The Redistributive Effects of Debtor Protection Laws

Abstract

A debtor-friendly bankruptcy regime limits the amount of assets creditors can seize from distressed individuals. In response, creditors may redistribute credit towards richer and more able individuals. We show that increasing the amount of asset protection in bankruptcy (exemptions) leads to higher income inequality in the state. Using geographic variation in banking market structure and variation in capital needs across industries, we show that the increase in income inequality is mediated by a credit market channel. We analyze different population groups and find that the increase in inequality is driven by a growing income gap between unskilled and skilled individuals that affects both self-employed and wage workers. We also find a drop in the employment rate and in the relative wage of unskilled workers. Our results indicate that the redistribution of credit leads to an imbalance in economic opportunities among entrepreneurs that reduces the aggregate demand for unskilled labor.