When it pays to be honest: How a variable period of good conduct can improve incentives in personal bankruptcy proceedings

Consumer bankruptcy regulation in the United States as well as in many other countries allow consumers to petition for a partial debt discharge. Usually, a debt release is possible when the debtor behaves in the creditors’ best interest and after filing for bankruptcy signs over her entire disposable income for a fixed period. Depending on the country the period lasts between three and six years. We show that a fixed period distorts the consumer’s ex-post incentives to work hard. Instead, we suggest to adequately reduce the outstanding claim and to make debt release contingent on payment. When the consumer manages to pay back the reduced amount, the rest of the initial debt should be discharged immediately. In effect, the consumer becomes the residual claimant of her endeavors. The period of good conduct is effectively variable.