Increases in woody vegetation and declines in grasses in arid and semi-arid ecosystems have occurred globally since the 1800s, but the mechanisms driving this major land-cover change remain uncertain and controversial. Working in a shrub-encroached grassland in the northern Chihuahuan Desert where grasses and shrubs typically differ in leaf-level nitrogen allocation, photosynthetic pathway, and root distribution, we asked if differences in leaf-level ecophysiology could help explain shrub proliferation. We predicted that the relative performance of grasses and shrubs would vary with soil moisture due to the different morphological and physiological characteristics of the two life-forms. In a 2-year experiment with ambient, reduced, and enhanced precipitation during the monsoon season, respectively, the encroaching C(3) shrub (honey mesquite Prosopis glandulosa) consistently and substantially outperformed the historically dominant C(4) grass (black grama Bouteloua eriopoda) in terms of photosynthetic rates while also maintaining a more favorable leaf water status. These differences persisted across a wide range of soil moisture conditions, across which mesquite photosynthesis was decoupled from leaf water status and moisture in the upper 50 cm of the soil profile. Mesquite's ability to maintain physiologically active leaves for a greater fraction of the growing season than black grama potentially amplifies and extends the importance of physiological differences. These physiological and phenological differences may help account for grass displacement by shrubs in drylands. Furthermore, the greater sensitivity of the grass to low soil moisture suggests that grasslands may be increasingly susceptible to shrub encroachment in the face of the predicted increases in drought intensity and frequency in the desert of the southwestern USA.