October 15, 2003
Testimony of Edmund J. McMahon before the Senate Labor Committee
Good morning, Senator Velella, and thank you for this opportunity to speak before your committee today.
My name is Edmund J. McMahon, and I am senior fellow for tax and budgetary studies at the Manhattan Institute for Policy Research. The Institute is a non-partisan, non-profit think tank, based here in New York City, whose mission is to develop and disseminate ideas that foster greater economic choice, opportunity and individual responsibility.
Although today’s hearing notice mentions municipalities, my focus will primarily be on the outsourcing of state government services—because innovative reforms at the state level can set an important example for counties, cities, towns and school districts throughout New York.
To begin with, it’s entirely appropriate to question whether outsourcing has produced “real savings.” After all, the entire point of finding new ways to deliver public services is to produce better value for the taxpayers.
Of course, it’s more important than ever to demand real savings when government at every level is under severe fiscal strain. But regardless of fiscal and economic conditions, elected officials should constantly strive to hold all government programs, contractors, managers and employees accountable for results—consistently and across the board.
Based on a review of contracting-out trends here in the Empire State, it’s fair to say that New York has done more outsourcing during the past decade than at any prior period in its history.
Unfortunately, much of this activity has occurred under the radar screen and on a piecemeal basis. The state has lacked a consistent and comprehensive strategy to ensure that in all cases the reasons for outsourcing are clear, the savings are documented and the results are clearly understood.
The good news is that, by drawing on best practices found in other governments, New York State can more effectively pursue opportunities in this field during the challenging times ahead.
As documented in more detail by our counterparts at the Reason Foundation, government reliance on private contractors has grown dramatically throughout the country during the 1990s. This trend isn’t confined to any particular region, or to states dominated by either major political party.
The reason for the appeal of outsourcing is simple: it works. According to a vast array of studies by the federal government, academic researchers and others, outsourcing on a competitive basis historically has resulted in cost savings in the range of 20 to 50 percent.
But cost savings aren’t the only benefit. A review of state practices around the country found that flexibility, access to personnel or skills available in-house, and tapping private sector innovation are all important factors in a state government’s decision to outsource services.
This is not to suggest that outsourcing is in all cases automatically preferable to providing these services in-house with government employees—especially when the government’s own rules impose added cost burdens or barriers to entry on outside firms. The key to unlocking savings, flexibility, innovation and better value is not contracting out, per se, but competition. Experience has shown competition can lead to big savings and more value even in cases where government already seems to be efficient, at least by the usual public-sector standards.
One of the best examples of this can be found in the city of Indianapolis. A little over a decade ago, that city’s two publicly operated wastewater treatment plants were regarded by experts as among the best in the country. The city employees who ran the plants had won numerous awards in competition against public plants owned by other governments. And yet, Mayor Stephen Goldsmith persisted in asking the same sort of question posed at this hearing today—can we save real money by outsourcing this operation? A Big Six accounting firm studied the operations and concluded that the answer was “yes,” but the likely figure was only 5 percent.
Nonetheless, Goldsmith persevered. The treatment plants were contracted out, to a consortium formed by a newly formed local company with partner companies from the global wastewater treatment industry. The new operator cut costs by 44 percent—and improved quality by every measure.
A second example from Indianapolis, illustrating another facet of the benefits of outsourcing, concerns that city’s Fleet Services operation, known as IFS. Unlike the wastewater treatment plant, IFS was not seen as a problem-free area when Goldsmith took office. As he later recalled “costs seemed high—although in the absence of competition, we had no idea how high.” Most importantly, the agency’s own government customers thought the service was lousy.
So Fleet Services seemed an obvious choice for outsourcing. But Goldsmith didn’t simply take bids from private firms. He also gave the existing IFS staff a chance to bid on the work. Faced with the prospect of losing out to competitors, the Fleet Services employees streamlined their operations and greatly improved their service. When the bids came in, the city employees won. But that’s not all. They voluntarily gave up a contractual pay increase in order to have a shot at incentive payments. In fact, they decided on their own to subcontract a portion of their own work.
This Indianapolis example, and many other projects throughout the country, highlight an important aspect of outsourcing: It is not inherently anti-union or anti-government worker.
In fact, government managers who have gotten the best results from outsourcing have long recognized that unions cannot be uniformly scapegoated as the cause of every problem or inefficiency. Often, union members are part of the solution. After all, the line workers are usually the best source of ideas on how to do things better. That’s why it’s beneficial to have a government policy that allows employees to take part in sourcing competitions.
In New York State, as I indicated, a lot of outsourcing has taken place over the last decade. As of 1997, for instance, the Government Accounting Office identified New York as being one of five states that had been the most active on the privatization front, up to that time.
