Competition and Privatization Strategies to Reduce Government Costs

As the 21st Century approaches, California local governments face a series of major challenges:

• A growing population is creating the need for more schools, roads, sewers and prisons.

• Quantum advances in customer service and technology in the private sector are causing Californians to demand more responsive, higher quality services at a lower price from the public sector.

• Proposition 218, passed by California voters in November 1996, will make new taxes harder to come by in the future. The result is likely to be slower future revenue growth for local governments.

In the wake of these challenges, California governments will have no choice but to find ways to cut the costs of government. One of the most proven ways of doing so is by introducing competition and privatization into public sector operations.

Proposition 218 and Local Government Finances

Now that Proposition 218 is the law of California, new taxes, assessments and property-related fees must be approved by voters or property owners. Many existing taxes and assessments also must be submitted to voters by specific deadlines. Proposition 218 also significantly restricts benefit assessment financing, a favored means of revenue financing by local governments since the passage of Proposition 13 in 1978. Local agencies that rely more on assessments - such as special districts - could face significant revenue losses.

In elections held through March 1997, most Proposition 218-related measures asking for voter approval of existing taxes passed with high margins of voter approval. In the San Francisco Bay Area, for example, voters approved all 12 property tax measures on the ballot last March. However, in the future it is unlikely that voters will be as willing to approve new tax increases as they have been so far to ratify existing taxes.

Even if Proposition 218 doesn't result in any substantial revenue losses, local officials contend that the existing mix of revenues will be insufficient in the future to fund services at current costs. They claim that many local agencies still are struggling with the impacts of the recession and the loss of more than $3 billion in ongoing property taxes shifted to the schools beginning in 1992. This offers another compelling reason for reducing the costs of government through privatization and other streamlining techniques.

Streamlining Techniques

A variety of institutional reforms and alternative service delivery techniques can be employed to maximize efficiency and increase service quality. Some methods will be more appropriate than others depending on the service. In searching for ways of cutting costs and increasing competition in service delivery, California cities and counties should consider using a combination of these techniques and tools:

Privatization Opportunities and Best Practices

• Infrastructure, Public Works and Transportation

Infrastructure, public works and transportation are amongst the ripest areas for employing a range of creative privatization techniques. In the infrastructure arena, recent state law grants local governments greater freedom to pursue partnerships with the private sector on infrastructure projects. This, combined with new IRS rules that allow tax-exempt financing of long-term public-private infrastructure partnerships, should make infrastructure privatization a far more attractive option for California governments.

One model is provided by the Southern California city of Hawthorne, which in March 1996, completed the first ever long-term lease of an existing municipal water system. The California Water Service Company (Cal Water) made an up-front payment of $6.5 million to the city and must pay annual lease payments of $100,000 for 15 years. The lease made Cal Water responsible for all needed capital improvements.

For services such as public transit, sanitation, parking enforcement and tree trimming, competitive contracting and public-private competition can lead to significant cost savings. West Hollywood saved 28 percent in operating costs and increased revenues by over $2 million from contracting out parking enforcement. Newport Beach is saving over $200,000 annually from contracting for tree trimming services.

• General and Administrative Services

Maintenance, janitorial, data processing and printing are among the most frequently contracted out services by public and private sector organizations. Many general and administrative services are delivered primarily internally to other government departments, making it easier to monitor service quality and iron out privatization transition problems.

In 1993, San Mateo put its fleet maintenance operations out to bid. The winning bidder, Management Logistics Systems (MLS), agreed to provide the service for 20 percent less than the city was delivering it. Said City Manager Arne Croce, "It's been very successful. The customer satisfaction reports we get back are showing high levels of satisfaction."

Public Safety Services

Public safety is one of the largest cost categories for California local governments, consuming up to 70 percent of many cities' budgets.

To meet ever-growing citizen demands for greater public safety, some California jurisdictions are experimenting with creative public-private partnerships for these services. The city of San Diego, for example, realizes more than $1.5 million worth of man hours from using more than 800 volunteers in its police department. The volunteers, a large number of whom are senior citizens, have enabled San Diego to add several new policing services and have emerged as an important component of the city's community policing program.

