Beneath the surface – the hidden costs of poor regulation

By Kevin Counsell, Chief Economist Ministry for Regulation

Regulation is often judged by its visible compliance burden yet some of its most significant effects are harder to see. This piece explores how poorly designed regulation can limit competition and innovation, creating hidden costs that affect productivity and prosperity over time.

Regulation is one of government’s most important tools. Good regulation can protect consumers, support competition, improve information, and deliver better environmental and social outcomes.

When people think about the costs of regulation, they tend to focus on the visible and personal ones.  They think about the time, effort, and money they spend complying with rules.

These costs are the most tangible for most people and regulators and are arguably fairly easy to calculate. 

Behind the scenes are less visible but equally impactful costs – the costs that happen when regulation unintentionally changes incentives, market behaviour, or economic outcomes. 

These are called distortionary costs.

Distortionary costs are often invisible and more difficult to measure, so they can be overlooked in policy design and analysis.

They can include the lost value from investments that are not made, innovations that are not pursued, businesses that never enter a market, or products and services that never reach consumers.

For instance, regulation can make it harder for new or smaller firms to compete, reducing the competitive pressure that drives productivity and innovation.

It can discourage investment by increasing uncertainty, imposing delays, or diverting resources away from growth and innovation.

It can weaken the price signals that help markets allocate resources efficiently, leading to unintended consequences such as reduced supply, lower quality, or fewer choices for consumers.

When regulation has these effects, the resulting loss is not just what businesses spend to comply with rules, but the value of opportunities that are never realised.

What makes such distortionary costs especially important is their long-term impact.

Compliance costs affect economic activity, but not in a way that builds over time. In contrast, distortionary costs can affect the rate at which an industry grows. By weakening price signals, competition, investment, and innovation, they can compound over time and have lasting effects on productivity and prosperity. 

Distortionary costs can therefore be the most important type of cost influencing long run prosperity.

Research suggests these effects can be substantial. In some cases, the costs associated with distorted incentives and reduced economic activity may be as large as the direct costs of compliance. In other cases, the distortionary costs can be up to four times greater than compliance costs, and possibly a lot larger.

Recognising distortionary costs does not mean regulation is undesirable.

Many regulations deliver significant public benefits by addressing market failures or protecting important public interests.

Rather, it highlights the need for a more complete assessment of regulatory impacts and designing regulation to limit the costs imposed by market distortions.

The challenge for policymakers is not whether regulation has costs, but whether its benefits outweigh both its direct compliance costs and its less visible effects on incentives and market outcomes.

Taking both into account can help ensure regulation achieves its objectives while supporting innovation, competition, productivity, and long-term prosperity.

Read the full paper

Distortionary costs can be difficult to see, but they may be among the most important economic consequences of regulation. Explore the full paper for a deeper look at the evidence, theory, and implications for regulatory design.