By James Kwak

William Baumol and some co-authors recently published a new book on what is widely known as “Baumol’s cost disease.” This is something that Simon wanted to include in White House Burning, but I couldn’t find a good way to fit it in (and it would have gone in one of the chapter’s I was writing), so I it isn’t in there. (Baumol is cited for something else.) But in retrospect, I should have put it in.



Baumol’s argument, somewhat simplified, goes like this: Over time, average productivity in the economy rises. In some industries, automation and technology make productivity rise rapidly, producing higher real wages (because a single person can make a lot more stuff). But by definition, there most be some industries where productivity rises more slowly than the average. The classic example has been live classical music: it takes exactly as many person-hours to play a Mozart quartet today as it did two hundred years ago. You might be able to make a counterargument about the impact of recorded music, but the general point still holds. One widely cited example is education, where class sizes have stayed roughly constant for decades (and many educators think they should be smaller, not larger). Another is health care, where technology has vastly increased the number of possible treatments, but there is no getting around the need for in-person doctors and nurses.

The problem is that in those industries with slow productivity growth, real wages also have to rise; otherwise you couldn’t attract people to become classical musicians, teachers, or nurses. Since costs are rising faster than productivity, prices have to rise in real terms. Note that university tuition and health care costs are both going up much faster than overall inflation. As a consequence, since GDP is measured in terms of prices paid, these sectors take up a growing share of GDP, just as health care is doing throughout the developed world.

But in Baumol’s formulation, that’s just fine. To see why, consider this figure from the Economist’s review of the book:

Look at the right-hand panel. The point is that if you extrapolate from current trends, health care will be a ridiculous proportion of the economy a century from now, even if we do nothing to slow its rate of growth; but because of productivity increases, the non-health care sector will still be much bigger than it is today, so we will still be much better off than today in aggregate.*

But that doesn’t mean that everything is fine and dandy. Unlike a lot of things in the light blue portion of that chart, health care is a necessity. If 60 percent of the economy is health care, health care will be a much larger share of the average family’s budget than it is today; and if it’s a huge share of the average family’s budget, then many families with below-average incomes won’t be able to afford it.

This is the basic problem with market-based approaches to our health care problem: in a free market, poor people won’t get any, and middle-class people won’t get very much. Baumol is right that in the aggregate our society will be able to pay for all the health care we need, and plenty of other stuff besides; but with our current level of inequality, many actual families won’t be able to get the care they need.

Now, Baumol himself realizes this. One corollary of Baumol’s cost disease is that as low-productivity sectors get relatively more expensive, it gets harder and harder to make a profit, so they tend to get taken over by the government. Again, consider health care and education. (Classical music, which cannot make a profit but is not a necessity—much as I love it—has instead been taken over by private charity.) And this is just the way it should be: Everyone needs health care, but the law of productivity increases dictates that it gets more and more expensive, so the only sane solution is to keep prices at an affordable level and let the government bear the losses. And by “bear the losses,” I mean distribute them to taxpayers (since there is no entity called “the government” that exists in isolation from the people) through a progressive tax system.

Guess what? That’s what Medicare does today. (The Medicare payroll tax isn’t progressive, but most of Parts B and D are funded through general revenues, which mainly come from the individual income tax.) By contrast, Romney-Ryan Vouchercare, by capping the growth rate of benefits at an artificially low level, shifts the growing stack of health care costs (dark blue in the chart) directly onto families, many of whom won’t be able to afford it. Vouchercare is an attempt to rein in health care costs through sheer force of will. It won’t work. It can’t work.

This was, in essence, one of the key arguments of White House Burning: health care costs are going to be what they are going to be, and we can pay for them. Yes we can. We can pay for them because we have plenty of room to raise taxes in all sorts of non-distorting or distortion-reducing ways. We can pay for them because productivity increases mean that, in aggregate, our after-tax real income is still going up. This means that tax revenues will grow as a share of the economy, but as Baumol’s cost disease implies, they should rise as a share of the economy. Comparing tax revenues today to tax revenues in a distant past when health care costs were much lower is just not relevant.

* That chart isn’t per capita, but eyeballing it it looks like a fourfold increase in non-health care GDP; with U.S. population growing at a little less than 1 percent, that’s still a big increase in per capita non-health care GDP.