The Spatial Dynamics of Local Government Capacity

State capacity is a key determinant of development, democratic stability, and institutional strength. This paper argues that in unequal contexts, class-based residential segregation shapes local labor markets and has negative consequences for investments in state capacity by political elites. In segregated cities, where low-income individuals have limited access to formal labor markets, many rely on informal economic arrangements to meet basic needs. Segregation decreases the visibility of informality across members of different socioeconomic groups, reducing demands for the presence of the state as a third-party enforcer of social contracts. This dynamic weakens pressure on elites to enforce fiscal regulations, allowing an equilibrium based on informality and non-enforcement that results in low government capacity at the local level. I assess my argument empirically using the case of Brazil. Leveraging an instrumental variables approach, I find that segregated municipalities experience higher economic informality, lower levels of fiscal enforcement, reduced tax collection, and weaker administrative structures. I investigate individual-level observable implications with a survey experiment, and find that individuals from different socioeconomic statuses are more supportive of enforcement and investments in local government capacity when exposed to informality. The experiment suggests that informality signals a breach of social contracts between fellow citizens and the state. This paper contributes to research on the endogenous nature of state capacity and the role of residential segregation in shaping urban development outcomes.