The States, Welfare Reform, and the Business Cycle

Our purpose in this paper is to speculate on the cyclicality of state fiscal responses under welfare reform. In particular, how will they respond during the next recession? We draw lessons from several literatures and present some new evidence. An important literature estimates the spending responses of governments to matching and block grants. We also summarize studies that examine the incentives states have to mimic their neighbors' spending levels, as well as studies of the substitutability of spending across programs. We conclude that the "price effect" of the shift from matching grants to block grants is likely to be small, at least in the short run; that the strength of the "neighbor effect", and thus the likelihood of a race to the bottom, is also small if not uncertain; and that the evidence that different welfare programs are close substitutes for one another in a state's budget is suggestive, but tentative.