Another innovative way that many California cities have reduced public safety costs is by contracting with other governmental entities (typically counties) to provide the service. Westminster is saving more than $2 million annually from contracting with Orange County for fire services, while San Clemente is saving the same amount from contracting with the county for police services.

Health and Human Services

Health and human services have been among the fastest growing budget areas for California local governments since the mid-1970s. Government health spending (as a percentage of personal income over this time period) has increased by 54 percent at the county level and 76 percent at the city level.

In the wake of a wholesale restructuring of the health care system in America, many governments are finding it undesirable to operate their own public hospitals and clinics because more cost-effective choices are available. Orange County, which runs its entire county health system with only seven employees (see box below), symbolizes the likely future of local public health care.

In the welfare arena, Governor Pete Wilson is encouraging counties to "enter into performance-based contracts" with non-profit or for-profit companies to operate all or parts of their welfare programs. In San Francisco, welfare recipients without small children now attend an employment and training program administered by Nebraska-based Curtis & Associates. The company is placing in jobs each month about 40 to 60 people who complete the program and has a dropout rate of only 17 percent - 20 percent better than when the city ran the program.

Parks, Libraries and Recreation Programs

Parks, recreation and library services were all hit hard by budget cuts during the last recession. County spending on parks and libraries has fallen by more than 22 percent since the mid 1970s.

Faced with dwindling budgets for these services, a number of California governments have creatively used privatization techniques to ensure that local citizens continue to have access to these services. Dozens of jurisdictions have reduced their costs and dramatically increased revenues by contracting out golf course operations. In Los Angeles County, which contracts out 16 of its 19 courses, revenues from some courses have doubled or tripled since operations were contracted out.

State-of-the Art Contract Management and Monitoring

As governments subject an increasing percentage of their services to competition, they must concentrate on becoming smarter shoppers. This means creating contracting systems that are outcome based; writing contracts that contain clear performance standards; incorporating financial incentives and penalties into the contract; and developing advanced measurement techniques. Such state-of-the-art contracting often is referred to as performance-based contracting. When properly structured, performance-based contracting holds great promise to reduce contracting costs while increasing service quality.

• Performance Incentives

Privatization gives public officials the freedom to creatively design contract payments to correspond with certain performance pegs. Incentives to increase productivity, cut costs and raise service quality can be built into the contract.

The city of Indianapolis has incorporated financial performance incentives into bids won by city units and private providers in services from street repair to waste collection. "They live and die by the performance measures," says Deputy Mayor Charles "Skip" Stitt. In 1995, the Indianapolis airport became the largest privately managed airport in the United States when BAA USA, Inc. won the bid to manage the airport. BAA guaranteed a minimum of $32 million in savings over a 10-year period, but hopes to achieve savings of $105 million. All savings over the $32 million baseline are shared by BAA and the Indianapolis Airport Authority, whose share ranges from 60-70 percent over the life of the contract.

Increasingly, funders are asking providers to deliver health and social services under a "capitated" arrangement, meaning they agree to deliver the services in bundles for a fixed price per case. In Milwaukee, which has contracted out its welfare program, each contractor is paid a flat amount to screen, train and place clients in jobs. This offers a powerful incentive to find jobs for the clients because otherwise the contractor could lose money. "Serious economic consequences exist if we are not successful," says one provider. "It's sort of like capitated welfare."

• Monitoring and Evaluating Contractor Performance

The public sector still has a long way to go in becoming a better purchaser and overseer of service delivery. How many people are needed to monitor contracts? What should they be doing? What kinds of internal structures are needed as governments shift from service provider to service facilitator and purchaser? These are the types of questions that must be addressed in a systematic way as governments embrace competitive service delivery.

