Welfare Reform and the Race to the Bottom: Theory and Evidence.

• Author: Brueckner, Jan K.

Jan K. Brueckner [*]

Economists have argued that welfare migration leads to a race to the bottom in the choice of welfare benefits. Although a system of federal matching grants can remedy this problem, the recent welfare reform law replaced the existing matching-grant structure with block grants, a policy change that appears undesirable. To judge whether this critique of welfare reform is justified, this paper evaluates the evidence in favor of a race to the bottom. After explaining the theoretical effects of welfare migration, the paper surveys the empirical evidence on the occurrence of such migration, concluding that the evidence is mixed. The discussion also considers recent empirical tests for strategic interaction, which show that benefit levels in nearby states affect a given state's benefit choice. The most plausible source of such interaction is a concern about welfare migration, which leads policymakers to look at benefits in neighboring states when making their own choices. Judging that the evidence appears consistent with the existence of a race to the bottom, the paper concludes that the demise of matching grants may be undesirable from a policy perspective.

1. Introduction

   The passage of welfare reform in 1996 dramatically altered the rules governing the disbursement of aid to needy families. The most widely noted features of the new law are its work requirements, which tie the receipt of benefits to labor-force participation, and its imposition of limits on the duration of benefits (two years without work activity and a lifetime limit of five years). A less noted but still important feature of the reform act is a change in the rules that govern the size of the federal contribution to welfare spending. Previously, federal contributions were determined by open-ended matching grants, with individual states determining the level of welfare benefits and the federal government paying a fixed share of a state's total outlay. [1] Under the new system, each state receives a yearly lump sum from the federal government, whose magnitude is independent of the level of state contributions. The block grants for individual states were set initially to equal the 1994 level of federal matching -grant payments, and the grants are fixed in nominal terms for most states through the year 2002. [2]

   Because of the new law's duration limits and work requirements, welfare spending is likely to fall as recipients are forced off the roles or leave voluntarily to enter the labor force. A further source of downward pressure on spending comes from the adoption of block grants. The reason for this pressure is that under a block-grant system, the state must pay 100% of each dollar of welfare costs beyond the federal contribution. Under matching grants, by contrast, the federal government covers part of each extra dollar of spending, lowering the "price" of welfare to the state. As is well known, this price effect means that state contributions to welfare spending will be higher under a matching-grant system even when the federal outlays under the two systems are the same, leading to higher total spending. Thus, the switch to block grants, viewed in isolation, should reduce total welfare spending. Surveying the evidence on the price sensitivity of welfare spending, Chernick and Reschovsky (1996) attempt to gauge the likely magnitude of this effect. They show that estimates in the literature are consistent with a benefit decline under block grants of between 10 and 85%, with their preferred magnitude lying in the 17-25% range.

   Anticipating this downward pressure on benefits, policymakers included in the new law a "maintenance of effort" requirement, which stipulates that state contributions cannot be less than 80% of the 1994 level. However, a substantial 20% decline in benefits, consistent with Chernick and Reschovsky's predicted range, is required before this floor on benefits becomes binding. Moreover, the floor will become less restrictive over time as a result of a general rise in the cost of living.

   Although the elimination of matching grants has raised the cost of additional welfare spending to the states, the new law's work requirements and duration limits may reduce the welfare system's unpopularity with taxpayers. The law also gives the states much more freedom in deciding how welfare funds will be spent. Under a matching-grant system, every expenditure eligible for matching must be defined with precision, a feature that may limit a state's ability to innovate. Some types of expenditures that turn out to be useful might not have been anticipated in the system's rules, making them inadmissible. Although waiver provisions under the old system provided some flexibility in changing its rules, innovation is fostered under a block-grant system because spending guidelines can be relatively loose.

   Greater taxpayer support and increased spending flexibility resulting from the new law may make welfare programs more appealing to the states, and this could offset the negative spending impact of switching from matching grants to block grants. However, despite these potential advantages of the new law, economists have long argued that matching grants are superior as a system for distributing federal welfare funds to the states. These arguments suggest that the switch to block grants under welfare reform may not serve society's interest. The arguments claim that welfare spending tends to be too low and that a cost reduction such as that offered by a matching grant is needed to stimulate it. Two reasons for the spending shortfall are identified.

   The first argument identifies interstate benefit spillovers as the reason for insufficient levels of welfare spending. The premise is that the well-being of all the nation's poor, regardless of their state of residence, is a concern of society's better-off members. Thus, in addition to caring about the poor living within their own state, the altruism of the better off also extends to poor households in other states. The problem is that in choosing the level of welfare benefits, the better-off residents of a given state ignore the altruistic gains to their peers in other states from aid to the local poor. Because these external gains are ignored, welfare benefits are insufficiently generous, a conclusion that applies within each state. To ensure that benefits are properly set, matching grants are then required to stimulate state contributions. The existence of spillovers has also been used to argue for federal rather than state control of the welfare system (Oates 1972; Ladd and Doolittle 1982). However, if s tate control is taken as given, reflecting current institutional arrangements, then matching grants are needed to correct the effect of spillovers.

   A second argument alleges that matching grants are needed to correct a distortion in state benefit choices caused by the phenomenon of welfare migration. Such migration occurs when welfare recipients move from low-benefit to high-benefit states to secure a better standard of living. To see the effect of welfare migration on benefits, consider the decision faced by a state's better-off residents as they contemplate an increase in the benefit level. These residents compare the altruistic gains from helping the poor to the increase in their tax burden. If the poor do not migrate, then the tax burden rises only because each of a fixed number of poor recipients receives a larger benefit. However, when welfare migration occurs, the size of the state's poor population grows as its welfare benefit becomes more generous. Because the higher benefit level per recipient is compounded by an increase in the number of poor households receiving benefits, the tax burden rises more rapidly than if the poor did not migrate. Ge nerosity is thus more "costly" with welfare migration, and this leads the better-off residents to rationally select a lower level for the state welfare benefit. To avoid becoming a welfare magnet, each state is not as generous as it otherwise might be, an outcome that has been dubbed the "race to the bottom."

   It is important to note that although this phrase provides a convenient shorthand description of the phenomenon of interest, it is likely to overstate the issue. The reason is that, in popular usage, a race to the bottom sometimes connotes a draconian tendency to slash welfare benefits to the bare minimum, mimicking the outcome in the least generous state. The theory, however, only points to a downward bias in benefits caused by a migration-induced escalation in the cost of providing welfare, without necessarily predicting such a dire outcome. In the subsequent discussion, "race to the bottom" should be understood as a shorthand for this downward bias and not as a reference to more extreme outcomes.

   Because the concern about welfare migration depresses benefits in every state, no state succeeds in repelling the poor by keeping its benefits low, and each ends up being less generous than it would have been in the absence of migration. Put another way, states defend themselves against the in-migration of welfare recipients by choosing a benefit level lower than would have been chosen if the poor could not migrate. As in the case of benefit spillovers, the remedy for this outcome is a system of matching grants, which artificially reduces the cost of welfare spending, stimulating an increase in benefits.

   Economists thus point to benefit spillovers and welfare migration as phenomena that justify the use of federal matching grants to support state welfare spending. If either of these phenomena is quantitatively important, then a key element of the welfare reform law may be undesirable. The theory suggests that instead of switching from matching to block grants, welfare reform should have left the matching-grant structure in place while relying on other changes in the law to restrict eligibility and to broaden the scope of the...