The Kornai effect with partial bailouts and taxes

Abstract

The model examines Kornai's observation that in the presence of bailouts, firms' demand for inputs will be greater than would otherwise be the case. This conjecture is examined in a model in which both revenue and cost uncertainty are present and in which firms making losses are partially subsidized and firms making positive profits are partially taxed. The Kornai effect is more prevalent the greater the subsidy rate, the smaller the tax rate and the greater the variance of the random variables through which uncertainty manifests itself. In the case of strongly positively correlated cost and revenue uncertainty, the absolute incidence of the Kornai effect is small.

The soft budget constraint

“…o Market demand gets out of control, even though some of it is not actually covered by available funds (see Chapter 4 of this volume: the 1983 study written with Jörgen Weibull, entitled "Paternalism, buyers' market, sellers' market" and these articles: Goldfeld and Quandt 1988Magee and Quandt 1994;Pun 1995;and Quandt 2000). Demand "runs away.…”

The Two Kornai Effects

“…While Goldfeld and Quandt (1993) supposed that such losses were completely offset, in the model here the proportional subsidy rate s is a fraction, 0 õ s õ 1. Studies by Abrus-Lakatos and Csaba (1990), Goldfeld and Quandt (1992), and Magee and Quandt (1994) explored the effect of taxing operating profit. Here taxes are mentioned briefly after examining the simple soft budget constraint model, which excludes them.…”

“…It includes a general error term representing production and price uncertainty. Randomness in input prices is neglected for simplicity; that specification is considered in Goldfeld and Quandt (1993) and Magee and Quandt (1994). A firm under a soft budget constraint receives a subsidy or bailout for operating losses.…”

The Kornai Effect and Soft Budget Constraints

“…In this section, our modeling follows Magee and Quandt (1994) in spirit, although the formulations are quite different. Consider a firm whose operating profit is given by…”

“…In this section, we may capture the intuition by defining the Kornai effect under nonrandom subsidy as dx * 1 /dc ú 0, since a higher subsidy rate c can be considered as softer budget constraints. Then we get the following result: 3 In Magee and Quandt (1994), 1 0 t is the tax rate and 1 0 c is the subsidy rate. 4 Throughout the paper, we assume that the first-order conditions and second-order conditions hold.…”