “There are half the number of public firms today as there were in the late 1990s, and investment capital is increasingly concentrated within a few institutional investors,” she says. “Large institutional shareholders are feeling increasing pressure to invest in socially responsible firms. These two trends in corporate ownership may converge to swing the pendulum back towards investing in workers, if enough external pressure is applied and if a sufficient business case can be made.”

Surprisingly, automation may play a role in reversing the trend. If more of the rote work becomes automated, we may be left with work where hard-to-contract softer skills matter more and correspondingly mean higher pay, “at least for a subset of workers,” says Gartenberg. “As an example, I was recently talking with the head of operations of a health care logistics start-up. She said their entire logistics operations were essentially automated, and a real source of advantage was that their call-center representatives were freed up to provide the human face to the company. They had no intentions to outsource or automate that function, as they recognized the value of engaged employees interacting with customers, rather than the mind-numbing IVRs [interactive voice response systems] that we have learned to hate over the past 20 years.”

Bidwell points out that the question of whether the use of contractors continues to grow depends at least partly on legal enforcement. “[For] the previous [presidential] administration, one of their priorities was around companies that were incorrectly classifying independent contractors as employees. Obviously once you are classified as a contractor you are outside of some of the protections — you are under a different tax code, not subject to the minimum wage, all of those sorts of things,” he says. “And contracting shouldn’t be a means for companies to stage an end-run around a bunch of laws that are there because we believe that fundamentally most employers have much more power in the bargaining relationship than employees and we want to even that up a certain amount.” Ideally, we would update the law, Bidwell adds, but “getting anything through Congress these days is not necessarily easy, and so, with a different administration, how fierce they are on who is a contractor versus an employee is going to have at least some impact on this market.”

“It’s great having these people who aren’t part of the headcount, but then you discover all of these hidden costs.”–Matthew Bidwell

As it is, the “legal situation in the U.S. is a light touch,” says Janice Bellace, Wharton professor of legal studies and business ethics. When it comes to companies contracting for workers with another company — a temp agency, for instance — the law has little to say. When a firm engages an individual as independent contractor, there are rules to be followed, and the firm that flouts them risks the government stepping in and determining that they are employees rather than contractors.

But those risks were greater under Barack Obama, when there was a more worker-friendly National Labor Relations Board. In addition, Donald Trump has drastically reduced the enforcement capacity of the Department of Labor by cutting the budget. “Consider that Trump’s first nominee for head of the labor department was a man who headed a fast food chain that had been repeatedly cited for wage/hour violations,” Bellace says.

But what should the policy response be to the increased use of contracting? Gartenberg says that it is important to take note of two factors. First, there is a difference between involuntary temp-workers or workers for contracting agencies, and freelancers/independent contractors. For the latter group, many prefer contract status to full-time employment, and “grouping these people into the overall pool of contract workers overstates the problem,” she says.

Second, alternative work arrangements enable firms to be more competitive overall by lowering costs and providing a better way to respond to market fluctuations. “If, in an alternate world with 100% full-time workers, these firms would be uncompetitive, then these arrangements may end up helping on net, even if some are worse off,” says Gartenberg. “Or, firms may be stuck in a downward spiral where workers end up net worse off, but no single firm can undo this because they cannot bear the costs and remain competitive. These two factors highlight why this isn’t necessarily a cut-and-dry problem with easy answers.”