The better the performance standards, the easier it is to effectively monitor the contract. Such interdependence means it makes sense to write the performance standards and the monitoring plan simultaneously. The monitoring plan should be quantifiable and specific and include reporting requirements, regular meetings with minutes, complaint procedures and access to contractor's records (if necessary).

Determining the appropriate technique for and level of monitoring for a given service depends on several factors, one of the most important being the level of acceptable risk for non-performance. Where there exists a high level of risk for even minor problems - aircraft maintenance, for example - high cost and high control preventive monitoring techniques are necessary.

Creating a Level Playing Field in the Competitive Process

Increasingly when governments decide to test the market for the best price and quality for delivering a particular service, in-house units also are given the opportunity to bid for the contract. This model of public-private competition sometimes is referred to as "managed competition." When setting up a public-private competition program, public officials should take great pains to create a level playing field between in-house public units and outside private providers.

• Full-Cost Accounting

Before agencies can make an informed decision about competitive contracting, they must first identify the total cost of in-house service. Public agencies routinely underestimate their true costs by as much as 30 percent. Common mistakes in estimating total costs include: cross-subsidizing, failing to allocate overhead, improperly depreciating capital assets, ignoring cost of capital, and excluding or underestimating costs such as pension plans, legal fees, insurance and administration. Without an accurate assessment of total costs, public officials face difficulty determining the most cost-efficient provider of a given service.

• Removing Special Privileges Enjoyed by Public Providers

To ensure a fair bidding process, conduct an arms-length relationship between the public entity administering the competition and the unit bidding on the contract. The particular bidder, whether a public or private entity, should be held to the same performance standards and be subject to the same financial penalties and incentives. To the extent possible, all protections and special privileges that public units usually enjoy over private firms should be removed.

• Giving Public Units More Flexibility

To be competitive with private firms, government units need to be relieved of many of the regulations and bureaucratic procedures that decrease their productivity. Unless government units are given more autonomy when governments institute competition, they are being forced to operate in both worlds - the entrepreneurial and the bureaucratic.

Political and Organizational Strategies for Streamlining

As we have examined hundreds of programs at every level of government across the country and around the world, we have identified six key political and organizational strategies for successfully implementing competitive strategies. These are:

• Strategy #1: Need for a political champion. Achieving privatization and competitive government requires leaders who will expend political capital on the issue and who have the skills to secure approval and support from other wings of government whose cooperation is key to success.
   
• Strategy #2: Adopt a comprehensive approach. Announce that you are launching a comprehensive competition program and that competition is to become a way of life in your government, meaning eventually nearly all services the government delivers will be subject to competition.
   
• Strategy #3: Don't study it to death (also known as "death by committee"). This process gives the illusion of progress, then degenerates into an exercise in generating paper. Spend some time putting together a sound Request for Proposal (RFP) that states precisely what outcomes you want (but leave inputs to the discretion of the contractor) and then see what you get back from the market.
   
• Strategy #4: Create a high-level executive position and specialized unit to manage outsourcing relationships. The successful operation of a given government increasingly depends on being able to manage a network of service providers and market-based arrangements (vouchers, internal markets and public-private partnerships). Doing so effectively requires creating a new high-level position and a centralized unit, where a critical mass of knowledge over streamlining issues is developed.

• Strategy #5: Uncouple the purchaser and the provider (also called the "purchaser-provider split"). Splitting policy functions from service delivery creates incentives for governments to become more discriminating consumers by looking beyond government monopoly providers to a wide range of public and private providers.
   
• Strategy #6: Design an employee and adjustment strategy. Making privatization attractive for affected workers is vital to achieving the political support needed to implement competition strategies. There are a number of techniques available to insulate workers almost entirely from the potential of job loss. Techniques than can attenuate the impact on current workers include: working within the rate of natural attrition; encouraging or requiring first consideration by contractors; offering early retirement incentives; and allowing public departments to bid for contracts.

The publication is available from Cal-Tax (916/441-0490), the California Chamber of Commerce (916/444-6670), the Howard Jarvis Taxpayers Association (213/384-9656), or the Reason Public Policy Institute (310/391-2245).