Debtor Rights, Credit Supply, and Innovation

Debtor-friendly laws can encourage innovation by reducing the cost of failure for innovators, but can also harm innovation if they tighten the availability of credit to innovators. We use state and year variation in U.S. personal bankruptcy laws, which affect the capital constraints of individual innovators and small firms, to investigate the effects of debtor protection on innovation. We find that stronger debtor protection decreases the total number of patent applications by small firms without increasing the average quality of their patents. The negative effect of debtor protection on innovation is amplified in industries with a high dependence on external finance and in concentrated banking markets. We also find that stronger debtor protection leads firms to innovations that can be categorized as “safer bets.” Our results suggest that the negative credit supply effect of debtor protection can dominate the positive tolerance-for-failure effect and thus reduce innovation. (JEL: G21, G33, K2, O3)