Why it Pays to File for Bankruptcy: A Critical Look at the Incentives Under U.S. Personal Bankruptcy Law and a Proposal for Change

Abstract

This article first examines the economic justification for having a personal bankruptcy procedure at all. I argue that it is economically worthwhile to have a bankruptcy procedure, but that costs rise more quickly than benefits as the exemption level increases. Thus the bankruptcy exemption level should not be too high. Next, the article explores various strategies that households can use to increase their financial benefit from bankruptcy and calculates the proportion of households that have a financial incentive to file for bankruptcy when they use these strategies. Current U.S. bankruptcy laws are so easily manipulated that almost any household can benefit financially from bankruptcy if it plans for bankruptcy in advance. Bankruptcy exemptions are in effect unlimited, which means that U.S. law gives too many households an incentive to file for bankruptcy rather than take responsibility for repaying their debts. I also analyze the effect of adopting the exemption proposals of the National Bankruptcy Review Commission and show that they would greatly exacerbate current problems. Finally, the article explores a proposed reform of the bankruptcy system under which debtors in bankruptcy would be obliged to use part of both their wealth and their future earnings to repay debt, but there would be exemptions for both. The proposed reform would end the anomaly under the current system that some debtors obtain discharge of their debts in bankruptcy even though they have high incomes and, often, high wealth. I show that under the proposed reform, fewer households would have an incentive to file for bankruptcy, but most of those who would be deterred from filing have high ability to repay their debts. Households that have low wealth and low income would still benefit from discharge of debt in bankruptcy and a fresh start.