Whereas ethnoregional favoritism by national leaders is widely studied, ethnic favoritism at lower government levels is likely a more salient source of ethnic resentment. Relying on individual-level panel data from Indonesia and a historical instrument we establish that ethnic favoritism is common among village governments allocating welfare benefits to specific villagers but only when villages have administrative and fiscal autonomy. Moreover, decentralization and observed local ethnic favoritism increase village-level interethnic distrust and inequality. We conclude that societies can struggle with ethnic disparities that are not reflected in aggregate statistics and that decentralization is not a panacea for alleviating ethnic tensions.