Segregation and the Fiscal Bargain: How Spatial Inequality Erodes State Capacity

Residential segregation shapes where governments invest, whom they serve, and who benefits from institutions—with consequences for economic mobility, infrastructure quality, and health outcomes. I argue that income-based residential segregation erodes local fiscal capacity by making unequal government responsiveness visible in daily life, weakening the quasi-voluntary compliance on which local revenue depends. I evaluate this argument in Brazil using 14 months of qualitative fieldwork, administrative data, and an original survey of over 1,100 formal and informal business owners in São Paulo. Instrumenting segregation with non-navigable waterways that fragmented urban development, I find that segregated municipalities exhibit greater informality and weaker fiscal capacity. At the individual level, residents of more segregated neighborhoods report worse perceived service quality and larger class biases in government responsiveness. These findings recast informality as partly reflecting demand-side disengagement from a one-sided fiscal bargain. How inequality is mapped onto space shapes whether compliance holds.