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THE MARGINAL COSTS OF TAXATION AND REGULATION by* W. Erwin Diewert Professor of Economics University of British Columbia Denis A. Lawrence Swan Consultants (Canberra) Pty Ltd and Fred Thompson Professor Atkinson Graduate School of Management Willamette University * The positive attributes of this review are due entirely to the first two named authors. Any errors, omissions, or infelicities are the responsibility of the third named author and are the result of deadline pressures and ignorance. THE MARGINAL COSTS OF TAXATION AND REGULATION 1. INTRODUCTION Taxes and government regulations, which are the economic equivalents of government taxing and spending, impose a number of costs on a community. The most obvious cost is the revenue they raise or, in the case of regulations, the outlays they induce on the part of individuals and firms to comply with regulatory mandates. These losses are known as the direct costs of taxation or regulation. From the standpoint of the community as a whole, these costs are offset, to a greater or lesser extent, by benefits supported by taxation/regulation. In addition to their direct costs, taxes/regulations impose additional resource costs on a community. These relate mainly to avoidance, evasion, compliance and administration (see Mikesell, this volume). In a free society individuals will arrange their affairs so as to minimize the amount of tax paid. Tax payments can be minimized legally by tax avoidance or illegally by tax evasion. In both cases significant resources of individuals, firms and specialist advisers are tied up in socially “unproductive” activities. Similarly, compliance with tax laws usually requires firms to keep additional records that they would not otherwise require. Enforcement and administration of the tax and regulatory systems also tie up significant amounts of society’s resources. This point is best summarized by Slemrod (1990) who notes: Taxation is a system of coercively collecting