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Consumer Bankruptcy, Economics Of

In many countries, individuals whose debts have become excessive have the right to file for consumer bankruptcy. Under certain circumstances, a court will partly discharge the person's debt. Consumer bankruptcy procedures have existed in the United Kingdom since 1705, in the United States as a permanent program since 1898, and in many Western European countries since about 1990. Consumer bankruptcy is an important economic issue, because several million households face financial distress. This entry addresses three aspects: (1) a survey of consumer bankruptcy law in the United States (softer on debtors) and in Germany (more favorable toward creditors); (2) a summary of the underlying economic reasoning; and (3) the empirical evidence.

Bankruptcy Laws

U.S. Consumer Bankruptcy Law

The U.S. Congress enacted a consumer bankruptcy statute in 1898, which it significantly amended in 1938, 1978, and 2005. Under the current regulation, consumers have the option to file for bankruptcy, and until 2005, they were free to choose between chapter 7 and chapter 13. Under chapter 7, all current assets above an exemption level are liquidated; however, the debtor keeps all earnings after bankruptcy. If total debt exceeds the value of the assets in place, the remaining debt is discharged (“fresh start”). Some assets are exempted, such as furniture, a car, and most notably, for reasons of equity, the debtor's principal residence (the “homestead exemption”). Even though bankruptcy is a matter of federal law, state legislation determines the homestead exemption levels, and they vary widely, from about $5,000 in Alabama and Georgia, for instance, to an unlimited amount in Florida and Kansas. Chapter 13, introduced in 1938, was intended for debtors who earn a regular income. Under current chapter 13 provisions, debtors are allowed to keep their assets in place, but they have to propose a plan to use part of their disposable future earnings to repay debt, usually over a period of three years, but sometimes up to five. The consumer must pay at least as much to creditors in chapter 13 as would have been possible under chapter 7. If the consumer complies with the plan, the court grants discharge of any remaining debt. Even if the debtor fails to complete the plan, a limited discharge is possible. Under chapter 7, there is no debt relief available for six years after filing, while under chapter 13, the period is only 180 days.

There is no limit on the amount of debt that one can discharge. For certain debts, such as recent income taxes, alimony, child support, government-supported educational loans, debts incurred through fraud, tort claims, or false financial statements, discharge is not possible. Most consumers (about 70 percent) were choosing chapter 7 until 2005. On October 17, 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA), Pub. L. No. 109–8 (2005), came into effect. It aims to reduce the debtor's choice of chapter, and to replace it with a “means test,” which puts the “can-pay” debtors under chapter 13.

German Consumer Bankruptcy Law

Before 1999, there was no consumer bankruptcy procedure in Germany. The law permitted creditors to both liquidate the consumer's seizable assets and garnish future disposable income. Since 1999, the Bankruptcy Code (Insolvenzordnung) has allowed debt discharge under more restrictive requirements than those found in U.S. law. First, almost all current assets are liquidated, including home equity and cars. There is no exemption, except for necessary goods, such as furniture or appliances. Second, discharge is possible only if private negotiations on debt rescheduling have failed. Third, in addition to the liquidation of the assets in place, the consumer has to pay his or her disposable future earnings to the creditors over a period of six years. As in the United States, debt discharge is not possible for tort claims, alimony, wrong financial statements, and so on. Only unsecured debt is dischargeable. Debt relief is possible only if there was no debt discharge over the previous ten-year period and the consumer maintains good conduct for six years. During these six years, the consumer has some obligations, most notably, to make a strong effort to find a job and pay her disposable income to a trustee, who collects the money on behalf of all creditors. If the consumer fails to do so, the court may not approve debt discharge.

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