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The US personal bankruptcy system allows debtors to discharge uncollateralized debts if they give up assets in excess of a threshold known as an “exemption”. However, since exemptions erode repayment incentives, they may increase borrowing costs. Our paper evaluates the tradeoff between credit costs and the insurance against failure created by bankruptcy exemptions. We find that exemptions change self-employment rates and the timing, size, and financing of projects. We also find that the positive relationship between wealth and self-employment rates may not arise from credit constraints: such a relationship is present even when credit is plentiful at low interest rates.

Borrowing constraints are seen as a significant barrier to entrepreneurial activity in the US. The perception of such constraints has led to the creation of agencies such as the US Small Business Administration, which channels billions of dollars of credit to those choosing self-employment or entrepreneurship.1 Moreover, current public policy is premised on the view that the fundamental source of borrowing constraints is default risk. Evidence for this view is seen in the pervasive use of loan guarantees, rather than outright grants. The former, after all, could be expected to improve access to credit only if borrowing constraints arose from default risk. If indeed default risk limits credit access, where does it come from? A primary suspect for small business borrowers is US personal bankruptcy law. As practiced, the non-waivable legal right to bankruptcy protections leaves entrepreneurs, and especially sole proprietors, with no credible way of committing to repay unsecured debts.2 The bankruptcy process not only removes all unsecured debt, but also allows, in many cases, for some wealth to be retained by borrowers. More generally, any legal limit to liability for debts means that borrowers, especially those with low personal wealth, pose a risk to lenders that implies greater costs to start a venture. Despite the clear drawbacks created by such statutes, small business is seen as an inherently high-risk activity where actuarially fair insurance against failure is difficult, or impossible, to obtain. And in the absence of markets against such risks, bankruptcy and other limits to liability allow borrowers to partially tailor loan repayment to avoid severe reductions in their standards of living in the event of poor returns on investment. In addition to credit conditions, those contemplating self-employment must evaluate its payoff relative to their prospects as paid workers in the “corporate” sector. The potentially important role played by opportunity costs arising from alternatives to self-employment is suggested by the empirical regularity that entrepreneurship is chosen relatively more often by those with poor current corporate-sector opportunities. Evans and Leighton (1989), Farber (1999), Rissman, 2003 and Rissman, 2006, and Fairlie and Krashinsky (2006) each show that in the data, poor opportunities for paid work are important in generating the switch to self-employment. Specifically, prior job loss, displacement, and high local unemployment rates are each associated with a heightened likelihood of entrance to self-employment. This feature motivates a central aspect of the timing of resolution of uncertainty in our model: Households first learn their productivity in the corporate sector and then choose whether or not to become self-employed. Since the bankruptcy system may actually create the credit constraints that other major policies aim to mitigate, it is important to clarify its effect on credit markets and, in turn, entrepreneurial activity in the US. The main contribution of this paper is to provide a quantitative evaluation of how US personal bankruptcy policy, as defined by asset exemptions, affects self-employment decisions and unsecured credit conditions and whether, in turn, the outcomes improve welfare. We model occupational choice over the life cycle, and our analysis emphasizes the role of household-level decisions in generating aggregate outcomes. In particular, we measure the role played by exemptions in influencing credit constraints, risk taking, and self-employment choices over the entire life cycle. Our main results are as follows. First, we find that when exemptions are increased substantially beyond current US averages, the insurance provided by the default option is largely offset by the disincentives arising from higher credit costs, resulting in only minor changes in self-employment activity. However, when exemptions are lowered relative to current US levels, the associated drop in default risk decreases credit costs sufficiently to expand credit use, and despite the loss of insurance, self-employment rates rise. Second, we find that changes in exemptions have distributional implications. In particular, high exemptions appear regressive with respect to age. We show that very high exemptions sharply affect the young, but have only minor effects on the old, primarily because the latter have accumulated wealth for retirement. In contrast to its effects on age, exemption policy does affect high- and low-skilled households differently. In particular, the percentage reduction in self-employment rates arising from high exemptions are much larger for the low-skilled than for the high skilled. In addition, the use of credit also drops much more rapidly. We also find that very high exemptions significantly alter the ability of households to switch occupations in the event of low corporate sector productivity. Third, we demonstrate that the positive correlation between wealth and self-employment does not imply the existence of credit constraints, and instead arises primarily from the interaction of risk and life-cycle savings behavior. Our study contributes along three dimensions. First, we provide a quantitative assessment of the role that US bankruptcy exemptions play in risk taking. By contrast, much recent work on bankruptcy has been on its role in risk sharing for an exogenous income stream. Second, by incorporating the “real” options of entry and exit, we are able to study the effects of exemption policy on not just the intensive margin (i.e., project size) of self-employment, but also the extensive margin (i.e., the rate of self-employment). As a result, we overcome the fact that data on self-employment is by definition censored, capturing only those for whom such a choice was preferred to an unobserved alternative. Relatedly, our model produces a full schedule of interest rates for debt, on and off the equilibrium path. This allows us to overcome the classical problem of the identification of credit demand and supply. As Berkowitz and White (2004, Footnote 27, p. 18) acknowledge: “Presumably, firms apply for the amount of credit they expect lenders to provide, and lenders may tell borrowers in advance how much they are willing to lend”. Third, our model allows for wealth accumulation. This is an important dimension to allow for in a model aimed at measuring the role of policies that alter the cost of credit. In