The consumption effects associated with filing for personal bankruptcy.

• Author: Filer, Larry H., II

1. Introduction

   Personal bankruptcy in the United States is part of the social-insurance structure provided by the federal and state governments. Other programs in this network include, but are not limited to, Unemployment Insurance (UI), Temporary Assistance to Needy Families (TANF), and food stamps. While these latter three programs are targeted to specific groups, the recently unemployed for UI and low-income households for TANF and food stamps, personal bankruptcy is not. Much like these other programs, though, bankruptcy reduces income uncertainty and reduces wealth uncertainty.

   Surprisingly little work has been done on the direct benefits to filing for bankruptcy. This is in contrast with the growing literature on the costs of bankruptcy. (1) Fay, Hurst, and White (2002) estimate the financial benefit to filing for bankruptcy, which equals the debt forgiven minus any lost assets. This measure is a good predictor of whether the household files for bankruptcy, but it is not clear that the financial benefit is the true measure of the welfare gain from bankruptcy. In fact, the financial benefit is most likely an overestimate of the household's gain in the year it files for bankruptcy. Unlike UI or TANF, bankruptcy provides no increase in money income for that period but rather increases net-of-debt income. This change is felt over the household's lifetime, and fliers will most likely smooth this effect over multiple years because households cannot file for bankruptcy again for six years. Further, using the financial benefit makes it difficult to compare results against the estimates of the consumption benefits from other programs that provide insurance (see Gruber 2000 for TANF, Browning and Crossley 2001 for UI, and Gunderson and Ziliak 2003 for food stamps).

   For these reasons, an analysis of bankruptcy's effect on the household's consumption profile may be more relevant. Bankruptcy provides benefits that may affect consumption growth through two channels. First, forgiving unsecured debt provides the household with greater net-of-debt income. In the face of idiosyncratic shocks such as job loss or divorce, protecting net-of-debt income allows a household to stabilize consumption in lieu of debt servicing. In this way, households realize a consumption insurance benefit in the year they file for bankruptcy. (2) Second, bankruptcy may prevent the liquidation of certain assets, thereby insuring wealth and the flow of consumption services from these assets.

   While other insurance programs also stabilize consumption, the unique aspects of bankruptcy are that it protects assets and that there are no eligibility requirements like there are for UI, TANF, and food stamps. As a result, bankruptcy could provide a consumption benefit that can be cashed in at a time of the household's choosing. In these ways, bankruptcy may be the most flexible insurance program, provided that it generates similar consumption benefits to other transfer programs.

   In this article, we use the Panel Study of Income Dynamics (PSID; Survey Research Center 2002) to estimate the consumption insurance benefits of filing for personal bankruptcy. First, we estimate the responsiveness of food-consumption growth to the financial benefit associated with bankruptcy. This follows the literature that examines the mechanisms that provide partial insurance, such as the progressive income tax structure (Kniesner and Ziliak 2002), food stamps (Blundell and Pistaferri 2003; Gunderson and Ziliak 2003), unemployment insurance (Browning and Crossley 2001), and Medicaid (Gruber and Yelowitz 1999). The results in this article suggest that a 10% increase in the financial benefit increases food consumption growth by 0.9%, which is smaller than the effect of an increase in UI or TANF benefits. For UI and TANF, a 10% increase in the dollar benefits increases food consumption growth by approximately 2-3% (Gruber 1997, 2000).

   Then we estimate how the choice of bankruptcy chapter that the household files under affects the growth in food consumption. The results indicate that (i) households that filed for bankruptcy under chapter 7 of the bankruptcy code experienced a 13% increase in food-consumption growth in the year they filed for bankruptcy and (ii) households that filed under chapter 13 experienced an insignificant change to their food consumption.

   The remainder of the article is organized as follows. The next section discusses the relevant features of bankruptcy law crucial to the estimation, with an emphasis on the differences between chapter 7 and chapter 13. The third section clarifies the data, uses the previous literature on consumption insurance to motivate the empirical model, and addresses some of the concerns surrounding estimation. Section 4 presents the empirical results. Section 5 concludes with a discussion of our results.

