FTB's project was a massive business process overhaul to help plug a $2.7 billion tax gap. Despite the project's expected revenue, legislators were more concerned about funding the state's basic needs -- health, transportation and education -- than with reengineering how the state's tax agency collected, processed and audited tax revenue.
Rather than sit back and wait until things got better, FTB decided to finance the project outside the traditional appropriation method. The idea: find a company willing to fund the project up-front and then pay for it from the benefits -- in this case, revenue captured by the new system. "The idea behind this approach," said Hunter, "is that you don't pay the vendor until the product has been delivered and has produced the agreed-upon business results."
Despite the large size of the project -- three individual programs affecting $23 billion in taxes -- FTB found vendors with which to partner and has already generated an enormous return on investment. On just one program, the vendor was paid five months after operation began and the state captured $42 million in additional revenue within 18 months, instead of the $7.4 million originally projected.
MATCHING
BENEFITS AND FUNDS
Every year, state and local governments spend $34 billion on information technology. For the most part, financing comes from annual appropriations. That practice is under increasing strain. Both state and local governments are expanding their use of IT and enlarging the size and complexity of the projects they build.
Trying to build multi-year IT projects that affect several agencies doesn't work when the funds must be appropriated one year at a time. "That approach doesn't match benefits with funding very well," said William Kilmartin, comptroller for the commonwealth of Massachusetts. "In fact, it actually discourages enterprise-wide coordination, because it encourages individual system building."
Traditional IT financing and procurement methods have raised the risk of IT project failure at a time when states need technology more than ever. To counter this problem -- and to raise confidence that they can do the job right -- state and local IT procurement and finance executives are becoming creative borrowers.
They are using lease-purchase programs to procure up-to-date hardware without having to struggle with a lengthy procurement cycle. By treating technology as an asset, they are able to raise crucial IT funds in financial markets by selling bonds. And, as in California, they are setting up performance-based contracts that generate revenue or cost-savings based on automation and reengineering.
"We're simply thinking of better ways to finance IT that fit the business of government today," explained Kilmartin. "There are several ways that government can finance IT today. It's all a matter of thinking strategically and matching the right funding methods or mix of methods with the right project."
SHARING RISK AND REVENUE
The financing method used by California's Franchise Tax Board goes by several names, including performance-based and business benefits-based contracting. The concept was first practiced in Chicago and Massachusetts, but has had its biggest impact so far in California. The contracting arrangement calls for the vendor to provide the customer with specific benefits -- either revenue or cost-savings -- and the customer to pay the vendor from the benefits generated by the project.
This form of contract is a radical change from the past, according to Michele Grisham, vice president of the public sector practice at G2 Research Inc. "It's an arrangement that shares risk and therefore becomes a partnership between vendor and customer, rather than simply a business relationship," she said. Instead of an adversarial association, where differences break out over what was promised and what was delivered, vendor and agency have a real incentive to work together.
"In performance-based contracts, everyone needs the system to be successful," said Grisham. "Both parties also have an incentive to be strategic in their thinking and realistic in their approach." Such contracts -- instead of dealing only with technology -- focus on changing the business process for maximum benefit. "It provides a contractual foundation between business goals and IT functionality," said Grisham.
In 1990, Chicago's Bureau of Parking Enforcement was considered a joke. Barely 10 percent of all parking tickets were paid. The city had more than $580 million in outstanding tickets. To turn matters around, the city signed a performance-based contract with EDS to completely reengineer the parking enforcement process. EDS did everything from creating regional payment offices and introducing imaging technology to streamlining the payment and adjudication process.
EDS's $26 million investment helped Chicago collect $336 million in tickets by the end of 1995 and has earned the company more than $50 million.
FRANCHISE TAX BOARD
Like Chicago, California's FTB reengineering project is comprehensive, with significant business process changes. The board decided to finance three tax-related programs using performance-based contracts. The $27 million Business Entity Tax System project was awarded to Andersen Consulting in 1994, and became operational in 1996.
