Doing Well by Doing Good

BERKELEY – If you get most of your ideas about government from speeches by America’s Republican presidential candidates, it’s easy to believe that the US federal government is incapable of doing anything right. But not even the Republicans actually believe it.

The proof is just beneath the surface, where a remarkable bipartisan consensus is emerging around an approach to America’s most serious social problems – including homelessness, criminal recidivism, preschool education, and chronic illness – that combines the best principles of conservatism and progressivism. It is a strategy that is playing out in Republican states such as Utah and Kentucky and Democratic ones like Massachusetts and California.

This nationwide trend is being catalyzed in part by the federal government. But it is being implemented mainly at the community level through partnerships among local governments, community groups, philanthropic organizations, and for-profit investors.

These are, in a sense, pay-for-success projects, sometimes structured as social impact bonds – formal contracts that tie payments to actual results. Private investors and philanthropic organizations finance the upfront costs of the pilot projects, and local or state governments (sometimes supplemented with federal money) pay the investors only if the project produces the promised results.

Though the pay-for-success model is still in its infancy, dozens of projects are now underway. Indeed, the United States is already the largest pay-for-success market in the world, with over $100 million invested in such transactions. Utah was an early pioneer, launching a novel pilot project in preschool education that is funded by $7 million from Goldman Sachs and the Pritzker Foundation. The city of Chicago has launched a similar but larger project for $17 million, with upfront funding from some of the same investors as in Utah. Massachusetts has a $27 million project to test a program for reducing recidivism among young men on probation.

Pay-for-success projects mark a radical departure from traditional approaches to funding solutions to complex social challenges. The most obvious difference is that taxpayers avoid the upfront financial cost of trying an unproven strategy.

Santa Clara County, California is introducing a pilot project aimed at reducing the cost of supporting people with acute mental illness. At least 250 people will receive temporary housing along with “wrap-around” support and psychiatric services. The goal is to lower public costs by reducing reliance on expensive acute-care hospitals, minimizing the number of emergency-room visits, and avoiding jail sentences. The program’s effectiveness will be evaluated by a randomized control trial comparing the data of patients who participated with those who did not.

The key to success is that the incentives are based on outcomes, not the outflow of money. A traditional social program is usually judged by the volume of services provided, such as the number of people trained or homeless people sheltered.

By contrast, in a pay-for-success model, the returns are based on the social benefits achieved or savings reaped by government. How many additional children were brought up to their proper reading level? How many additional former inmates obtained jobs? How much money did government save as a result of reduced prison time or lower safety-net payments?

That is a big change from traditional privatization of public services, in which government contractors reap profits simply by billing for services. It also provides relief from the bean-counting rigidity that comes from policing every dollar that a contractor spends.

President Barack Obama’s administration has been extremely active in this area, and it is now doubling down. The White House Office of Social Innovation and Civic Participation (SICP) has been working with agencies across the federal government to spur pay-for-success efforts around the country.

The Social Innovation Fund has provided matching grants to dozens of communities, which are working closely with organizations such as Harvard’s Social Impact Bond Lab and Third Sector Capital, to identify and structure promising pay-for-success ventures. The SICP just launched a competition for a new $10.6 million round of matching grants.

If the broad social goals sound “Democratic,” the method and strategy are in many ways “Republican.” They rely heavily on the private sector, require tough quantitative evaluation, and devolve most of the actual work to states and localities.

Call this “progressive federalism.” The “progressive” component is in taking on major social problems. The “federalism” consists in the recognition that states and local communities are the primary sources of bold and effective new strategies.

Lawmakers in both parties have teamed up to introduce a variety of bills that would encourage and fund pay-for-success projects. Meanwhile, the Obama administration has pushed through two important regulatory changes that could free up billions of dollars in private capital for social-impact investing, including pay-for-success schemes.

In September, the Treasury Department provided new regulations to philanthropic foundations that relaxed the perceived barriers to “mission-related investments.” It was an important move: Foundations oversee some $600 billion, but had long worried that certain social-impact investments might jeopardize their tax-free status. In October, the Department of Labor followed up with a “clarification’’ that eased worries at pension funds about investing in ventures that produce social as well as economic returns.

Of course, though these changes open the way for philanthropic foundations and pension funds to become major investors in pay-for-success projects, success is not guaranteed. For example, a project to reduce recidivism among juvenile inmates at Rikers Island in New York City produced disappointing results. But that is exactly how the approach is supposed to work: risk-conscious investors, rather than taxpayers, assume the upfront financial costs of innovating. Failed efforts are not only inevitable; they are essential to finding real solutions.

Americans are generally wary of “big government,” but they do want solutions to their country’s biggest social problems. A results-oriented pay-for-success approach, based on what we know works well in the private sector, provides an ideal opportunity to test bold and innovative solutions, learn from scores of competing projects about which work, and ramp up those that do.

Laura Tyson, a former chair of the US President’s Council of Economic Advisers, is a professor at the Haas School of Business at the University of California, Berkeley, and a senior adviser at the Rock Creek Group. Lenny Mendonca, Senior Fellow at the Presidio Institute, is a former director of McKinsey & Company.

By Laura D. Tyson and Lenny Mendonca