IPR News: Bankruptcy Reform

Economist Explains Why More Consumers Going Broke

Reprinted (and updated) from Institute for Policy Research News
Summer 1997.

More than a million households filed for bankruptcy last year, a rise of 27% over 1995. The first quarter of 1997 saw the greatest number of filers ever for a three-month period. And one in every 100 are projected to file by the time the year ends, according to the National Bankruptcy Review Commission (NBRC), which [has just proposed] reforms in federal bankruptcy laws to Congress.

In a period of sustained economic growth, why are so many consumers in financial trouble? Some point the finger at more lenient bankruptcy laws. Others think there is less social stigma attached to going broke.

Economist Ian Domowitz, an IPR faculty fellow, thinks the blame lies elsewhere.

In testimony before a Senate Judiciary subcommittee on April 11, and before the NBRC on May 14, Domowitz cited uninsured medical debt and credit card debt as the primary culprits. When medical debt is more than 2% of income, the average household is 28 times more likely to declare bankruptcy than one whose medical debt is less than 2%, he testified.

Uninsured medical debt also has some lethal side effects. According to Domowitz, if the average household's credit card debt rises to the level of the typical Chapter 7 bankruptcy filer, and the household has medical debt in excess of 2% of income, such an increase in credit card debt makes that household nine times more likely to file for bankruptcy, compared with a six-fold jump in the absense of medical debt.

Health care and health insurance reform may be the best antidote to rising consumer bankruptcies, Domowitz said. He told the legislators that reform of those industries, "in the direction of more affordable care and wider insurance coverage, may do more to discourage bankruptcy filings than any new bankruptcy legislation."

Though he concurs with industry assertions that credit card use is only a small fraction of debt, Domowitz insists it is very highly correlated with, if not a causal determinant of, consumer bankruptcy. This is regardless of income characteristics, homeownership, and other family characteristics. Like other critics, he thinks a slowdown in issuing preapproved credit cards could staunch some of the flow of filings.

Some observers suggest that bankruptcy carries less stigma these days, which has also contributed to the rise in filings. Domowitz has found no evidence of this. His research also contradicts a widespread belief that more lenient bankruptcy laws have encouraged more people to file.

In addition to medical debt and overextended credit, the economist says both population growth and macroeconomic forces, including ebbs and flows of the business cycle, and unexpected jolts, similar to the steep jump in oil prices during the late 1980s, may explain some of the rise in personal bankruptcies. Thus, he does not believe that 'tinkering' with the bankruptcy system will affect the rate of aggregate filings by consumers.

Congress is concerned that too many consumers may be opting to file for bankruptcy under the more lenient Chapter 7 rather than Chapter 13 of the U.S. Bankruptcy Code. Chapter 7 requires liquidation of personal assets to pay off a portion of one's debts; the rest (except for home mortgages) are forgiven, and future income may be retained. Chapter 13 permits a person to keep his assets and pay off part of his debts (usually 70%) within a set time period (usually three years). The remainder of the debts are discharged.

Domowitz says his evidence indicates that households are correctly self-sorting by income, debt, and equity levels (e.g., lower-income under Chapter 7 and higher under Chapter 13). He finds no evidence of substantial Chapter 7 abuse.

The economist cautions that more research is needed before any new legislation is passed. 'No one has produced any research that asks 'what are the economic determinants of bankruptcy at the household level?' We really don't know why people file," said Domowitz, who is currently at work on this issue.