Does Baumol's cost disease produce adverse growth effects under a balanced budget rule?
A major drawback of balanced budget rules such as the new fiscal compact of the European Union (EU) is that the impact of exogenous determinants such as population aging is not taken into account. In particular, many government services would appear to suffer from Baumol’s cost disease, which is technologically driven. Given fiscal restraints, public expenditure items that suffer from the cost disease might be crowded out in the budgetary process. If these expenditures are productive, adverse effects on economic growth can be expected. Unit costs of sectors that suffer from Baumol’s cost disease increase faster than in the overall economy. Thus, their cost share as a percentage of GDP increases. In contrast, a balanced budget rule usually implies that total government expenditures in terms of GDP are stabilised or even reduced. Apart from an early discussion the conflict between Baumol’s cost disease and fiscal rules has so far almost been neglected. This is all the more surprising as the current debate in the EU revolves around generating growth in EU-crisis countries. This present paper fills this gap by providing evidence for the relevance of Baumol’s cost disease for government expenditure decomposed by function and analyses the impact of the cost disease under a balanced budget rule. Thus, this present paper draws the attention to an important economic-policy issue pertinent to the new fiscal framework of the European Union. To estimate the impact of Baumol’s cost disease on government expenditure we apply an innovative approach, recently developed, the Baumol variable. This approach avoids using deflators of government services, which are notoriously difficult to calculate. Moreover, in the field of macroeconomics only non-high quality data are available, which can cause the widely used OLS estimator to become inefficient and biased. To deal with the latter we apply a fixed-effects model with a robust SMDM estimator.
Data
We carry out regressions with a panel database of the OECD for 25 OECD countries in the period from 1990 to 2010.
Conclusions
It is expected to show that balanced-budget rules produces adverse growth effects if productive government expenditure such as expenditures on education suffer from Baumol’s cost disease. Consequently, governments are well-advised to exclude productive government services caught by the cost disease from the balanced budget rule.