Analysis of the 2004-05 Budget Bill Legislative Analyst's Office February 2004

Contracting Out for State Services

Based on provisions in the California Constitution, services provided by state agencies generally must be performed by state civil service employees. Article VII, Section 1, of the Constitution provides for the establishment of the state's civil service system:

(a) The civil service includes every officer and employee of the State except as otherwise provided in this Constitution.

(b) In the civil service permanent appointment and promotion shall be made under a general system based on merit ascertained by competitive examination.

While this article does not expressly prohibit the state from contracting out, the courts have held that it restricts the use of non-state employees in many circumstances. Consequently, case law and state statute have established parameters for contracting out state services. State law requires that proposals for contracting must, at a minimum, meet the following criteria:

• Contracts must result in cost savings to the state.
• Contractors' wages may not significantly under-cut state pay rates.
• Contracts cannot cause the displacement of civil service employees.

In November 2000, Proposition 35 added Article XXII to the Constitution to explicitly allow for the contracting out of services for architectural and engineering services. These are the only types of state services with such authorization.

Administration's Proposal

The administration proposes a constitutional amendment to expand the circumstances in which the state can contract with private entities. While the administration has not yet released the specific language of its proposal, the stated purpose of the amendment will be to permit the state to "contract with non-state entities for ministerial functions whenever doing so will reduce costs, improve efficiency, or improve services." The constitutional amendment, if approved by the voters, is intended to provide greater legal certainty and therefore opportunities to contract out for services. In conjunction with this constitutional amendment, the administration is also proposing in the 2004-05 Governor's Budget to contract for services currently provided by state employees. For instance, the administration proposes such changes in the Departments of Developmental Services and Veterans Affairs.

Key Considerations

In The 1996-97 Budget: Perspectives and Issues (please see pages 173-189), we discuss the advantages and disadvantages of the privatization of state government functions. Contracting for services is one of the more common means of privatizing state government. The evidence suggests that carefully managed privatization can, under the right circumstances, provide specialized expertise, save money, and/or result in improved service delivery. It also shows, however, that poorly managed privatization, or privatization under the wrong circumstances, can lose money and result in poor service delivery.

In the report, we also discuss the challenges that governments face when they privatize. Understanding the potential problem areas and being aware of the risks involved are important for maximizing the likelihood that privatization will be successful. As the Legislature evaluates the administration's proposed constitutional amendment and the specific contracting proposals, it may want to consider the following:

• Accountability. How can government ensure that it does not "lose control," but rather retains an appropriate degree of oversight and responsibility for provision of a service being privatized?
• Accurate Cost Comparisons. Government needs to ensure that it accurately projects the savings from privatizing. This requires accurate cost comparisons between providing a given service directly by the government and by the private sector.
• Realization of Net Benefits. What steps are needed to ensure that the potential benefits of privatization are captured for taxpayers? For example, how can government make sure that potential benefits to taxpayers are not shifted to contractors through increased profit margins and overcharging, as has reportedly happened to some governments elsewhere throughout the country?
• Quality Control. What steps can be taken to make sure that the desired quality of privatized services is provided and maintained?
• Service Disruptions. How can governments protect against untimely disruptions in the provision of needed public services by private entities with whom they contract, either due to lack of adequate performance or withdrawal from service?
• Transitional Workforce Problems. How can governments best deal with the practical transition problem of one-time government job losses that will occur when, for example, private sector jobs replace government jobs? Some governments have dealt with this situation by requiring contractors to give laid-off public workers priority when hiring.
• Dismantling of Public Institutions and Skills. If privatization shifts the provision of governmental services from existing public institutions and governmental workforce to private parties, what are the short-term and long-term implications of dismantling these institutions and losing these public labor skills, in the event that privatization turns out to be less desirable than initially hoped for?