Using Elasticities to Derive Optimal Bankruptcy Exemptions

This paper studies the optimal determination of bankruptcy exemptions for risk averse borrowers who use unsecured contracts but have the possibility of defaulting. In a large class of economies, knowledge of four variables is sufficient to determine whether a bankruptcy exemption level is optimal or should be increased or decreased. These variables are i) the composition of households’ liabilities, ii) the sensitivity of the credit supply schedule to exemption changes, iii) the probability of ling for bankruptcy with non-exempt assets, and iv) the value given by households to a marginal dollar in different states, which can be mapped to changes in households’ consumption. I recover empirical estimates of the sufficient statistics using U.S. data over the period 2008-2016 and find that increasing exemption levels improves overall welfare, although there is substantial variation in estimated welfare gains across U.S. states and income quintiles.

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