particular, as noted above, households in the model, and presumably in the data, can overcome tight constraints by saving enough to eventually self-finance a project. Importantly, the ability to save to overcome constraints will differ across households, especially across those with differing levels of human capital. Therefore, a central feature of our model is to explicitly model the decisions of those with high- and low-human capital. Our work is part of a growing literature that studies bankruptcy and entrepreneurship.3 Important empirical work here includes Fan and White (2003), who also provide a theoretical analysis of exemptions which we build on, and Berkowitz and White (2004). Most closely related to our equilibrium approach are the papers of Meh and Terajima (2008), Jia (2009), and Mankart and Rodano (2009). However, there are important differences. First, in contrast to our work, in both Meh and Terajima (2008) and Jia (2009), the within-period decision to work in the non-entrepreneurial sector is taken before the productivity in that sector is realized, which alters the risk-sharing conferred by the ability to switch after realizing current labor productivity in the non-entrepreneurial sector. Mankart and Rodano (2009), on the other hand, innovate by allowing for both secured and unsecured credit, but in contrast to our work, abstract from the life-cycle. Additionally, as with Meh and Terajima (2008) and Jia (2009), Mankart and Rodano (2009) endow all agents with knowledge of their productivity in both sectors before the occupational choice decision is made. Lastly, unlike our work, all three preceding papers abstract from heterogeneity in human capital across households. Relative to the more general issue of how limits to liability alter financing and risk-taking, Moss (2002) suggests that the introduction of limited liability was strongly influenced by the idea that it would foster investment in projects that would otherwise be too risky, and thereby too expensive, to fund. Relatedly, Herranz et al. (2008) evaluates limited liability in a manner intended to represent bankruptcy exemptions. These authors allow for heterogeneity in risk-aversion, and estimate that such heterogeneity is likely to be non-trivial. Unlike our work, however, these authors study an infinite horizon and do not allow for separate realizations of productivity in paid work and self-employment. Lastly, recent work of Glover and Short (2010) evaluates limited liability more generally than is done here in a model where agents are both infinitely lived and homogenous in human capital. These authors examine the choice between accessing limited liability through remaining unincorporated and using personal bankruptcy, or incorporating themselves and then using corporate bankruptcy. However, in Glover and Short (2010) there is no uncertainty in paid work, which shuts down the channel that we are interested in. Our work is also related to a broader literature on self-employment and credit frictions arising from limited commitment, including Cagetti and DeNardi (2006), Mondragon-Veléz (2007), Polkovnichenko (2003), Terajima (2006) and Hopenhayn and Vereshchagina (2009).4 Our work differs from these papers in some key ways. For example, there is no default in equilibrium in any of the preceding papers, and as a result, no use of credit at rates other than the risk-free rate. Moreover, in Cagetti and DeNardi (2006) production is riskless, as the self-employed know their productivity at the time of borrowing. As a result, in the latter, limited commitment to repay debt can only limit borrowing. By contrast, in our model, households first borrow, then realize the stochastic output from the project. Our set-up thereby captures the original impetus for debt relief of allowing debt repudiation to encourage risky investment. Second, we do not derive debt limits by assuming that default is met by permanent autarky. Rather, we treat the decision not to repay debt as it is treated in practice, whereby households are forced to surrender wealth above a threshold in return for debt forgiveness. In turn, our model generates such exchanges in equilibrium, which are naturally interpretable as “bankruptcies” as they are measured in the data. Additionally, the presence of equilibrium bankruptcy means that interest rates will vary with the risk associated with any entrepreneur-project pair. Therefore, our model captures the empirical regularity that low-wealth borrowers face higher credit costs, and hence are more credit “constrained”. Next, in contrast to Polkovnichenko (2003), which is particularly innovative in setting up a static model to study occupational choice, our work allows for households to accumulate wealth to undo the effects of credit constraints. Lastly, Hopenhayn and Vereshchagina (2009) study occupational choice, and allow for varying degrees of risk-taking in project choice, but limit borrowing and abstract from bankruptcy. The remainder of the paper is organized as follows. Section 2 illustrates the key tradeoffs that we evaluate. 3 and 4 present and parameterize the model; Section 5 reports and discusses results. Section 6 concludes.

The main message of this paper is that personal bankruptcy asset exemptions alter the timing, size, financing, and to a lesser extent, the rate of self-employment, especially at levels that are high relative to current US practice. Low exemptions, by contrast, appears to generate offsetting effects. Namely, while cheap credit encourages self-employment, the absence of a generous default option makes such a choice risky. In high-exemption regimes, while the cost of credit dominates the insurance benefits, the flexibility of households to switch occupations and save to overcome high borrowing costs leads to nearly identical allocations relative to the US mean exemption level. This is particularly true for aggregate self-employment rates. We also find that the positive relationship between wealth and self-employment rates cannot be seen as evidence for credit constraints. In particular, we show that such a relationship is present even when exemptions are set to levels that essentially eliminate personal bankruptcy protection. Additionally, our finding suggest that credit constraints, when “tight”, will primarily affect the timing, rather than the overall rate of self-employment. That is, under even exemption levels that nearly eliminate the ability of most to borrow, the overall self-employment remains within three-fourths of its level under benchmark exemptions. It is useful to note that our current approach employs inelastic labor and homogeneous risk for self-employment projects. To the extent that availability of limited liability discourages effort, the disincentive effects may be larger than measured here. Similarly, the insurance provision of personal bankruptcy may lead households, if allowed, to choose projects that are inefficiently risky. In addition, even if personal bankruptcy law is modified, incorporation remains an option, as studied in recent work of Glover and Short (2010). These dimensions are clearly worthy of further investigation.