Going for Broke: The Benefits of Bankruptcy Protection

While not generally considered part of the national safety net, consumer bankruptcy protection is a fundamental component of social insurance in the United States. In 2010, 1.5 million Americans attempted to utilize the consumer bankruptcy process in filing for over $450 billion in debt relief. In theory, individuals granted bankruptcy protection would lead better lives upon receipt of debt relief, but previous research has found no effect on hours worked by recipients and a simultaneous decrease in wealth and credit access upon receiving bankruptcy protection.

In a new National Bureau of Economic Research working paper, Will Dobbie and Jae Song link Chapter 13 bankruptcy filings to administrative tax and foreclosure records to estimate the causal effects of bankruptcy protection on individual economic and health outcomes. They find that Chapter 13 Bankruptcy, which is meant to protect against home and asset foreclosure, increases annual income by $5,562, decreases five-year foreclosure rates by 19.1 percentage points, and decreases five-year mortality by 1.2 percentage points.

The authors come to this conclusion by utilizing unique features of the bankruptcy court system, which has standards for granting Chapter 13 bankruptcy protection, but often leaves the granting of this protection to the marginal filer to individual judges’ discretion. Individuals who file for protection are randomly assigned judges in many courts, which presents a randomization that conveniently allows for statistical study controlling for unobserved variables.

Through statistical analysis, the authors find significant benefits to receiving Chapter 13 bankruptcy. The marginal recipient’s annual earnings are increased by $5,562 in the five post-filing years. These individuals are employed at a rate 6.8 percentage points higher, have a mortality rate 1.2 percentage points lower, and face home foreclosure 19.1 percentage points less over the same time period. These outcomes are not absolute gains to those receiving protection. Rather, they represent relative gains compared to similar filers who did not receive bankruptcy protection.

Different demographic groups did not experience these benefits equally. In particular, the health outcome gains were largely experienced by individuals over age 60. For this demographic, mortality rates dropped 10.9 percentage points compared to those not granted bankruptcy protection.

The bankruptcy system provides debtors the choice between Chapter 7 bankruptcy, which reduces debts and prevents wage garnishment in exchange for non-exempt assets, and Chapter 13 bankruptcy, which adds protection of most assets in exchange for a fractional repayment of debt. Chapter 7 is granted far more often and with less variation, so the same study design does not apply for analyzing Chapter 7 bankruptcy benefits.

Because both types of bankruptcy protect against wage garnishment, the authors argue that both increase an individual’s incentive to work. And Chapter 13 in particular is designed to protect against home foreclosure. The results of this study suggest that these programs are meeting their stated goals, as there is a relative increase in the employment rate and decline in foreclosure rate amongst marginal recipients.

This research sheds light on the likely impacts of this social safety net and allows policymakers to better understand the benefits of bankruptcy protection to the indebted. Even as consumers have deleveraged since the financial crisis, the policymaking implications of bankruptcy will remain prevalent as real wages continue to stagnate for most Americans. Balancing debt forgiveness of individuals with the resulting incentive for individuals to overdraw will be the challenge to policymakers who seek to maximize employment, homeownership, and positive health outcomes.

Article Source:  Debt Relief and Debtor Outcomes: Measuring the Effects of Consumer Bankruptcy Protection, Will Dobbie and Jae Song, NBER Working Paper No. 20520, September 2014. 

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