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Bankruptcy, Incorporation and the Nature of Entrepreneurial Risk

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Author Info

  • Jacob M. Short

    (University of Western Ontario)

  • Andy Glover

    (University of Minnesota)

Abstract

Entrepreneurship is risky; entrepreneurs forgo wages and invest their time and resources into a business with large potential gains, but uninsurable risks. It is vital to know the extent of these risks, and the insurance available against them, in order to assess corporate tax and personal bankruptcy reforms. We document that incorporated entrepreneurs operate larger businesses, accumulate more wealth, and are on average more productive than unincorporated entrepreneurs. We embed the U.S. bankruptcy and incorporation legal systems in a quantitative macroeconomic theory of occupation, incorporation, and default choices that accounts for the cross-sectional facts. In the model, as in the U.S., incorporation provides insurance via limited liability beyond personal bankruptcy exemptions, at the expense of administrative burdens and an endogenous interest rate premium. Our model suggests that capital embodied shocks are important entrepreneurial risks. A calibrated economy in which each unit of installed capital entails a small probability (1.0%) of a catastrophic shock (full destruction of capital) is able to account for the data along multiple untargeted dimensions. We find the welfare gains for entrepreneurs from eliminating investment risk are huge (5.9% increase in annual consumption). And, the welfare loss from removing limited liability to be large.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2011 Meeting Papers with number 836.

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Date of creation: 2011
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Handle: RePEc:red:sed011:836

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  1. Igor Livshits & James MacGee & Michele Tertilt, 2003. "Consumer bankruptcy: a fresh start," Working Papers 617, Federal Reserve Bank of Minneapolis.
  2. Kartik Athreya & Ahmet Akyol, 2009. "Credit and self-employment," Working Paper 09-05, Federal Reserve Bank of Richmond.
  3. Marco Cagetti & Mariacristina De Nardi, 2006. "Entrepreneurship, Frictions, and Wealth," Journal of Political Economy, University of Chicago Press, vol. 114(5), pages 835-870, October.
  4. Sumit Agarwal & Souphala Chomsisengphet & Chunlin Liu & Lawrence Mielnicki, 2005. "Impact of State Exemption Laws on Small Business Bankruptcy Decision," Southern Economic Journal, Southern Economic Association, vol. 71(3), pages 620-635, January.
  5. Neus Herranz & Stefan Krasa & Anne P. Villamil, 2009. "Entrepreneurs, Legal Institutions and Firm Dynamics," Centre for Growth and Business Cycle Research Discussion Paper Series 128, Economics, The Univeristy of Manchester.
  6. Fan, Wei & White, Michelle J, 2003. "Personal Bankruptcy and the Level of Entrepreneurial Activity," Journal of Law and Economics, University of Chicago Press, vol. 46(2), pages 543-67, October.
  7. Césaire A. Meh & Yaz Terajima, 2008. "Unsecured Debt, Consumer Bankruptcy, and Small Business," Working Papers 08-5, Bank of Canada.
  8. Vincenzo Quadrini, 1997. "Entrepreneurship, saving and social mobility," Discussion Paper / Institute for Empirical Macroeconomics 116, Federal Reserve Bank of Minneapolis.
  9. Satyajit Chatterjee & Dean Corbae & Makoto Nakajima & José-Víctor Ríos-Rull, 2007. "A Quantitative Theory of Unsecured Consumer Credit with Risk of Default," Econometrica, Econometric Society, vol. 75(6), pages 1525-1589, November.
  10. Kjetil Storesletten & Chris I. Telmer & Amir Yaron, 2000. "The Welfare Cost of Business Cycles Revisited: Finite Lives and Cyclical Variation in Idiosyncratic Risk," NBER Working Papers 8040, National Bureau of Economic Research, Inc.
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Cited by:
  1. Fatih Guvenen, 2011. "Macroeconomics with hetereogeneity : a practical guide," Economic Quarterly, Federal Reserve Bank of Richmond, issue 3Q, pages 255-326.
  2. repec:fip:fedreq:y:2011:i:3q:p:255-326:n:vol.97no.3 is not listed on IDEAS
  3. Neus Herranz, & Stefan Krasa, & Anne P. Villamil, 2013. "Entrepreneurs, Risk Aversion and Dynamic Firms," Centre for Growth and Business Cycle Research Discussion Paper Series 189, Economics, The Univeristy of Manchester.

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