Vouchers as innovation contracts

Abstract This paper models voucher systems for welfare services as contracts through which the public sector pays firms to discover cost-reducing innovations. By allowing providers to retain the difference between the voucher payment and their realized costs, the system creates residual claimancy and incentives for experimentation when innovative effort cannot be directly contracted upon. Fiscal savings for taxpayers require that the voucher be set below the cost of public production. Using a two-period model, it is shown that if the government lowers vouchers in response to observed cost reductions, a ratchet effect arises, weakening innovation incentives. The ratchet result remains when the model is extended to include quality shading and costly monitoring. The theoretical results are applied to the debate on profits and school vouchers in Sweden.