Even though the economy is strong and unemployment is low, about 1.4 percent of all U.S. households filed for bankruptcy last year. Why? Because many households have a financial incentive to file for bankruptcy, since the value of debts erased by bankruptcy is greater than the amount that must be repaid plus the cost of filing. In fact, in a recent study I calculated that at least 15 percent of American households are in this position.
Many households can cash in even more by engaging in some simple advance planning. Debtors who file for bankruptcy under Chapter 7 are obliged to turn over their nonexempt assets to the bankruptcy court trustee for payment to creditors. Because there are several types of exemptions, debtors can increase their benefit by shifting assets. If, for example, a household has a savings account or other financial assets, which are almost always nonexempt, then that household can use the funds to pay off part of its mortgage, assuming that it owns a home and that its home equity is less than the home equity exemption (almost always the largest bankruptcy exemption). If all households that could benefit from this did so, the proportion of households that would benefit from bankruptcy rises from 15 to 20 percent.
Another strategy is for households to borrow more on their credit cards before filing, since both new and old credit card debt is discharged in bankruptcy. When households follow both of those strategies, the proportion that would benefit rises to one-third.
Because households can rearrange their assets to increase their financial benefit from bankruptcy, households with more assets benefit more. In Texas, for example, households in the top third of the distribution of ability-to-pay gain five dollars from filing for bankruptcy for each one dollar of gain by households in the bottom third of the distribution. Thus households that already have the most also gain the most from bankruptcy -- as evidenced by the steady stream of well-heeled actors, governors and financiers who have filed over the past few years.
Are households more likely to file for bankruptcy when their financial benefit from filing is higher? In a recent study with Scott Fay and Erik Hurst of the University of Michigan, I found that households are indeed more likely to file as their financial gain increases. For every $1,000 of additional financial benefit, the probability that households will file for bankruptcy rises by 3 percent.
Congress is currently considering a series of reforms to the bankruptcy system. Right now, there are two bankruptcy procedures between which filers may choose. Under Chapter 7, debtors are obliged to use their nonexempt assets to repay debt, but they are not obliged to use any of their future earnings to repay debt. Most debtors have no nonexempt assets when they file under Chapter 7, so that they repay nothing to creditors. Under Chapter 13, debtors keep all their assets but are obliged to use part of their future earnings to repay debt. Because debtors currently can choose, most file under Chapter 7. Under the House bill, debtors having more than the median income level would be obliged to file under Chapter 13.
A serious problem with this reform is that these debtors would be obliged to use all of their earnings beyond a fixed threshold to repay debt. This amounts to a 100 percent "bankruptcy tax" on the earnings of debtors in bankruptcy who are above the threshold. As a result, debtors who are considering bankruptcy would have an incentive to quit their jobs in order to avoid being subject to the tax.
A more sensible approach would be to combine Chapters 7 and 13 into a single procedure. Debtors would be obliged to repay debt from both assets and future earnings, but there would be exemptions for both. This change would recognize that debtors' ability to repay their debt depends on both their assets and their future earnings. It would base the obligation to repay on ability to repay.
Suppose the current bankruptcy exemptions for assets were retained and that the new exemption for future earnings is set at 90 percent. Then debtors in bankruptcy would be obliged to use all of their nonexempt assets plus 10 percent of their postbankruptcy earnings for three years to repay debt.
Under those assumptions, the proportion of households that have an incentive to file for bankruptcy would fall by one-half, from 15 to about 8 percent. Since many fewer households would have a financial incentive to file for bankruptcy under this reform, the bankruptcy filing rate would fall substantially. Also the greater a household's ability to repay, the more it would be discouraged from filing for bankruptcy. Thus the proposed reform would eliminate the perverse incentive structure that currently allows households having the highest ability to repay to benefit the most from bankruptcy.