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In the Nation's Interest

Social Impact Bonds: Innovative Public Finance or Pie in the Sky?

By Sean Hicks

Social impact bonds (SIBs), a unique approach to public finance that is gaining momentum in states and municipalities across the country, could alter the way major social problems are addressed by increasing the role of business and private individuals, while allowing governments to avoid spending taxpayer dollars on inefficient programs. According to an annual survey conducted by the public relations firm Edelman, Americans’ trust gap, defined as the difference between the trust in business the trust in government, is at a near-record high of 21% (58% for business and 37% for government). Cost savings aside, social impact bonds provide an opportunity to close the gap, and raise the public’s level of trust for both sectors.

Not quite a “bond” in the traditional sense, a social impact bond—also known as “social innovation financing” or “pay for success”—can be more accurately thought of a as a results-based public-private contract undertaken to solve a specific social problem. In the traditional case, a government sets out to solve a social issue, usually one that is combated by preventive programs, such as prison recidivism or homelessness. The government then enters into a contractual agreement with an intermediary (bond-issuing organization) that is tasked with raising capital for the project and finding service providers (typically nonprofits). Before the project is carried out, the government details measurable outcomes to be monitored by an independent evaluator. If the outcomes are met, the government repays the investors after the fact at a rate of return based on anticipated future savings to the government from having the problem nixed. However, if the outcomes are not met, the government does not pay the investors a dime. See the infographic below for a visual explanation.

McKinsey & Company, 2012

Social impact bonds offer pecuniary incentives to investors, in the form of high yields and diversification (returns don’t depend on market activity or interest rates), and non-pecuniary incentives such as corporate citizenship. Governments meanwhile save money, in theory, as they are only paying for those programs that achieve results. Governments also benefit from the private sector’s experimentation with creative new approaches to solve complex social problems. With incentives for governments and investors alike, social impact bonds have the potential to be widely adopted across all levels of government.

In fiscal year 2014, the White House proposed allocating $500 million toward social impact bonds, but the request was not authorized by Congress. Although Congress has not yet utilized social impact bonds, state and local governments have been increasingly turning to them for alternative means of funding—a trend that has been amplified by shrinking public budgets. In August, New York City authorized the first social impact bond in the United States with the goal of reducing recidivism among 16-18 year old males imprisoned at the Rikers Island complex in the Bronx by at least 10% over four years. In Utah, the state used a social impact bond to expand high-quality early childhood education to an additional 3,700 low-income children in two school districts. Both the project and Utah and New York City were undertaken with considerable investment from Goldman Sachs.

Social impact bonds are not without their drawbacks. First, they are limited to use only where quantifiable metrics and historical data are easy to come by, such as in the above examples on early childhood education and prison recidivism. Since the payout of the bond is solely determined by the results of the program, all parties involved must agree in the definition of the metrics, which could limit options considerably.

Second, operating in a capital market may make it difficult for social impact bonds to spur innovation. Investors with a medium to high degree of risk-aversion, which is typically the majority of investors, will likely be drawn to investing in programs with a proven record of success in order to increase the likelihood that they will realize returns. If this practice becomes widespread, social impact bonds will be restrained in their ability to encourage bold new ideas.

Third, despite being touted as a cost-saver to governments, social impact bonds can be cost inefficient to society as a whole. As long as the United States federal government remains solvent, general obligation bonds will remain the cheapest means to finance government spending. So a conventional pubic finance perspective would be that the federal governments should undertake all projects that have expected net benefits, and finance all others through standardized general obligation bonds. 

Fourth, social impact bonds are novel and essentially in an asset class of their own. As a result, their increased use will require the creation of new laws, the proper regulatory environment, and potentially additional independent monitoring agencies. Additionally, it’s a sure bet that lawsuits will emerge from social impact bonds in cases where investors disagree with how results were measured. These factors will amount to additional costs to taxpayers after all.

As social impact bonds develop, questions of costs and benefits will become clearer. Regardless, social impact bonds show potential in their ability to bring the public and private sectors together to address some of our nation’s most serious and complex issues.

Employee blogs are the views of an individual employee and not the official policy of CED.