Bankruptcy and Small Business

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Will reform harm small business growth?
Bankruptcy and
Small Business

B y M i c h e l l e J . W h i t e
University of California, San Diego
ach of the past three years, con-
Future earnings First, owners of failed businesses can file
gress has passed a bankruptcy reform bill
for personal bankruptcy, in which their unsecured per-
that was later vetoed by Bill Clinton. This
sonal and business debts are discharged. Their future earn-
year, the same bill — now titled “Bank-
ings are exempt from the obligation to repay debt, so they
ruptcy Abuse Prevention and Consumer
can start new businesses or take jobs working for others
Protection Act of 2001” (H.R. 333/S. 420)
without having their future earnings taxed to repay their
— is making its way through Congress and could be
pre-bankruptcy debt. The future earnings provision —
signed by President Bush. The main purpose of the bill is to
referred to as the “fresh start” — applies uniformly
reduce the number of personal bankruptcy filings by mak-
throughout the United States.
ing bankruptcy less favorable for households whose
incomes are above the median level.
Current assets Second, business owners (like other bank-
Reforming personal bankruptcy law would do more
rupt debtors) must surrender current assets that are above
than change the attractiveness of bankruptcy to house-
an exemption level set by the state in which they live. The
holds; it would also alter the economic environment for
non-exempt assets, in turn, are used to repay debt. Because
small business. Under current law, the debtor-friendly per-
the exemptions vary by state, states with higher bankrupt-
sonal bankruptcy procedure makes it more attractive for
cy exemptions are more attractive to entrepreneurs.
potential entrepreneurs to go into business. Changing the
Most states have several bankruptcy exemptions for
law to make bankruptcy less favorable for debtors would dis-
different types of assets, but the most important is the
courage many would-be entrepreneurs from going into
exemption for equity in an owner-occupied home (the
business. And because small business is one of the primary
“homestead” exemption). Seven states have unlimited
sources of new jobs in the U.S. economy, the change could
homestead exemptions: Arkansas, Florida, Iowa, Kansas,
have important negative effects.
Minnesota, Oklahoma, and Texas. Unlimited exemptions
allow individuals or couples who file for bankruptcy to
shelter millions of dollars of assets from creditors, as long
How does the U.S. personal bankruptcy procedure affect
as the assets are converted into equity in an owner-occupied
small businesses? Because most small businesses are unin-
home before the bankruptcy filing occurs.
corporated, debts are personal liabilities of the business
Several other states have homestead exemptions of
owner. Lending to those small businesses is legally equiv-
$100,000 or more. At the other end of the spectrum, Mary-
alent to lending to their owners. If the business fails, the
land and Delaware have no homestead exemption at all
owner is likely to have large business debts that legally are
and seven other states have homestead exemptions of
personal debts.
$5,000 or less. Besides the homestead exemption, most
The Chapter 7 procedure of current U.S. bankruptcy law
states also exempt clothing, furniture, and cooking utensils,
provides two important protections for small business
and have small exemptions for other types of personal
owners who are faced with business debt:
property and some retirement accounts.
In states with the highest exemptions, owners of failed
Michelle J. White is a professor of economics at the University of Califor-
businesses can shelter assets worth millions of dollars. That
nia, San Diego, and a senior economist for RAND. Her areas of interest
include public finance, law and economics, and urban economics. She can be
encourages even risk-averse individuals to go into busi-
contacted by E-mail at [email protected] and [email protected]
ness. In states with low exemptions, owners of failed busi-
R e g u l a t i o n
18 S u m m e r 2001

nesses can shelter their clothes, furniture and cooking uten-
than $2,000 per month. We found that the probability of
sils, but little else. That discourages risk-averse individuals
homeowning households owning big businesses was 28
from going into business.
percent higher in states with unlimited homestead exemp-
tions as compared to states with low exemptions. Again, that
difference was statistically significant.
