The Political Economy of Personal Bankruptcy Law

In this paper we study the political and economic determinants of US states' choices of homestead exemptions. We develop a political economy model in which homestead exemptions are ex-post beneficial to borrowers who default (because they shield some of their wealth from creditors) but ex-ante costly to all borrowers (because they increase borrowing costs). Assuming that state residents vote on homestead exemptions, we predict that states with higher levels of income inequality adopt higher levels of homestead exemptions. We test this prediction for three sample periods: cross-sectional data for 1975 and for 1860, and panel data over the 1978-2005 period. Across these three samples, we find evidence consistent with the prediction of the model. Our findings are robust to controls for other differences across states, including state fixed effects (in the panel regressions)