Are Private Debt Collectors a Bad Bet for Cities?

Studies find municipalities are more cost-effective using their own people. And there's less palm greasing

By Jessica Silver-Greenberg and Peter Carbonara

States and cities are desperate for cash—so desperate they're turning to private debt collectors to go after delinquent taxpayers and other scofflaws. The thinking is that it's cheaper to outsource the task of collecting unpaid utility bills, library fines, and the like to independent contractors than to hire more public employees.

Turns out the opposite may be true.

That, anyway, was the conclusion of the IRS, which on Mar. 6 ended a four-year, $80 billion program to chase down tax deadbeats. "After a thorough review of the program, I have decided not to renew the contracts," says IRS Commissioner Douglas H. Shulman, who plans to hire more than 1,000 tax collectors at the agency. "I believe this work is best done by IRS employees." Recent IRS studies have found that the program recouped far less than the IRS could have collected on its own.

It gets worse. Not only are private debt collectors less effective than public ones, but a number of companies benefiting from the privatization trend have been slammed by regulators and prosecutors for overcharging municipalities, bribing public officials, and other predatory behavior. Some municipalities have stopped outsourcing their debt collection efforts altogether.

Private players defend their practices, arguing that they pursue debts that municipalities don't have the resources or skills to recover. "The entities wouldn't get that money otherwise," says Bruce Cummings, president of Municipal Services Bureau, a large debt collector in Austin, Tex., that recently won a contract with the government of Hamilton, Ohio. "The industry provides a worthwhile service."

That argument continues to hold sway for many states and cities suffering from declining tax receipts and a deep economic downturn. Consider tiny Bluff City, Tenn. To help fill its depleted coffers, the town of 1,500 near the Virginia border is farming out its collection work to private contractors. Officials figure that the city is owed $50,000 in back taxes and unpaid speeding tickets—real money in a municipality with an annual budget of $1 million. "We're fighting a very tight budget," says Todd Malone, Bluff City's mayor. All told, some $24 billion of uncollected municipal debt is up for grabs nationwide, according to mygovwatch.com, which tracks government contracts. That's up from $16 billion a few years ago.

Debt collectors are also angling to cash in on the U.S. Treasury's "bad bank" proposal to buy mortgages, credit-card debt, auto loans, and other distressed assets. An investing consortium has offered a plan to purchase portfolios of toxic debt. If they have their way, debt collectors would help work out the underlying loans, tracking down delinquent borrowers and ultimately sharing in the profits. The debt collection industry feasted on similar government work after the savings and loan crisis of the late 1980s. "This is a real growth area," says Mike Ginsberg, president of industry researcher Kaulkin Ginsberg.

The privatization boom, oddly enough, comes just as the IRS is retreating from private collectors. The government's decision follows research done by the IRS taxpayer advocate, Nina E. Olson. She found that two firms, CBE Group in Waterloo, Iowa, and Pioneer Credit Recovery (SLM) in Arcade, N.Y., collected $37 million last year on behalf of the IRS, pocketing $7.5 million in fees and commissions. Olson calculates that if the IRS had used that same $7.5 million to retrain existing staff, the agency would have collected $250 million. "You really do get much more money for spending $1 on a federal employee than you do paying a $1 commission to a private collection firm," says Olson.

THE UPPER HAND

The IRS and other public agencies have a major advantage in their collection efforts. Unlike private players, federal and municipal employees can impose liens or garnishee wages to recoup unpaid debts. Private debt collectors, in contrast, rely mainly on their powers of persuasion to get consumers to pay up.