How does the variation in bankruptcy exemption levels
We also examined whether entrepreneurs behave dif-
affect small business? We can hypothesize that, in states with
ferently depending on whether their businesses are incor-
high exemption levels, individuals would be more likely to
porated. We predicted that owners of non-corporate busi-
own businesses because the more generous exemptions
nesses would respond more strongly to changes in the
cushion entrepreneurs against the consequences of business
homestead exemption than owners of corporate business-
failure. We can also hypothesize that lenders would be
es, because owners of corporate businesses are not per-
more likely to deny applications for credit from small busi-
sonally responsible for their businesses’ debts. They there-
nesses in high exemption states because entrepreneurs in
fore would not be affected by whether the exemption levels
those states would be more likely to file for bankruptcy
in their states are high or low. However, exemption levels
and would repay less when they file.
could still affect the creation of incorporated businesses
To test the hypotheses, two fellow researchers and I
because lenders know that owners of small corporations can
examined the entrepreneurship and lending patterns in states
easily transfer assets from the corporation to themselves and,
with different exemption levels.
Specifically, we used the home-
stead exemption as the basis for
comparison because it is the
largest exemption in nearly all
states and it is also the most vari-
able. As we made the compar-
isons between states, we kept in
mind that renters cannot make
use of homestead exemptions
and, therefore, they cannot shel-
ter as many assets when they file
for bankruptcy. Bankruptcy
therefore provides a much more
generous “insurance policy” for
homeowners who go into busi-
ness than for renters.
Bankruptcy reform could discourage
people from starting new businesses
Entrepreneurship effects Uni-
at home or elsewhere.
versity of Michigan researcher
Wei Fan and I used the Survey of
Income and Program Participation
, a large government dataset,
as a result, lenders often require that owners of small cor-
to examine how variations in bankruptcy exemptions
porate businesses sign for personal liability for business
across states affect individuals’ decisions to choose self-
loans. That abolishes the legal distinction between the cor-
employment versus working for an employer. We estimat-
poration and its owner for purposes of the loan.
ed a model explaining whether one or more workers in a
Our results show that the probability of homeowning
sample of households choose self-employment as a func-
households owning non-corporate businesses was 37 per-
tion of the bankruptcy exemption level in the households’
cent higher in states with unlimited exemptions as com-
state of residence and other variables.
pared to states with low exemptions. What is more, the
Holding other factors constant, we found that the pre-
probability of homeowning households owning corporate
dicted probability of owning a business was 35 percent
businesses was 14 percent higher in unlimited exemp-
higher for homeowners in states with unlimited home-
tion states as compared to low exemption states. Both
stead exemptions as compared to states with low exemp-
increases are statistically significant.
tions. What is more, renter households in states with unlim-
Finally, we examined whether homeowners are more
ited exemptions were 29 percent more likely to own a
likely to start (as opposed to own) businesses if they live in
business as compared to renters in low exemption states.
states with high homestead exemptions. We found that the
Both increases are statistically significant.
probability of starting a business was 23 percent higher in
The average business owned by a self-employed person
states with unlimited exemptions as compared to states
is small. We therefore re-estimated the model for large busi-
with low exemptions. All of the figures, taken together,
nesses, defined as those having business income greater
indicate that bankruptcy law has a strong effect on the
R e g u l a t i o n
19 S u m m e r 2001

number of people who choose self-employment.
from taking well-paying jobs, because taking a job that
pays more than the median income level would prevent
Lending In the second study, University of California, Irvine,
them from filing for bankruptcy under the more favorable
researcher Jeremy Berkowitz and I examined how bank-
Chapter 7 procedure. And lenders would be loath to lend
ruptcy law affects the availability of small business credit. We
to once-failed business owners who try to start new busi-
used data from the National Survey of Small Business Finance,
nesses, because the owners would be discouraged from
produced by Federal Reserve and the Small Business Admin-
working hard by the bankruptcy tax on their earnings
istration, to test whether small businesses are more likely to
from the new business.
be turned down for business loans if they are located in
Our research suggests that potential entrepreneurs are
states with higher bankruptcy exemptions.
very responsive to the terms of the bankruptcy insurance
Holding other factors constant, we found that the prob-
policy. Because the new bankruptcy policy would be much
ability of a typical non-corporate firm being turned down
less favorable to small business owners, all but the most risk-
for credit was 40 percent higher in states with unlimited
loving potential entrepreneurs would find it much less
exemptions as compared to states with low exemptions. For
appealing to go into business.
corporate firms, the rejection rate was 30 percent higher.
