Equilibrium and efficient provision of local public goods with peer effects

• Decentralized determination of local public goods and peer groups can enhance welfare.
• Decentralized determination better aligns public good and peers with preferences.
• Realization of benefits depends on policy regarding finance and community access.

We study equilibrium and efficient allocations in a multi-community model with households that differ in income and a taste parameter, flexible housing supplies, and local public goods of quality impacted by community peer characteristics. An efficient allocation could be implemented by a type- and community-dependent tax that includes pricing of the peer externality in an otherwise laissez-faire economy. Based on an estimated model, we show the most empirically relevant case of Tiebout equilibrium provision with local property taxes is less efficient than equilibrium with expenditure equalization and an economy-wide property tax but with household sorting driven by peer effects.