The aim of this paper is twofold: First, we show that governments face a serious dilemma under a balanced budget rule if Baumol’s cost disease affects government expenditure. Either policy-makers have to cut those government services that are affected by the cost disease, or they have to breach the rule to maintain disease-prone government services. Second, we provide empirical evidence that Baumol’s cost disease matters for the government sector.
Background
A major drawback of balanced budget rules, such as the one for the new fiscal compact of the European Union (EU), is that the impact of exogenous determinants (such as population ageing or Baumol’s cost disease) are not taken into account. Services that suffer from the cost disease have low productivity growth compared to other sectors (such as manufacturing). In the long run, wages in the Baumol sector should increase in line with wages in other sectors of the economy. As a result, services that suffer from the cost disease incur above-average inflation. Thus, to maintain the quantity of government services that suffer from the cost disease, government expenditure has to increase faster than gross domestic product (GDP). However, a balanced budget rule requires that government expenditure should be stabilised in terms of GDP, or even reduced. Apart from an early discussion in the literature, the conflict between Baumol’s cost disease and fiscal rules have so far almost been neglected. This paper fills this gap by showing that Baumol’s cost disease is inconsistent with a balanced budget rule.
Data
We run regressions with panel data from 24 Organisation for Economic Co-operation and Development (OECD) countries for the period from 1990 to 2010. The database originates from the OECD National Accounts. We apply an innovative approach to test for Baumol’s cost disease that avoids using flawed deflators of government services. Moreover, we use an outlier-robust estimator, the MM estimator, to cope with the distinct heterogeneity of panel-data sets.
Results
We conclude that Baumol’s cost disease matters in the government sector. The findings suggest that, in particular, expenditure on total government services, on healthcare, and on education suffer from Baumol’s cost disease. Consequently, in order to maintain the quality of disease-prone government services and sustain economic growth, Baumol’s cost disease should be included in the framework of a balanced budget rule such as the EU Fiscal Compact.