Brussels says it's concerned about judicial interference, corruption, freedom of expression and the rights of minorities and migrants.
Hungary's far-right leader has rejected a report by the EU which says the country is failing to respect the rule of law.
In a speech to parliament on Monday Prime Minister Viktor Orban promised that Hungary would now take legal action against the report.
Brussels says it's also concerned about the weakening of other democratic values such as the freedom of expression and the rights of minorities and migrants.
"This report can only be described as an absurd collection of lies. The way it was adopted clearly infringes the Statute of the European Union, even a law student can see that," Orban said.
"They want to initiate proceedings against a memberstate citing so called rule of law deficiency by ignoring themselves basic rule of laws."
On Wednesday the European Parliament voted to sanction Hungary for flouting EU rules on democracy, civil rights and corruption.
It was an unprecedented step that left Orban isolated from some powerful allies in the European Parliament.
However, Hungary is unlikely to be suspended from voting in the EU since Poland and the Czech Republic have said they would back Orban and veto any sanction against Hungary.
Since he came to power in 2010, Orban has used his parliamentary majority to pressure courts, media and non-government groups in ways his opponents say breach European Union rules.
He has been one of the strongest opponents of the EU's migration policies.
The leftist opposition of the Democratic Coalition, and the Socialists and Parbeszed (Dialogue) party is in disarray after Orban won a third