Financial incentives and their potential to drive inclusive growth

As the devolution agenda has gathered pace over the last decade or so, we are seeing greater powers and responsibilities handed down to city-level stakeholders, and a shift in the financial framework for local government. This offers advantages of greater flexibility in the way funding is allocated, breaks down policy silos, shares risk and reward and, in particular, is also strengthening the nature of financial incentives deployed. The growth in use of financial incentives are increasingly being seen as valuable policy measures by Government. On the one hand, they enable Government to specify intended outcomes, whilst also sharing an element of risk and reward. But, on the other hand, they afford city-level stakeholders greater flexibility to develop solutions that best address local complex issues. In this way, they are argued to foster innovation, whilst improving outcomes and increasing accountability. 

The research explores the use of such measures to understand their potential in supporting poverty reduction in cities, and city regions in future. In particular, at a time when the use of financial incentives in the context of local government funding is relatively new and untested, it examines 3 questions. That is:

Q. the lessons learned from existing incentives or outcome-based payment schemes;

Q. the scope to use financial incentives to encourage and support city-level stakeholders to connect growth and poverty in local strategies, and;

Q. how such schemes might work in practice, capturing the conditions necessary for their success.

The review suggests financial incentive schemes generally fall into three main categories: 

1. Premiums – which tend to attach funding to individuals as opposed to outcomes. They are designed to provide additional funding in response to the enhanced need or risk associated with supporting certain groups.

2. Payment by results (PbR) programmes – which attach funding to specific outcomes. In this way, they transfer some degree of risk from government to providers. Few programmes are ‘pure’ PbR and many feature upfront payments for engaging individuals or delivering an element of the service. 

3. Gain-share or earn-back mechanisms – which are a distinct sub-set of PbR, where payments are explicitly tied to and scaled by the fiscal benefits of specific outcomes. These have tended to focus on sharing some, or all, of the additional tax revenue generated from growth between central and local government. 

This research has considered the evaluation evidence for four financial incentive schemes introduced by Government – the New Homes Bonus, pupil premium, business rate retention and the Work Programme. Looking across the breadth of the evidence for these schemes, it is clear that even where financial incentives might be a valuable addition to the policy framework in principle, designing an effective incentive mechanism can be difficult. 

The study finds some signs of success. This is, particularly in the: scheme’s ability to create a direct and tangible link between target outcomes and fiscal benefits; flexibility they afford local providers in designing interventions that meet local needs; and option in some cases to promote collaboration and the pooling of funding between local stakeholders and across local authority boundaries. But, the evaluation evidence also points to a number of challenges. This is especially with regard to: the trade-off between simplicity and refinement; the scale of incentives and the degree to which they are driving real behavioural change; the risk of creating spurious incentives and unintended consequences; and the indirect use of the funds they generate. The research identifies a number of critical design considerations that will ultimately influence the efficacy of any new financial incentive.

Consultations conducted to consider specifically the potential to use financial incentives to support, city-level stakeholders to manage poverty reduction, found wide-ranging interest. This draws attention in particular to the scope for gain-share or earn-back mechanisms to be deployed in new policy areas such as welfare, social housing and childcare. The consultations are also supportive of additional incentive payments, to enhance funding to local projects and hence local sustainability. Further, the research identifies four outline policy proposals which have the potential to fulfil the requirements of a ‘Green Book’ style appraisal and for which outcome-based payment mechanisms are likely to be appropriate. These involve: 

- Enabling local authorities to agree bespoke earn-back deals with Government to share the fiscal benefits of reduced welfare spending in their local areas. 

- Commissioning a new wave of social impact bonds through a payment by results-based fund for programmes targeting those with complex barriers. 

- Establishing a national gain-share scheme for local authorities, securing social value outcomes through their large works and services contracts. 

- Enabling local authorities to agree bespoke earn-back deals with government to share the fiscal benefits of reducing housing benefit spending.

That said, whilst some fertile areas for applying financial incentive schemes have been identified, which warrant further exploration, it is clear that financial incentives are not a policy panacea. In practice, schemes are hard to get right and must be designed with care. As such, each of the proposals we have outlined, carry with them inherent risks and design challenges, which will need to be carefully managed to ensure their effective implementation and use. In that context, it is recommended that cities already pioneering earn-back and gain-share models are further explored as useful sites for additional learning, and drawing practical and actionable lessons about what works.