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One of the key factors explaining the geographic dispersion of entrepreneurship is US personal bankruptcy law. The US personal bankruptcy system functions as a bankruptcy system for small businesses as well as consumers. If a firm fails, the entrepreneur has an incentive to file for bankruptcy under Chapter 7, since both business debts and the entrepreneur's personal debts are discharged. The entrepreneur must give up assets above a fixed dollar exemption level for repayment to creditors. However, future earnings are entirely exempt. Bankruptcy exemption levels are set by the states (since the Federal Bankruptcy Code of 1978) and vary widely across states and over time. They can be either homestead exemptions i.e. exemptions against equity in owner occupied homes, or personal property exemptions for items like motor vehicles, jewelry etc. For example, in 1996 the homestead exemption in Alabama was $10,000, while in Arizona was $100,000. The effect of high exemptions, as documented in the literature, is potentially two-fold. Fan and White (2003) have shown that the wealth insurance effect of exemptions encourages entrepreneurship (since entrepreneurs' can retain some assets like their homes while filing for bankruptcy), while Berkowitz and White (2004) find that small firms are more likely to be denied credit if they are located in states with high or unlimited exemptions.

This paper extends the existing research on entrepreneurship by using spatial econometrics techniques to answer the following question: Do entrepreneurs take account of bankruptcy regulations and business conditions in other (competing) locations, such as neighboring states, when deciding to start a business in a particular state? In our paper, we argue that this is indeed so. To test for this, in our estimation equation we include apart from the entrepreneur's home state bankruptcy exemption and tax rates, (population and distance) weighted averages of exemptions and tax rates in neighboring states. Including these "spatial" variables in the traditional regressions yields significant results. The evidence indicates that entrepreneurs are significantly more likely to start businesses in states that are neighbors to states with worse business conditions. In particular, if neighboring states have lower (average) bankruptcy exemptions than the entrepreneurs' current state of residence, then this significantly increases the entrepreneur's likelihood of starting a business. By our calculation, the predicted probability of starting a business is 25 percent higher for states with more favorable exemptions than their neighbors' compared to states with worse exemptions than their neighbors. Further, we find that including these spatial variables (such as average exemptions in neighboring states), reduces the significance of home state exemptions. This suggests that the estimated coefficients on home state exemptions obtained by Fan and White (2003) and Georgellis and Wall (2002) may be biased upwards due to exclusion of these variables from the regression equation. . . .

Aparna Mathur is a research fellow at AEI.