A Theory of Social Impact Bonds

Social impact bonds (SIBs) are an innovative financing mechanism for public goods. In a SIB, an investor provides capital to a service provider for a social intervention. The investor receives a return based on the outcome of the intervention relative to a predetermined benchmark. We describe the basic structure of a SIB and provide some descriptive statistics for these financial instruments. We then consider a formal model of SIBs and examine their ability to finance positive net present value projects that traditional debt finance cannot. We find that SIBs expand the set of implementable projects if governments are pessimistic (relative to the private sector) about the probability an intervention would succeed or if the government is particularly averse to paying costs associated with a project that does not generate offsetting benefits. As both these features are present in various public programs, we conclude that SIBs are a real innovation in public finance and should be considered for projects when traditional debt finance has been rejected.