Redistributive Labor - Income Taxation and Bankruptcy in US States ∗

Both bankruptcy regulation and redistributive taxation vary considerably across US states. We model the interactions between these two policies: redistributive taxation targets intratemporal inequality whereas asset exemptions in bankruptcy procedures help agents to smooth consumption across time. We derive sufficient conditions under which more redistributive taxation makes bankruptcy exemptions less attractive both with respect to the intratemporal-insurance and intertemporal consumption-smoothing motive. In particular, more persistent shocks can make bankruptcy exemptions less attractive because they create credit constraints, but this effect is less important if agents receive redistributive transfers. Using data for 18 US states in the time period 1980-99 we find considerable support for our model’s predictions: (i) redistributive taxation and bankruptcy exemptions are negatively correlated; (ii) both policies are associated with more equal consumption growth whereas the effect on household debt is less clear-cut.