Rules Change Entrepreneurial Activity

...home-owning families are 35 percent more likely to own businesses if they live in states with high or unlimited homestead exemptions rather than low homestead exemptions. Families who rent are 29 percent more likely to own businesses if they live in high exemption states.

Exemption levels, which determine the amount of assets a person declaring bankruptcy may retain, are the only aspect of U.S. bankruptcy law that varies from state to state. In Personal Bankruptcy and the Level of Entrepreneurial Activity (NBER Working Paper No. 9340), co-authors Wei Fan and Michelle J. White examine how variations in exemption levels affect incentives to launch, to own, and to end small businesses.

The authors consider the most common personal bankruptcy procedure, Chapter 7, which is particularly favorable to small business owners. Under it, all of debtors' unsecured business and personal debts are discharged when they file for bankruptcy. Debtors must give up all of their assets above the state's exemption level, but their future earnings are entirely exempt from the obligation to repay (the "fresh start" in bankruptcy). Fan and White show that the bankruptcy system provides entrepreneurs with partial wealth insurance, since they can keep wealth up to the exemption level in their state if their businesses fail. Assuming that potential entrepreneurs are risk averse, this makes going into business more attractive because the consequences of failure are not as bad. Since states with higher exemption levels provide higher levels of wealth insurance, the authors show that potential entrepreneurs are more likely to go into business if they live in states with high rather than low exemptions.

Fan and White use data from The Survey of Income and Program Participation (SIPP), which gives information on whether families contain one or more workers who are self-employed. The authors estimate models explaining whether the decision to be self-employed depends on the exemption level in the family's state of residence. States have several types of exemptions, but authors focus on the homestead exemption since it is the largest and most variable. Homestead exemptions range from zero in two states to unlimited in eight states (including Florida and Texas). Because homestead exemptions benefit homeowners more than renters, authors estimate separate effects for the two groups.

The results show that home-owning families are 35 percent more likely to own businesses if they live in states with high or unlimited homestead exemptions rather than low homestead exemptions. Families who rent are 29 percent more likely to own businesses if they live in high exemption states - and both differences are statistically significant. The authors also show that bankruptcy exemptions affect the decision to start a business: home-owning families are 28 percent more likely to start businesses if they live in states with unlimited rather than low homestead exemptions. But Fan and Whit find no significant relationship between exemption levels and whether families end their businesses.

Finally, Fan and White note that personal bankruptcy law is currently under review in Congress, largely for the purpose of reducing abuse of the bankruptcy system by well-off debtors. But the proposed bankruptcy reforms may have unintended consequences for small business. For example, the proposed reforms would bar debtors who earn more than the median income from filing for bankruptcy under Chapter 7. Fan and White caution that such a change could reduce the attractiveness of going into business, since owners of businesses that fail might be forced to use their future earnings to repay old business debts. And lenders would be loath to lend to once-failed business owners who want to start new businesses, because those owners have little incentive to work hard if any additional earnings mainly benefit their old creditors. All of this, Fan and White warn, could reduce the number of small businesses and could slow the overall growth rate of the U.S. economy.

-- Matt Nesvisky