Forgive Us Our Debts: New Research Finds That One of the Best Ways to Encourage People to Start Businesses Is to Have Lenient Bankruptcy Laws, Writes Aparna Mathur. We Need to Send the Message That It's O.K. to Fail

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Entrepreneurs power the American economy. They enter and exit in a continuous, harmonious process that Joseph Schumpeter in 1942 called "creative destruction, ... the essential fact about capitalism." The toll is heavy. One-third of new businesses die in the first two years, and the majority fail to survive to year four. Despite such odds, the number of new entrants has been steadily increasing over time, and serial entrepreneurs thrive, resurfacing again and again. As a result, small businesses account for more than 95 percent of all enterprises in the United States, and close to 50 percent of all employment.

Much of the national policy debate about small businesses centers, naturally, on firms that survive. Taxes, healthcare costs, and capital subsidies are the concern of businesses that have more than minimal incomes, employees on their payrolls, and investment options. But what about firms that don't make it? How do we treat entrepreneurs who fail? The latest research suggests that this may be the most important question of all.

Over the years, America's personal bankruptcy system has served as a hedge against entrepreneurial failure. When businesses fail, entrepreneurs can shield some of their assets from creditors by filing under Chapter 7 of the federal bankruptcy laws, the usual route for consumer filings. In fact, nearly 20 percent of all personal filings list business debts, and the value of business debts represents half the total liabilities of bankruptcy filers. But entrepreneurs are seldom the focus of debates about bankruptcy reform, which rarely distinguish consumers from small business owners.

America's bankruptcy law is rooted in the "fresh start"--the idea that honest debtors experiencing a spot of bad luck, such as temporary job loss, illness, or divorce, are capable of putting the past behind them and moving on. This concept works especially well for owners of small businesses. By wiping out debts and pardoning failure, American bankruptcy gives the entrepreneur a chance to bounce back.

It's no surprise that these laws--seen as lenient not just by creditors but by much of the general public--have increasingly become a subject of debate in recent times. There is a growing fear that the system is too forgiving of debtors, and there is evidence that such criticism may be valid. The number of Americans seeking relief from creditors each year has more than doubled in the past decade to two million. This steady and rapid rise in bankruptcy filings has coincided with a generally robust economy (only one shallow and brief recession), leading to claims that filing for bankruptcy is simply a ploy to avoid paying debts.

Among the high-profile cases of abuse: O. J. Simpson, the pro-football player acquitted in a 1995 criminal trial of murdering his wife, moved to Florida to protect his extravagant home after losing a civil lawsuit two years later in California that required him to pay $33 million to the victims' families.

Under pressure from creditor groups, including banks and credit card companies, Congress in 2005 passed the Bankruptcy Abuse Prevention and Consumer Protection Act, which makes debtors jump through many more bureaucratic hoops to get relief. Signing the act, President Bush said, "In recent years, too many people have abused the bankruptcy laws. They've walked away from debts even when they had the ability to repay them. This has made credit less affordable and less accessible."

But there is something important missing in the debate on bankruptcy: the implications of such legislation for entrepreneurial behavior.

Does bankruptcy regulation affect entrepreneurship? My own research--along with that of Michelle J. White, professor of economics at the University of California at San Diego--answers with an unequivocal "yes." Studying variations in laws across the country, we find that the states that more extensively protect the assets of those filing for bankruptcy have more likely probabilities for business start-ups. …