The estimated income elasticity of demand for public consumption expenditure of 0.85 suggests that Wagner’s law is not confirmed. In contrast, price-inelastic demand combined with a strong increase in the prices of public services relative to private goods suggest that Baumol’s cost disease is at work.
A counterfactual exercise shows that in the absence of the rise in the relative price of publicly provided goods, current public consumption would equal 15.98% of GDP instead of the actually observed 19.92%. We further confirm the main observations using a cointegration model. 129 -> 250!
In this paper, we analyze two complementary theories which aim to explain the growth of the public sector over time. The one focuses on the role of demand for public services which, as formulated by Wagner, should grow over time as the population becomes richer. The other stresses the role of the increasing costs of production of public goods, resulting from increasing wages in the public sector without accompanying increases in the productivity of the public sector.
We show that the latter hypothesis is confirmed by the data for Austria and that demand cannot explain the growing nominal public consumption expenditure since the 1940s. For many, Baumol’s cost disease is an inherent feature of labor-intensive sectors of the economy and as such cannot be counteracted. It is, indeed, quite difficult to increase productivity in the performance of a string quartet playing Beethoven, following Baumol’s original example. However, the other problem is that Baumol’s cost disease is often presented in relation to sectors that cannot increase productivity, but it is often applied to sectors that will not. This holds true for many goods and services typically provided by the state, including general administration.
Public sector administration could be performed much more efficiently, as though it were not a “monopoly”: services of general administration are no different from market-oriented financial or professional services, and they could certainly make more use of access to new technologies and digitalization.