The social benefit of being destructive: entrepreneurship and loan diversion

This paper analyzes the effect of credit costs on the entrepreneurial choice to engage in informal activities. Unlike previous studies, which mainly focus on the decision to divert business assets, we present a model where some entrepreneurs may have the incentive to divert part of the business loan received to illegal or personal uses, rather than investing it in the formal project. We first show that the equilibrium is more likely to be efficient when there is a relatively large proportion of potential diverters. In the case of inefficiency, a regulatory intervention can be welfare improving, but the cost and desirability of the policy depend on whether the proceeds from diversion are classified as a contribution to social welfare or not.