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Escaping the debt trap: Long-run effects of individual debt relief

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High debt levels can discourage people from participating in the labor market

Debt is a common and significant part of household finances. It helps fuel economic growth by allowing households to borrow against future incomes, smooth consumption, and make important investments. However, too much debt can become problematic. It can create a cycle of financial trouble, cause economic distress, and lead to a lower quality of life. There is also a concern that people with large debts may have less incentive to work, as future creditor claims can act like an implicit tax on their earnings.

About 40 years ago, some countries in Europe introduced a new way to help overindebted individuals: debt relief. These programs offer partial or total forgiveness of unsecured personal debt through the courts. Despite the widespread availability of such programs for decades, there is limited evidence on their impact on debtors. Our recent IZA Discussion Paper provides evidence on the effects of debt relief in Denmark, focusing on labor market outcomes (like earnings and employment) and financial status (like assets, homeownership, and types of debt). We collect detailed data on individual debt relief applicants and combine it with Danish register data.

We track applicants from the time they applied for debt relief, following them for up to 16-34 years. This long timeframe allows us to see whether the effects of debt relief are temporary or if recipients fall back into unsustainable debt habits. We use two methods to estimate the impact of being granted debt relief. One method compares applicants who received debt relief with those who did not over time. The second method uses the quasi-random assignment of debt relief applicants to court trustees with different approval rates.

Our findings show significant increases in earnings and employment for those who received debt relief. Specifically, recipients have 26% higher earned income and are 11.7 percentage points more likely to be employed. There are also significant improvements in their financial status. Recipients have less unsecured debt, more secured debt, and accumulated more wealth compared to those denied debt relief. The increase in assets is partly due to a higher likelihood of owning a house or apartment.

The most striking result is the long-term impact of debt relief. The positive effects persist for at least 34 years after the court decision. About two-thirds of the increase in earned income for recipients can be attributed to higher employment levels. This suggests that high debt levels discourage people from participating in the labor market.

Overall, our study supports debt relief as an effective way to help overindebted individuals in both the short and long term. However, it is important to balance the benefits with the costs, such as potential moral hazard, higher interest rates, and a reduced supply of credit.

© Gustaf Bruze, Alexander Kjær Hilsløv, and Jonas Maibom 

Gustaf Bruze is Economist at Karolinska Institutet 
Alexander Kjær Hilsløv is PhD student at Aarhus University 
Jonas Maibom is Associate Professor in Economics at Aarhus University and IZA Research Fellow

Please note:
We recognize that IZA World of Labor articles may prompt discussion and possibly controversy. Opinion pieces, such as the one above, capture ideas and debates concisely, and anchor them with real-world examples. Opinions stated here do not necessarily reflect those of the IZA.

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Income contingent loans in higher education financing by Bruce Chapman Lorraine Dearden
Does homeownership affect education outcomes? by Stephen Whelan
Effects of entering adulthood during recession by Lisa Dettling

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