For those who would like to see the evidence I mentioned that bankruptcy enhances entrepreneurship--well, the Economist article I linked (UPDATE--sorry, link was broken, now fixed), which appears to have been written by a correspondent of unusual depth and perspicacity, is a good place to start. Some other suggestions:
Legislators in Europe have recently sought to promote entrepreneurship by reducing the harshness of the consequences of personal bankruptcy law. Yet at the same time, US legislators have been seeking to make it more difficult for individuals to declare themselves bankrupt. Whilst there is an intuitive link between bankruptcy law and willingness to take entrepreneurial risks, little attention has been paid to the question empirically in the international context. We investigate the link between bankruptcy and entrepreneurship using data on self employment over 16 years (1990-2005) and 15 countries in Europe and North America. We compile a new indices reflecting how 'forgiving' personal bankruptcy laws are, reflecting the time to discharge and other aspects of bankruptcy laws. These measures vary over time and across the countries studied. We show that personal bankruptcy law has a statistically and economically significant effect on self employment rates when controlling for GDP growth, MSCI stock returns, and a variety of other legal and economic factors. The results have clear implications for policymakers.
This paper considers bankruptcy law design in a setting that is appropriate for entrepreneurial firms. These firms are characterized by a dependence on an owner-manager who is essential to the firm and must be given incentive through an ownership stake to maximize the value of the project. The relationship banks that fund entrepreneurs cannot capture the gains from providing the entrepreneur with this stake and this leaves the entrepreneur emerging from bankruptcy with a larger debt burden than is socially efficient. In this setting, a fresh start bankruptcy policy provides greater debt relief than the bank would approve voluntarily, and this generates greater social surplus. The results shed light on the ongoing debate over a separate small-business bankruptcy chapter resembling the current Chapter 13.
Homestead exemption is defined as the level of home equity that a household declaring bankruptcy can keep. This exemption level varies across states in the United States. As entreprenurial activities are risky, small business owners value the insurance the bankruptcy law provides. In their empirical study, Fan and White (2003 find that a probability of homeowners running a business is 35\% higher if they live in the states with unlimited rather than low homestead exemptions. Moreover, Sullivan, Warren and Westbrook (1999) estimate that about 20\% of bankrupts had debts from a failed business. As this numbuer is higher than the fraction of households who own a small business, an unproportionally high fraction of small business owners declare bankruptcy. In this paper, we ask the following question. What are the effects of reducing homestead exemption on entrepreneurship activity, bankruptcy rate, homeownership and welfare? We build a general equilibrium model with uninsurable idiosyncratic risks, where the agents make entrepreneurial, housing and bankruptcy choices. In the model, house is defined as a good that people derive utility from, has frictions in buying and selling, people can borrow against, and the government has special regulations on. The model also features a distinction between unsecure debts and secure debts. The unsecure debts are subject to a waiver when declaring bankruptcy while the secure debts are collateralized by house and not waiverable. We calibrate the model to the US economy and study the effects of eliminating homestead exemption on entrepreneurship activity, bankruptcy rate, homeownership and welfare. Our preliminary findings suggest that, when homestead exemption is eliminated, there will be a decrease in entrepreneurial activity, a decrease in bankruptcy rate and a decrease in home equity but no change in homeownership rate.
In this paper, we investigate how personal bankruptcy law affects small firms' access to credit. When a firm is unincorporated, its debts are personal liabilities of the firm's owner, so that lending to the firm is legally equivalent to lending to its owner. If the firm fails, the owner has an incentive to file for personal bankruptcy, since the firm's debts will be discharged and the owner is only obliged to use assets above an exemption level to repay creditors. The higher the exemption level, the greater is the incentive to file for bankruptcy. We show that supply of credit falls and demand rises when non-corporate firms are located in states with higher bankruptcy exemptions. We test the model and find that small firms are 25% more likely to be denied credit if they are located in states with unlimited rather than low homestead exemptions.
The U.S. personal bankruptcy system functions as a bankruptcy system for small businesses as well as for consumers. When firms are non-corporate, debts of the firm are personal liabilities of the entrepreneur/owner. If the firm fails, the entrepreneur has an incentive to file for bankruptcy under Chapter 7, since both business debts and the entrepreneur's personal debts will be discharged. The entrepreneur must give up assets above a fixed bankruptcy exemption level for repayment to creditors, but future earnings are entirely exempt. Exemption levels are set by the states and they vary widely. We show that higher bankruptcy exemption levels benefit potential entrepreneurs by providing partial wealth insurance. This means that the predicted relationship between the probability of owning a business and the exemption level is positive at low exemption levels, but may be either positive or negative at high exemption levels, depending on whether higher bankruptcy costs outweigh the gain from additional insurance. We test this prediction and find evidence that the probability of owning a business is about 28% higher if potential entrepreneurs live in states with unlimited exemptions rather than low exemptions. We also find evidence that families are significantly more likely to start businesses if they live in states with high or unlimited, rather than low, bankruptcy exemptions. They are also more likely to organize their businesses as non-corporate rather than corporate if they live in states with high exemptions.
Congress is again attempting to reform federal bankruptcy law by making bankruptcy less favorable for households whose incomes are above the median level. Whatever the merits of that legislation, it would have a negative impact on small business and on U.S. workers who receive their income from such businesses. Among the proposed reforms are limits on the current "fresh start" provision that protects bankrupt individuals' future earnings. Data show that small business growth is more vigorous when bankruptcy laws offer more protection of entrepreneurs' assets. That suggests that, if "fresh start" reform is adopted, it could dissuade risk-adverse potential entrepreneurs from starting new businesses.
Overall, the expert with the most work on this is Michelle White, who effectively has a specialty in bankruptcy. Her work is vastly more rigorous than that of Elizabeth Warren, the more famous bankruptcy figure, who is an expert on the law, not empirical method. The important thing to remember is that while these results are not morally intuitive for most of us, they are economically entirely unsurprising. The only real economic issue to be resolved was an empirical question--does the decrease in the supply of credit from easier bankruptcy outweigh the effect of the increase in demand for it? The answer is pretty clearly no: while supply decreases somewhat, overall, easy bankruptcy increases entrepreneurial activity. This, too, should not be surprising. America has always been a nation of entrepreneurs--and it has always been the nation with the most generous bankruptcy laws. We should not find it so hard to swallow that the prudent bourgeois virtues have economic costs--as well as great benefits.
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