Public-service output depends on input expenditures, on own personal characteristics, and on the characteristics of the other residents in the community (the peer group effect). In a community model with public expenditures set by voting, with migration between communities, and with land price differentials (capitalization), it is shown that communities may become heterogeneous in composition and (second-best) inefficient. This equilibrium occurs when the peer group effect is neither "too strong" nor "too weak." The inefficiency arises because an externality is created by migration. The land price differential does not play the part of the "price" of the better peer group but of a transfer payment.

Public-service output depends on input expenditures, on own personal characteristics, and on the characteristics of the other residents in the community (the peer group effect). In a community model with public expenditures set by voting, with migration between communities, and with land price differentials (capitalization), it is shown that communities may become heterogeneous in composition and (second-best) inefficient. This equilibrium occurs when the peer group effect is neither "too strong" nor "too weak." The inefficiency arises because an externality is created by migration. The land price differential does not play the part of the "price" of the better peer group but of a transfer payment.

Previous property tax capitalization studies assume that families itemize, that they save in taxable assets, and that real interest income is taxed. However, many families do not itemize, many families invest in tax-deferred assets, and nominal interest income is taxed. As a consequence, prior studies likely misspecify the property tax capitalization equation for roughly ninety percent of their samples. Taking federal tax provisions into account increases the precision of our estimated capitalization rate. In addition, our results suggest that biases in prior studies likely contribute to the variety of capitalization estimates in the literature.