The Collection Account Processing System (CAPS) and the Pass-through entity Automated Screening and Support (PASS) system were awarded to American Management System (AMS). CAPS is a client/server system that manages the collection of bank and corporation taxes. It's one of the few collection systems that uses a computerized risk-analysis tool to prioritize actions for collectors, according to Hunter. So far, CAPS has made a substantial return on its investment.
PASS has been partially im-plemented and will be completely operational by June 1998. The system provides state auditors with case management, audit modeling and performance contracting tools. If all goes according to plan, PASS will generate $200 million in additional state revenue over a five-year period.
According to Grisham, vendors such as Andersen and AMS are participating in such contracts for many reasons. "These vendors are well-positioned [for] performance-based contracts, which carry a lot of risk," she said. "Not all vendors are in that position. If you are not 100 percent certain that you can guarantee the system will work, you can't afford to bid on it."
Ross Kory, vice president of
AMS's Government and Education Management Systems Group, agreed that performance-based contracts carry an element of risk for the vendor, but pointed out there are ways to lower the risk factor. "Before you can sign up, you need to work with the client to define the benefit stream, how business processes will be changed, who's responsible and how will the project be executed," he said. "This kind of detailed information sharing reduces the risk to an acceptable level."
According to Kory, performance-based contracts put IT projects on an entirely new footing. "They shift the focus from inputs to outputs," he explained. "In traditional IT projects the emphasis is on monitoring inputs -- there's little discussion of goals. But with performance-based contracts, you have an entirely new relationship --based on partners -- that involve the most senior officials in the organization, and the focus is on working together toward common output goals."
Besides working with FTB, AMS is partnering with the Kansas Department of Revenue on a $9.5 million contract to restructure the state's tax ad-ministration process. The multi-year project, known as KT2000, could generate an additional $40 million in revenue.
Not surprisingly, performance-based contracting is gaining attention around the country. By the end of 1997, Kory expects another four to six state tax agencies to offer performance-based contracts for revenue. There are other areas that benefit the revenue side, like parking enforcement and health and human services [see "Technology Drives Revenue Maximization," Government Technology, March 1997].
SAVINGS
Projecting revenues for an IT project is not always easy, so some performance-based contracts use cost-savings to pay for the project. Grisham warns, however, that these projects -- while workable in deriving benefits from performance -- are harder to quantify. She said vendors walked away from a recent California project they thought was too risky because the benefits were nebulous.
According to Kory, the best projects for performance-based contracts are those where agencies are clear on the benefits they want to achieve and are willing and able to accept change in a big way.
TECHNOLOGY BONDS
In 1992, Massachusetts decided to do something about its piecemeal approach to IT funding and proposed bond sales to pay for two dozen badly needed technology projects. The state Legislature agreed to the idea, dubbed "Info-Tech Bond I," and issued a $109 million general obligation bond, marking the first time a state financed an IT project with long-term borrowing.
To engage in bond financing, Massachusetts had to convince people that computers and software were assets lasting five years or more, instead of the 12-month duration of a typical generation of technology.
Comptroller Kilmartin, who crafted the idea of borrowing to pay for technology assets, said the purpose of bond financing was not to replace traditional annual appropriations, but to offer the state an option for funding IT, especially large, integrated projects that affect several agencies.
Based on a positive response by recipient agencies, Gov. Weld submitted a second IT bond bill to the Legislature last fall, this time to borrow more than $300 million.
The bonds -- which don't have to be approved by voters in Massachusetts -- give the state's agencies authorization to spend for five years, instead of the more typical one year. "This kind of funding is geared toward big business-application-oriented projects," said Kilmartin. "It's not a funding mechanism for pieces of a system."
The projects listed in IT Bond II range from networking infrastructure and artificial intelligence, to an enhanced benefit eligibility system and electronic commerce. The last two projects have multiple sources of financing, including federal funds, revenue from customers and bonds. For Kilmartin, these projects represent the way governments will finance IT projects in the future. Rather than rely on a single source, they include several options.
But more choices for financing doesn't mean funding for everybody's pet technology project. "You still have to prove the business purpose of the project," cautioned Kilmartin. "These funding mechanisms have to be used, not abused."
The California Franchise Tax Board has written a report about its financing project entitled "Performance Based Procurement: Another Model for California." The report is available on the Internet at:
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