Peer-group externalities: Their impact on the locational choices of households and the policy decisions of local communities

This research focuses on the provision of local public goods where the composition of residents in a community is a determinant of the quality of services received in that community. Several earlier studies provide empirical evidence that local public services, such as public safety and public education, are affected by the characteristics of a community's residents. The implications of these peer-group effects are investigated within the framework of a spatial model where independent communities set their own tax and expenditure policies. Mobile households affect land prices and the quality of public services through their locational choices. This has an impact on local public policy. The peer-group externalities can distort local expenditures, provide an incentive for the erection of zoning barriers, and alter the design of local tax policy. This research (a) explores the equity and efficiency aspects of local government policy when peer-group externalities are present; (b) investigates how the action of a higher-level government, particularly through grant policy, can improve efficiency and equity in the region; (c) estimates the external cost of a marginal household, net of taxes and grants, for a sample of school districts in Indiana; and (d) examines how the decisions of local governments shape the equilibrium when a region is dominated by one community and the impact of intergovernmental grants in this noncompetitive structure.;Locational efficiency occurs when the net cost of an additional household is the same in all communities. Intergovernmental grants can achieve this objective when constraints prevent local communities from determining their own tax policies. If one community has market power, the equilibrium allocation of households among communities is not efficient when taxes are determined locally. Correctly designed, regional population-based grants can improve efficiency and equity. Instead of promoting locational efficiency, Indiana's educational grant formula has enlarged the net cost differentials among Indiana school corporations, exacerbating locational inefficiencies without improving equity.