Is health care infected by Baumol's cost disease? Test of a new model

Rising health care costs are a policy concern across the Organisation for Economic Co-operation and Development, and relatively little consensus exists concerning their causes. One explanation that has received revived attention is Baumol's cost disease (BCD). However, developing a theoretically appropriate test of BCD has been a challenge. In this paper, we construct a 2-sector model firmly based on Baumol's axioms. We then derive several testable propositions. In particular, the model predicts that (a) the share of total labor employed in the health care sector and (b) the relative price index of the health and non-health care sectors should both be positively related to economy-wide productivity. The model also predicts that (c) the share of labor in the health sector will be negatively related and (d) the ratio of prices in the health and non-health sectors unrelated, to the demand for non-health services. Using annual data from 28 Organisation for Economic Co-operation and Development countries over the years 1995-2016 and from 14 U.S. industry groups over the years 1947-2015, we find little evidence to support the predictions of BCD once we address spurious correlation due to coincident trending and other econometric issues.