Putting aside the privatization of government assets, which is a separate category of value-building activity, there are numerous examples of areas where services have been contracted out to the private sector. These include janitorial and custodial work, warehousing, courier and package delivery, state bakeries and warehouses, and the management of park concession stands at state parks. Probably the largest single outsourcing contract involved the processing of income tax returns, which nine years ago was contracted out to Fleet bank. New York’s automated tax processing system is now widely regarded as a model for other states.
Somewhat surprisingly, New York State has not produced an authoritative compendium of its outsourcing projects. It seems clear, however, that this activity is a key reason why the executive branch state government is now operating with about 20,000 fewer employees than it had on the payroll a decade ago. And while there is no single, consistent measure of savings from the contracting-out of services, this much is clear: The state operations budget over the past 10 years has risen at just one-fourth the rate of the previous 10 years, after adjusting for inflation.
To the extent that legitimate questions persist about the real savings generated by outsourcing, they stem from several shortcomings in the current program. The degree of emphasis and priority attached to reforming service delivery methods seems to have varied from agency to agency. Moreover, the Division of the Budget’s contracting guidelines (as set forth in item H-100 of DOB’s policy manual) stipulate that agency documentation required to justify outsourcing decisions shall be strictly internal. In keeping with that philosophy, the performance standards and benchmarks used by agency managers are also treated as closely held, internal documents, not open to public scrutiny. Thus, while agencies need to internally demonstrate cost and performance expectations for outsourcing, those expectations rarely become part of the public record.
Based on our preliminary review, there are many more state government activities that could be subjected to outsourcing on a competitive basis. The state can pursue those opportunities most effectively with a process that is designed to maximize.
Experience suggests the three most important elements of government reform are as follows:
To generate real savings, the sourcing process should encourage private and public entities to compete for the right to provide government services—for under the right rules, competition creates a “race to the top” in almost any undertaking. Truly competitive environments force innovation, demand improvements and maximize benefits while preventing price-gouging. Without routine and robust sourcing, federal agency processes will become stale and inefficient.
Decision makers and the general public need more information on the range of sourcing choices and the costs and outcomes of sourcing decisions. If we had a more open process in New York, the sort of “questions” that are the subject of today’s hearing would already be answered. (Exceptions should be made for work that involves sensitive security issues, such as anti-terrorism surveillance.)
Expectations should be crystal clear. The winner of a contracting competition, whether it is an in-house unit or a private firm, should be held accountable for delivering on cost and performance expectations over the life of the contract. There should be financial incentives for improved performance and stiff penalties for failing to deliver on promises. Contracts should include an escape hatch to allow early termination in cases where the provider is not doing its job.
When it comes to implementing these principles in practice, it is absolutely essential to have a sound system for monitoring contract performance. More often than not, in cases where outsourcing has failed to produce savings and quality improvements for government, it has been because of a failure of administrative oversight on the managing agency’s end. Indeed, incompetent or insufficient monitoring of contract performance is the surest way to guarantee that savings will fall short of projections.
The state government needs to conduct a thorough inventory of public services, dividing them into two categories. One would consist of services that are “inherently governmental,” and thus not suitable for outsourcing. An example would be any activity that involves exercising discretion on the use of government authority, as typified by a hearing officer. The other would consist of “commercial activities”—those which are not inherently governmental and which are widely provided by private sector. This would include a wide range of administrative services, operation of public facilities and the like.
The development of this inventory should be overseen by a permanent commission set up for that purpose and composed of representatives of the executive and legislative branch as well as of the private sector. Virginia’s Commonwealth Competition Council is showing how such a group can provide a permanent impetus for continuous improvement at every level of government in a state. Among its functions, the Council oversees the process of identifying commercial activities and provides reliable. It has developed a PC-based program that computes the full cost of government “commercial” activities and also provides a unit cost for competitive comparisons.
Government workers potentially affected by outsourcing decisions need and deserve the assurance that they will be treated fairly. The key priority in this regard is to require openness and communication at every step of the process—another reason why the principle of transparency is so vital to success. The techniques for ameliorating the impact on workers include:
- allowing public employees to bid for contracts—and, in some cases, helping them form their own private firms.
- working within the natural rate of attrition.
- encouraging or requiring private contractors to give first consideration in hiring to employees displaced by an outsourcing agreement.
- targeting special severance or early retirement benefits to affected government employees.
In outsourcing various services in recent years, the state has to some degree used each of these techniques—with the possible exception of the first. But, as noted, this has not been part of a comprehensive strategy that combines competition, transparency and open performance standards.
In closing, I want to commend the committee for its attention to this vital issue. I hope this hearing represents the start of a serious redoubling of New York’s efforts to pursue the potential benefits of competitive sourcing at a time when we so desperately need to get more bang from our buck at every level of government.