2.2  Benefits and costs of regulation and fiscal illusion

Ultimately, for every regulation there will be a net social impact and a range of private impacts, so that the regulation will change both the total welfare of society and the manner in which that welfare is distributed among individuals and groups. It is usually easier to identify the direction of the redistributive effects than to quantify the size of those effects or of the total impact, especially for social regulations.[2]

It is also important to distinguish (1) transfers between groups within society from (2) actual economic costs to society or deadweight losses, which include costs associated with the payment of the transfers.[3]

As far as costs of regulation are concerned, key issues are size and incidence. Beyond those factors, a number of classifications are used. These tend to focus on the initial incidence of the cost, as the ultimate incidence would require a general equilibrium analysis. Table 1 illustrates two common approaches.

Table 1 – Costs of regulation

An economic perspective (den Hertog, 1999)

1. Costs of formulation and implementation
2. Costs of maintenance
3. Costs of compliance
4. Deadweight costs (associated with distortions from 1-3)

A government perspective

1. Fiscal (excluding administrative) costs
2. Administrative costs
3. Compliance costs
4. Economic (resulting from 1-3) costs

Government tends to focus on fiscal costs (including administration), while businesses concentrate on those compliance costs which fall directly on them. Economic costs, or deadweight losses, tend to be the hardest to estimate and the least transparent.

Benefits from regulation can take many forms but these can be distilled down to an improvement in the welfare of an individual or group. Whether this occurs through reduced costs or increased income is not as important as whether the source of the gain is wholly or partially from a net increase in society’s welfare, rather than simply a transfer from another individual or group with the inevitable deadweight costs.

The concept of fiscal illusion”[4], is well established as a factor in public policy where undesirable expenditure is undertaken because the true costs are hidden; eg, because neither the revenue nor the expenditure have to be reflected in government accounts. More generally, decision-makers face incentives to undertake expenditure which has a net social cost, because the benefits are concentrated and transparent but the costs are diffused and opaque.

Regulatory illusion includes fiscal illusion, and can be used to explain some of the incentives faced by regulators. Many regulatory decisions do not involve actual revenue collection or expenditure by government, but still impose costs. Regulators tend to focus on the costs that directly affect them. For example Treasuries focus on fiscal costs, reflecting their budget management role and the transparency of expenditure, while departments concentrate on administration costs and implementing policy, and interest groups emphasise compliance costs.

A wider form of regulatory illusion is the view that regulation is necessary to correct market failure on the assumptions that (1) the market will not compensate for factors such as transactions costs, and (2) that government regulation is effective and efficient. In fact, whether these assumptions hold needs to be tested for each case.

There are two ways for regulators to deal with costs while progressing a proposal – to modify the proposal to improve the benefit/cost equation, or to shift the costs on to another party. The latter approach is easiest when shifting the costs reduces their transparency. Reduced transparency of costs also reduces barriers to approval of the underlying policy.