The Impact of Personal Bankruptcy Law on Entrepreneurship

Abstract

Limited personal liability has long been thought to promote entrepreneurship by providing partial insurance through debt relief in the event of business failure. However, providing this insurance through debt relief makes borrowing more costly and tightens borrowing constraints. To examine the quantitative effects of these two opposing forces on entrepreneurship, I study a life cycle model where households choose between running a risky business and working. Households in the model differ in entrepreneurial abilities and face both labor income and business productivity risks. I calibrate the model to the U.S. economy, and then consider the effect of alternative personal bankruptcy regimes. For reasonable parameter values, a less lenient (higher post bankruptcy garnishment of income) bankruptcy law deters households with moderate entrepreneurial ability from entering entrepreneurship, while variations in bankruptcy systems have negligible effects on higher ability households' occupational choice decisions. The effect of personal bankruptcy law on the level of entrepreneurship is driven primarily by the insurance effect rather than the borrowing cost effect. Consequently, entrepreneurs prefer more lenient bankruptcy regimes that provide higher insurance values.