In this paper, we construct a quantitative model of entrepreneurship and consumer bankruptcy and use the model to address the following question: what are the effects of bankruptcy regulation on entrepreneurship, bankruptcy rate and welfare? This is motivated by the following observations:
- Entrepreneurial activity is widely regarded as essential for innovation, capital accumulation, and development.
- The consumer bankruptcy data show that a substantial fraction of debtors in bankruptcy under Chapter 7 are entrepreneurs. Specifically, Sullivan, Warren, and Westbrook (2000) and Sullivan, Warren, and Westbrook (1989) show that about 20% of bankruptcy filings are accounted for by small businesses.
- A distinctive feature of bankrupt entrepreneurs is that they carry extremely large amounts of unsecured debt. In fact, they account for more than half of all unsecured debt listed among bankrupts.
- Entrepreneurs hold almost 3.5 times as much unsecured debt as non-entrepreneurs. Their debt-to-income ratio is higher than that of non-entrepreneurs.
Despite these observations, the interaction between consumer bankruptcy and entrepreneurship has received relatively little attention in quantitative macroeconomic models. In this paper, we propose a quantitative model that is consistent with these facts and then use it to examine the effects of tightening bankruptcy rules on entrepreneurial activity, bankruptcy rate and welfare. Specifically, we consider the elimination of bankruptcy asset exemptions and the elimination of the whole consumer bankruptcy system. A bankruptcy asset exemption is the level of household assets that a debtor declaring bankruptcy can keep.
We observe the presence of entrepreneurs in consumer bankruptcy because the U.S. personal bankruptcy system, although designed for consumers, also functions as a bankruptcy system for small businesses. When firms are non corporate, debts of the firm are personal liabilities of the entrepreneur owner. If the business fails, the owner of the firm can declare personal bankruptcy under Chapter 7, since both business and personal debts will be discharged. Small business owners declaring bankruptcy under Chapter 7 must give up all assets they own in excess of a pre-determined exemption level. However, all their future earnings are exempt from the obligation to repay pre-bankruptcy debt and they can start new businesses and take new jobs—this is known as the “fresh start” in bankruptcy.
The quantitative assessment of consumer bankruptcy laws on entrepreneurship and welfare entails the evaluation of two opposite effects. On the one hand, in incomplete markets, the personal bankruptcy system, by giving both the option to discharge debt and to have bankruptcy asset exemptions, provides partial insurance against business failure and job loss. Because entrepreneurship is risky, this partial insurance allows business owners to smooth consumption across state and as a result provides risk averse agents with incentives to undertake entrepreneurial activity. On the other hand, financial intermediaries charge a higher premium on borrowing to cover for default risks. To the extent that financial constraints exist, such high interest rates may discourage entrepreneurship and limit the ability of households to smooth consumption across time.
There is indeed evidence suggesting that entrepreneurs face financial constraints (Evans and Jovanovic (1989)) and that bankruptcy makes it difficult for entrepreneurs to get funding in U.S. states with generous exemptions (Berkowitz and White (2004)). We denote the first effect, the insurance effect and the second the credit supply effect. Evaluating the effects of bankruptcy laws mainly involves assessing the trade-off between the insurance and credit supply effects. These effects also exist with non-entrepreneurs, but with entrepreneurs, there are direct implications for economic performance.
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