Testing the Baumol–Nordhaus Model with EU KLEMS Data

Abstract

Baumol's (1967) seminal model of structural change predicts that large service industries financed mainly through taxes and social contributions - like health care and education, for instance - will acquire ever-larger shares of total expenditures and that, concomitantly, overall productivity growth will decline. Applying a new testing strategy for Baumol's model, Nordhaus (2008) finds strong evidence in favor of the “cost and growth diseases” in U.S. GDP-by-industry data (published by the Department of Commerce's Bureau of Economic Analysis). The aim of the present paper is twofold. The first is to check whether Nordhaus's results can be reproduced using U.S. industry data from the EU KLEMS database. Second, Nordhaus's testing methodology is applied to European Union data from the same database. The results suggest that - although there are differences vis-a-vis the U.S. - the EU also shows symptoms of “Baumol's diseases.”