California’s Scary New Way to Raise Public Money

In a rare act of fiscal responsibility, the California Assembly voted 73-0 earlier this month to place stricter limits on a high-yield, long-term bond that was used primarily by desperate local school districts.

This being California, however, even as lawmakers were reining in the use of “capital-appreciation bonds” -- which became notorious when one San Diego-area district revealed that it was making a $1 billion interest payment on a $105 million debt -- the state Senate advanced an ill-defined new “bond” plan to provide schools with a fresh source of cash.

The Dropout Reduction and Workforce Development Bond Act of 2013 is based on social-impact bonds, a creative financing mechanism popularized first in the U.K. as part of the Conservative Party’s “Big Society” effort to use market discipline to improve public services.

Typically, financing for social-intervention projects is obtained from investors, not taxpayers, and government contracts with nonprofit institutions to do the work. Government gets to borrow money for social programs and shift the risks to investors, who get paid back only if the programs reach certain performance and cost-saving goals.

But leave it to California’s dominant Democrats to turn a concept designed to apply some measurable standards to hard-to-measure social programs into a shameless effort to grab more money for existing government agencies.

Education Financing

The legislation promises to “revolutionize public education” by offering three tools. First, businesses can buy bonds “and earn a rate of return tied to performance measures.” Second, those businesses receive tax credits for their investment. Third, the bill creates trust funds in every school district to collect those business investments and other funds to finance expanded career programs.

Government agencies normally finance tightly prescribed activities, says the Center for American Progress, the Washington-based liberal research group, which promotes the social-impact-bond concept.

“In a Social Impact Bond, however, a government agency defines an outcome,” according to a center fact sheet. “The agency contracts with an external organization that promises to achieve that outcome and pays the organization only if it is successful.”

In the U.K., the Justice Ministry contracted with a nonprofit to help reduce prison recidivism. In return for their financing, private investors receive an agreed-upon return as long as recidivism rates declined by a set amount.

Yet even the best-designed social-impact bonds have problems. An earlier U.K. program, which involved the London subway, failed and left the British taxpayer to pay the tab.

While the aim of social-impact bonds is to save the government money by providing services more efficiently -- for example, fewer recidivists should mean lower prison costs -- such savings are illusory in the world of government.

“Given the costs of attorneys, consultants, program evaluators, the potential for a return on investment to third-parties, and a second tier of program managers, using an SIB relative to direct financing will therefore increase pressure on the budget,” said Kyle McKay, a Maryland policy analyst, in an April article in the Stanford Social Innovation Review.

And then there are those darned details. Instead of a tight standard to measure success, the skeptic in me expects a more Sacramento-like result: a complex system that is a product of bureaucratic demands, political wrangling and lobbying. It’s also easy to imagine endless litigation over goals and payments.

There are no specific performance metrics in the bill’s language. And there’s no doubt the measure would put return-on-investment decisions in the hands of a committee, which is a far cry from a profit-or-loss standard. These clearly aren’t bonds in the traditional sense of the term.

Murky Measure

Even in the unlikely event that the government saves money on a particular program, there is little chance legislators will spend less or return money to taxpayers.

Mark Hedlund, the spokesman for Senate President pro tempore Darrell Steinberg, told me “this is an over-and-above investment,” reinforcing the idea that this is about spending more, not saving anything. Steinberg needs to find the money to pay for this from some budget item.

The bill will redirect funds from other public-private partnership programs -- for example, job credits that the state currently offers businesses -- and from the widely abused enterprise-zone project.

The financing proposal is so murky that even the business leaders who back it confess they are confused.

“I’m not sure I completely understand it,” California Chamber of Commerce President Allan Zaremberg told Los Angeles Times columnist George Skelton.

Unlike traditional social-impact bonds that give nonprofits the power to provide services, the California plan funds existing school and community-college districts and their union employees -- a predictable outcome, given the closeness of Democratic leaders to the unions.

Critics, such as Kevin Dayton, the president of Labor Issues Solutions LLC in Roseville, California, wonder why state leaders aren’t simply diverting more general-fund dollars to the program, given that they have to find state-funding sources to pay for this anyway.

Hedlund answered that they “did not want to create just another government program” and preferred one that would give businesses incentives “to put some skin in the game.”

That’s fair enough, but the real goal seems more transparent: to allow the state to borrow large sums of money without having to seek voter approval.

Even supporters of these types of bonds wonder about an approach that finances government rather than nonprofits.

“For governments, social impact bonds offer a way to transfer some of the financial risks involved in implementing or scaling preventive programs until they are proven successful,” said Kristina Costa, an economic-policy researcher at the Center for American Progress. “That benefit may be lost if different agencies or different levels of government are, in effect, working on both sides of a social impact bond.”

Who will buy into this convoluted deal if it becomes law? The same people who once championed capital-appreciation bonds.

(Steven Greenhut, a contributor to Bloomberg View, is vice president of journalism at the Franklin Center for Government and Public Integrity. He is based in Sacramento, California. The opinions expressed are his own.)

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.