An Optimal Personal Bankruptcy Procedure and Proposed Reforms

We investigate a proposed reform of U.S. personal bankruptcy law which combines Chapters 7 and 13. The proposed reform obliges debtors in bankruptcy to use part of both their wealth and their future earnings to repay debt and therefore bases the obligation to repay in bankruptcy on debtors' ability-to-pay. An important function of personal bankruptcy is to provide partial wealth insurance for risk averse debtors by discharging some debt when debtors' ability to repay turns out to be low. However the current bankruptcy system encourages debtors to le for bankruptcy even when their ability to repay is high. The proposed reform maintains the insurance function of bankruptcy, but reduces debtors' incentive to take advantage of the system. Using simulation techniques, we show that the reform improves e ciency relative to the current system. An Optimal Personal Bankruptcy Procedure and Proposed Reforms Hung-Jen Wang and Michelle J. White The US is extremely unusual in having very pro-debtor bankruptcy laws and, alone among the industrialized countries, it has a high and rapidly rising bankruptcy ling rate. The total number of bankruptcy lings rose from under 300,000 per year in 1984 to 1.1 million in 1996 and about 1.4 million in 1997. Lenders' losses as a result of bankruptcy lings have been estimated at over $44 billion in 1997 (Lauritano, 1998). Because of concern about the soaring bankruptcy ling rate, a number of bankruptcy reforms have recently been proposed. Most of these proposals are seriously awed. The National Bankruptcy Review Commission's (1997) recent report proposed large increases in bankruptcy exemptions, which would have encouraged many additional debtors to le for bankruptcy. The Gekas bill which was recently passed by the House of Representatives, H.R. 3150, 105th Congress, 2d Session, would go in the opposite direction by strongly discouraging bankruptcy lings. It would force debtors in bankruptcy whose income is above the median to use 100% of their post-bankruptcy earnings above a predetermined level to repay debt. Such a plan would give debtors who le for bankruptcy a strong incentive to quit their jobs|an outcome not in either debtors' or creditors' interest. A key aspect of current U.S. bankruptcy law is that there are two separate personal bankruptcy procedures, known as Chapter 7 and Chapter 13, and debtors are allowed to choose between them. Under both procedures, debtors who le for bankruptcy receive a 1 We received very helpful comments from Eric Posner and the members of the Public Finance Lunch at the Univ. of Michigan. We are also grateful for research support from the N.S.F. Economics and Law and Social Science Programs under grant number NSF-SBF-9617712. 2 Bankruptcy ling data are taken from the Administrative O ce of the U.S. Courts and from the Statistical Abstract of the U.S., various editions. 3 See Fay, Hurst and White (1998) for an analysis of the e ect of adopting the Commission's exemption proposals.