The article examines Janos Kornai's influential argument that soft budget constraints impede innovation, and finds that under certain conditions, they may promote it instead. Kornai's concept is derived from his analysis of socialism. In capitalism, soft budget constraints can promote innovation if competition is enforced and finance is well regulated. This argument is developed using the same Schumpeterian foundation as Kornai, illustrated empirically with the case of innovation in post-war Japan. Implications are relevant for innovation and industrial policy in general.