Vouchers as Innovation Contracts

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. Using a two-period model, it is shown that if the government lowers vouchers in response to observed cost reductions, a ratchet effect arises that weakens innovation incentives. The government thus faces a fundamental trade-off between capturing immediate fiscal savings for taxpayers and sustaining innovation incentives. This also holds true when allowing for cost-cutting that reduces quality. The theoretical results are applied to the debate on profits and school vouchers in Sweden.