Personal Bankruptcy and the Level of Entrepreneurial Activity

The U.S. personal bankruptcy system functions as a bankruptcy system for small businesses as well as consumers, because debts of noncorporate firms are personal liabilities of the firms’ owners. If the firm fails, the owner has an incentive to file for bankruptcy, since both business debts and the owner’s personal debts will be discharged. In bankruptcy, the owner must give up assets above a fixed exemption level. Because exemption levels are set by the states, they vary widely. We show that higher bankruptcy exemption levels benefit potential entrepreneurs who are risk averse by providing partial wealth insurance and therefore that the probability of owning a business increases as the exemption level increases. We test this prediction and find that the probability of households owning businesses is 35 percent higher if they live in states with unlimited rather than low exemptions. The U.S. personal bankruptcy system is primarily intended as a bankruptcy procedure for consumers, but it also is the de facto bankruptcy procedure for small firms. When firms are noncorporate, debts of the firm are personal liabilities of the entrepreneur/owner. If the firm fails, entrepreneurs have an incentive to file for personal bankruptcy under the procedure known as Chapter 7, because both their business and personal debts will be discharged. Entrepreneurs filing under Chapter 7 must give up all assets they own in excess of an exemption level, but all of their future earnings are exempt from the obligation to repay—this is known as the “fresh start” in bankruptcy. Bankruptcy exemption levels are set by the states and vary widely. Higher exemption levels make it more attractive for potential entrepreneurs who are risk averse to go into business, because more of their assets are sheltered from creditors if the firm fails. The fact that 20 percent of personal bankruptcy * We are grateful for comments from Mitchell Berlin, Charlie Brown, David de Meza, Alan Schwartz, and participants at talks at the University of California, Berkeley, Columbia University, the University of Michigan, Tilburg University, the Federal Reserve Bank of Philadelphia, the Bank of England, the American Law and Economics Association annual conference, and the National Bureau of Economic Research Summer Institute in Law and Economics. The National Science Foundation provided financial support under grants SBR-9617712 and 0212444. 544 the journal of law and economics filings list business debts suggests how important personal bankruptcy procedures are for entrepreneurs. In this paper we examine whether individuals are more likely to become entrepreneurs if they live in states with higher bankruptcy exemptions. There is a large literature explaining whether workers choose self-employment or working for others; in this paper, we test whether the bankruptcy system is an important part of the decision. We first develop a model of how variations in exemption levels affect incentives to own, start, and end small businesses. We show that higher exemption levels provide partial wealth insurance, which makes potential entrepreneurs who are risk averse more likely to choose selfemployment. However, the relationship can turn negative if exemption levels are sufficiently high. We test the model empirically and find that families are more likely to own and start businesses if they live in states with higher bankruptcy exemption levels. Section I of the paper discusses bankruptcy law, Section II reviews the prior literature, and Section III contains the model; in Section IV, we discuss our data and empirical results. Section V concludes and discusses policy implications.