Bankruptcy, Incorporation and the Nature of Entrepreneurial Risk

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 occupational, 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 shocks are important entrepreneurial risks. A calibrated economy in which each unit of installed capital entails a small probability (0.6%) of a catastrophic shock (full destruction of capital) is able to account for the data along multiple untargeted dimensions. A counterfactual exercise is performed to see if reducing the costs of incorporation can account for an increase in wealth inequality in line with US data. ∗The authors would like to thank José-Vı́ctor Ŕıos-Rull, Jonathan Heathcote, Thomas Holmes, Ellen McGrattan, Fabrizio Perri, James Schmitz, Kjetil Storesletten and seminar participants at the Federal Reserve Bank of Minneapolis

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