Creditors lose when consumer debtors misreport income

A Canadian government policy that was intended to force insolvent consumer debtors to pay a larger fraction of their debt is having the opposite effect, says an international study contributed to by researchers at the Alberta School of Business.

The issue concerns “consumer proposals,” which are long-term, negotiated debt-repayment plans. If such a plan is successfully completed the remaining debts are forgiven. The repayment amount depends on a concept called Surplus Income, which is calculated based on the debtor’s income and allowable expenses.

In 2009, Canada’s Bankruptcy and Insolvency Act increased the amount that some debtors below an arbitrary cutoff in Surplus Income were required to pay.

That created an incentive for those debtors to report less than the arbitrary cutoff in Surplus Income. Indeed, the researchers found that since the act’s reform, almost eight per cent of filings fell just below the arbitrary cutoff, in what’s called “bunching.”

That’s a significant proportion of debtors — almost 1/12th, say Professors Sahil Raina and Barry Scholnick of the Alberta School of Business. They co-authored the research with colleagues from the Federal Reserve Bank of Philadelphia and the National University of Singapore. Their paper is titled Debtor Income Manipulation in Consumer Credit Contracts and is forthcoming in the Journal of Financial Economics.

The researchers also discovered that these “bunching” debtors have a lower probability of default on their repayment plans than their peers because they have access to hidden (unreported) income.

The researchers estimated that each income-manipulated filing cost creditors 12 to 36 per cent of their total repayment amount.

There are several implications that arise from this study, say Raina and Scholnick.



"Imposing arbitrary cutoffs in payments by regulation can be problematic because it induces perverse incentives,” said Raina. “A well-known example is in tax filings, where it has been shown that taxpayers bunch on the advantageous side of various arbitrary cutoffs."

Among the other implications: government intervention in a credit market can cause an increase in data manipulation or other information asymmetry between debtors and creditors — and that’s the opposite of the government’s goal to improve the functioning of credit markets.

As well, this strategic manipulation may lead to credit market distortions, such as a reduction in debtors’ repayments.


Finally, requiring debtors to make higher payments contingent on their income may increase their avoidance of such payments and, in the end, cost creditors.

Overall, the researchers caution regulators to carefully consider how market participants might react when regulators introduce thresholds.

The researchers also warn that similar incentives exist in other credit markets, such as means-tested programs, wage garnishment schedules and mortgage markets thresholds, and that this reaction might apply there, as well.

Along with their international research colleagues, Raina and Scholnick believe that these Canadian findings have direct implications for markets around the world.