06/12/2013 12:06 pm ET Updated Aug 12, 2013

Improving Social Services in an Era of Budget Cuts: Social Impact Bond Competition Gives Six States the Tools to Lead the Way

State and local governments deliver and fund many of the nation's most important social services -- educating our children, training our unemployed workers, and caring for our seniors, among many other important functions. But even as tax revenues begin to rebound with the strengthening economy, the funding outlook for most social services remains bleak. In inflation-adjusted dollars, per capita state and local spending remains 4 percent below pre-recession levels, even before the full impact of the federal budget sequester kicks in. And health care spending -- for Medicaid and the health benefits of current and past government employees -- is projected to continue to absorb an increasing share of state and local tax dollars. According to the U.S. Government Accountability Office, state and local governments face a long run fiscal gap equal to 14 percent of expenditures.

One result of this fiscal environment is that governments find themselves making penny-wise but Pound-foolish decisions -- forgoing upfront investments that would yield both social and fiscal benefits down the road. States are cutting back on job training programs in prisons, even though such programs can reduce the number of costly re-incarcerations. States are finding it difficult to increase investments in early childhood education, despite growing evidence that effective early childhood programs have benefits that greatly exceed their costs.

When budgets are tight, there can also be a temptation to cut back on innovation. How can we allocate resources to promising new strategies when we can't even afford to fund everything we are currently doing? But difficult times can also breed some of the greatest breakthroughs, and that is the case today. Governors and mayors throughout the country are beginning to test an innovative approach that could fundamentally change the way in which they pay for some social services.

The new approach is called "pay for success" contracting. What is novel about this approach is that the government contracts for the outcomes produced by the social services rather than for the services themselves. Consider, for example, the world's first pay-for-success project, which is financing reentry services for inmates at a prison in Peterborough, England. In that project, the UK government is paying based on the extent to which the service providers can reduce the number of released prisoners who are subsequently reconvicted of new offenses. If the service providers fail to reduce recidivism by at least 7.5 percent, the government doesn't have to pay.

This approach is a radical shift from the usual way governments pay for social services. Today governments purchase units of service and rarely measure the outcomes that are achieved, allowing ineffective programs to endure.

In contrast, under the pay-for-success approach, taxpayers are doubly protected because the government doesn't have to pay if the service provider doesn't achieve the minimum performance target and because programs that fail to achieve successful results will be discontinued or fundamentally restructured.

A new financial instrument, called a "social impact bond" or "SIB," has emerged to enable this type of contracting to occur. Private investors, both commercial and philanthropic, are providing the upfront operating funds for the service providers in exchange for receiving most of the results-based payments that result from successful service delivery from the governments. This instrument introduces market discipline into the social services field since only those service providers who can convince investors that they can achieve the performance targets will be able to attract funding. In addition, the private investment is what allows these projects to overcome the inability of cash-strapped governments to make investments in preventive services.

So far only one pay-for-success project is operating in the United States -- New York City has established an initiative to deliver services to young offenders jailed at Rikers Island. The City will make payments only if the services manage to reduce recidivism rates.

But this approach is beginning to spread. Massachusetts and New York State are developing projects that would house homeless individuals, serve youth aging out of the juvenile correction system, and provide transitional employment for recently released adult offenders.

With support from The Rockefeller Foundation, the Harvard Kennedy School established the SIB Lab to assist state and local governments that want to try the pay-for-success approach. After testing our technical assistance model with Massachusetts and New York State, we launched a national competition, inviting governments seeking assistance to apply. Today, we are happy to announce the winning jurisdictions - new pay-for-success initiatives will soon be launched in Ohio, Connecticut, Colorado/Denver, South Carolina, Illinois, and New York to meet challenges like reducing the number of low-weight child births, expanding high-quality early childhood education, putting troubled youth on the path to successful adulthood, helping seniors avoid nursing homes, and preventing diabetes- and asthma-related hospitalizations.

The appeal of the model to government is clear: paying only for success, rigorously assessing the impact of social programs, a shift to preventative services, unlocking private capital so that more effective solutions to social problems can be developed. It is no wonder, then, that we have seen interest in the pay-for-success approach from political leaders from across the political spectrum. Indeed, the SIB Lab competition received applications from 28 states and localities, representing the full political and geographic spread of the U.S.

Social impact bonds have gone from concept to execution faster than any other social innovation we have seen in years. The challenge now is how to test social impact bonds, while at the same time creating and supporting the ecosystem necessary for them to succeed. The SIB Lab competition is a critical component of that process in the U.S., and we are excited to be working with six leading states to blaze the trail.