Studies of policy innovation and diffusion have focused on internal determinants and diffusion as factors leading to adoption, but diffusion theory has relied on event history analysis to explain the adoption of discrete policy choices, such as state lotteries (Berry & Berry 1990). Building on this foundation, we rely on diffusion theory to explain the adoption of innovative state economic development policies, and in so doing expand diffusion theory by exploring its utility in explaining qualitative differences (traditional versus innovative) in policy adoptions within a single policy domain (economic development). This paper investigates the causal mechanism behind federal welfare spending and state development policy innovation. Our study suggests that the federal government’s redistributive spending motivates states to adopt innovative economic development policies, which help to increase economic performance within states. Specifically, of the many factors that affect policy innovation and adoption, institutional capacity and fiscal condition, which can be improved by federal financial assistance on redistributive programs, induce economic development policy innovation. As a result, federal redistributive spending can stimulate states to adopt innovative economic development policies because it can help state governments not only to exercise better governing capacity, but also to facilitate greater fiscal stability. To investigate the empirical relationship between federal redistributive policy and state economic development policy innovation, we employ a revision of Hall's (2007) Innovation Capacity index that measures the degree to which a state adopts innovative economic development policies. We also include two major intervening variables, the level of state fiscal comfort and administrative capacity, to measure the indirect impact of the federal welfare spending on state development policy innovation. We find that while federal welfare spending directly increases a possibility that states will choose innovative economic development policies, it indirectly stimulates states to adopt innovative economic development policies through improving administrative capacity.