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Posted at 5:49 PM ET, 02/ 9/2011

Heads taxpayers win, tails they don't lose

By Ezra Klein

There are basically two models for encouraging the private sector to do things the public sector wants done. You can pay them to try, or you can pay them to succeed. It's subsidies vs. prizes. According to David Leonhardt, the Obama administration is going to announce more than $100 million in prize programs next week -- but these come with a twist:

The idea goes by one of two names: pay for success bonds or social impact bonds. Either way, nonprofit groups like foundations pay the initial money for a new program and also oversee it, with government approval. The government will reimburse them several years later, possibly with a bonus — but only if agreed-upon benchmarks show that the program is working.

If it falls short, taxpayers owe nothing.

The first British test is happening at Her Majesty’s Prison Peterborough, where 60 percent of the prisoners are convicted of another crime within one year of release. Depressingly enough, that recidivism rate is typical for a British prison.

To reduce the rate, a nonprofit group named Social Finance is playing a role akin to venture capitalist. It has raised about $8 million from investors, including the Rockefeller Foundation. Social Finance also oversees three social service groups helping former prisoners find work, stay healthy and the like. If any of those groups starts to miss its performance goals, it can be replaced.

For the investors to get their money back starting in 2014 — with interest — the recidivism rate must fall at least 7.5 percent, relative to a control group. If the rate falls 10 percent, the investors will receive the sort of return that the stock market historically delivers. “It’s been only a few months,” says Tracy Palandjian, who recently opened a new Social Finance office in Boston, “but the numbers are coming in O.K.”

This isn't quite a prize program. In a prize program, you're competing with an unknown number of other groups to hit a goal first. If there's a big prize awaiting on the other end, you're likely to be up against a lot of folks. That means your likelihood of success is low. Investing a lot of money and manpower into the project is thus a bad bet.

In a pay-for-success program along the lines of what Leonhardt is describing, you get paid as long as your program fulfills it goals. Indeed, you not only get paid, but you get paid back for everything you invested into the project. Thus, if you believe that success is likely, you have an incentive to invest a lot more money and manpower into the project than you would under any of the other scenarios. So if this program works, it could unlock a lot more private money, at a lot lower taxpayer risk, than either a traditional prize program, where the incentive is to underinvest, or a traditional subsidy, where taxpayers lose their investment if the program fails.

The danger with a pay-for-success program is that it pushes against more experimental efforts. The incentives are set up to reward projects that are likely to work, not projects that have a high risk of failure. But sometimes, projects with a high risk of failure also have the potential for more breakthrough success. So discouraging their pursuit can cut both ways. All that said, it's not as if these bonds are the only way we'll be attempting to solve social problems, so this isn't a huge issue.

By Ezra Klein  | February 9, 2011; 5:49 PM ET
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"There are basically two models for encouraging the private sector to do things the public sector wants done."

Where do you get these premises?

Which part of "free country" entitles the public sector to tell *anyone* what to do???

Posted by: whoisjohngaltcom | February 9, 2011 6:19 PM | Report abuse

"The danger with a pay-for-success program is that it pushes against more experimental efforts."

And you've completely overlooked the arrival of new lobbyists who will wine and dine policymakers and beancounters to lower the bar and document the "success" of their program in order to secure the prize. Or are you going to pretend that won't happen???

Posted by: whoisjohngaltcom | February 9, 2011 6:24 PM | Report abuse

Smart idea. The Obama Administration might just have exceeded my expectations in its willingness to try out new ideas in public policy. We still need a LOT more such willingness in America. But it's a start.

Posted by: Chris48 | February 9, 2011 6:30 PM | Report abuse

"Which part of "free country" entitles the public sector to tell *anyone* what to do???"

The Constitution? And they aren't telling anyone to do amything. They are creating incentives to do certain things, which no one is required to do.

Btw: Ayn Rand was a welfare queen. That is who John Galt is.

Posted by: DavidCEisen | February 9, 2011 7:42 PM | Report abuse

"They are creating incentives to do certain things"

It's none of the public sector's business what the private sector's doing, as long as it's not violating anyone's rights. And if anyone in the private sector is violating someone else's rights, then the public sector has guns and jail cells for that -- no "encouragement" required.

The Constitution was crafted and ratified by independent nations who deliberately worded it to protect their own sovereignty. Federal powers are enumerated and few by design. Which amendment changed that???

Posted by: whoisjohngaltcom | February 9, 2011 8:07 PM | Report abuse

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