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Based on a panel of 24 OECD countries this present paper shows that the total government sector is contracted by Baumol's cost disease. The most affected government services are education and healthcare. Furthermore, this paper shows that Baumol's cost disease produces adverse consequences under a balanced budget rule such as a debt brake, which is a key element of the EU Fiscal Compact. Governments face a serious dilemma. Breaching the rule would certainly cause reputational losses for governments, which might affect their borrowing costs. Adhering to the balanced-budget rule means risking budget-crowding out of cost-disease affected public expenditure with an ensuing long-run deterioration of these services and/ or foregoing growth opportunities. Governments of the EU member states and EU policy makers should therefore revise the EU Fiscal Compact to reconcile it with Baumol's cost disease. Additionally, we apply an innovative statistically robust estimation method, which is particularly suited to deal with the distinct heterogeneity of panel datasets.