2. Personal Bankruptcy Law and Process

   An individual filing for bankruptcy chooses between chapter 7 and chapter 13. Of the 1.62 million personal bankruptcy filings in 2003, 1.15 million (71.2%) were filed under chapter 7. (3) Under chapter 7, the debtor forfeits all assets exceeding the bankruptcy exemption levels set by the state. A bankruptcy trustee sells the nonexempt assets and distributes the money to the creditors. In return, a chapter 7 filing discharges most unsecured debts. Secured debts are discharged only if the debtor forfeits the collateral.

   The other option when filing for personal bankruptcy is chapter 13. Filers do not turn over assets to the bankruptcy court but instead propose a repayment plan for a portion of the outstanding debts. Essentially, chapter 13 fliers put themselves on a strict budget through this repayment plan. If the repayment plan is successfully completed, the filer receives a discharge of some of the unsecured debts. Because the discharge of debts does not occur until the repayment plan is completed, the full benefit of chapter 13 is not realized until then. ff the plan is not completed, the filer does not receive the discharge. The largest advantage to filing under chapter 13 is that fliers do not have to turn over any assets to the Bankruptcy Court, while chapter 7 fliers lose nonexempt assets.

   Federal law gives bankruptcy judges the discretion to dismiss any bankruptcy filing that constitutes a substantial abuse of the process (Bankruptcy Reform Act of 1984). Dismissal of a bankruptcy filing request requires clear evidence of fraud on the flier's behalf, such as a transfer of property while the filer retains the property or transfers executed at much less than face value. In addition, the antifraud provision prevents accumulation of significant debt in the 12 months before filing. This prevents the household from using debt to fund current consumption in the months before filing. We argue that this provision insures that the financial benefit is exogenous to consumption growth, which becomes important in identifying the consumption insuring effect of bankruptcy.

3. Data and Empirical Model

   Data

   For all empirical work in the article, we use the PSID, which is a longitudinal household survey that began in 1968. The PSID follows 8000 U.S. households and collects economic, health, and social behavior data from each household and each member of the household. In 1996, the PSID included an extra set of questions on personal bankruptcy; households were asked whether they ever filed for bankruptcy. If the household filed for bankruptcy, the PSID collected additional information including the year and the bankruptcy chapter. Because the bankruptcy information was only asked in the 1996 wave, the household must have been interviewed in 1996 to be included in our sample. Because the 1996 survey took place during the spring of 1996 rather than at the end of the year, some households may have filed for bankruptcy in 1996 but after they were surveyed. Therefore, the last year used in our sample is 1995. If we included the 1996 wave in the panel specifications, we may incorrectly identify some bankruptcy fliers as households that did not file. (4)

   The other important aspect of the PSID data is the expenditure questions. The PSID includes information regarding food eaten out, food eaten at home, and food-stamp usage. We sum these components to create one food-expenditure variable. Because the 1988 and 1989 waves of the PSID do not include the food questions, 1990 is the first year in our sample. Unfortunately, the PSID does not include a more comprehensive measure of consumption. (5) However, the PSID is the only data set that has the necessary bankruptcy information and longitudinal data on at least one measure of consumption. The focus on food consumption is not just a data constraint, however. From a policy perspective, social insurance programs should be designed to maintain reasonable standards of living in the face of idiosyncratic shocks to the household. While bankruptcy is not designed to target food consumption directly, it seems reasonable to evaluate this program's effect on one of the basic elements of the household's utility function. Further, if we find that bankruptcy affects an income inelastic good such as food, then we would expect that it would affect broader measures of consumption as well.

   There are other restrictions placed on the sample. First, if the household had imputed values for food or income, it was excluded from our sample. Second, the household is required to have valid values for the independent variables in our specification. If there was a change in household composition, such as a divorce, during the sample period, the household is included in the sample. Previous studies that examine consumption changes in the PSID, such as Zeldes (1989), exclude these types of households. We include these households and control for changes in family size and marital status. If we excluded households that changed composition, we would lose potentially interesting households...