Both increases are statistically significant.
The similar results for non-corporate and corporate
At the macro level, the reform is likely to have mixed effects
firms suggest that lenders ignore the legal distinction
on the U.S. economy. On the positive side, some entrepre-
between non-corporate and corporate small businesses
neurial activity in the United States is essentially disguised
when deciding whether to lend. We also found that lenders
unemployment and wiping it out would have little effect on
are approximately three times as likely to turn down appli-
U.S. output. Also, business owners who have not previ-
cations for credit if the owner of the business (corporate or
ously failed and filed for bankruptcy are likely to find cred-
non-corporate) has previously filed for bankruptcy.
it easier to obtain, because business loans would be less risky
and creditors would be more willing to extend loans.
But the reform will discourage many potential entre-
How would the current bankruptcy reform bill change the
preneurs from going into business and some of the dis-
small business environment? The most significant change
couraged businesses would inevitably involve innovative
would be that debtors who earn more than the median
new ideas that would have generated jobs and economic
income level would no longer be allowed to file for Chap-
growth. That should make us worry that the proposed leg-
ter 7 bankruptcy and take advantage of the “fresh start.”
islation would make the U.S. small business environment
Instead, they would have to file under a new version of
more like that of Germany, where bankruptcy law has never
Chapter 13 of the U.S. Bankruptcy Code.
included a “fresh start,” risk-taking is frowned upon, there
Under the proposed new Chapter 13, debtors would
are many fewer entrepreneurs, unemployment is higher, and
keep all of their assets but would be obliged to use all of
economic growth is slower.
their future earnings beyond a not-very-generous Internal
Revenue Service formula to repay debt. That obligation
would continue for five years. That differs from the cur-
r e a d i n g s
rent Chapter 13 bankruptcy procedure, which is voluntary
rather than mandatory for all bankruptcy filers. Under
•“Bankruptcy and Small Firms’ Access to Credit,” by Jeremy
the current Chapter 13, debtors propose their own repay-
Berkowitz and Michelle J. White. Working paper, Department
ment plans, which usually involve using only a small pro-
of Economics, University of Michigan, 2000. Available on the
Web at
portion of their future earnings over a three-year period
to repay debt. Only the bankruptcy judge must approve
•“Determinants of the Consumer Bankruptcy Decision,” by
the repayment plan.
Ian Domowitz and Robert L. Sartain. Journal of Finance, Vol.
54, No. 1 (February 1999).
Impact The proposed bankruptcy reform would have a
•“The Household Bankruptcy Decision,” by Scott Fay, Erik
Hurst, and Michelle J. White. American Economic Review,
chilling effect on incentives to start or own small busi-
nesses. Instead of entrepreneurs being able to shelter all of
their future earnings and some or all of their current assets
•“Personal Bankruptcy and the Level of Entrepreneurial
Activity,” by Wei Fan and Michelle J. White. Working paper,
from creditors if their businesses fail, they would be
Department of Economics, University of Michigan, 2001.
required to use most of their future earnings for five years
Available on the Web at
after the bankruptcy filing to repay debts from the failed
business. Owners of failed businesses who have filed for
•“Why It Pays to File for Bankruptcy: A Critical Look at
bankruptcy under Chapter 13 would not find it attractive
Incentives under U.S. Bankruptcy Laws and A Proposal for
to start new businesses because any future income would
Change,” by Michelle J. White. University of Chicago Law Review,
be heavily taxed to repay debts of the old businesses.
Vol. 65, No. 3 (Summer 1998).
Owners of failed businesses would also be discouraged
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20 S u m m e r 2001