31 - Soft Budget Constraints

Abstract

This chapter discusses soft budget constraints. The concept of the soft budget constraint was developed by Kornai. He used this term to describe an Eastern European system of redistribution between public enterprises, from the profitable to the nonprofitable. This system consisted of rules of subsidization and taxation that were negotiable between government and enterprises. Kornai's concept meanwhile has often been used to characterize particular inefficiencies of the former socialist countries. In many studies, the transition from socialist to market economies has been seen as a process of hardening the soft budget constraint. Privatization of public enterprises in the process of transition was said to harden the budget constraint because the owner's commitment to close a nonviable firm is credible if the firm is privately owned in contrast to the case of public ownership. The installation of a social security system was said to harden the budget constraint. The softness of budget constraints is also a problem in Western market economies where renegotiations of public firms' budget constraints or of the price paid for a public investment is nothing out of the ordinary.