Optimal Bankruptcy Code: A Fresh Start for Some

Abstract

What is the optimal consumer bankruptcy law? I examine this question in the context of an incomplete markets lifecycle model with a planner who can choose state-contingent bankruptcy costs. I develop two key theoretical characterizations. First, the optimal policy has a bang-bang property: The planner either gives a household a "fresh start" or forbids it from filing. Second, it is optimal for the planner to always allow bankruptcy if the household cannot repay or would prefer an outside option. Consequently, a natural borrowing limit economy - an economy where bankruptcy is never allowed - is suboptimal. Quantitatively, the optimal policy results in large amounts of debt and default with ex-ante welfare gains, relative to a no-borrowing economy, as large as 12.8% of lifetime consumption. While the optimal policy is complicated, a simple cutoff rule allowing bankruptcy when a household's debt is 2.6 times its endowment results in a welfare gain of 12.2%.