Tightening the soft budget constraint in reforming socialist economies
Nagaoka, Sadao | Atiyas, Izak
The concept of the soft budget constraint has been quoted as appearing "when the strict relationship between expenditures and earnings has been relaxed, because excess expenditure over earnings will be paid by some other institution, typically by the state." The soft budget constraint has been recognized as a key structural characteristic of socialist economies, and its tightening is regarded as one of the central issues in the economic reform of socialist economies. While much has been written on the consequences of these constraints, little has been devoted to its causes. The objective of this paper is to analyze the causes of the soft budget constraint and to suggest effective strategies for tightening it. The authors review the major mechanisms by which budgets are softened and give a short account of recent reform measures undertaken in Hungary and Poland. The report focuses on the divergence of social surplus from profits, discusses how such gaps undermine the credibility of hard budget constraints, and how they result in dynamic efficiency losses. The paper concludes by proposing strategies for tightening the soft budget constraint.
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