Baumol’s law and the welfare state

Baumol’s law says that a two-sector economy with a permanent difference in productivity
growth has no steady state.2 That is, a Baumol-problem will always emerge.

[...]

The analysis in the paper deals with a simple two sector model, which is in perfectly balance, if the two sectors grow at the same rate. However, as the public sector has lower productivity growth than the private one, no steady state growth is possible. This is shown in general, and in two policy cases, where the government adopts a policy fixing a major ratio. A Baumolproblem occurs in both policy cases.

The problem is only in the order of 7-10% of GDP in a 20-years perspective. Within one election period, it is just 1-2% of GDP. So, it is small and easy to neglect – also, it is difficult to explain to people and to busy policy makers. One of the most well established results in modern political economy is that political processes enforces myopia on the decision making process. Consequently this theory predicts that Baumol’s law is ignored by the political decision process, as is indeed the case. But still, it never stops growing.

The problem can be delayed in several ways: (a) The most obvious is to try to increase productivity in the public sector, i.e., by privatization and outsourcing. (b) It also helps to run a public sector surplus that tilts the tax pressure curve to a lower slope, by increasing taxes now and permitting lower taxes later.
Furthermore, luck in the form of good, but transitory events, may occur. (c) Unemployment may fall below its natural level reducing public expenditures and increasing the tax base. (d) Variations in the population age structure may cause the dependency ratio to fall below its long-run value. (e) Conditions may allow a relative reduction in public sector wages.

When luck runs out the problem returns with a vengeance: (c) Unemployment rises above its natural level; (d) the dependency ration rises above its long run-value; and (e) the public sector wage arrears leads to strikes and compensations. Consequently, Baumol’s law will turn up in one period as one concrete problem and in another period as another problem. It will then be ascribed to the concrete problem. This blurs the underlying “creeping” character of the fundamental Baumol-problem: The welfare state has no steady state.

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From this brand new working paper by Martin Paldam. Given the self-reported mathematical skill level of my readers, I found it prudent to exclude the model itself and the underlying assumptions from the post – but if you are even the least bit curious, and you think you know enough mathematics and economics to understand the model in question, which ie. most undergrad econ students ought to do, you really should read this paper.