Though the economy is strong and unemployment is low, about 1.4% of all U.S. households filed for bankruptcy last year. Why? Because many households have a financial incentive to do so.
This incentive exists when the value of debts erasable in bankruptcy exceeds the amount that must be repaid plus the cost of filing. In fact, in a recent study I calculated that at least 15% of American households are in this position.
Many households can cash in even more with 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 gain advantage by shifting assets.
If for example a household has a savings account or other financial assets, which are almost always nonexempt, then it could use the funds to pay off part of a mortgage, assuming that its resulting home equity stays under the exemption ceiling (almost always the largest bankruptcy exemption). If all households that could benefit from this tactic did so, the proportion of households that would benefit from a bankruptcy filing rises to 20%.
Another tactic is for households to borrow more on their credit cards before filing, since both new and old credit card debt is discharged in bankruptcy. Households that could benefit from bankruptcy if both tactics were used are one-third of the total.
Because households can shift assets to increase their financial benefit from bankruptcy, those with more assets benefit more. In Texas, for example, households in the top one-third of the distribution of ability to pay gain $5 from filing for bankruptcy for each dollar of gain by households in the bottom one-third. Thus households that already have the most gain the most from bankruptcy -- as shown by the steady stream of well-heeled actors, governors, and financiers who have filed in recent 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 potential financial gain increases. For every $1,000 of additional financial benefit, the probability that a household will file for bankruptcy rises 3%.
Congress has been considering a series of reforms. Right now, filers may choose between two bankruptcy procedures. Under Chapter 7, debtors are obliged to use their nonexempt assets to repay debt, but they are not obliged to use future earnings for this purpose. Most debtors have no nonexempt assets when they file under Chapter 7, so they repay nothing to creditors. Under Chapter 13, debtors keep all their assets but are obliged to use a portion of future earnings to repay debt. Because they can choose, most debtors file under Chapter 7.
Under a House bill, debtors making more than the median income would be obliged to file under Chapter 13. A serious problem with this reform is that these debtors would be obliged to use all their earnings beyond a fixed threshold to repay debt. This amounts to a 100% "bankruptcy tax" on earnings above the threshold. As a result, debtors who are considering bankruptcy would have an incentive to quit their jobs in order to avoid 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 depends on both their assets and future earnings. It would base the obligation to repay on ability to repay.
Suppose the current asset exemptions were retained and a new exemption for future earnings was set at 90%. Then debtors in bankruptcy would be obliged to use all of their nonexempt assets plus 10% of their post-bankruptcy earnings for three years to repay debt.
Under these assumptions, the proportion of households with an incentive to file for bankruptcy would fall from 15% to about 8%. Since many fewer households would have a financial incentive to file under this reform, the bankruptcy rate would fall substantially.
Also, the greater a household's ability to repay, the more it would be discouraged from filing. Thus the proposed reform would eliminate the perverse incentive structure that gives the biggest benefit from bankruptcy to the households best able to repay.
