Debtor Rights, Credit Supply, and Innovation

Firms’ innovative activities can be sensitive to public policies that affect the availability of capital. In this paper, we investigate the effects of regional and temporal variation in U.S. personal bankruptcy laws on firms’ innovative activities. We find that bankruptcy laws that provide stronger debtor protection decrease the number of patents produced by small firms. Stronger debtor protection also decreases the average quality, and variance in quality, of firms’ patents. We find evidence that the negative effect of stronger debtor protection on experimentation and innovation may be due to the decreased availability of external financing in response to stronger debtor rights, an effect amplified in industries with a high dependence on external financing. Hence, while it is typically assumed that stronger debtor protection encourages innovation by reducing the cost of failure for innovators, we show that it can instead dampen innovative activities by tightening the availability of external financing to innovative firms. This paper was accepted by David Hsu, entrepreneurship and innovation.