Validity of Baumol cost disease in the health sector: Empirical evidence from the Euro Area

Steady and cumulative increases in health expenditures put severe pressure on public budgets. The reasons for this situation, which is met with concern by policymakers and citizens, have been addressed in various studies, but no common consensus has been reached. Considering that health expenditures are generally financed by the public, determining the reasons for these expenditures is very important regarding fiscal sustainability. In this context, one of the explanations that remains on the agenda is Baumol's cost disease. According to Baumol, one reason for this continuous and cumulative increase is the rise in unit costs in the health sector, which is based on the fact that wage growth is higher than productivity growth. Baumol emphasizes that cost increases exceed inflation and draws attention to the steadily increasing share of related expenditures as a percentage of GDP. Therefore, it is important to investigate whether Baumol cost disease effectively affects the upward trend in health expenditures. This study investigates the validity of Baumol's cost disease in the health sector in selected Euro Area countries by using novel panel time series techniques for 1995-2019. The Baumol variable is calculated based on the difference between wages and productivity in the health sector. Thus, contrary to the existing empirical literature, a unique model was developed by decomposing the health sector from the total economy or stagnant sectors. The role of possible explanatory variables such as per capita income, life expectancy, population structure, medical technology, and trade unions was also controlled to test the effect of the Baumol cost disease. The findings indicate that the Baumol cost disease affects current health expenditures in the Euro Area countries. Moreover, the results remained unchanged when re-estimated in real prices. On the other hand, the findings show that income per capita and life expectancy are important explanatory factors of current health expenditures in the relevant sample.