The Economics of Informality: The Financing of the Informal Economy, criminal activities and nonregulatory capital

The coexistence of formal, informal, and criminal sectors in developing economies presents a complex challenge for policymakers seeking to promote sustainable growth and development.Foreign capital inflows can play a significant role in influencing the dynamics of these economic sectors, with the potential to either enhance or hinder economic progress. This paper develops a theoretical model that examines how a small open economy receives and allocates foreign capital across these distinct sectors. Our model uniquely incorporates mechanisms for the detection and penalization of capital flows directed towards the informal and criminal sectors, assessing the risks and regulatory responses associated with these investments. Moreover, the model posits that the criminal sector exerts a rent-extracting impact on the productive sectors, siphoning a fraction of their outputs.Numerical simulations reveal that stringent enforcement of penalties and effective detection mechanisms can substantially diminish the criminal sector's influence while simultaneously promoting growth within the formal sector. Striking a balance in regulating the informal sector is crucial, as over-regulation can stifle entrepreneurial spirit while under-regulation may not adequately curtail the negative externalities associated with informal economic activities.Differentiated policies that clearly distinguish between informal and criminal activities are more effective.The model further identifies an inverse relationship between the rents extracted by the criminal sector and the stringency of policies targeting capital flows into the criminal and informal sectors.There is a trade-off between the beneficial impacts of control policies on the formal sector and their detrimental effects on the informal sector, prompting the need for optimal regulation levels. When the formal sector is less exposed to the criminal sector, there tends to be an increase in formal output and a reduction in both informal production and criminal activities, leading to a decrease in optimal Gross National Product (GNP). This phenomenon underscores the diminishing returns to scale and highlights the complex interactions between sectorial productivity and criminal interference.These findings underscore the necessity for targeted and nuanced policy measures that can adeptly manage the intricate relationships between different economic sectors in the presence of foreign capital. By strategically regulating and guiding these capital flows, governments can enhance economic stability and promote inclusive growth.